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International Flavors & Fragrances Inc. (NYSE:IFF)

Q2 2008 Earnings Call

July 31, 2008 9:00 am ET

Executives

Yvette Rudich - Director of Corporate Communications

Rob Amen - Chairman and CEO

Doug Wetmore - CFO

Analysts

Mike Sison -KeyBanc

Silka Koopf - JPMorgan

Lauren Lieberman - Lehman Brothers

John Roberts - Buckingham Research

Frank Bisk - Pilot Advisors

Mike Sheridan - Cobalt Capital

Operator

Good morning, everyone, and welcome to the International Flavors & Fragrances second quarter 2008 Earnings Call. Today's call is scheduled to last about one hour including remarks by IFF's management and then question-and-answer session. Today's conference is being recorded.

And now at this time for opening remarks and introductions, I would like to turn the conference over to Miss Yvette Rudich, Director of Corporate Communications. Please go ahead ma'am.

Yvette Rudich

Hello, and welcome to the IFF second quarter 2008 conference call. With me are Rob Amen, Chairman and Chief Executive Officer, and Doug Wetmore, Chief Financial Officer.

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

For additional information concerning factors that could cause actual results to differ materially from the forward-looking statements, I ask that you refer to the cautionary statement and risk factors contained in this earnings release and in IFF filings with the Securities and Exchange Commission, available on our website.

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

Here is what we are going to cover on today's call. Rob will open with an overview of our second quarter performance. Then Doug will provide a review of our Q2 financial results. Following closing comments from Rob, we will then take your questions.

With that, it is my pleasure to introduce our Chairman and CEO, Rob Amen. Rob.

Rob Amen

Thanks, Yvette and welcome to everyone. As you may have seen, International Flavors & Fragrances has reported good sales growth in the second quarter. With notable top-line gains in the world's emerging markets, where sales were up double-digits in many cases. This performance was achieved despite the lower growth in the North American market and Western Europe where the economies remain a bit of a drag on results.

Specifically, total sales were up 11%, as reported. Using local currency figures, which we believe makes for a better comparison to prior periods; total IFF sales were up 4%.

Turning to our businesses, Flavors, again, had a great quarter with sales up a strong 15% as reported and 8% in local currency. This is the eighth consecutive quarter of market share growth in that business. These results were driven by new wins, higher volume and low erosion of existing products. Our Fragrance business sales increased 8% as reported, or 1% on a local currency basis.

It's worth noting that while the Fragrance business continues to be challenged in North America, this region's sales decline improved from the first quarter. And increases in other regions contributed to the positive growth for the quarter.

Based upon what we saw this quarter, the inventory correction and Fine Fragrance we spoke of last quarter is nearing an end and we see light at the end of that tunnel. We have seen a good increase in our Fine Fragrance wins over the past six months, and expect these launches to contribute to the progress over the third and fourth quarter of this year and into 2009.

Functional Fragrance results were impacted by slower growth at a few accounts, and pulled down by erosion in a couple of others, especially in North America. Lastly, our Fragrance Ingredients business has improved as we expected a result in part of the initiatives we discussed last quarter. The Fragrance Ingredients second quarter results reflect a bounce back from the weak first quarter. And I believe a six month '08 versus six month '07 comparison is more representative of the underlying demand which shows a positive 2% growth.

Looking at the highlights of our operating results during the quarter, we saw raw material and input costs edging higher from the 4% I mentioned in the first quarter '08, to about 5% in the second quarter with transportation, energy and packaging costs contributed to the increase in raw materials.

As you can see, these increased costs are having an adverse impact on our margins. Our operating margin was 16% in this past quarter, versus 18% in the prior year quarter. This decline is attributable to first; our cost recovery has not kept pace with our escalating costs.

And secondly, we selectively increased our resource investments and staff in Eastern Europe, and selectively in Asia, to ensure we are positioned to capitalize on the growth in the markets we see there.

From bottom-line perspective on an adjusted basis, earnings per share increased 13%, when adjusting for items provided as indicated in the press release. During the quarter, we completed our accelerated stock repurchase program, or ASR, which in total enabled us to repurchase nearly 10 million shares of stock. While not a second quarter item, in July we announced a 9% increase in our quarterly dividend effective in the third quarter. Both initiatives are consistent with our commitment to returning cash to our share owners.

Now, I would like to turn the call over to Doug for more detailed review of our second quarter results. Doug?

Doug Wetmore

Thanks, Rob. Good morning, everybody. Let's begin with an overview of sales. This chart provides a breakdown of sales and growth by our two business units and as you can see, Flavors grew 15% in dollars on an 8% local currency increase. About two-thirds of the Flavors local currency growth was a result of new business won. Volume increases of existing businesses accounted for about 20% of the growth, and pricing accounted for the remainder of the Flavor sales increase.

Fragrance sales increased 8% on the 1% local currency increase, and this represents an improvement from Q1 when Fragrances declined 4% in local currency versus the prior year quarter. Q2 growth was driven by Fragrance ingredients, will Fine and Functional, respectively, declined 4% and 1% in local currency. The Fine and Functional performance was mainly volume driven, partially offset by some price increases, and the Ingredients growth was split almost evenly between volume growth and price increases.

