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International Flavors & Fragrances Inc. (NYSE:IFF)

Q2 2012 Earnings Call

August 8, 2012 10:00 am ET

Executives

Shelley Young – Director-Investor Relations

Douglas D. Tough – Chairman and Chief Executive Officer

Hernan Vaisman – Group President, Flavors

Nicolas Mirzayantz – Group President, Fragrances

Kevin Berryman – Executive Vice President and Chief Financial Officer

Analysts

Mark Astrachan – Stifel, Nicolaus & Co.

Lauren Lieberman – Barclays Capital

Edward Aaron – RBC Capital Markets

Jeffrey Zekauskas – JPMorgan

John Roberts – Buckingham Research

Edward Yang – Oppenheimer & Co.

Operator

At this time, I would like to welcome everyone to the International Flavors & Fragrances’ Second Quarter 2012 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 their questions, we request a limit of one question per person.

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 second quarter conference call. Earlier today, we issued a press release announcing our second quarter 2012 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 and will be available for replay for up to one year on our website.

Before turning the call over to management, I’d like to take care of a few housekeeping items. 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 second half and full-year 2012. 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 today’s 10-Q filing with the SEC as well as our 2011 10-K filed on February 28, 2012 and our press release that we filed this morning, all of which are available on our website.

Some of today’s prepared remarks will discuss 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.

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

Now I’d like to turn the call over to Doug Tough, our Chairman and CEO.

Douglas D. Tough

Thank you, Shelley, and good morning and good afternoon everyone. We are pleased with our performance this quarter, especially in light of the macroeconomic challenges presented by the ongoing difficulties in Western Europe and external sales volume declines in our Fragrance Ingredients business. Despite these challenges, we were able to deliver solid top line growth and even stronger double-digit earnings per share growth due to our efforts to diversify our revenue base, focus on our customers and control our costs.

Our diversity in terms of our customers, our end-use categories and our geographic footprint allowed us to continue to grow our business this quarter and deliver local currency sales growth of 4% and on a like-for-like basis, local currency sales growth of 5%. The growth we achieved this quarter, the highest since the first quarter of 2011 is due to the momentum we have established in many areas of the business. Our global reach and our customer intimacy enable us to better serve our customers and capitalize on opportunities that are available today for market share growth.

IFF’s growth this quarter was driven by our Flavors business, which delivered 8% local currency growth on top of 8% local currency growth in the prior year quarter. The year-over-year performance reflects the balanced and the consistent nature of our business, and a strong and growing presence we have in emerging markets. We also saw growth in our Fragrance Compounds business this quarter, which delivered 6% local currency sales growth.

Solid growth in both the Fine & Beauty Care and the Functional Fragrance categories offset continued erosion in Ingredients. Nicolas Mirzayantz will provide more details on our Ingredients business later in the call. As anticipated this quarter was an inflection point for our business in terms of volume, costs and profitability and we are pleased with the results.

Raw material cost increases started to ease this quarter. However, they remain at high levels. As you know, raw material prices have been increasing for the last five quarters on average by 11% each quarter. We have been able to mitigate this inflation through pricing resulting in a more favorable relationship between raw material price increases and pricing this quarter.

Our other margin enhancing efforts including cost efficiencies and volume leverage when combined with pricing led to gross margins expanding 210 basis points to 41.8% this quarter versus 39.7% in the year-ago and 40.2% in the first quarter of 2012. Our adjusted operating profit increased 8% to $132.3 million driven by gross margin expansion and our cost management discipline. Our adjusted operating margin expanded 130 basis points to 18.3% of sales from the second quarter of 2011.

Our enhanced operating profit combined with lower interest expense and other income and expense gains resulted in our ability to achieve earnings per share of $1.08 this quarter. We are able to achieve these results off of modest top line growth due to a continued focus on margin improvement opportunities, which include the exit of low-margin business that Hernan will talk to.

We’ll now turn the call over to Hernan and Nicolas, who will provide you with an update on the progress of our business units, and then to Kevin Berryman, our CFO who will provide an overview of our financial performance. After their respective sessions, I will give you some perspective on our outlook for the balance of the year.

I would now like to introduce our Group President of Flavors, Hernan Vaisman.

Hernan Vaisman

Thank you, Doug. I am pleased to report that this quarter, the Flavor business delivered 9% local currency growth on a like-for-like basis, which excludes approximately one percentage point associated with the strategic exit of low-margin sales activities, on top of that 8% local currency growth that we delivered in the second quarter of 2011. This is our 26 consecutive quarter of local currency sales growth. This quarter, we delivered a strong growth across all regions and categories with sequential growth over the first quarter in every region. Our beverage category achieved double-digit growth this quarter while Savory, Sweet, Dairy also delivered solid growth.

