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International Flavors & Fragrances Inc. (NYSE:IFF)

Q1 2010 Earnings Call Transcript

May 6, 2010 10:00 am ET

Executives

Michael DeVeau – Manager, IR

Doug Tough – Chairman and CEO

Hernan Vaisman – Group President, Flavors

Nicolas Mirzayantz – Group President, Fragrances

Kevin Berryman – EVP and CFO

Analysts

Mike Sison – KeyBanc

Mark Astrachan – Stifel Nicolaus

Edward Yang – Oppenheimer

Lauren Lieberman – Barclays Capital

John Roberts – Buckingham Research

Operator

At this time, I'd like to welcome you to the International Flavors & Fragrances first quarter 2010 earnings conference call. All participants will be on a listen-only mode until the formal question and answer portion of the call. Participants will be announced by their name and company and in order to give all participants an opportunity to ask a question, we request a limit of one question per person.

I would now like to introduce Michael DeVeau, Investor Relations Manager. You may begin.

Michael DeVeau

Thank you, operator, and thanks everyone for joining us this morning. With me on the call is our Chairman and CEO, Doug Tough, our Group President, Flavors, Hernan Vaisman, our Group President of Fragrances, Nicolas Mirzayantz and our Executive Vice President and CFO, Kevin Berryman.

This call is being recorded and will be available for playback on our website. Please keep in mind that during this call, we may make forward-looking statements about the company's performance. These statements are based on how we see things today and may contain elements of uncertainty. For additional information concerning risk factors that can cause actual results to differ materially from forward-looking statements, I ask you to refer to the cautionary statements and risk factors contained in today's earnings release and IFF's filing with the FCC. Some of today's prepared remarks will exclude those items that affect comparability. These items are laid out in our non-GAAP reconciliation, which is also available under the Investor Relations section of our website.

With that, I'll like to turn the call to Doug.

Doug Tough

Thank you, Michael. Good morning, good afternoon to everyone. Before moving on to discuss our very strong Q1 results, I'd like to make a few introductory comments. As you know, effective March 1st of this year, I officially joined IFF full time as Chairman and Chief Executive Officer. While it's still premature for me to make comments regarding any actions we might take on any possible changes to the strategic focus for IFF, I'd like to elaborate on some key items on which I will be focused.

Priority number one is to pressure test our current strategies and our business model to ensure we are operating to the best of our ability. While it is early in our review, I will say that my initial expectations of the organization I had prior to joining are no different after my first 60 days. I continue to believe that the IFF team has tremendous people and capabilities that provide our customers with winning products which translate into profitable growth for IFF.

Second, as I begin my new journey, it'll be imperative to ensure we continue to accelerate our short-term performance. The executive team as well as all IFF employees have done a very nice job delivering strong results in the back half of 2009 and in the first quarter of 2010. Capitalizing on this success, I expect we will continue to deliver on current commitments while reviewing options regarding our long-term strategies.

Finally, at the very heart of our organization, our most important asset are people as a critical priority. I believe that this organization has incredible talent as my objective to nurture and align that talent in such a way that I can ensure our future leaders of tomorrow are being developed from within the organization today.

I have taken a considerable amount of time to meet with many IFF employees and functions throughout various parts of the world to learn the issues and to provide a sense of my priorities and expectations. I will continue this process over the upcoming few months until I have reached all of our major constituents.

While I am focused on the long-term objectives, our organization remains committed to furthering our partnerships with key stakeholders. Starting with our customers, we continue to be an innovator of technological advancements versus a mere component of the supply chain.

Utilizing our capabilities and consumer insight in R&D and in creative insight, we partner with our key customers to create unique scent and taste experiences that our consumers love. This in turn helps bolster our customer's market share and helps grow the equity of their brands. If we continue to do this while providing overall superior customer satisfaction, we believe it will lead to increased customer loyalty that in turn drive our future business.

In order to continue to create shareholder value, we must ensure we are capable of driving consistent and sustainable long-term growth. Our recent results are an example of our financial potential. Our priorities going forward must focus on growing our top line, accelerating our productivity and investing in future growth in order to ensure that we are maximizing shareholder returns.

We also understand that our responsibility extends to being strong partners in the communities where we work and live and vigilance around our commitment to sustainability, through IFF charitable giving, we are proud to be able to provide financial support and countless hours of employee volunteerism to many community-based organizations.

And last, but not least, we will continue to support our valued employees. As our people represent a large component of our success as well as a competitive advantage, the people of IFF are a critical focus for me. As such, some additional comments are appropriate.

Our business comes to light through the 5,400 or so employees who create our unique scent and taste experiences. Without their passion, their dedication and creativity, we would not be who we are today. Our executive leadership team is seasoned and talented. As I stated earlier, these individuals have done a terrific job during the period of recent transition.

