International Flavors & Fragrances, Inc. Q1 2008 Earnings Call Transcript

| About: International Flavors (IFF)

International Flavors & Fragrances, Inc. (NYSE:IFF)

Q1 2008 Earnings Call

May 1, 2008 9:00 am ET

Executives

Yvette Rudich - Director of Corporate Communications

Rob Amen - Chief Executive Officer

Doug Wetmore - Chief Financial Officer

Analysts

Douglas Chudy - KeyBanc

Jeffrey Zekauskas - JP Morgan

Erik Sjogren - Morgan Stanley

John Roberts - Buckingham Research

Chris Leshock - Perkins Wolf

Operator

Good morning and welcome to the International Flavors & Fragrances First Quarter 2008 Earnings Conference Call. Today’s call is scheduled to last about one hour including remarks by IFF Management and question-and-answer session. Today’s conference is being recorded.

I will now turn the call over to Yvette Rudich, Director of Corporate Communications. Please go ahead.

Yvette Rudich - Director of Corporate Communications

Hello and thank you for joining us today. With me are Rob Amen, Chief Executive Officer and Doug Wetmore, Chief Financial Officer.

Our earnings release was issued and our 10-Q was filed earlier today. Both are available on our website at iff.com in the Investor Relations section. As you know, during this call, we may make certain forward-looking statements about the Company’s performance. These statements are based on how we see things today so they contain elements of uncertainty.

These forward-looking statements may be identified by words such as expect, believe, outlook, guidance, may, or similar expressions. Actual results may differ materially due to risks and uncertainty. For a more detailed explanation of the inherent limitations in such forward-looking statements, please refer to the cautionary statement and risk factors contained in today’s earnings release and in our 10-K and 10-Q filings available on our website.

Some of today’s prepared remarks will exclude those items that affect comparability. These excluded items are captured in our GAAP to non-GAAP reconciliations available on our website.

For today’s call, Rob will begin with some high level comments on the quarter. Then Doug will provide a review of the financial results. Following closing comments from Rob, we will then take your questions.

With that, I’ll now turn the conference over to Rob. Rob?

Rob Amen - Chief Executive Officer

Thanks, Yvette, and good morning. Welcome to the call. I thought I would start with some overview comments on the flavor and fragrance markets and then take a look at the quarter.

Demands for flavor and fragrances really reflects both the economic mentality of a country as well as its stage of economic development. For example in mature economies, we expect flavor and fragrance demand to be inline with GDP. While in a country like India, demand should be far higher than GDP growth, double or even higher. The rising number of middle class consumers fuel rapid growth for our customers’ products. Consequently, while the US market demand may be adversely impacted by a weak economy, we are seeing solid growth in demand in China, India, and Brazil.

Now, for the first quarter 2008, IFF reported sales growth of 5% over the first quarter 2007. Excluding currency parity changes, the increase would have been 1%. Sales were driven higher by strong performances in the emerging economies of Asia, Latin America and the Middle East. The European region was up sharply in dollar terms and stable in local currency.

Operating margins improved in fragrance ingredients due to mix and cost recovery while margins in regions outside of North America benefited from higher sales and good cost control. We had challenges with our business in North America and with the Fine Fragrance business globally. These businesses were clearly impacted by the weak retail environment and an inventory correction.

As I suggested on our last call, the fragrance business was likely to face a tough quarter. The inventory correction we suspected is real and pronounced. I am pleased that the fragrance business activity as measured in new projects is up year-to-year and we are again winning a healthy share of the projects. This will be reflected in sales in late 2008 and in 2009. I will have more to say on how we are working through our challenges and why I remain confident that we will meet our financial goals.

However, now, I would like Doug to take you through the details of the quarter.

Doug Wetmore - Chief Financial Officer

Thank you, Rob, and good morning everyone. Let’s begin with an overview of sales.