As I mentioned in our Q1 call, in 2008 we've also begun to realign our portfolio of Fragrance Ingredients following the pricing pressure and margin compression we experienced in 2007. In the second quarter this year, Ingredients shed about $5 million of low margin products and for the first half, we've shed about $11 million of such sales.

Just speaking of the foreign currency difference between local currency and the dollar, the primary driver of that difference was the euro compared to the prior year, and in the second quarter the euro was about 18% stronger than the 2007 second quarter.

As you can see from the map, we had solid growth in each geographic region, but North America Fragrances. Having said that, North America improved over a very weak Q1 when Flavors was flat and Fragrances declined 23%. Europe reported strong growth over the second quarter last year, but quarterly sales benefited from the strength of the Euro, and sales were essentially flat in local currency for both Flavors and Fragrances. You have to have a cautious view regarding the European macroeconomic environment for the balance of this year.

Latin American sales increased 21% and the growth was particularly strong in Flavors which grew 36% in the quarter, led by new wins and strong volume of existing creations. Latin America Fine Fragrances increased 29% as sales to essentially all Fine Fragrance customers in the regions improved. Greater Asia achieved excellent growth driven mainly by new wins and improving volumes.

Asia sales increased 14% in local currency, and 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 3% in the second quarter. This pace of growth was somewhat lower than our overall growth rate and that's mainly due to the Fine Fragrance sales performance.

Now let's discuss each of the business unit performance in a little more detail. As you can see, Flavors has continued to achieve very strong sales growth, however, in Q2, profit leverage was not what it had been in the last several quarters and there were a couple of factors that impacted this. First, it was a very difficult comparison with the second quarter 2007 when operating profit increased 31% on an 11% sales increase.

The sales mix in Q2 of this year was less favorable than the past several quarters and we've had some increase in raw material costs, as Rob mentioned previously, that are beginning to flow through the P&L. And while we have achieved price increases to offset, overall operating leverage was still negatively impacted.

And finally, again, as Rob mentioned, we are investing in certain initiatives, in terms of further building and improving our creative and sales development talent in certain geographies. Those initiatives increased expenses in the current quarter, but the corresponding benefit in sales growth will be evident in the quarters and years ahead.

This chart depicts the percentage growth in Flavor sales in both local currency and reported dollars over the last three years. As you can see, the local currency sales performance for Flavors continues to excel, driven by increased wins and improving volumes. Flavors has grown 12 consecutive quarters in local currency and we're confident that such growth will continue. Again, as Rob mentioned, we've delivered above market growth for eight consecutive quarters now, increasing our market share during that period of time.

The Fragrance operating environment continues to be challenging and Fragrance profitability has suffered, however, there was improvement from the first quarter of this year. Consistent with the first quarter, each geographic region other than North America had solid growth. North America improved in comparison to the first quarter when Fragrance sales declined 23%. However, the 11% decline in North America Fragrance sales still had a marked impact on profitability for the business unit as you can see.

Volumes in North America fell sharply in Fine and Functional Fragrance compounds, and a strong 9% increase in Ingredient volume partially offset the weakness in the compound sales. The local currency sales performance have been quite strong throughout 2006 and much of 2007 for Fragrances, driven by new wins and the sustained success of existing creations. As you can see, the second half of 2007 was difficult in local currency terms, as was the first quarter of this year.

The continued weakness in North America in the second quarter was more than offset by strong performances outside the United States, notably in Asia and Latin America. The Fragrance business unit returned to positive local currency growth in Q2 this year.

Now, turning to consolidated operating results. As a summary, our sales increased 11%, resulting in a 7% increase in gross profit. As we've noted, product mix with continued weakness in Fine Fragrance and overall weakness in North America Fragrance compounds, as well as the material cost increases that Rob mentioned, were the primary factors impacting gross margin as a percentage 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 this increase. Excluding exchange, R&D would have increased about 7% versus the prior year quarter.

Selling and administrative expenses increased 15% compared to the second quarter of '07. These expenses include about $3.4 million of employees' separation costs. Excluding these costs, selling and admin expense would have increased about 11% over the second quarter 2007, and would have been 15.9% of sales, in line with last year's quarter.

Now in reconciling earnings per share, I think it's important to first set the table by reviewing the unusual items in the second quarter of 2007, and here is a reconciliation of that. You can see we reported $0.87 per share last year. In that result, we had a one-time gain on land sales, which was included in other income of about $0.04 per share, and we also had a substantial one-time tax benefit accounting for $0.11 per share. As adjusted, earnings per share for the second quarter 2007 was $0.72 cents per share.

Now moving from that $0.72 per share to what we reported for the current year, as always, we've not isolated the impact of translation, so other than for shares outstanding, exchange is embedded in each caption and there's also some rounding in the analysis. But our sales growth added $0.09 per share and the gross margin decline reduced earnings per share by $0.07 per share. This was mainly due to the margin erosion in the North America Fragrance, the mix impact and the Flavors margin decline we've talked about.