I am very confident that they will achieve even greater success as we work collectively to elevate IFF's performance to new heights in the new decade. We think our global teams including our creative and our R&D employees are the best in the industry. Their leadership from South Brunswick to Sao Paulo from Moscow to Manoa gives us local marketplace knowledge, great continuity and the ability to connect with communities and customers where we do business.

We will dedicate resources to ensure they continue to excel in their area of expertise. And I'm committed to giving them opportunities that will help them succeed in their careers. These offices interface with our customers to deliver superior solutions. I have seen firsthand results of this labor by attending numerous meetings with many of our customers, both global and regional. These customers fully respect IFF's creativity, ability to understand their needs and IFF's pension for providing winning solutions.

Now before turning over to the rest of the team, I'd like to make a few comments on our Q1 performance. The improved trends in the second half of 2009 continued through the first quarter of this year. Our strong new business performance combined with some elements of customer restocking and favorable comparisons resulted in accelerated levels of growth.

Our worldwide local currency sales grew 13% year-over-year as the commercial environment continued to show improvement versus the full year of 2009. This growth in our top line, when combined with continued discipline in cost management, supported a substantial improvement in margin as operating profit margin improved 220 basis points year-on-year. The end result was extremely positive, as adjusted earnings per share increased 42% year-on-year.

With that, I'm now pleased to introduce our Global President of Flavors, Hernan Vaisman who will provide further context surrounding our strong Q1 results in Flavors.

Hernan Vaisman

Thank you, Doug. Good morning, everyone. I'm pleased to say that local currency sales in the first quarter increased 8% over the comparable 2009 period, marking the 19th consecutive quarter of local currency growth. Our strong performance was led by double-digit growth in Europe, Africa, Middle East and Greater Asia regions, as increased volumes and new business dropped results. In North America, local currency sales declined 1% due to the overall drop in volume which was not upset by new successes.

While we hope for better results, we are prepared to put this one quarter performance with the overall context of the strong growth we have seen in North America over the last years and especially versus our most difficult comparison of 2009 of flat 6% growth. We continue to feel good about our long-term share growth opportunities in these regions as we work with our customers and new business opportunities.

In EAME, local currency sales increased 12% year-over-year, as both categories were positive. In particular, the Flavors category continues to perform very well as new wins and stronger volumes are giving results. This marks the second consecutive quarter of double-digit growth in these categories. Regionally, it was high single-digit growth in developed countries while developing European markets grew at double-digit growth.

Africa, our Middle East market posted high double-digit growth into new wins and higher volumes across all categories. Sales in Latin America have reversed recent trends, growing 6% as new business and volume recovering Savory, Confectionary and Dairy offset the loss of non-strategic business that began in third quarter of 2009. We finished extremely positive above these results and we expect an accelerating growth base in the second semester due to critical wins in key categories.

Lastly, in Greater Asia, local currency sales were up 14%, as every category recorded impressive double-digit growth. The great momentum of our business in India, China and most Asian countries contributed substantially to the double-digit growth in this important part of the world. This was fueled by higher volumes and new wins across all categories and strategic customers.

While our track record of local currency sales growth is impressive, the level reported in the first quarter of 2010 marks one of the highest achievements. The Flavors teams continued to do an excellent job capitalizing on new business opportunities to drive above-market growth.

Further, our outstanding consumer understanding, unique product portfolio and differentiating test solutions help us to fully support our customers from positioning, making the effect the unique department in the creation of winning consumer products.

Turning to profit, Flavors operating profit in the quarter was very strong, increasing 17%, or $9 million to $62 million. This increase can be attributed to accelerated sales growth, improving input cost dynamic and our continuous success in improving our efficiencies.

As a result, operating profit margin continued to improve, increasing 60 basis points to 20.5% versus 19.9% in the prior year period. While we are very early in Q1 – in Q2, sorry, we have started the quarter with good momentum.

While it remains difficult to predict some element of our performance due to the volatility in our customer ordering patterns. We do expect to see solid local currencies – solid local currencies sales growth, that when combined with our continued focus on improving efficiency to result in continued margin improvement.

Now I would like to turn the call over to Global President of Fragrances Mirzayantz, who will provide an update on the Fragrance business.

Nicolas Mirzayantz

Thank you, Hernan, and good morning and good afternoon, everyone. In Q1, local currency sales grew 18% year-over-year marking the third consecutive quarter of growth. Overall growth can be attributed to the (inaudible) strong base of new wins, some elements of customer and retailer restocking, improvement in underlying demand and favorable comparisons versus a year-ago period. In terms of performance, we grew double-digit in all regions, as well as every category.

In the Fine Fragrance and Beauty Care category, local currency sales grew 28%. Fine Fragrance has reversed its recent trends, growing very strong double-digits. The success can be accredited to the team's constant commitment to win new business and grow market share position.