We provided the breakdown of sales and growth by our two business units. As you can see, Flavors grew 12% in dollars and on 8% local currency in Greece, and Fragrance sales were flat in dollars with the 2007 quarter, declining 4% in local currency. The primary drivers of the difference between the local currency growth and the reported dollar performance, was the strength of the euro compared to the dollar. The euro was about 11% stronger than the prior year quarter. A basket of other currencies accounted for the remainder of the exchange effect. The Fragrance decline resulted mainly from sharp declines in North America Fragrance sales in all categories, which I will touch on in more detail in a few moments.

In 2008, we’ve also begun to realign our portfolio of Fragrance ingredients following the pricing pressure and margin compression experienced in 2007.

During the first quarter, we discontinued the sale of certain ingredients, which in total accounted for about one half of the Fragrance local currency decline in the first quarter. While sales declined as a result of this portfolio realignment, the benefit was improved ingredient profitability. We also undertook a series of price increases in ingredients that had a modest impact on Q1 results but such impact will increase in the second quarter and as the balance of the year progresses.

As you can see on the map, we had solid growth in each geographic region, but North America. Europe reported very strong growth increasing 9% over Q1 ’07 and quarterly sales benefited from the strength of the euro as I mentioned but the reported growth reflected a local currency increase of 1% led by a 3% increase in Flavors. Latin America sales increased 12%. This growth was particularly strong in Flavors, which grew 37% in the quarter led by several new wins and strong volume of existing creations.

Greater Asia also achieved excellent growth driven mainly by new wins and improving volumes. Asia sales increased 15% in local currency and 19% in dollars. Fragrances led the Asia performance with an 18% local currency growth, but Flavors was not far behind with 13% local currency growth. Growth in Asia was strong in all product categories. Local currency sales to our top 30 customers, which account for about 56% of our sales, grew 2% in the quarter or about twice the rate of our overall local currency growth.

Now, let’s discuss each of the business units’ performance in a little more detail.

As you can see, Flavors had a very solid start to the year. The wins and volume growth of existing business drove improved margin performance. The very strong operating profit leverage results from solid sales performance enabling excellent absorption of manufacturing costs. All of this was enhanced by continued good cost control. The end result was a 27% increase in operating profit. It’s bear noting that the 2008 performance was against the difficult comparison in the first quarter of 2007 when Flavors operating profit increased 20% on an 11% sales increase.

And also as discussed in our 10-Q, the 2008 result is inclusive of about $1 million of restructuring costs allocable to Flavors, impacting the operating profit comparison with the prior year by about 2%. This chart depicts the percentage growth in Flavor sales in both local currency and reported dollars for the last three years. As is evident, the local currency sales performance for Flavors continues to excel driven by the wins and improving volumes.

As we noted in our press release today, we delivered above market growth for seven consecutive quarters increasing our market share during that time. And overall, Flavors has now grown 11 consecutive quarters in local currency and we are confident that that growth will continue.

The Fragrance story for 2008 to-date is markedly different from Flavors. The Fragrance operating environment has been more challenging and Fragrance profitability has suffered.

In the first quarter, as I mentioned, each geographic region other than North America had a very solid start as we saw in the earlier slides. However, North America sales fell 23% declining in all categories. The quarter comparison was made more difficult by the 11% increase achieved in the first quarter of last year for North America. But overall, volumes fell sharply in Fine, Functional and Ingredients, driven mainly by overstock positions at many customers following a weak holiday season in Fine Fragrance, and by destocking efforts at many functional and ingredient customers in view of the weak macroeconomic environment.

This North American weakness, especially the 30% decline in Fine Fragrance, materially impacted North America and consolidated operating profit in the quarter. Mainly, as a result of the sales decline, North America operating profit for the quarter fell $13 million from the prior year quarter. Fragrance operating profit on a consolidated basis also reflects $2.5 million of restructuring costs in the quarter, accounting for 4% of the operating profit decline in comparison to the prior year quarter, also again as discussed in our 10-Q.

As you can see in this graph, the local currency sales performance for Fragrances had been quite strong throughout 2006 and much of 2007 driven by new wins and the sustained success of existing creations. Comparison with the last year first quarter was particularly difficult, as I noted, especially for North America as well as for Fragrance Ingredients overall. But, as you will recall from our last call, we saw a sharp slowdown in Q4 in Fine Fragrances most notably in North America and Europe and that North America slowdown continued into 2008.