Research, selling and administrative expense, RSA expenses, reduced EPS by $0.04 per share, and the employee separation costs accounted for $0.03 of that $0.04 decrease. Other income and interest expense combined accounted for a net decrease of $0.03 per share. And this change resulted from interest expense which increased about $10 million in connection with the debt taken on to implement the accelerated share repurchase program.

The interest increase was partially offset by favorable exchange gains compared to 2007. It was about a $3 million swing in the quarter. And there were no significant asset sales in the second quarter of 2008.

Our overall ongoing lower effective tax rate favorably influenced the second quarter, adding $0.02 per share compared to last year. And then separately, we've broken out the impact of the reversal of certain reserves resulting from favorable tax results in various taxing jurisdictions during the quarter and that added $0.05 per share.

We reduced the number of shares outstanding, adding $0.09 per share. And average shares declined 11% from the year ago quarter in connection with the completion of the ASR. The company repurchased no shares on the open market in the second quarter, although as you saw from the recent press release, we did account for the completion of the ASR. Taking into account all of these components, a reported earnings per share for second quarter 2008 were $0.83 per share.

Now just to show you the impact of excluding the employee separation costs and the one-time tax benefit, this chart just identifies those two items and we come down to our reconciled or adjusted earnings per share for 2008 second quarter of $0.81per share.

Looking briefly at the cash flow. For the six months ended June this year, cash flow from operations declined about $17 million from the prior year period, and there were two main drivers that account for that change.

First of all, higher interest expense paid due to the debt taken on in connection with the ASR. Interest expense paid increased $22 million compared to the prior year period. And we also, as you can see from the statement of cash flows in the queue, a higher level of inventory purchases accounted for the use of $23 million more than last year's period. We have built up inventory of certain items and also the impact of higher purchase costs of raw materials are beginning to work their way through the financial statements.

We remain pretty tight on capital spending for the quarter. For six months capital spending is just under $30 million, although that is going to accelerate in the third quarter as we progress with the construction of our new creative center in Brazil, an expansion of ingredient facilities in China, and a new creative and administrative center in China.

We reduced debt by a modest amount during the quarter, and the overall dividend payout reflects the 10% increase announced last year, but essentially offset by a reduction in shares outstanding.

Share repurchase activity is essentially unchanged from Q1 with the sole difference being some additional shares issued in connection with equity compensation programs. But as I said, the company repurchased no shares on the open market in Q2.

Overall from a status perspective, our share buyback, year-to-date we've spent just under $30 million in share repurchase. In so doing, we've bought back about 700,000 shares and at quarter end, June 30, 2008, shares outstanding stood at just about $79 million, down 10% from the prior year quarter.

We have a remaining authorization of about $269 million at the end of the quarter and just to remind you, the ASR concluded in June 2008 at which time we received about 2 million more shares than were initially received at the time we entered into the ASR. And total aggregate shares repurchased under the ASR were about 9.7 million at an average purchase price of $46.53.

So with that, I'll turn it back over to Rob. Thank

Rob Amen

Thanks, Doug. While we're pleased with our performance this quarter, there's no denying that we faced some headwinds and we anticipate the second half of the year will hold some challenges. The external environment is very different from what it was 12 months ago or even six months ago.

For instance, the key economies in the developed world continue to slow. And while there's still solid growth in the emerging economies, there are signs in Asia of slowing growth. China, for example, is projected to have GDP growth of 8 to 9%, down from greater than 11%. Additionally, cost pressures persist and I see no signs of this abating.

As I mentioned earlier, this is having an adverse effect on our margins which we have to turnaround. We're undertaking several initiatives to offset the cost pressures we're experiencing. First, cost recovery. We have raised prices on many materials and products. However, we also prefer to work closely with our customers to recover these costs in a mutually beneficial way. One option to a price increase is to jointly reformulate products or formulas to reduce the cost impact. This may include adding substitutes or extenders to mitigate the cost increases.

Secondly, we're re-examining make versus buy. We're actively evaluating the potential to make materials that we currently buy if it is economically advantageous to do so.

Lastly, we have several ongoing initiatives to reduce our internal expense, such as the consolidation of back office functions which is going on right now and which will benefit us in 2009 as well as judiciously managing our internal costs and shifting resources from areas of lower growth to areas of greater opportunity.

As many of you recall, in late 2006, we outlined a series of three-year financial goals. We said that over the period 2007 to 2009, we would increase sales by something greater than 4% a year in local currency. Our goal was to improve operating margins to above 18% at an annual run rate as we exited 2009. Our goals were to increase earnings per share on average initially greater than 10% and then we raised it to greater than 11% per year. Our approach to dividends was to increase dividends in line with earnings per share growth.

We also indicated a goal to execute a stock repurchase plan and to pursue capability building acquisitions. Well, we're about halfway through this period, so it's a good time to reflect and to evaluate our progress. In 2007, we over delivered on our sales and earnings per share goals by increasing sales 5 percentage points in local currency and earnings per share growth of 14%.