In North America, like-for-like growth was 12% excluding the exit of low-margin sales activities. The best-performing category was once again beverage, which was up strong double-digit due to new exciting wins in a steel beverage and other refreshing drinks. Dairy also delivered double-digit growth in the second quarter. We also saw incremental sales related to our sweetness modulation tools. Savory also increased on a like-for-like basis of winning part to savory modulation tools as part of our health and wellness initiatives.

Within our EAME region, like-for-like growth of 8% was led by strong growth in savory. Western Europe continues to be positive territory overall, due to continued strong wins in the market and volume growth in the emerging market of Africa and the Middle East.

In Latin America, local currency growth was 6%, led by double-digit growth in Sweet and a strong growth in Dairy and Beverage. We are looking to improve our sales momentum in Latin America. Greater Asia is our largest region, and once again this region delivered a strong growth with 9% local currency growth. On a like-for-like basis, Greater Asia grew at 10%. This growth was led by double-digit growth in Dairy and high single-digit growth in Beverage, Savory and Sweet.

As you know, our Flavors business is heavily indexed in the emerging markets, which are growing a bit much faster rate than other areas of the world due to changes in disposable income and lifestyle. People in these markets are not only looking for great, authentic taste and convenience. They are looking for healthier options in the food they eat.

To better support our customers in the emerging markets, we are building new facilities in Singapore and China, and expect to be making announcement of the opening of Singapore later this year and China early next year. We continue to invest in building creative centers that expand our global footprint and put us in closer proximity to our customer base.

In June, we announced the opening of a new facility in Delhi, India to house creative, technical, sensory and sales professionals. This facility will help us to better serve our global and regional customers’ present and future needs and create the best taste for the Indian market. We have an 80 years history in India, and this investment together with our investment in Singapore and China demonstrate our faith and commitment to the region.

This quarter, Flavors in emerging market achieved double digit increase on a local currency basis for the eleventh consecutive quarter. This performance was driven by double digit local currency growth in Africa, the Middle East, Asia, as well as strong growth in South Cone and Brazil.

Turning to profit, second quarter segment operating profit increased $10 million or 13.5% to $81 million. The strong volume, driven in part by new wins, favorable mix, pricing increase, the exiting of low margin business and ongoing cost reductions, more than offset rising raw material costs and resulted in increased gross margins. Improved our gross margins more than offset increases in research, selling and admin expenses.

Operating profit margin increased 170 basis points versus the previous year to 22.3. This quarter, RSA was negatively affected by a payment to our biotech partner. As we reach a milestone in our collaboration much sooner than expected, we are excited about this collaboration and look forward to telling you more about the project as it evolves. Looking ahead, we expect to see consistent sales growth in the second half of 2012, led by continued momentum in the emerging markets, offset in part by the accelerated exit of low margin sales activities, which I expect will be more than twice the levels seen in the first half of this year.

However, our consistent underlying sales growth remains strong driven by new businesses wins, using our sweetness and savory modulation tools to make our customers’ end products healthier. We are excited of our future growth prospect.

With that, I’d like to turn the call over to Nicolas Mirzayantz, our Group President of Fragrances.

Nicolas Mirzayantz

Thank you, Hernan, and good morning, everyone. For Fragrances in the second quarter of 2012, local currency sales were flat compared with the prior year quarter. Improved pricing, new business wins and favorable product mix were offset by declining ingredients volume. We saw positive trends in many areas of the business, resulting in a sequential improvement over the prior quarter in our Fragrance Compound business.

Local currency sales gross in Fine & Beauty Care increased 4% with strong growth in hair care in all regions and in toiletries especially in Latin America and EAME. The Fine & Beauty category was up 29% in LatAm and 11% in Greater Asia. In Functional Fragrance, we saw strong growth led by fabric care. Local currency sales growth of 7% was positive for the 16 consecutive quarter as new business wins, less erosion in the base business and the realization of price increases continue to drive results.

The Functional Fragrance category was up 11% in Latin America, up 6% in Greater Asia and up 8% in EAME. Our Fragrance Compound business was up 6% overall led by strong growth in Latin America and Greater Asia. This growth reflects the strength of our strategic relationships with our global and regional customers and our long-standing presence in the emerging markets.

Sales from encapsulation technology continued to increase double-digit and supported the growth in our Functional Fragrance business. Unfortunately, we’re facing continued challenges in both Western Europe and in Fragrance Ingredients.

Our total Fragrance business in EAME had negative local currency growth due to a 4% decline in Fine & Beauty Care and 24% decline in ingredients offset in part by the growth of 8% in Functional Fragrances. Sales in our EAME region were negatively affected by the ongoing Eurozone issues and the effect of economic uncertainty and unemployment on disposable income.