Having said that, at the same time we’ve begun to see improvement in Functional Fragrance performance supported by new wins and by the launch of the next encapsulation products. We had a very strong performance in Functional in all regions outside North America.

Now, turning to consolidated operating results. The 2008 first quarter is summarized on this chart. Now, note that the chart excludes the impact of this $6.2 million of restructuring charges. Just on that subject for a moment, we’ve spoken to you in the last several quarters regarding certain initiatives underway to transform our business processes.

The principal enabler of this transformation is our single global instance of SAP. In this quarter, these restructuring charges related to employee separation costs due to the elimination of about 125 positions in administrative functions mainly accounting and finance, as we move to outsource these functions to a third party service provider. The first steps in outsourcing will commence in the second quarter and will proceed over the balance of the year. We will begin to see benefits of these initiatives in the second half of 2008, and there are additional details regarding these charges in our Form 10-Q.

Now, looking at the P&L for the quarter, as we mentioned sales increased 5% resulting in a 4% increase in gross profit and as I mentioned before the weakness in North America Fragrance impacted gross margin because of poor manufacturing expense absorption, which is accounting for the decline as a percent of sales.

While R&D expense increased this quarter in both absolute value terms as well as a percentage of sales compared to the prior year, exchange was a significant element of the value increase. Excluding exchange, R&D would have been increased about 7% versus the prior year quarter. And also bear mentioning, the 2007 first quarter was unusually low as a percentage of sales, 8.2%, and the first quarter of 2008 is more inline with the full year 2007 spending rate.

Selling and administrative expenses declined 1% compared to the first quarter last year. And excluding exchange, selling and admin would have declined 4%. The decline reflects continued good cost control as well as somewhat lower incentive compensation accruals compared to the prior year quarter.

Selling and admin also reflect the benefit of an insurance recovery of $2.6 million relating to a 2005 product contamination matter. The recovery reduced current year selling and admin expense because the related costs were charged to that same caption three years ago. The end result of all the matters I just mentioned was a 7% increase in operating profit compared to a year ago.

The evolution of earnings per share from the $0.69 reported in the 2007 first quarter to our current year’s quarter is depicted on this slide. As in the past, we have not isolated the impact of translation, so other than per shares outstanding, exchange is embedded in each caption and also as you would expect, there is some rounding effect in each caption.

But having said that, sales growth added $0.04 per share. The operating margin declined, breaking out the insurance recovery separately, reduced earnings per share by a penny and that was mainly due to the gross margin erosion on North America Fragrance weakness.

As I just mentioned, we recovered $2.7 million related to the 2005 contamination issue and aftertax this recovery accounted for $0.02 per share. Other income and interest expense combined accounted for a net decrease of $0.09 per share. Most of this change resulted from interest expense, which increased about $10 million in connection with a debt taken on to implement the accelerated share repurchase program we undertook last September.

We also had somewhat unfavorable exchange results in the current quarter compared to the first quarter of ’07, which accounts for much of the remaining difference. There were no sales of assets or related gains in the current quarter.

Taxes favorably impacted the current quarter’s result as well adding $0.02 per share and as we mentioned in our press release, the effective rate for the quarter of 25.4% benefited from favorable tax rulings with respect to prior years. These tax rulings added about $0.03 per share to the first quarter results. And absent these rulings, our effective tax rate for the quarter would have been 28.2% about the same as the 2007 first quarter.

We reduced the number of shares outstanding adding $0.08 per share, and average shares declined 10% from the prior year quarter and as I just mentioned a moment we recorded restructuring costs in the quarter of $0.06 per share. Taking into account all these components, our reported EPS for Q1 ’08 was $0.69 per share and excluding those restructuring charges EPS would have been $0.75 per share.

The detailed cash flow is available in our 10-Q and here is the summary on the slide. There were no major fluctuations in cash flow from operations. The first quarter is historically our smallest quarter for operating cash flow. For the full year 2008, I would expect cash flow from operations to have about the same relationship to net income as it did in 2006 and 2007, about 120 to 125% of net income.