As I look at 2008 so far, sales are up about 3% in six months, operating margins, excluding non-recurring items was 16.8%, and earnings per share have increased about 11%. So we're a little behind this year's sales goals and clearly I am not comfortable with where we are in operating margins.

As I mentioned earlier, we have increased our dividend 9% this year, bringing the total dividend increases since the end of 2006 to $0.25 per share or a 35% increase.

As Doug mentioned, we've completed the stock repurchase ASR and that means since the end of 2006, the combination of open market purchases and ASR, we have bought in excess of $600 million of stock. While we have not made an acquisition, we continue to evaluate opportunities that will bring us capability or technology we don't currently have. So on balance, we've made good progress against our goals and I feel comfortable.

I'm pleased, though not satisfied, with where we are today. We continue to chart a course to build a stronger company that offers above-average rewards to our customers, employees and our share owners. To continue to balance short-term performance with long-term goals, that's really what we're doing and that means our goal is to build a stronger, more profitable company.

We must continue to invest to meet expected growth, and that means building some new facilities to increase our creative and technical capabilities, and to allocate greater resources in areas where we have been under represented in the past, areas such as Poland and Russia. IFF's success in part will be led by the growth in China, Russia, India and Brazil. R&D is a core capability for us and remains a high priority which we will continue to stress and invest in. We continue to make progress in this area.

For instance, I am pleased with the delivery system progress we've made and the products that have been developed for the Flavors and Fragrance businesses. I believe they offer us and our customers an important opportunity to help differentiate their products in the marketplace.

Building a stronger IFF also requires we invest in our people. We continue to attract, develop and retain the best and brightest from the global community. In addition, our people need the best tools and creative resources available. Therefore, we're selectively enhancing and upgrading existing facilities such as the creative centers in Brazil, and China and in New Jersey. These investments allow IFF to provide better customer support, enabling us to improve productivity, so we can grow our market share efficiently.

In closing, I believe we have the strategies, people and products in place to grow IFF for the long-term. Now, before I open the call up to questions, I want to recognize Doug Wetmore. After a long and productive career at IFF, ten years as CFO, Doug is stepping out to pursue his dreams. I want to say thanks to, Doug for all that he has contributed to IFF over these many years and for personally how he has supported my entry into the company. Doug, you cast a long shadow and you will be missed. Thank you for all you've done.

Doug Wetmore

Thank you.

Rob Amen

Now, Matt, I think we can open up to questions.

Questions- and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question today will come from Mike Sison with KeyBanc.

Mike Sison -KeyBanc

Good morning. Certainly going to miss you, Doug, and good luck on your future endeavors there.

Doug Wetmore

Thank you.

Mike Sison -KeyBanc

My first question is, Rob you commented on slowing in North America and Europe, and you saw some progress in Fine Fragrances in terms of year-over-year sales growth in the second versus the first. You also saw some progress in Functional Ingredients. So is your sense in at least those two businesses that customer inventories are fairly drawn out?

Rob Amen

Mike, that's a good question and a reasonable conclusion. Yes, I think the issue in Fine Fragrance now has been isolated to just a couple of accounts and as I say, light at the end of the tunnel. I don't necessarily know that Fine Fragrance in North America, or Fine Fragrance overall, is going to be positive in the third quarter, but I expect it will be close. And the fourth quarter, I think we're going to show you a positive year-over-year comparison.

Mike Sison -KeyBanc

Okay. Then in Functional Fragrances, it didn't appear that there was sort of that inflection point in terms of customer destocking. Is that going to be a little bit more of a headwind heading into the third and maybe some improvement into the fourth?

Rob Amen

Well, the challenge on Functional in North America isn't so much inventories as stocking or destocking.

Mike Sison -KeyBanc

Okay.

Rob Amen

We lost some business and we haven't gotten the launches and the growth that we were hoping to achieve. Some we didn't get and some have been delayed. But I think that's not just a challenge, it's going to take three months to solve. I think I told you earlier last quarter that we've got a challenge, particularly in our fabric business in North America, and we've got to turn that around.

Mike Sison -KeyBanc

Okay. And last question, you sort of talked about raw materials maybe continuing to be a headwind in the second half of '08. It didn't seem like the squeeze was that large, I mean, in total, in the second quarter.

So can you just give us an update as how much more intense is that pressure going to be in the third and fourth quarter? And do you think the delta between your pricing or recovering the cost expands, stays the same, or actually maybe potentially shrinks as you try to get pricing?

Rob Amen

You're asking me to solve the calculus equation of inflation and pricing. Let me kind of break that down in a couple of areas. First of all, I think I've indicated a couple of quarters in a row I am concerned about the escalating input costs and that's not just purchased raw material, that's energy and packaging and freight. As we see the higher energy prices roll through all kinds of products, it's impacting us and I don't have a forecast for it. But clearly whether it's ocean freight, truck freight, packaging materials, we're seeing higher increases than we have in the past six months or so.

Raw materials are also in part reflected by currency and the dollar didn't have a great quarter and that's pushed it up. If that turns around, that could reverse. Now the other side of that is while we had initiated a number of cost recovery initiatives to raise some prices and do some things, I'm not satisfied we got enough done in the first six months and our margins narrowed. We've got to do more.