In 2009, our Fine Fragrance team was successful in maintaining our market share and showed the ability to win new business by securing many of the key launches of 2010. This combination has proven to be beneficial in Q1.

When new business gains has helped support the strong Fine Fragrance results, I believe it is important to note that a portion of this improvement can be attributed to favorable comparisons as well as elements of customer and retailer restocking. While the elements of restocking are difficult to predict, I am confident that our team will continue to perform well, driven by our strong new business performance.

Turning to Beauty Care, the momentum we experienced in the second half of 2009 continued in 2010. For the fifth consecutive quarter, we have seen accelerated growth in the Beauty Care category as both Hair Care and Toiletries increased double digits. The strong performance can be attributed to successful introductions within key regions.

Functional Fragrance once again performed very well growing 10%, as Fabric Care performance remains strong. Our success continues to be accredited to a long standing expertise and continued investment in consumer insight within the key emerging market as well as Europe. This investment in category expertise are the primary drivers behind our consistent above-market growth. In addition, Home Care and Personal Wash also exhibited solid growth.

Finally, Fragrance Ingredient sales also improved. Local currency sales increased 21%, reflecting an underlying improvement in demand, some elements of customer's restocking and a favorable comparison versus a year-ago period.

Continuing on the trends since last year, the emerging markets of Brazil, Russia, India and China drove strong results. In this market, Hair Care, Fabric Care and Personal Wash continue to drive strong double-digit results. While this trend is impressive, I'd like to note that the developed markets of Europe and North America have also grown strong double-digits. I'm very proud of all Fragrance employees around the world as they accomplished great success in the first quarter.

From a profitability standpoint, adjusted operating profit grew an impressive 66% or $24 million to $61 million, excluding a $5 million expense related to a previously announced European facilities rationalization. As a result, adjusted operating profit margin for the quarter increased 470 basis points to 17.2% as higher volumes, moderating input cost and benefits from previous cost reductions initiatives drove the impressive performance.

As we look toward Q2 and beyond, we do note that our underlying business trends remain strong. While these trends have helped support our strong business results, it is important to note that a portion of this improvement can be attributed to customer and retailer restocking. While it's difficult to predict the effort of restocking for the balance of the year, we do not expect that these benefits will continue as our customers reach their targeted inventory levels going forward.

With that, I'd like to turn the call over to Kevin.

Kevin Berryman

Thanks, Nicolas, and good morning and afternoon to everyone. On our Q4 conference call, we highlighted four key trends that we would expect to see in 2010. While we are only a quarter of the way through the year, I'd like to update you on how we're progressing in these areas.

First, we communicated that local currency sales trends were expected to improve for the full year. As you've already heard, each of the businesses were able to realize improvement growth in Q1.

Second, we highlighted that we would see an improving input cost picture. Specifically lower input costs, when combined with our accelerated sales performance, allowed us to improve gross margin by 160 basis points year-over-year to 41.3%.

When combined with a strict discipline in the management of our research, selling and administrative expenses, or what we call RSA, we managed to capitalize on fixed cost leverage to deliver 220 basis points of adjusted operating margin improvement. This improved performance resulted in a substantial increase in our adjusted EPS.

In the quarter, adjusted EPS grew 42% to an all-time company high of $0.85. Our results are clearly aligned with our expectations that first half results would be relatively stronger than those that we would expect in the second half.

Looking at the recent sales trends, there's a clear indication that the challenges of 2009 appear to have subsided and there are signs we're beginning to see an improved operating environment. It is also clear, however, that customer restocking and favorable comparisons in Fine Fragrance and Ingredients specifically have aided results.

As seen in the chart, both Fine and Ingredients realized 20% plus growth levels in Q1, after having seen softness over most of 2009. While we have entered Q2 with good momentum, the growth levels achieved in Q1 are not projected to be sustainable, as our visibility through the balance of the year remains limited given economic volatility we have seen over the last 18 months.

I'd like to provide a bit more clarity on our input costs, as we have seen a year-over-year decrease in the levels of higher cost inventory. In the first quarter, our input costs decreases represented a 3% decrease in our overall cost to goods sold. As communicated earlier in the year, we expected to see this reduction in input costs in the first half of 2010.

Looking ahead, we expect input costs to remain favorable for the second quarter and full year. Although we are starting to see some increases in raw material categories that may reduce the favorable impact in the second half of 2010. Specifically, increases in the cost of oil will begin to place selective pressure on some oil-related costs and freight surcharges in the second half of the year.

From an overhead cost standpoint, we continue to remain disciplined in the management of our fixed cost structure. RSA, as a percent of sales, declined 50 basis points to 24.6%, as our fixed costs realized improved absorption rates due to our strong sales growth.