As you can see, we reduced debt somewhat during the quarter and we also remained pretty tight on capital spending. Having said that, capital spending is expected to scale up somewhat in Q2 as we progress with construction of a new creative center in Brazil and expansion of our ingredient facilities in China and a new creative and administrative center in China.

The dividend payout reflects the 10% increase announced last year essentially offset by the reduction in shares outstanding and we continue to buyback shares in addition to the shares being purchased on our behalf in connection with the ASR that ASR remains in progress at this point in time.

Year-to-date, we have spent just under $30 million in share repurchase activities and in so doing we bought back about 700,000 shares. At quarter-end, shares outstanding stood at about 80 million. At quarter-end, we also have remaining authorization of about $269 million. As I just mentioned, the ASR remains in progress and we expect completion of the ASR in the second quarter 2008.

Based on current prices and the shares held back at the time we entered the ASR, I would expect to acquire upwards of one million more treasury shares sometime in the second quarter 2008, on completion of the ASR, but at no further cash cost for the company.

In looking at a couple of other metrics that we believe are meaningful to investors, our overall return on invested capital for the trailing 12 months ended March 31, 2008 of 14.4% is inline with that achieved for the prior year comparable period. Our return on equity has improved significantly over the prior period driven by the solid operating results and augmented by the impact of the accelerated share repurchase program. For the comparable prior year period, our return on equity was just under 26%.

Finally, in terms of our EBITDA margin for the trailing 12 months ended March 31, 2008, EBITDA totaled 461 million or 20% of sales compared to 443 million or 20.6% of sales in the prior year comparable period.

Now, I would like to turn the call back over to Rob.

Rob Amen - Chief Executive Officer

Thanks, Doug. 2008 is and will likely remain a challenging year. The greatest challenge remains the US. I am not an economist and I’m not making a forecast, but it’s hard to see a recovery this year. The next unknown we are dealing with is whether or by how much the US slowdown will impact other economies. We have seen some slowing of growth in several emerging economies, but growth remains in the 7 to 10% range. Fine Fragrance business will be a challenge. First quarter sales reflected lower sell-through and an inventory correction, which we expected. I can’t forecast to turnaround this business until sales enable inventory at our customers to be back at more normal levels.

Lastly, in the past, we’ve reported raw material price increases of about 2 to 3%. In Q1, we saw this tick up slightly to 4%. Now, we continue to work hard to recover these cost increases. However, the inflationary pressures on raw materials is a concern. That being said, I believe IFF is well positioned to deal with the challenges of 2008. IFF is a truly global company with a strong position in every marketplace of importance. Yes, the North American market, which accounts for about 27% of our sales, is currently weak. This is a cyclical issue and we believe is a long-term potential of the US market.

Our presence in the emerging markets is a key strength and the key opportunity. I am very pleased both with our current performance and our future prospects in these fast growing economies.

Consequently, we continue to build IFF for the future. As a result, we remain focused on our strategic priorities, growing our market share by helping our customers win, increasing profitability by improving effectiveness and efficiencies, and the outsourcing initiative Doug mentioned is representative of these efforts.

We will continue to invest to meet the needs of the future. For example, we are investing in new and larger creative facilities to drive future growth in China, Brazil, and here in the US. These are key assets which are integral to winning new business. Our goal is to build a stronger company based on materials excellence, in-depth understanding of consumers, and superior creativity. I believe by focusing on these strategic comparatives, IFF will deliver on its financial goals.

And now, Steve if you can help me, we will open up the call to take questions.

Question-and-Answer Session

Operator

Certainly. (Operator Instructions). Our first question will come from Douglas Chudy from KeyBanc.

Douglas Chudy

Good morning

Rob Amen

Hi Doug.

Douglas Chudy

Hi. I just want to check with you, you noted the inventory correction in Q1. Do you think this is largely complete or should we expect this to flow through into the next quarter or next couple of quarters?