Now, I’d like to say a few words on Fragrance Ingredients since this has been a concern to investors. Over the past year, we have seen continued deterioration on the external sales components of our Fragrance Ingredients business. This has prompted a thorough strategic review of our Ingredients business.

Unprecedented increases in input cost and the resulting change in both competitive pricing and our customers’ willingness to take additional supply chain risk to minimize their own input cost pressures have resulted in a change in industry dynamics. With the availability of cheaper materials from low price manufacturers in China and India, we are seeing incremental pressure on the top line, particularly in those non-patent protected ingredients that are commonly found in the marketplace.

Our strategic review and evaluation of options to improve the overall performance of our Ingredient business has confirmed that the Ingredient business has been and continues to be of strategic value to IFF due to the supply of cost advantage ingredients to our Fragrance Compounds business and the profitable sales of ingredients to external customers at acceptable margins. Overall, we have maintained our gross margin in this business even on the lower volume.

I want to make clear that we are not looking to close or sell this business based on our current views. However, changes to operating models are required. We are now developing the specifics for how we will execute against the plan that will reduce cost to levels consistent with existing realities of the market. We will be communicating further actions to you at the appropriate time, so as not to impact our competitive positioning and ability to successfully execute.

After four challenging quarters, our continued focus on cost savings initiatives and discipline, improved mix and pricing allowed us to more than offset continued although lower increases in raw material input costs. As a result of these factors, gross margins expanded over the prior year helping support gross margin expansion at the consolidated level and resulted in improved segment operating profit.

Segment operating profit increased 2% or $1 million this quarter to $64 million. Our segment operating margin expended 90 basis points to 17.7%, up from 16.8% a year ago. We expect category and geographic diversification to help mitigate continued volume declines in Fragrance Ingredients. We expect to see continued momentum in Fine & Beauty Care and moderate growth in Functional Fragrance.

We are encouraged by the pipeline of new business in our Fine & Beauty Care and Functional categories, as well as continued traction against our encapsulation technology, but we still must be mindful of potential economic weakness in Europe where economies are under pressure and in ingredients. We also expect continued margin recovery as we continue to implement further increases in pricing and focus on cost efficiencies and cost discipline.

Now, I would like to turn the call over to Kevin Berryman, our CFO.

Kevin Berryman

Thank you, Nicolas, and good morning and good afternoon, everyone. Reported revenues for the second quarter totaled $721.3 million, an increase of 1% versus the prior year quarter. Excluding the impact of foreign currency, local currency sales increased 4%. On a like-for-like basis, excluding the impact of lower margin discontinued sales activities, our local currency sales growth was 5%, reflecting improved sales trends in many parts of our global business.

As you’ve heard from Hernan, Flavors achieved high single-digit growth in every region, an 8% growth overall. This is on top of 8% growth in the year-ago quarter, which speaks to the consistency and stability of this business. Excluding the impact of discontinued business, Flavors growth was 9% led by a long list of new product wins among a diverse set of customers.

In Fragrance, the growth in Fine & Beauty Care and Functional was much improved from the first quarter, although the 6% local currency growth in compounds was offset by volume softness in Ingredients, resulting in flat Fragrance local currency sales growth for the quarter.

I want to saw a few words about our performance in Europe. We have seen some weakness in Western Europe, particularly in those countries as economies are challenged by low growth and high unemployment. Overall, our Flavors business continues to grow, but our Fragrance business, which accounts for nearly two-thirds of the volume in Western Europe, has been pressured by both the weakness in European economies as well as pressure in Ingredients.

On the positive side, we are not heavily indexed to the countries that are most under economic pressure and even though our volume is somewhat impacted, our geographic diversity has muted the impact. As you know, we have a large geographic footprint in both developed and emerging markets.

We are extremely well indexed in the emerging markets, perhaps better than any of our competitors, but we are seeing emerging market growth of 9% this quarter on a local currency basis led by very high growth in Indonesia, Singapore and Malaysia, and Vietnam. The emerging markets represented 48% of our sales in the second quarter, up from 46% of sales in the first quarter, so they continue to grow much faster than the developed markets.

Many of you have been asking about our ingredients progress and I wanted to add a few words to what Nicolas has shared with you about the strategic review. As he said, we are developing a detailed plan for making changes to our business model. I’d like to provide some insight into how that will play out over the near-term.

Due to the complexities of the business, we do not expect to see any material changes to our business in the near-term, especially in the third quarter. However, we do believe our plan will result in a stronger and more sustainable foundation longer-term.

Turning to bottom line growth, adjusted operating profit increased to 8% to $132.3 million this quarter due to pricing actions and volume gains, which more than offset increases in raw material costs and increased incentive compensation accruals.