As an indicator of our continued discipline in cost management, while RSA expenses increased $21 million, the increase was almost entirely driven by foreign currency parity and additional incentive compensation expense. Excluding these currency and additional incentive compensation provisions, RSA expense increased only $3 million year-over-year. Within RSA, R&D expense, as a percentage of sales, decreased 50 basis points to 8%, compared to 8.5% last year driven by the fixed cost growth leverage noted above.

In 2010, we will continue to maintain strict discipline in the management of our fixed cost structure to ensure we are operating as efficiently and effectively as possible. However, we will continue to monitor our performance throughout the balance of the year as we look to make targeted operating investments to strengthen our marketplace division. As always, potential operating investments of resources, R&D efforts and commercial opportunities will be driven by our belief in the growth opportunities that these investments will deliver.

Moving to currency, for the second consecutive quarter, we have experienced positive currency tailwinds. In general terms currency was slightly accretive to operational performance, although this benefit was offset by some short-term fluctuation and balance sheet activities.

Looking ahead, if rates stay where they are today, we expect a relatively minor impact to our results in the second quarter of 2010 due to currency parity.

As we look further out, at current rates, we expect to face some pressures in the second half of 2010. It is important to note, however, we are in the process of analyzing different options that will help minimize this financial risk. In particular, we have a process of evaluating hedging strategies and business opportunities that could provide for decreased volatility in this area.

Turning to our EPS reconciliation, I will not spend a lot of time going through the detail as I have already covered most of the topics early in my presentation. As highlighted on the slide, however, we continue to see improved operational performance. Improving EPS by $0.23, or 38% improvement, versus the year-ago period. When including a net $0.02 benefit associated with foreign exchange and interest partially offset by higher income tax and other items, adjusted earnings per share substantially improved versus the first quarter 2009, again growing 42%.

As we move from our adjusted EPS to our reported EPS, I would like to note that the $0.05 difference is entirely related to our previously announced European rationalization. As a reminder, we announced during the third quarter 2009, that we had initiated a collective consultation process with employee representatives, regarding the potential closure of our fragrances compounding facility in Drogheda, Ireland, as well as a potential partial closure of fragrance ingredients chemical plant in Haverhill, United Kingdom.

In the beginning of 2000 – excuse me, in the beginning of Q4, we announced that we concluded the consultation process and determined that we would proceed with the facility rationalization plan. As a result, we have reported a $19 million provision, $10.5 million in Q3, $3.5 million in Q4 and $5 million in Q1 related to this restructuring activity. We now expect our cost for this initiative to be approximately $27 million to $29 million, with targeted annual cost savings of $17 million to $20 million annually beginning in 2011.

From a cash flow perspective, we continue to make improvements in all elements of working capital efficiency. The largest component of our success in the first quarter came from our ability to increase inventory leverage and improve our discipline around payables.

As a result of this improvement, as well as the relative business strength in the quarter, operating cash flow from operations increased $46 million from the year-ago period to $32 million in Q1. This improvement was primarily driven by the reduction of working capital, as noted above.

As communicated in our previous conference calls, we continue to expect our future capital expenditures to grow to levels, near 4% of sales. These investments will focus on supporting strategic growth with a specific concentration in the emerging markets. And driving efficiencies by strategically improving our manufacturing and supply chain footprint. While our spending has started relatively slow, it is expected to ramp up to higher levels over the balance of the year, primarily in the second half.

Looking ahead to the full year, we expect local currency sales to trend above our long-term growth targets. We do expect relative strength in the second quarter, as we continue to have favorable year-over-year comparisons.

As mentioned earlier by Hernan and Nicolas, while it is difficult to predict the impact of customer restocking beyond Q1, we do believe that these benefits will subside over the balance of the year as customers and retailers work towards their targeted inventory levels.

Regarding our margin structure, while we do expect input post – input costs to be favorable for the full year, we are starting to see some increases in raw material categories that will reduce this benefit in the second half of 2010. We could also see some currency pressures in the second half of 2010 which also may adversely impact our results.

So what does that mean for 2010? Even though economic conditions remain fluid, we continue to be optimistic. The second quarter has started strong and is expected to have relative strength versus the second half, when stronger comparables and potential currency parity may dampen our year-over-year performance.

In wrapping up, we're very pleased with a strong start to 2010. Both our Flavors and Fragrances teams have done an excellent job capitalizing on new business opportunities to grow both sales and profits to record levels. While as we entered the second quarter with some good momentum, our visibility through the balance of the year remains limited, given the evolving economic landscape, particularly in North America and Europe. We remain cautiously optimistic in our full-year outlook and we are aware that the extremely strong Q1 sales momentum is not sustainable.