Rob Amen

Doug, as I indicated it’s really impossible to know whether or not it’s complete until after the fact. I think the overhang remains with us. I think it will be an impact in the second quarter and will slowly diminish over the course of the year.

Douglas Chudy

Okay. And secondly you mentioned that new project activity picked up year-over-year in the first quarter, is this on a consolidated basis, can you maybe breakout what you are seeing in Flavors versus Fragrances? I assume maybe the Flavor side was a little bit stronger?

Rob Amen

Well, I actually I made the comment referencing Fragrance and it’s interesting to know we are seeing a pickup of Fragrance projects here in the United States and that’s very very good and as I said we are winning up a good share of those things. So I feel better about the Fragrance business as we move through the year. The Flavors business is doing terrifically around the world and the activity is up, the win rates are up, we are winning in the categories that we said. I mean, Doug indicated, but I have to tell you, I am really impressed with our Flavors team and what they are achieving.

Douglas Chudy

Okay. And just finally, one other question. I know you don’t provide specific guidance, but given the current state do you think that the Fragrance in a tough start to the year, the Fragrance segment can get I guess local currency growth positive in 2008 or you think that may be a challenge at this point?

Doug Wetmore

I think at this point in time, first of all, we have very difficult comparisons in Fragrance for the first half of the year and that will certainly be an element, but only an element. But I think we are seeing very good growth outside the United States and while, as Rob mentioned, you have to be somewhat cautious about the US market. We are pretty confident that overall we will deliver local currency growth for the Fragrance business unit during the course of ’08.

Douglas Chudy

All right. Thank you very much.

Rob Amen

Thanks Doug.

Operator

(Operator Instructions). Our next question comes from Jeffrey Zekauskas from JP Morgan.

Jeffrey Zekauskas

Good morning. This is Silka Koopf for Jeff. How are you?

Rob Amen

Hi Silka. Good morning.

Jeffrey Zekauskas

I have got a couple of questions. Can you breakout the 1% local currency growth by volume and price or can you just generally talk about prices in the quarter?

Rob Amen

Silka, there was not a measurable price increase impact in the quarter. As we mentioned, we passed through some price increases on the Fragrance Ingredients, but that was just an element, but it’s really overall that 1% is primarily volume related and driven by the new wins and volume increases on existing creations.

Jeffrey Zekauskas

Secondly, related to the restruction you are taking and on cost savings that may slow some of the income statement in the second half of the year, what benefits should we be looking for, like could it be like 1 million or 1.5 million a quarter in savings beginning in the second half or is that too larger number?

Rob Amen

I would prefer at this point in time not to quantify. As I said, we expect some savings to begin in the second half of the year. But at this point in time, it’s probably a bit premature to quantify that Silka. But it does bear mentioning that these are one of the things that we’ve talked about in the past as a contributor towards our getting to that 18% plus operating profit as we exit 2009.

Jeffrey Zekauskas

And maybe a last question, I’ll get back into queue. On the -- there has been very strong growth on the Flavor side, and can you at all disaggregate what amount is due to share gain, market share gains, what portion is due to new product introduction and at what rate the base business has grown?

Rob Amen

That’s great question, Silka. We had really good market data we would be able to give you good analysis. We think there is a decent market share gain and the market share gain comes from new wins. I mean, you either have growth in existing business, growth and erosion in existing business and then the new wins. So Doug, I would imagine it’s about half and half.

Doug Wetmore

Yes, pretty close to that. I think, Silka, we do have some disclosures in the MDA portion of the Q, which depending on how you print it off, I have it on page 14 in mine, but it provides a breakdown of some of the new wins and then the balance of the growth in those regions was volume related.

Jeffrey Zekauskas

Okay. That’s helpful. Thanks very much. I’ll get back into queue.

Rob Amen

Thank you.

Operator

(Operator Instructions). And we have a follow-up question from Jeffrey Zekauskas, JP Morgan.

Jeffrey Zekauskas

I’m sorry. I guess I'd just stand in the call. I had a question related to the encapsulation technology and you mentioned that you launched a new product on the functional side related to encapsulation technologies. In which region was it launched? And just like, how many products are in the market today on the functional fragrance side that use encapsulation technology?