Interest expense declined to $1.4 million in the quarter, reflecting lower levels of outstanding debt and other income, expenses improved to $1.9 million year-over-year due to favorable exchange gain and losses on outstanding working capital balances.

I’d also like to talk briefly about our second quarter tax rate. This year our effective tax rate was 27.7% versus 27.4% a year-ago. This is primarily due to a reserve adjustment related to one of our tax defaulting cases in Spain. Other provision adjustments on uncertain tax positions and the absence of an R&D tax credit in U.S. during the second quarter of 2012. Despite a slightly higher tax rate of 27.7%, adjusted EPS was still able to increase 11% to $1.08, up from $0.97 in the second quarter of 2011 when excluding restructuring and other charges of $0.04 per share in the prior year quarter.

As expected, and as we discussed on our first quarter conference call, our raw material cost increases started to moderate in the second quarter. As you can see in the slide, material costs were up 5% this quarter, and they are growing at a slower rate than in the second quarter of 2011 when they were impacted by a 12% cost increase. While increases in raw material costs are moderating, they remain at high levels.

Since the second quarter of 2011, we are seeing on average and 11% increase in raw material cost each quarter. We saw the highest increase in the third quarter of 2011. Again, we expect that raw material cost increases will continue to ease over the balance of the year.

In the second quarter, with the easing of raw material cost increases, increased realization of pricing and achievement of other margin improvement initiatives, we believe we have reached an inflection point in our gross margin percentage from both Q1 2012 and the year-ago period.

As a result, our consolidated gross margins improved to 41.8% compared with 39.7% in the second quarter of 2011 reflecting gross margin improvements in both businesses, although both remained below the gross margin pre-inflation levels of 2010. This gross margin improvement resulted in adjusted operating profit margins improving to 18.3%, up from 17% in the prior year quarter or 130 basis point improvement.

From an overhead cost standpoint, RSA expenses, as a percentage of sales increased to 80 basis points to 23.5% of sales, up from 22.7%. The increase in RSA reflects continued R&D spend of close to 8% of sales combined with planned spend in sales activities to support our growth in the emerging markets and higher pension cost. The year-over-year change in RSA is expected to increase in the second half of the year, primarily due to increased compensation accruals in the second half of 2012, over the second half of 2011.

Foreign exchange in the second quarter had an approximate 300 basis point impact on the top line, but had a lesser impact on profitability as a result of our cash flow hedging activities, which we’ve discussed in the past. Looking ahead, over 70% of our euro-dollar exposure in 2012 remains hedged at a rate near 1.39. However, given the deterioration of the euro with current rates at 1.24, we expect headwinds from foreign exchange to increase despite our hedging activities.

The full-year FX impact on our EPS is approximately $0.05 versus what we outlined on our first quarter call, when the euro was trading more in the range of 1.30. Of course, this will be affected by any change in rates throughout the second half of the year. Note also that we are nearly 50% hedged against the euro for 2013 at levels that approximate 1.30.

From a cash flow perspective, for the first half of the year, our operating cash flow increased by $133 million of the first half of 2011. This was driven by increases in net income, improved core working capital, lower incentive compensation payouts in the first quarter of the year, and lower tax payments.

As anticipated, capital expenditures increased in line with our guidance due to our investments in Singapore and China, and we expect capital spending to approach 5% of sales for the full-year 2012. Our investments in the Singapore and China are progressing well, and we will continue to be focused on supporting our strategic growth with a specific concentration on the emerging markets and the addition of new technology platforms.

Our history has proven the willingness to return cash to shareholders and our Board authorized a quarterly dividend of $0.34 per share of the company’s stock, an increase of $0.03 from the current quarterly dividend of $0.31 per share. We expect to continue to increase our dividend in line with our earnings growth while investing in attractive growth opportunities.

I would also like to make some comments regarding our recently announced settlement with the Spanish tax authorities. As a result of the settlement, we will report an after tax charge of $72.4 million or $0.88 per share in the third quarter of 2012. We have agreed to pay an aggregate amount of €86 million or approximately $106 million before the end of the year.

The settlement was the result of recent discussions and we are satisfied with the outcome. Not only does it remove much uncertainty related to our past tax position, but importantly, we were able to agree upon the key principles that will establish the company’s tax basis in Spain for 2012 and future years. We expect to formalize this agreement before the end of 2012, and believe the terms of our agreement will not have a material impact on our effective tax rate going forward.

With that, I would like to turn the call over to Doug for his perspective on the balance of the year.

Douglas D. Tough

Thank you, Kevin. Although we are pleased with our performance this quarter, we are mindful of the challenges that lie ahead related to slowing macroeconomic growth in Western Europe, the foreign exchange headwinds coming from the strengthening of the dollar versus the euro, and ongoing top line pressure we anticipate on the ingredients business. Although we’re cautious about the second half of the year, we are positive about many aspects of our business. We’ve seen strong and consistent growth from Flavors in every region and our Fragrance Compounds business enjoyed strong growth in Greater Asia and Latin America.