As a result, we will continue to proactively monitor our performance to evaluate potential operating investments that could strengthen our long-term growth opportunities. Our efforts will be guided by our objectives to continue to build a stronger IFF for tomorrow while simultaneously driving consistent growth and profit performance today.

With that, we would be happy to take any questions that you might have.

Question-and-Answer Session

Operator

(Operator Instructions) We'll pause for a moment to compile the Q&A roster. Your first question comes from Mike Sison from KeyBanc.

Mike Sison – KeyBanc

Hi, guys. Great start to the year.

Doug Tough

Thank you.

Mike Sison – KeyBanc

In terms of – I'm trying to get an understanding of what you guys think based, demand is. And then – and then, when you think about the second quarter, it sounded like your customers are continuing to restock, they're not at the levels they want to be at?

Doug Tough

Well, I'll take a stab at that and then I would invite Hernan and Nicolas to weigh in, Mike. I don't think there is any clarity as to the level of restocking that really has occurred in the context of inventory changes. I make that comment both because we broadly discussed that internally, obviously. But also taking the opportunity to read many of our competitors and our customers their fellow first quarter results and they're all uncertain about the level of restocking.

I think the important point though is – really two, number one is the restocking elements in some parts of the world don't ever seem to have ever occurred. There wasn't destocking, per se in some parts of Asia and Latin America. Those economies continue to be robust. So the buoyancy that Hernan and Nicolas talked about, we've seen that buoyancy off of a sustaining inventory platform which is obviously very encouraging. I think it may be a different story in parts of Europe, particularly Western Europe, as well as in North America, where there was some destocking, but the finger on the pulse of how much restocking is going to occur. It's just not to be defined. I think it is important though that they all talk about the buoyancy we're seeing in H2 or in Q2, so far, and it's early. Nevertheless, it gives us confidence if there's real momentum as well as some elements of restocking. I'd invite Hernan and Nicolas to add to that.

Hernan Vaisman

We see (inaudible) I mean, we see, as I mentioned before, we are gaining momentum in the developing markets. I think that all economies are performing well as well as our businesses and in terms of the developing markets, I mean, we don't know exactly going to happen and what it's going to be restocking or not. Their source will be depending in our ability to win business. So far we see dimension to be still very strong, even in those markets.

Nicolas Mirzayantz

Good morning, Mike, it's Nicolas. I would echo Doug's comments. I think that the restocking dynamic has been obviously much more pronounced in Fine Fragrance and Ingredients. We're still seeing a bit of that trend in Q2, but we have no more visibility as our customers as far as, in fact, for the second half of the year. But it's really mostly related to these two categories.

Mike Sison – KeyBanc

Okay. And just as a quick follow-up, if given new product momentum and on a seasonal basis, if you go back for some time historically, Q2 tends to be stronger in sales than 1Q. So I guess, is the strength you're seeing enough to continue that trend? Meaning should 2Q be better than 1Q on a sales basis? And if that's the case, would there be any reason why – or any sort of offsets that earnings wouldn't also follow that same trend?

Kevin Berryman

Mike, this is Kevin. Let me take a stab at that. I think, look, we're early into Q2, is the first point I would make and although there's some buoyancy to, to how we started at the end of the day, we're not prepared to really fundamentally talk to, to a number that is, is going to be approaching the, kind of, growth rates we've seen in Q1. We started, we started well. We liked the picture that we've seen so far, but we're early in the quarter and I think it's important for us to communicate that to you. I do think that depending upon how it plays out. There would be an expectation if we continue to have some good growth that we would continue to have some good profitability associated with that. So, I think that's a general comment I would make. And we'll see how the second quarter plays out and we liked how it started and we'll see how we end.

Mike Sison – KeyBanc

Okay. Great. Thank you.

Operator

Your next question comes from Mark Astrachan from Stifel Nicolaus.

Mark Astrachan – Stifel Nicolaus

Good morning, everyone. First question, just relating to the Flavors business in particular, the operating profits and operating margins. Curious, how much of an impact there was from the losses of non-strategic business in Latin America and then somewhat related to that, just curious what the impact was in North America in terms of the slight decline in the quarter? And then just your thoughts on a go-forward basis about what you're seeing in the environment in North America.

Kevin Berryman

Hey, Mark, this is Kevin. Let me – a few preliminary comments. I'll hand it over to Hernan for some additional follow-up. In our third quarter call last year, we talked about the decision on the strategic side for the Flavors business in Latin America and we had talked about actually how our expectations at that point in time is. Even though, we were doing that, we thought we would be able to offset that loss by some strong underlying performance in the rest of the portfolio. That actually didn't end up occurring in Q4. We were off by one quarter, I guess, but what I think you're seeing in Q1 is again, the actual results tying into our feeling that the underlying strength of the portfolio was pretty strong and we would be able to more than offset some of that lost strategic business.