Rob Amen

We have had two major launches, we’ve got some other ones, but we have got one major launch in Europe and then we had one major launch in this quarter in Latin America. And I’m very pleased with the response in the marketplace. Both products have gained meaningful amount of market share against their competitor products, our customers are happy, and it’s a demonstration of the technology. So we remain very very optimistic about the potential of encapsulation to help our customers.

Jeffrey Zekauskas

And maybe just follow-up on that. If I look at the functional -- if I look at the local currency growth on the functional fragrance side of 3% this quarter, is that something you think may be sustainable throughout the year like a similar rate given the -- given like the success on encapsulation and maybe other products?

Rob Amen

I think the 3% is definitely sustainable. If you take a look at what’s going on in North America. If we just get North America stabilize a little bit, you can envision numbers well above the 3%. This is really a tale of two cities in Fragrance, I mean you had all other and then you had North America.

Jeffrey Zekauskas

Right.

Rob Amen

And, if we understood North America was going to be weak we are working in and that will improve not quickly not dramatically, but it will improve. And to the extent that the inventory corrections starts to be behind this, we’ll see much better numbers. But outside of North America, we are seeing really excellent growth in functional fragrance and certainly flavors on a global basis.

Jeffrey Zekauskas

So, if I had to summarize, like to me it sounds that some of the -- on the Fragrance side that local currency growth and functional maybe improved throughout the year. Fine Fragrances maybe a bit challenging just because it’s been weak demand, it’s not really clear what the inventory levels are on the retail level. Ingredients business may have a little bit of headwind because of some of the probably like lower margin product that you chose to exit, which over time should then improve the margin and Flavors has a good win rate and a good rate of growth, which it seems to expect to continue throughout the year?

Rob Amen

I think you’ve summarized the quarter very effectively.

Jeffrey Zekauskas

Okay. Thanks very much and I will stay on for the call.

Rob Amen

Thank you, Silka.

Doug Wetmore.

Thank you.

Rob Amen

Steve, any more questions?

Operator

Yes. Our next question comes from Erik Sjogren from Morgan Stanley.

Erik Sjogren

Yes, good morning.

Rob Amen

Good afternoon, Erik.

Erik Sjogren

Good afternoon. Thanks. I just had two quick questions. First on the bit more color on the North America fragrance market. Could you talk a little bit more about which category is it, which is driving this weakness? Is it really just the perfumes or is it across all the different one? And also within the Fragrance Ingredients, is discontinued price pressure here or is it the actual volumes, which are falling off? And then secondly, just on the margin, nice seeing the SG&A coming down so much as a percentage of sales, is this kind of a leverage sustainable during the rest of the year do you think or was it mainly related to this compensation expense during the first quarter? Thanks.

Rob Amen

I will try to answer each of them and if I overlook one healthy factor that’s a lot. First of all, I would encourage you to take a look at the table in the 10-Q because we explore the sales by area, by region or by product category by region. And North America was most products decline in Fine, but Functional and Ingredients following that because Ingredients follows Functional, and we think that is, as I said, some decline in consumption but certainly in inventory correction.

Erik Sjogren

Okay.

Rob Amen

And I certainly don’t anticipate that we are going to see that continue. I expect that will improve through the course of the year. Don’t look for an enormous balance from the second quarter but certainly in the latter part of the year, this should be strong. Now, Fragrance Ingredients, there is a lot of good things going on there. Last year we saw pricing pressure. I said we will, on our December call that we were addressing it, we have gone to the market on these materials and increased prices. We saw a very modest amount of that in the first quarter. Those will be -- those increases will be more evident as we move through the remaining quarters of this year. So you did see an improvement in margins in the first quarter and there will be further improvement in margins as we progress through the course of the year.

Erik Sjogren

Okay.

Rob Amen

And maybe you asked about Fine Fragrance.