We have often said that our customers’ products are resilient even in a slowing economy, and we are seeing signs of this. Given the strengths of our customer relationships, based in part on our ability to provide them with valuable insights related to consumer preferences as well as our robust pipeline of innovation from R&D, we expect to continue to grow. From a top line perspective, we expect to see continued local currency sales growth in Flavors, offset in part by the accelerated exit of low margin sales activities in the second half of this year.

In Fragrances, we expect momentum to improve in Fine & Beauty Care while also maintaining solid growth in functional. In total, we believe that many parts of our business will demonstrate continued growth. The one area where we see risk to our forecast is in Ingredients as current trends remain weak on our external portfolio due to price competition on non-patented ingredients that are commonly found in the marketplace. Ingredients, although an important part of our business, accounts for less than 10% of our external sales and we want to put their performance into perspective.

We expect to see Fragrance Ingredients continue to experience top line pressure in the near term, certainly during the third quarter. Decisions that are made by our customers, based on price or anything else for that matter have long-term implications for the business and we need to adjust our business model as needed to the new insights into the current market dynamics. With regard to margin trends, we expect that raw material cost will continue to stabilize at current rates. We expect our gross margins will continue to trend above year ago levels.

With regard to earnings per share, it is our policy not to give guidance; however, excluding the impact of the Spanish tax settlement, we believe that if our business continues to perform as we expected, we will be able to deliver year-over-year earnings per share growth more in line with the current marketplace estimates. We will continue to make investments in our business, which are vital to sustain long-term profitable growth, which remains our focus. Overall, we remain cautiously optimistic in our outlook given the lagging and uneven recovery cycle for foreign exchange pressures and softness ingredients.

In conclusion, our strong performance this quarter is a result of our geographic footprint, our product diversity, and our ability to work with our customers year-in and year-out to develop new products that define the industry and delight consumers. Going forward, we remain cautiously optimistic in our outlook, given the lagging economic growth in many areas of the globe. We will proactively manage our performance and calibrate our costs in line with our top line growth as we continue to execute against our business plans.

With that, here at IFF, we would be glad to take any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) And your first question comes from Mark Astrachan with Stifel Nicolaus.

Mark Astrachan – Stifel, Nicolaus & Co.

Thanks. Hey, good morning everybody. Two quick questions. One, Kevin, on incentive comp, could you just give us an idea of what you think the headwinds will be in the back half of the year given some of the comparisons from a year ago? And then more just a broader comment, could you talk a bit about the competitive outlook for pricing over the balance of this year. And then maybe Hernan and Nicolas could give a bit of an update on how they’re thinking about it in their own businesses, especially versus some of the competition that seems to want to continue to take more pricing?

Kevin Berryman

Sure, no problem, Mark. this is Kevin. Good morning to you. Look, I think in terms of the incentive comp, the way I would direct you is to look at our second quarter numbers that is pretty much very close to a normalized level of incentive comp and that would probably be a good measure to talk to or to model out for the balance of the year, that would not be a bad assumption, assuming we could continue to perform at our level of expectations. As you know, deterioration over the back half of last year resulted in us changing our incentive comp. so there will be differences versus year ago. if you use kind of the year-to-date figures, they’re going to be pretty close in terms of what our expectations might be going forward.

As it relates to pricing, I think as you look at our total pricing for the quarter, effectively we had nearly 3% of pricing that was seen in the quarter. However, I will let you know that’s certainly skewed because of the dynamics of the Fragrance and Ingredients business. So if you look at the 3% kind of pricing number or close to it versus the 4%, it looks like the majority of the sales growth is coming from pricing. but if you eliminate the ingredients dynamic and really talk to just the effects relative to our compound business, we actually saw a greater than 50% of our growth in the compound business came from volume with, let’s call it 45% coming from pricing. So that continues to be an effort that we have been working on over the course of 2011, and there will be some subsequent discussions that continue to occur over the balance of 2012 as well, although much of the pricing has already been put in place.

Nicolas Mirzayantz

Mark, good morning, it’s Nicolas. How are you?

Mark Astrachan – Stifel, Nicolaus & Co.

Fine.

Nicolas Mirzayantz

Mark, regarding your questions about the pricing, it is important to mention that and as indicated input cost remained at high level in 2012, which required us to have ongoing discussions with our customers to capture additional price increase as needed. So we’re still engaged in price increase discussion with our customers.