And I think that, that, we're seeing with that good solid single-digit growth number for Latin America and Flavors, I think you're seeing that. So the momentum's good there and we start to lap against the new base, really in third quarter. So you'll start to see probably some better numbers in the Flavors at that point in time, but I'll turn it over to Hernan if there is any other comments.

Hernan Vaisman

Well, I think you said it, Kevin, really, really fine. Regarding your question, the impact of this non-strategic business and profit of the Flavors. I mean, basically, I said non-strategic because it was not part of the core business. On the other hand, it was not a high margin business. So, the impact is really, wasn't seriously minimum in this sense. Regarding North America, as I mentioned before, you have to consider the context. I mean the first quarter 2009 was very strong, was 6%, was in the middle of a crisis with really outstanding results.

Now going forward, I mean, we are feeling confident. As I mentioned, the pipeline is strong. In some way, we understand that the low performance in the first quarter was because some, I mean, there were some delaying launches for our customers, now are coming through. That's why our expectations into North America are very possible.

Mark Astrachan – Stifel Nicolaus

Okay. Great. And then just shifting broadly to your overall volumetric trends, a common theme across the entire consumer universe, whether it’s household products, food and beverage, seems to be innovation, seemingly at all-time highs are pretty near to that type of activity level. What are you all seeing in terms of how that's benefiting your business now versus how that should potentially ramp in terms of benefiting organic growth over the balance of this year and frankly into next year as they continue to really ramp the R&D spend on the consumer business level?

Doug Tough

Well, I think innovation was key. My sense is it's – even gets dialed up more recently as we come out of some of the recession and the difficulties in getting prices, particularly at the retail level by some of our customers has ramped up, therefore their quest for innovation, which might provide the opportunity for a price increase. Certainly from – I've been in a number of businesses in the consumer area and that quest for innovation has always been there or since, it seems a little bit stronger now. But while I probably feel particularly good in my early days so far here is really a function of the alignment, if you will, simpatico that exists between IFF and their various groups and our customers of both regional and the global customers that I've met. And there's quite a lot already. Their, their needs are well articulated. They're aligned with our groups. So, I think that the number of wins that our – Nicolas and Hernan have talked about today is indicative that we’re fulfilling that innovation request from our customers. And that alignment is uppermost in our minds and make sure we continue that.

Operator

Our next question comes from Edward Yang from Oppenheimer.

Edward Yang – Oppenheimer

Hi, good morning. Kevin, you mentioned that input costs should be favorable for the full year. But I would imagine by the fourth quarter, you would start to see some significant year-over-year pressure, just as your anniversary $30 oil. So, looking into 2011, how do you feel about your ability to pass rising raw materials through and maybe refresh my memory in terms of how it works. Is your pricing basically set at – when the product is developed and it is not adjusted for raws and do you renew price only on new products?

Kevin Berryman

I'll make some preliminary comments and then turn it over to the two business presidents if they want to augment it or make any additional comments. At the end of the day, as we enter into some of our relationships with our customers on, on specific, with their, their portfolio of products. We, we lock in and that business is, is certainly in place for depending upon the specific opportunities, can be two, three, four or five years thing. And we do look when we get significant volatility and input costs, we will look to partner with our customers to talk through that as it relates to issues on input costs, acceleration. And we did that in 2009 as you might recall. The other piece that's important to note is that on our financing, excuse me, Fragrance Ingredients business. That is a business that we do price more aligned with some of the input cost dynamics that are occurring in the marketplace. So, to the extent some of our, what's called more oil-based related input costs associated with the Fragrance Ingredients business.

If we continue to have upward trends in, in oil-related costs, we will adjust prices in our Fragrance Ingredients portfolio consistent with what the market will bear. So it's – that's kind of the overlying dynamic. Back to the point as it relates to 2010 and fourth quarter, we continue to believe we're going to be positive as it relates to our input cost dynamics over the course of the year. It's just that we think that positive picture that we're seeing in Q1, for example, will start to probably reduce by the end of the year. But it's still expected to be positive.

Operator

Your next question comes from Lauren Lieberman from Barclays Capital.

Lauren Lieberman – Barclays Capital

Thanks, good morning. I was hoping we could similarly get some color on the North America Functional Fragrance business. I know we got details on the dynamics of Flavors, but also wanted to hear similar conversation around functional. Thanks.

Nicolas Mirzayantz

Good morning, Lauren. It's Nicolas. In Q1 last year, we did experience very strong growth of 8% in North America. Functional Fragrances was a very strong pipeline of new introduction. I think here we're dealing with phasing of introduction and reordering patterns. So I think that it's really related to this quarter and strong comparable as in 2009. So we believe that the underlying trends of the business are still positive.

Operator

(Operator Instructions) You have a question from John Roberts from Buckingham Research.