Doug Wetmore

Erik, if you look in the Q as Rob said, we breakout the category performance by geographic region. I think that we talked about it a bit. But I think your second question was on the selling and admin and can we continue at the current level. As we mentioned, the lower incentive compensation accruals, we had a very strong first quarter in 2007, which drove higher incentive accruals and they were not quite as high this quarter because our performance was not quite as good and they are very much performance-driven incentive accruals. But our goal is to continue to reduce the selling and admin expenses and that’s really why we have undertaken some of the initiatives such as the outsourcing that I mentioned on the call and those will benefit selling and admin, basically the admin expense in this case. And I think Rob mentioned in his comments that this is just an example of what we are undertaking, which means that there are other initiatives that we have to undertake to further take on value added costs out of our business and the primary tool for that is to leverage this wonderful tool that we have in SAP.

Erik Sjogren

Okay. That’s great. Thanks very much.

Rob Amen

Okay. Steve?

Operator

Our next question will come from John Roberts from Buckingham Research.

John Roberts

Good morning Bob. Good morning Doug.

Rob Amen

Good morning.

John Roberts

Could you compare or contrast the current economic cycle impacts on your business with past quarter cycles, is this divergence between Flavors and Fragrance performance in North America kind of unprecedented?

Rob Amen

I guess on the causative story and I have that John so let me address that. There is a couple of differences between this one and the last let's say 2001 and dating back to the early 90s and I think that’s probably -- you can argue about the disconnect between the global economies now and or the de-linking of the global economies and I think that’s certainly an element because the growth in India and Brazil and China and Indonesia are examples, it might be effective a little bit by the US, but I don’t think it’s going to cause those economies to come to a screeching halt because they have acquired so much momentum on their own. And only the fullness of time will prove whether that assessment is correct.

The second thing for us typically in an economic slowdown, it’s always been the Flavor business that is perhaps been a little bit more impacted, which is I think a surprising change for this one because Flavors, typically the food companies would really slowdown new product launches, would curtail marketing expenditures and all with the focus on driving or maintaining their earnings and I think now they are continuing to launch new products and they are really focusing on growth and so that’s probably a difference from the last two cycles that I have experienced here in North America.

John Roberts

Are there substantial supply chain difference that is down the Fragrance customer applications versus the food ones of it, wouldn't expect inventories (inaudible) flavors that you are seeing over on the Fragrance side?

Rob Amen

I think the one key difference in Flavors from Fragrances is you have a much shorter shelf life for our Flavor and Fragrance compounds. Food has a shelf life whereas Fragrance as long as it's properly stored really has a very long shelf life, so that makes it just that there could conceivably be more inventory of the detergent product or a Fine Fragrance product than other snack or a beverage product.

John Roberts

That’s what I was trying to get at because you really got the same consumer at the end of the day, buying either a food product or a household cleaning and personal care product.

Rob Amen

Well, there is a different dynamic if you think to John on the product development and introduction. Flavor product development is much quicker. I mean we can see things as rapidly as three or four months being in, going from development to being in the market, where in Fine Fragrance, it's always it seems to me close to a year and sometimes longer. So they are the end consumer, but how they develop the product, the intricacies of the customer supply chain and the supply chain complexity cause there a difference.

Doug Wetmore

I think the other thing that has to -- our experience has shown is that the phenomenon of destocking is pretty much contained within North America. We have never seen the European or Lat Am or Greater Asia companies accumulate the inventory in their distributor chain as we have seen in North America. So that when the destocking effect happens or the pendulum swings the other way that impact is most pronounced in North America.

John Roberts

Has there been a shift over the past couple of cycles and a difference between Flavors and Fragrances between them, say discretionary applications of, I am thinking about a candle scent being discretionary for example, versus a shampoo scent or a cleaner scent being a basic. I mean, I don’t know what you are more exposed these days or the industry is more exposed to a lot of new things that have been introduced that I viewed as discretionary purchases by customers. I mean so that some of the functional business has become kind of like the Fine Fragrance business?

Rob Amen

Yeah. We have not seen enough evidence to suggest there is any change in consumption in the functional area, data -to-date. Now, may be in a year’s time, we will have some different insights on that.

John Roberts

Okay.