Hernan Vaisman

Hi, Mark, it’s Hernan here. I mean similar comments what Nicolas mentioned, we are still in ongoing discussion with customers. Our belief is that by the end of the year, we will be at least covering the whole impact of the input cost. But having said that, I mean it still have a negative impact in the margin on a percentage basis.

Mark Astrachan – Stifel, Nicolaus & Co.

Thank you.

Operator

Your next question comes from the line of Lauren Lieberman with Barclays.

Lauren Lieberman – Barclays Capital

Thanks, good morning. Just wanted to first ask about Asia and particularly China, if you’ve seen any kind of slowing in demand or deceleration in base business volume or if it’s kind of a steady issue goes?

Hernan Vaisman

Yeah, hi Lauren, it’s Hernan. Yes. in fact, we see deceleration in the volumes; I think that is basically because I mean you have a different consumer sentiment there. Having said that, I mean we are seeing now, I mean this quarter, the sales picking up a little bit, but the overall I mean having these relationships in China, overall Greater Asia were very strong. We have a very good momentum in Southeast Asia. That’s why I mean we started believing that it’s going to keep on growing at the current rate.

Douglas D. Tough

I would say Lauren, just one additional comment, I think that the strength of the Greater Asia numbers that we have been able to show even with some slowing in China indicates the diversity of the portfolio, and the ability to continue to drive growth even when there can be specific markets that show a little bit of softening versus others. So I think that that’s a positive, relative to the ability to continue to put pretty good growth numbers up in the second quarter.

Lauren Lieberman – Barclays Capital

And then what about the same questions for Nicolas, just in terms of Fragrance in China?

Nicolas Mirzayantz

Yes. We have seen also some pressure and lower demand in China, but to really echo what Kevin was saying, the introduction of new product is in encapsulation and the diversity in the region are enabling us to deliver good growth in the region and to offset some of the softness in China at the moment.

Lauren Lieberman – Barclays Capital

Okay, great. And then just also, I was curious about sort of base business volume trend, I think erosion was a bigger issue kind of Q4 and Q1. and then it sounded like Q1 was ending and moving into Q2 the reason is you have a little bit more confident was that the win rate here are even strong, but base business volumes are stabilizing. So, how did that sort of develop through the quarter, I guess from an aggregate basis. and then where do you stand as you look into the back half? Thanks.

Kevin Berryman

I’m sorry, could you repeat the question again, Lauren?

Lauren Lieberman – Barclays Capital

Sure, yeah. So, Q4 and Q1, you guys had already been talking about an accelerating rate of wins, but that the drag on the businesses in compounds was base business was weak. So, I’m asking how that has evolved, because at the end of last quarter, you said that things looking into Q2 were looking a little bit better when you are looking at the first month of the quarter from a base business standpoint. So, I was curious about that dynamic base business volume, and the outlook for the rest of the year versus new wins?

Kevin Berryman

Thanks for the repeat. Look, the underlying volume of the business did improve in the second quarter as we expected. Wins continued to be positive, so we saw a good win, new win momentum. But we did see an improvement in the underlying volume of the existing business, which certainly helped support the improvement in the growth dynamics.

Lauren Lieberman – Barclays Capital

And was the bigger shift, was there a greater improvement in the Fragrance side of the business, I mean obviously flavors has been strong throughout?

Kevin Berryman

I think directionally, yes, but we saw improvements in both.

Lauren Lieberman – Barclays Capital

Okay, thanks.

Operator

Your next question comes from the line of Edward Aaron with RBC Capital Markets.

Edward Aaron – RBC Capital Markets

Thanks, good morning. I wanted to just start with the question on the raw materials. So, I think you’re kind of running maybe upper single-digits for the first half, and I think from last quarter, you had mentioned an expectation for the year to be kind of have a modest inflation. So, is it fair to assume that inflation will turn negative in the second half of the year on a year-over-year basis? And then can you give us any kind of early insight into how you’re thinking about the cost backdrop for 2013 in light of some of the stuff that we’ve seen with kind of the drought impacting certain costs?

Kevin Berryman

Ed, let me take a crack at that and then if any of my colleagues would like to jump in. Certainly, if you look at our year-to-date figures on the input costs, if you just assume that we’re flat over the balance of the year, we kind of get to that moderate level of input costs that we’ve been talking about over the balance of the year or for the full-year. So, I think that it’s probably too early to say at the end of the day exactly what happened on input by the end of the year, because it will depend upon the mix and the use and so on and so forth. But certainly, it’s trending in the right direction.

And then I would echo the comments of my business units, our colleagues who have talked that the input costs continue to remain at elevated levels and certainly, well above the levels of 2010 before the inflation that we saw significantly in over the course of the last 12 months or thereabout. So, certainly, we’re expecting to see that continue to improve. As it relates to 2013, a little bit early to say at this particular point in time and we’ll provide some additional guidance when the time is appropriate, but certainly the comments that we would make is, we’re continuing to see stability versus anything other than that. But it’s too early to say for 2013.