Doug Tough

Good morning, John. John, are you there?

John Roberts – Buckingham Research

Good morning, John. Yes, can you hear me? I'm sorry, I was muted.

Doug Tough

Yes. Can hear you fine.

John Roberts – Buckingham Research

Could you remind us about how big Fine Fragrance and Fragrance Functional Ingredients are today? I mean, it used to be much more meaningful. They dropped down a lot and I've lost track a little bit in terms of how big they are, approximately, in the portfolio.

Nicolas Mirzayantz

We talked about the Fine being around 10% of the total portfolio of IFF. And we're not really dissimilar from that number currently. I think certainly there was a soft – a softness to that business over 2009. And we've caught back up to our numbers in the first quarter of 2009 for all intents and purposes. Given the strong performance that we saw in that particular category in first quarter 2010.

John Roberts – Buckingham Research

So…

Nicolas Mirzayantz

Back to pre-economic volatility levels.

John Roberts – Buckingham Research

And functional Ingredients?

Nicolas Mirzayantz

The Fragrance Ingredients is roughly about 10% as well.

John Roberts – Buckingham Research

Okay, and secondly, I guess it's logical that we've got inventory effects in those because the Fine Fragrance is more of a durable product that the customer can have inventory issues whereas most of the other products are consumable. The functional is you're really a raw material supplier, so you've got the typical chemical industry inventory and what might occur there. Do you think in the other products that are more recurring consumables and have less inventory effects, that there's a pantry inventory? Your customers often talk about the consumer pantry inventory which may have been pulled down a little bit during the recession. They may have had less food – less processed food in the cabinet and less laundry detergents at home and in the laundry room, so forth. And that, that's expanding again as well?

Kevin Berryman

Let me clarify your question, John. You said functional ingredients and I'm interpreting that as Fragrance Ingredients.

John Roberts – Buckingham Research

Fragrance Ingredients, right, Fragrance Ingredients.

Nicolas Mirzayantz

Okay. So then your other question, as it relates to just, let's call it destocking by the consumer. Is that…

John Roberts – Buckingham Research

That's correct. Yes. So you've got an inventory between you and your customers, which is what you're seeing expanding. What your customers have inventory issues and sales in the entire retail chain? I think it gets back to some of Doug's comments in terms of through the supply chain and what's happening. I'm not so sure we can give you a great answer as it relates to what is going from a restocking perspective. There is some element of it. We think given the very strong numbers that we have in Q1. But I'm not so sure we can pinpoint the specificity of that and I think as we look at the results of our competitors and our customers, they certainly are talking that there's some element of potential improving dynamic, but they're also being very cautious as well. Okay. Thank you.

Operator

You have a follow-up question from Edward Yang from Oppenheimer.

Edward Yang – Oppenheimer

Thank you. On Fragrance margins, the category margins in general were very strong, up about 500 basis points year-over-year. And I was wondering how that looked by segment in terms of Ingredient, Functional and Fine Fragrance?

Kevin Berryman

We don't talk at that level of detail, but, but certainly we saw some, some improvement in the Fine business and there was some element of mix that, that helped in that endeavor. We've told you in the pass that Fine is a nicely profitable business so there was some benefit of mix. And certainly given the very strong growth that the fragrance business had, you got good, good fixed cost leverage and so that was a big driver to the numbers. Got good gross margin improvement as well but at the same todken, there was a big chunk of fixed cost leverage that we saw there.

Edward Yang – Oppenheimer

So the Fine category was strongest in terms of driving margin performance?

Nicolas Mirzayantz

Well, on a, versus year-over-year performance, I think that we saw good solid growth across all of the categories. It wasn't necessarily a one particular category where we saw this one significantly more profitable this year than last year on a gross margin basis. So effectively, we saw good profitability improvements across the portfolio. A lot of it was driven by the growth leverage we had.

Edward Yang – Oppenheimer

Okay. Thank you.

Operator

You have a follow-up question from Mike Sison from KeyBanc.

Mike Sison – KeyBanc

Hi guys. Mother's Day tends to be a pretty important season for Fine Fragrances. Any sense of how the season's going? Is sales at your customers going pretty well? Obviously, they've restocked for it.

Nicolas Mirzayantz

Mike, it's Nicolas, indeed you're right. Mother's Day and Christmas are the two most important milestone in terms of sales opportunity for the brands we're partnering with. We don't have yet any sense of the buoyancy of that period right now. But we are definitely part of sole, one of the drivers behind restocking to make sure the retailers and customers were ready in case the consumer demand and consumer confidence was really there to lead the sales.