I'm not prepared to project what the third or fourth quarter change is going to be, but I'm not satisfied with suffering the margin decline that we've seen in Flavors. As Doug pointed out, it was unusually pronounced because of the strong second quarter of '07. If you take a look at Flavors on average in '07, I think their margins were about 41.5, down about 50 basis points. So they're down, but they're not down as pronounced.

Mike Sison -KeyBanc

I think in the last conference call you noted that raw materials could be up 4% or so. Is it going to be a lot higher than that or do you have any sort of - -?

Rob Amen

Mike, I think I said in the second quarter we saw 5%.

Mike Sison -KeyBanc

Okay.

Rob Amen

I think personally we're planning on it to be in the 5 or plus 5 range as we go through the second half of this year.

Mike Sison -KeyBanc

Okay. Great. Thank you.

Operator

Our next question today will come from Jeff Zekauskas with JPMorgan

Silka Koopf - JPMorgan

Good morning. This is [Silka Koopf] for Jeff.

Doug Wetmore

Hi, Silka.

Silka Koopf - JPMorgan

Good morning. I have a couple of questions. The very good growth rate in South America, is there a particular reason for it, is it like a seasonal component, is that of price increases, or do you just have very good wins and market share gains. And do you think this is a sustainable growth rate?

Doug Wetmore

Silka, they've been growing at that pace for about the last two and a half or three years. And it's been driven mainly by just an enormous number of wins and then successful volume growth of those wins. So there's a very small element of pricing in the Latin America growth. That's basically wins and volume as I mentioned in my remarks. The flavors components, Silka has been steady. They've been doing very, very well quarter-by-quarter, for an extended period of time.

The Fragrance business had a weak first quarter, which was very disappointing to us and they've come back based upon good growth. And you see it whether it's in Fine and certainly Ingredients, but we believe the economies there are strong and we feel we're in pretty good shape there. So it's not cyclical or seasonal.

Silka Koopf - JPMorgan

In terms of the margin pressure on the Flavor side, in your comments you said that there has been mixed changes in Flavors. Is that a geographic mix change or a product mix change and which products or regions are the lower margin ones?

Doug Wetmore

It's more of a product mix change and it's not specific to any geographic region, but I think one of the other elements, Rob mentioned the cost of materials going up and we also just in North America while the impact was more pronounced in fragrances because of a decline in sales, the benefit of absorption, obviously, is much better with stronger sales growth. And while we're pleased with the 3% in Flavors, we'd obviously get much better profit leverage if we had stronger Flavors growth in North America.

Silka Koopf - JPMorgan

And then lastly, can you just talk a bit more, what is happening in the Functional Fragrance business? If I look at the North American/European business, I understand there's maybe some lost business and some delayed launches, but these numbers seem sharply negative from what I remember. And so I was just trying to understand what changes are happening there.

Doug Wetmore

I think if you go back and you talk about it, the Functional in North America was roughly the same in the first quarter. Europe had a good first quarter and the second quarter has slowed, so Functional, it's not that different. I've indicated now we're struggling a little bit in our Fabric Care area.

We've seen some of our customers' demands have been a little bit lower where we've had good wins. I think there's not one answer to it. We've got to get North America fixed. We've got to get Europe ramped up a little bit stronger and this is a key product area for us. I think our goal is to certainly improve off of where we are. We're going to turn it around. But this does take a while. I mean this is a big, tough business and I'm more confident that the future comparisons are going to be better.

Silka Koopf - JPMorgan

Thanks very much. Best wishes to Doug and I'll get back into queue.

Rob Amen

And, Silka, while in the context of JPMorgan being on the line, Jeff's report earlier today highlighted a gain on sale of assets and quite frankly, so that everybody hears it at the same point in time, the bulk of that is attributable to the amortization of the gain of a sale of the New York office and our New Jersey facility several years ago where that gain is spread over the initial term of the lease. So that gain was in both 2007 results and 2008 results. It just gets offset by other things and we actually had a slight loss on some disposal of assets. So if you're working your models, I would exclude that $0.01 adjustment that Jeff had in his initial write up.

Silka Koopf - JPMorgan

Thank you for clarifying.

Operator

(Operator Instructions) Our next question will come from Lauren Lieberman from Lehman Brothers.

Lauren Lieberman - Lehman Brothers

Thanks, good morning.

Doug Wetmore

Good morning, Lauren.

Lauren Lieberman - Lehman Brothers

I guess the first question I had was your outlook overall on consumer products industry volume growth. So everything that you've really spoken about so far is more about new business wins or losses rather than the fact that there is a lot of pricing taken by your customers and that is resulting in slower volume growth. For example, Unilever reported this morning with pretty good revenue growth, but it was primarily pricing. To what degree are you building in that to your thought process over the next couple of quarters as consumers react to cost inflation?