Edward Aaron – RBC Capital Markets

Okay, thanks. And then I think you had mentioned in your prepared remarks that you thought that growth in Fine & Beauty would improve in the second half of the year. Can you maybe just speak to the drivers of that? Is that more of a kind of an easier comparison issue or are there some new wins that are kind of flowing through that’s going to give you some lift in the second half?

Douglas D. Tough

I think it’s a combination of the two, but there is obviously a very good momentum in new wins, as we had spoke before, and that you have different ways of launches for the new wins and this year the majority of the wins in which we participate are more geared towards Q3 and Q4. So, we are benefitting from this new introduction to the marketplace and also another component is lower erosion levels. So the three combine are providing good level of momentum and good level of confidence for the second half.

Edward Aaron – RBC Capital Markets

And then just my final question related to FX, so I think Kevin you mentioned a $0.05 incremental headwind, is that relative to kind of what you’re expecting when you reported last quarter or is that the total impact on a year-over-year basis for the year? And then can you maybe just also help me understand $0.05 seems like, I understand that euro has weakened quite a bit but $0.05 seems like kind of lot just considering that you are about 70% hedged, so I’m just struggling with the math on that a little bit as it relates to the full year.

Kevin Berryman

No problem. Mark, look, it’s the difference in the balance of the year in terms of how the euro has changed in value relative to what we were talking three months ago. The reason is, because as you think about our structure of our cash flow hedges, those hedges are supporting investments or purchases of materials. Those materials go into inventory at the hedged levels and consequently as we get closer to the end of the year, the benefits of those hedges start to rollover into the 2013 year as opposed to seeing the benefits this year.

So effectively, if the euro continues to deteriorate in this year specifically, we’ll see incremental pressure because the hedges that are impacting our current purchases will more likely than not impact next year as opposed to this year.

Edward Aaron – RBC Capital Markets

Thanks.

Operator

Your next question comes from Jeff Zekauskas with JPMorgan.

Jeffrey Zekauskas – JPMorgan

Hi, good morning. When you look at your Fragrance business on a sequential basis, your revenues were flat and your operating profits were up $8 million. Can you parse the $8 million as to where that improvement came from? Was it raw materials? Was I don’t know a quarter of it raw materials, a quarter of it price, and then there is some cost efficiencies? How do you look at that $8 million number?

Nicolas Mirzayantz

Yes. Good morning. It’s Nicolas.

Jeffrey Zekauskas – JPMorgan

Hi, good morning.

Nicolas Mirzayantz

The improvement was $1 million to the $64 million. I think that as we have mentioned, a lot of the margin improvement initiative, cost discipline, also the restructuring benefits that we announced earlier this year, and pricing actions are all contributing to offset the continued input cost increase and deliver some improvement in operating margins.

Jeffrey Zekauskas – JPMorgan

And then, for the company generally, did your sequential prices increase in the quarter and do you expect them to sequentially increase in the third quarter?

Kevin Berryman

Yeah, this is Kevin. Yes, they did. So if you kind of look at two-year stacks of pricing, which is the way to think about it, yes, we did have higher levels of pricing in the second quarter. And given the discussion that both Hernan and Nicolas had alluded to in previous responses to questions, there is some incremental pricing that is continuing to be discussed with our customers over the balance of the year. So to the extent that those occur, those would be sequential pricing on top of the sequential pricing we have been able to realize.

Jeffrey Zekauskas – JPMorgan

Okay, and then if I can just squeeze in the last one on ingredients. The Ingredients business has contracted at a double digit rate for four quarters in a row. So the comparisons will really ease. Come the third and the fourth quarter, are you now expecting volume growth but price erosion, is that the operative dynamic or is there a different dynamic that you expect in the second half?

Kevin Berryman

Jeff, this is Kevin. I’ll take a crack and then Nicolas would like to add any additional color commentary that would be appropriate.

Jeffrey Zekauskas – JPMorgan

Sure.

Kevin Berryman

But I think as we outlined in our prepared remarks, we continue to see there will be pressure in our Ingredients business. It is certainly something that we have been incorporating into our review of the business and our actions that we are working on finalizing and developing are really embedding the most recent views as it relates to the ingredient business. So we continue to see some pressure certainly in the third quarter. There certainly has been volatility in this part of the portfolio. And Nicolas has already alluded to the fact that gross margin however has continued to be held in that business, which is a positive aspect, even with these pressures that we’ve seen on volumes. And so as we go forward we will provide additional updates into the future. but certainly, in the third quarter, we continue to expect to see some pressure.