Mike Sison – KeyBanc

Okay., And then, just generally speaking, Doug, when – I guess you weren't here in January but any major changes in sentiment from your customers now versus what they were feeling for this year and January, has it – it sounds like it's improved. Has it improved significantly? Are they asking to do more new products? New – that type of stuff? Is – just give us a feel of, maybe, the change there sort of their sentiment over the last three months to four months for this year?

Doug Tough

Sure, Mike, I do think your hypothesis is broadly correct. There's been an improvement that I would – between January and I was involved to a degree with IFF at the time with my other organization as well. The sentiment has improved overall. I'd say it nevertheless is mercurial and fluid and things around the world – parts of the world remain very dynamic. So, we'll be extremely cautious about, as Kevin already articulated. We'll be cautious about the investments and the things we do.

I think IFF is blessed with the diversity of its geographic footprint and its portfolio of businesses because sentiments that I've seen in Asia and in Latin America were positive then and they remain positive now and there's been a relative improvement in particularly North America and I'd say to a lesser extent in Europe but nevertheless, directionally going that way. But here in North America, there is an improvement, the customer propensity for new products and investment. Both born out of the need to win back customers exists but the overall trend seems to be our friend everywhere. But as I say, I'm probably most pleased by the footprint that IFF has that, it hasn't – We're trying to go, if you will, from strength to strength in some parts of the world, while in other parts of the world, there's an economic rebound and we're a part of that.

Mike Sison – KeyBanc

Okay and last question, in terms of Fragrance operating margins, you've got it back 16% or close to 16%, you have about 100 basis points kicking in from cost savings heading into 11. So seems like the 18% goal you've had historically is within striking distance. What do you think you need to do to close that gap heading into 2011?

Kevin Berryman

Mike, you've appropriately identified the continued work on our cost structure and that is, the reorganization that we alluded to in the prepared comments, which is effectively getting us close to 100 basis points of incremental profitability. But I think that we're going to continue to be diligent in terms of ensuring that we're going to have growth – fixed cost leverage. We're going to look to ensure that we continue to have growth and that growth element requires us to make investments at particular points in times. So that may dampen a little bit of that but at the end of the day, I think that is very clearly, our thinking that we would be diligent, we'll be focused and disciplined as it relates to making those investments so we ensure that we have top line growth. I think the other point is that there is a significant increase in some of the incentive numbers we have in this particular quarter because we are very low last year, higher this year. So, if you look at, like a new standard base, some of the costs that you're seeing in RSA won't necessarily be at those levels assuming we continue to be more a normalized level incentive comp over the long haul.

That'll be a piece of it, too. So, the first thing is, the $17 million to $20 million in 2011, the next piece is how incentive fits into the picture. Its variable right now that's because we're recovering from such low levels. The rest of it is our continued drive for improvements in gross margins and discipline in the management of our fixed cost structure.

Mike Sison – KeyBanc

Great. Thank you.

Operator

You have a follow-up question from Mark Astrachan with Stifel Nicolaus .

Mark Astrachan – Stifel Nicolaus

Hi. Just following up on one of the earlier questions regarding innovation. Wondering if there's any mixed benefit from some of the higher priced products that are coming to market?

Kevin Berryman

Mark, I'll take a stab at that and then I'll ask if anyone wants to add additional points to it. I think that not necessarily in our numbers today can we point to significant increases in margins as it relates to the new portfolio. It's a mixture. Some of our new wins, obviously if it's in the Fine areas is going to be a driver to incremental mixed benefits. And certainly, the technology and to the extent we bring that to bear in terms of the new efforts that, that lends itself potentially to a longer improvements in margins.

So, I think, to Doug's point, innovation's going to continue to be key. It would be the lifeblood of us to be able to maintain our margins and improve them overtime but that's got to be one element of our efforts. The second part, which I've talked about in the past and I continue to talk about is our continued discipline in the management of our, say our controllable cost structure. And I think the business units have continued to do a great job over the course of the last 18 months. That's going to be an important element for us to continue to be able to do that in the future.

Doug Tough

I would only add, certainly on the Flavors side of the business, the opportunities to influence consumer trends of health, wellness, nutrition and so on, which are very much at the forefront of our customers agendas equally are on the forefront of ours. Obviously, we're not positioned nor would we divulge any intellectual property issues, with some of the technological opportunities that Kevin referenced. We'll be right up the alley of the health, wellness, nutrition and so on. And the willingness, I think, to sell those at better margins is both within our ambit and frankly, right up the alley of what the customer wants to do also. I'm optimistic we can achieve some of that and it would always be our goal to improve margin with innovation and new products.

Operator

At this time, there are no other questions.

Doug Tough

Thank you all for your attendance and participation today. Look forward to talking to you in three months. Thank you.

Operator

This concludes today's International Flavors and Fragrances first quarter 2010 earnings call. You may now disconnect.

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Source: International Flavors & Fragrances Inc. Q1 2010 Earnings Call Transcript

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