Doug Wetmore

Good question, Lauren. I know that's been a concern of yours. We're still studying the customer releases. We've seen some very good volume growth at some customers, less at others. We haven't adjusted enough to give you an answer. Clearly when we work on our forecasting with them, we're trying to get into it, but underlying it I think there are going to be challenges in North America.

I think everybody is familiar with the pressure on consumers in North America and increasingly in Europe, and I think you need to stratify where they're seeing the growth and what's driving it. So I can't answer for all my customers and I don't have it all there.

Clearly one of the reasons we want to work with our customers to mitigate the cost pressures is we don't want them just raising prices because we don't want to facilitate demand destruction. If we can help them not have to raise prices, I think it's better for everybody and that's where our technology on replacers and extenders comes in.

Lauren Lieberman - Lehman Brothers

Okay.

Doug Wetmore

So I can't give you an honest answer because I haven't factored all that in.

Lauren Lieberman - Lehman Brothers

Okay. And then on Western Europe Fine Fragrance, you've spoken a lot about US, seems like there's light at the end of the tunnel. Haven't seen much impact on European Fine Fragrances yet and wonder if you'd comment on what you thought inventory levels were like there. And demand, how that is shaping up for the second half.

Doug Wetmore

We don't really break out Fine Fragrance, but overall I would say the outlook in our European Fine Fragrance business is as positive as the total. I mean they did not have a great second quarter as the inventory cycle sort of rolled through there, but I also feel that the period ahead is going to be more positive.

Lauren Lieberman - Lehman Brothers

Okay. And then in Doug's remarks, you mentioned that your inventory was up a bit in the first half of the year. One, definitely in commodity inflation and currency, I understand that impact. But I thought there was a mention of physical inventory billed and was curious what the reasoning was behind that?

Doug Wetmore

I think overall some of it was the timing of purchases and that was actually in the context of my comments on the cash flow, Lauren, where we used about $23 million more year-to-date this year compared to last year. And some of that just had to do with timing of purchases and there were a couple items like, Patchouli, which we've talked about in the past, that had a run-up in price last year where we actually ate into some of our safety stocks, which we hold for just such emergencies and didn't purchase, but now we've resumed repurchasing. So it's basically a timing. Overall, our inventory days are pretty much constant, about 131 days this year compared to 133 days last year for the same six-month period.

Lauren Lieberman - Lehman Brothers

Okay. Great. And then just one further one and then I'll jump back in the queue. We've been thinking about dollar cost savings really accelerating, mostly in the second half, but a little bit this quarter, even starting with some of the headcount reductions that you did in Q1. Can you quantify how much the savings were this quarter or what you're expecting for the full year?

Doug Wetmore

Do you mean regarding the outsourcing?

Lauren Lieberman - Lehman Brothers

Yes.

Doug Wetmore

Yes, well the second quarter there was very little. We may have actually had some incremental costs because we were running parallel because we've begun the transfer in North America and several European locations. But the learning and the training before that transfer was primarily done in the second quarter. And the actual transfer began in July where the transactions are being accounted for by TCS.

So you'll see a little bit of a benefit in the third quarter as we eliminate the positions in the United States and a couple of the locations in Europe. You'll see a little bit more incremental benefit in the fourth quarter, but really the payback accelerates sharply beginning in the first quarter of 2009.

Lauren Lieberman - Lehman Brothers

Okay. The one-time expenses in SG&A, SG&A was pretty good, so I was just wondering if there were any notable cost savings in there.

Doug Wetmore

No. I think we're getting some of the benefits of some of the initiatives we've undertaken in the past and as we've talked and as we've said on last calls, there's no silver bullet for us in terms of one action gives us $10 million or $15 million or $20 millions dollars of savings. There are just a number of other initiatives that have been undertaken such as closing off the pension plan in the United States and a number of other initiatives, as well as just really leveraging the benefit of SAP on a global basis.

Lauren Lieberman - Lehman Brothers

Okay. That's great. Thank you so much.

Doug Wetmore

Thank you.

Operator

(Operator Instructions) Our next question comes from John Roberts with Buckingham Research.

John Roberts - Buckingham Research

Good luck, Doug.

Doug Wetmore

Thanks, John.

John Roberts - Buckingham Research

This may be the last time I can cap your historical perspective. But does the US/ European slowdown feel like a normal economic cycle impact on your business or does it feel somewhat different than what we've had in the past?

Doug Wetmore

I'm not that old.

Rob Amen

Let me get you your slippers, Doug. It's a little bit early to say. I was in Europe last week and I mentioned in my comments, I think you have to be a little bit cautious about Europe during the second half of this year because there is a sense, and obviously it's in the financial press and so forth, that there is some evidence of slowing down, but how much and for how long remains to be determined. I think we'll only know that with the fullness of time.

But I think we are in kind of uncharted waters with this macro economic slowdown and just a question of the delinking and all the other global factors. I just don't have an answer for you.

John Roberts - Buckingham Research

Do you track mix within your product categories and maybe even across them? I don't know if you have many customers that might go from buying a Functional compound to buying an Ingredient and doing compounding themselves. Or even within Functional Fragrance compounds or Flavors, where they might trade down to a more simple compound from something more complex?