Nicolas Mirzayantz

It’s Nicolas, as you know the dynamic in the Fragrance Ingredients are really contract commitment every six months and as we’re negotiating for the second half, some of these contracts were renewed and retained and some were not. One thing, which is important to mention is that we really elected to older margins and some of the contracts that were lost, many of them were at margin that will be value destroying or EP negative. So we’re seeing pressure for the second half of the year, and we know that margin protection was really important for us and we didn’t want to chase low margin business.

Kevin Berryman

Okay, thank you very much.

Operator

Your next question comes from John Roberts with Buckingham Research.

John Roberts – Buckingham Research

Good morning. Can you hear me?

Kevin Berryman

Yeah. Good morning, John.

Douglas D. Tough

Yes.

John Roberts – Buckingham Research

After you take your actions on Fragrance Ingredients, do you expect the external sales to remain large enough to justify separately reporting this business or do you think we might end up with it folded into both Functional, Fragrance and maybe little in Fine Fragrance?

Douglas D. Tough

I think we have to understand the full impact of the plan that we have. At this juncture, we would leave it reporting as a standalone item. and I expect we would want to continue to do that in the short-term, particularly as a function of it is very important from the Board to look at. I think the important part about this, I think is to understand how important it is within both supporting the current compounds business, but also the focus of our R&D continues to be on the development of products and molecules, which we then would sell on an external market basis and not be subject to the vagaries of commodity pricing and high volume, but lower pricing that we’ve seen. So we still see there is a bright future, we’ve done the economic profit analysis to understand how important this business is, revisiting briefly a comment that Jeff made a while ago, we did not foresee the magnitude of the shift in volumes.

So we’ve had four quarters of some softness and thought at this stage of the game, we would be coming out of that trough and comparing against an acceptable target in order to achieve growth that hasn’t happened. but that’s really what the focus is right now, but how important it is both internally and continues to be externally, despite the growth, it’s still a large part of the volume, we’ll keep the microscope on it at a very big level.

John Roberts – Buckingham Research

And then secondly, was the incentive comp accrual above budget. And did you increase the rate sequentially or it was expected to be above year-over-year and it was in-line with what you were budgeting?

Kevin Berryman

It was pretty close to budget.

John Roberts – Buckingham Research

Great, thank you.

Operator

Your next question comes from the line of Edward Yang.

Edward Yang – Oppenheimer & Co.

Hi, good morning, thank you for taking my question. First a clarification, did Kevin say that in Western Europe – your Western Europe exposure, two-thirds of that is Fragrance?

Kevin Berryman

Yes.

Edward Yang – Oppenheimer & Co.

Okay. and just an update on your currency hedges, so you have that I think 70% this year at $1.39, 50% hedged on the euro in 2013 at $1.40. So what’s the best way to think about that once those hedges all rollover and assuming the euro stays where it is? Does that mean that your base level earnings from a translation basis is, I calculated something back-of-the-envelope maybe 3% or so?

Kevin Berryman

Yeah. This is just a quick comment, you mentioned $1.40 for 2013, it’s actually $1.30.

Edward Yang – Oppenheimer & Co.

Okay, got it.

Kevin Berryman

In terms of the 50% coverage, so if the euro were to stay at, for example, current levels and we continue to layer in hedges that would obviously result and that number coming down over time, because of assuming that the rates and the futures as it relates to the current spot don’t materially change. That will translate into a lower effective number at the end of the day when we finalize with our layering end of the hedge programs. We haven’t talked specifically about what the impacts will be, but certainly our hedging program doesn’t eliminate ultimately dynamics of currency over the long-term. It certainly eliminates volatility and fluctuation, and I think that’s the way you need to think about it.

Edward Yang – Oppenheimer & Co.

Okay. And on the Spanish settlement, about $100 million in U.S., what’s the timing of the payouts there and does that affect our interest expense?

Kevin Berryman

Yes. We will be making payments. It’s expected that that money will be paid over the course of the balance of the year; probably the bulk of it is going to be in Q3, maybe most of it in Q3. We are effectively going to be able to access our revolver to make any potential payments in the short run, but as you know, we have good cash flow dynamics in our business. So at the end of the day, we’ll be able to fund the operations from our funded payment from our cash from operations. And consequently once we do that, we should be able to eliminate existing bank guarantees that are in place relative to those tax matters with Spain and certainly the payments or the interest rates relative to our revolver are quite low.

Kevin Berryman

Got it; thank you.

Operator

I am showing no further questions at this time.

Douglas D. Tough

Well, thank you very much, to all our participants on the call discussing our second quarter results, and particularly the relevant questions which came from the participants. Thanks very much and we look forward to participating with you on the third quarter call in a few months.

Operator

Thank you for joining today’s conference. You may now disconnect.

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