Rob Amen

And certainly, I mean let's all be open and honest on this, the American consumer, the working class family is going to face some real tough challenges over the course of 2008. They are going to be making trade offs. How they are going to make? I don’t think we understand yet nor is it evident. But so far, we have not seen a significant shift. We are seeing in the functional fragrance area more supply chain adjustments and more sort of adjustment and some push back on some of the ingredients price increases to some degree, but that’s now sort of returning to more normal levels.

John Roberts

Okay. My concern was that in the food side, I think a lot of the new product introductions by the customers have been new drinks, new things that might be discretionary purchases by customers, on the food side even not basic foods but more of these alternative new age beverages and so forth. But if you aren't -- you are saying you aren't seeing really pull back in Functional on discretionary type product, you don’t think you would see it in the food side either?

Rob Amen

No good data with which to draw conclusions yet, John.

John Roberts

And then lastly, I thought R&D as a percent of sales might just gradually trend down a little bit because you’re going to this center of excellence model globally in R&D and that there would be some savings in that function as well. What's really the evidence of that I guess in the quarter?

Rob Amen

You know, John to be fair I think you would have seen that come down. It was at 8.7%. North America sales just stayed flat, it probably would have been down to about 8.5%. So, long term you can’t just look at an individual quarter, you have to look at it long term and I think that long term because of a higher rate of sales growth and a very tight focus on certain R&D initiatives that the R&D expenditure will trend down closer to 8% than to 9% over the course of the next couple of years and that’s really what we have been saying all along.

Doug Wetmore

We are committed to spending between 8 to 9% on R&D because ultimately we have got to develop unique materials to help our customers. They may be more powerful materials, they may be materials that enable the customers’ product to be lower cost. But we see enormous potential for new products and new materials and we are going to continue to invest. So that’s in our strategic plan to be in the 8 to 9% range.

John Roberts

Thank you.

Operator

(Operator Instructions). Our next question will come from Chris Leshock from Perkins Wolf.

Chris Leshock

Good morning, Rob and Doug. Have you just put any numbers around the impact of the inventory destocking during the quarter?

Doug Wetmore

I think there is a couple of things you can do. First of all, we know we haven’t lost a significant amount of business in terms of it just being replaced and certainly that’s the case in Fine Fragrance where you just don’t -- you are not replaced. So, it really is an element of destocking or just a slowdown in order activity, a slowdown in the restocking activity. But I think, if my experience over the last decade has been any indication, it typically takes a couple of quarters after the destocking effect passes before you really come to grips with what the impact was. I think back to the fourth quarter, it’s rather ’03 or ’04 where we certainly had the surge in Functional Fragrance activity, North American sales for Functional jumped 20% give or take in that quarter. We knew we didn’t have any wins that would drive that order of magnitude, but it was more along the lines of the restocking because at some point in time the customer was concerned that they were going to lose the sale because they didn’t have sufficient inventory in their pipeline. So it’s 20/20 [hindsight] that will only allow us to really analyze that.

Chris Leshock

Okay. Next question I guess is probably the bigger one in my mind is you have mentioned you are seeing the raw material inflation rate tick up here and now looking at about I guess around 4% and your pricing is more or less flat. How do you tackle that 4% cost inflation, which in my opinion is probably only going to get worse here in the next quarter or two or three, how do you about getting that back?

Rob Amen

Well, there is really two ways of going back. First of all, we have to go to our customers on some materials and get cost relief and that’s a big part of it. The other part is you design the higher cost into new products. Every time we are developing a new product, we understand the new cost and we are developing those new products with those cost in place. So, in effect, you are capturing that on a go-forward basis. We are out and we have been seeking cost relief and achieving it. So, we will get a little bit more of that but as the portfolio turns you are effectively re-pricing your materials.

Chris Leshock

Great, thank you.

Operator

And at this point, we have no further questions.

Rob Amen

Well, thank you all for joining us, and we look forward to speaking with you in future quarters.

Doug Wetmore

Thank you very much.

Operator

And this concludes the teleconference. We thank for your participation. Have a great day.

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