Rob Amen

We own the formulas and the customer doesn't know the formulas. So it's very difficult for them to, say, begin buying ingredients from us and then do some of the compounding themselves. But every customer is different and some might trade down, some might use less fragrance, some might use the opportunity to gain share by using more fragrance. So you've got the full gamut, but we track the mix on a very detailed basis. What we share publicly is Fine Fragrance, Functional Fragrance, Ingredients and then Flavors, but there's several categories in Flavors and then within Fine and Functional, there's Fabric Care and Personal Care and so forth. I don't see us in the future providing a further breakdown.

John Roberts - Buckingham Research

But you don't think mix effect is not a big factor going on here?

Rob Amen

No. We work with our customers. If the cost pressures are such, we work with them constructively if we need to reformulate to take out costs, or they're changing base materials in the Functional material, we have to reformulate to deal with that. But typically, the fragrance or the flavor is really an important element of that brand. So, someone's not likely to shift that too much because it really would leave the consumer confused. But if they are facing cost pressures, we work with them to deal with their cost issue, but do it in such a way that it doesn't disrupt the perception of that product in the market.

John Roberts - Buckingham Research

Lastly, does Unilever's exiting of the North American detergents business, is that just a change in ownership and will have no impact to you or is there something there we need to think about?

Rob Amen

We don't comment on customer's activities, but this isn't entirely new. People have dealt with it. I think it will be a shift. Our role is to support the brand growth no matter who owns the brand and we'll continue to support whatever customer's brand teams.

I think the other thing too is it takes some time to transition in any case. So whoever has the fragrance business for pieces of that business, it would not be a near-term of the next month or two where you would suddenly see a change. And secondly, I think to the extent that [Huish] bought the business, they're buying it to grow it and to the extent that you're in, you have a fragrance in those brands, it may be very opportune because they're committed to growing that business.

John Roberts - Buckingham Research

Thank you.

Rob Amen

Matt?

Operator

And our next question will come from Frank Bisk with Pilot Advisors.

Frank Bisk - Pilot Advisors

Hi. Good morning. Could you just talk a little bit more about pricing and how you would get pricing in both segments? Is it in the contract? Kind of just walk me through that. Since [rows] are going up, if you can't reformulate with your customer and you do need to get pricing. How does that work?

Doug Wetmore

It varies. Every customer is different. No one ever likes to have a price increase. It can be very difficult negotiations. But I think in this environment, many of our customers understand because they're facing many of the same issues. And it may be in the one extreme, just an absolute increase in the invoice price. But as Rob mentioned earlier, there may be other variations where we work together with the customer to reformulate to attempt to take costs out or to otherwise improve profitability. So it runs the full gamut.

In the quarter as I mentioned in my comments, about 20% of the growth in Flavors was due to price increases. And we had some price increases in fragrance compounds as well. And then about half of the growth in ingredients in the quarter was attributable to pricing and the other half was attributable to volume. So you really run the full gamut.

Frank Bisk - Pilot Advisors

Okay. Thank you. And then lastly, I guess the fabric business that you're talking about in Fragrance, can you just give me a little more color as to kind of what's going on? You mentioned that, I guess, you won some new products, but those aren't doing well. We lost share, is that what happened or --?

Rob Amen

It's a combination of things. Some products that we thought were going to ramp up faster have come up slow or slowly. As products are withdrawn, as they go through their life cycle, we can lose that, that's through erosion. Erosion of existing business comes from either the product being pulled or selling less, and the demand for that is typical in consumer products. We had indicated we had struggled. We had lost some business in our key account.

So yes, we've lost share in fabric. I mean you couldn't be down these numbers and not having lost share and we have a fundamental program underway to get that turned around in a big way.

Frank Bisk - Pilot Advisors

Okay. Thank you.

Operator

We'll now take a follow-up from Mike Sison with KeyBanc.

Mike Sison -KeyBanc

Hi, guys. Rob when you think about your operating margin goal of 18% plus by 2009, you're a little bit behind as you noted for '08. What needs to happen do you think, heading into '09 to get there?

Rob Amen

Well, it's clear. We have got to restore the operating margins. That's the key thing. We've got to restore our pricing spread. The growth has been about what we anticipated. A little greater growth would help. The internal initiatives are coming along maybe a little slower than we originally envisioned, but they're coming along

So I think it is largely we've got to restore our gross margins if we're going to get the operating margins back in there. And I think this year we're averaging about 16.8. And we're behind where I would like us to be. I'm concerned about it. The business leaders and I have had lengthy discussions and analysis of what do we need to do to get that restored. While I am comfortable overall on where we are against our financial goals, the operating margin I have to say is the one that is lagging.

Mike Sison -KeyBanc

How much progress do you think you'll make some progress this year year-over-year, or is it sort of a tough year to make progress in and you get a bigger ramp up in '09?

Rob Amen

It would be fool hearty of me to say, yes, we're going to make progress. We've destroyed operating margin a little bit in the first half of the year by suffering the raw material and not getting the full recovery of that. So to make progress, we'd have to more than make that up.

Mike Sison -KeyBanc

Right.

Rob Amen

I don't think that's likely. I mean I think progress is maybe made in small steps and we are not abandoning the goal. I think it's going to be a stretch, but we're not abandoning the goal.

Mike Sison -KeyBanc

Okay. Then I just wanted to get a better feel for the raw material outlook for this year. I mean is it a case where you're looking for 5% plus and that the petrol side is up like everybody else, 30%, 40%, 50%, 60% and the natural product side is sort of down?

Rob Amen

It is such a mixed bag, Mike, we're buying about 10, 000 different raw materials and there are, in fact, a number of materials that are down because they're agricultural products and they're more driven by the volume of the crop rather than inflationary prices that obviously, you know, the petro, as an example. So we track costs very closely and what we're telling you is what we're seeing it based on our latest estimate on a weighted average basis for the materials that we use. And that ties in partly to the inventory strategy.

One of the reasons we carry the inventory we have is to insulate us from some of the short-term swings or to mitigate those cost pressures, at least for some period of time. And that works in part, but it's such a big portfolio of materials, we look at it and the average weighted increase is something greater than 5% as we look out over the balance of the year. And we're not happy with that.

And I think, too, remember, you mentioned petro and petrochemical byproducts. And we buy about ten or 11 byproducts and overall, that petrochemical related spend is about 10% of our raw material spend. So the 30%, 40%, 50% increase in petro products that you referred to basically translates down to an impact of 3%, 4%, 5% on our raw material spend.

Mike Sison -KeyBanc

Okay. And then lastly, on encapsulation, isn't that business recorded in Fabric Care? As I recall that business is doing okay this year, right? You're seeing the growth that you had hoped for?

Rob Amen

Well we've seen the launches we've hoped for. Actually, the second quarter didn't develop as well because as we look back, there was more inventory stocking on the customer's part in the first quarter. But it's developing well and quite honestly, all of the encapsulation products are getting more attention in the marketplace. And I'm hoping that we're going to start to see an acceleration of commercialized encapsulation.

Mike Sison -KeyBanc

So when an encapsulation product hits the shelves, does it replace something in year one and then maybe the incremental improvement in sales and profitability because of the destocking doesn't occur until year two? Is that sort of the way to think about it?

Rob Amen

There's not enough data there. The things we've launched are a couple of different countries, a couple of different products. There's not enough data to draw those kinds of conclusions, Mike.

Mike Sison -KeyBanc

Okay. Great, thank you.

Operator

We'll now take a question from [Mike Sheridan] with Cobalt Capital.

Mike Sheridan - Cobalt Capital

Good morning, guys. Just had a quick question on the price of CST and availability. I heard a rumor that some of the providers were trying to push through large price increases and/or take it off the market, if you could just comment.

Rob Amen

Well, as you know, CST is getting to be used in any number of ways and largely the pricing of it is driven by its chemical value or in thermal value because if it's not a satisfactory price, the paper mill will burn it. And CST has gone up with energy prices. But at this stage, we've got good availability. It's costing us more, but we have availability.

Mike Sheridan - Cobalt Capital

Okay. So you don't see any back half adjustment? It was kind of my impression that they were trying to get pricing kind of last quarter maybe talking to buyers in the last quarter. You don't see any real changes in the margin?

Rob Amen

No, let me be clear. Prices of CST have gone up.

Doug Wetmore

They have gone up. They actually went up in the latter stages of last year.

Mike Sheridan - Cobalt Capital

Okay.

Doug Wetmore

And they have not moved measurably above what they did last year. They have crept up a little bit further, but not by any order of magnitude.

Mike Sheridan - Cobalt Capital

So I think they were up like 20% and what I had heard was potentially 75%. But I think that was when crude was $1.40, and it's also from a guy who's selling it.

Rob Amen

At that stage, you have complete destruction. For people not familiar, CST is the base material where we pull a lot of things out, but primarily things with a pine fragrance and that's distilled at our chemical plant in Jacksonville.

Mike Sheridan - Cobalt Capital

So you guys view it as you have to have a view on energy to know where CST is going and that's kind of what's changing, I mean it's the same equation it's always been?

Rob Amen

If you back it up, CST comes from brown paper mills.

Mike Sheridan - Cobalt Capital

Okay.

Rob Amen

Linerboard mills are running pretty full in the United States because of export. There's a good quantity of CST, but if you want to get it, you have to pay at least a thermal value and that's the market price.

Mike Sheridan - Cobalt Capital

Great. Thanks very much.

Rob Amen

Okay. Matt?

Operator

All right.

Rob Amen

I think the time has come. We really do appreciate everyone's time this morning and, Doug, anything more you want to say?

Doug Wetmore

No. Thanks for a wonderful ten years and if you have any more questions or follow-up questions, I'll be in the office through the balance of today. But catch me today; I'm on the golf course tomorrow.

Operator

And that does conclude today's teleconference. We would like to thank everyone for their participation, and wish everyone a great day.

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Source: International Flavors & Fragrances Inc. Q2 2008 Earnings Call Transcript
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