At this time, I would like to welcome everyone to the International Flavors & Fragrances Third Quarter 2012 Earnings Conference Call. [Operator Instructions] I would now like to introduce Shelley Young, Director of Investor Relations. You may begin.
Thank you, operator. Good morning, and good afternoon, everyone, and welcome to IFF's third quarter conference call. Earlier today, we issued a press release announcing our third 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 1 year on our website.
Before turning the call over to Doug Tough and our senior management team, I'd like to read our forward-looking statement. Please keep in mind that during this call, we will be making forward-looking statements about the company's performance, particularly with regard to the fourth quarter 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; Nicolas Mirzayantz, our President of Fragrances; Hernan Vaisman, our President of Flavors; and Kevin Berryman, our Executive Vice President and CFO.
Now I'd like to turn the call over to Doug Tough.
Douglas D. Tough
Thank you, Shelley, and good morning, and good afternoon, everyone. Our focus on the call this morning is a review of our third quarter results and a short discussion on our outlook for the remainder of the year.
As a company with significant operations in New York and in New Jersey, we are very well aware of the impact that Hurricane Sandy has had on people in the area. Our thoughts and our prayers go out to everyone who was affected by this storm, including our own numerous employees in the region.
The solid growth we achieved this third quarter is due to the strategic priorities we have implemented over the past few years to deliver profitable growth, by improving the profitability of our product portfolio, strengthening our innovation platform and leveraging our geographic reach. You have heard us say many times that the diversity of our business model, in terms of geographies and use categories and customers, helps to provide us with stable results in good times and bad.
This quarter, we are seeing the cumulative effect of our strategy, combined with the diversity of our business model, resulting in solid momentum and strong growth in both Flavors and Fragrances even with ongoing economic uncertainty in many parts of the world. We are very pleased with our progress and encouraged by our results and believe we are on the right path.
Both our Flavors and Fragrances Compounds businesses delivered strong top line growth and margin recovery this quarter, and we saw strong contributions to overall profitability from both our businesses.
For the total company, we delivered top line local currency sales growth of 5%, which is the highest quarterly sales growth we have seen since the first quarter of 2011. On a like-for-like basis, which excludes the impact of the exit of low-margin sales activities, our local currency sales growth was, in fact, higher at 7%.
This quarter, we continued to execute on our plan to exit lower-margin sales activities in Flavors. We also saw a better mix of business, both in the developed and in the emerging markets.
As expected, we are seeing lower increases in raw material costs, although they remain at elevated levels and we continue to take pricing. These factors, in addition to ongoing manufacturing efficiencies and other elements, such as product mix and new business wins, resulted in gross margin expansion of 350 basis points this quarter to 42.5%, up from 39% in the prior year quarter.
Our adjusted operating profit increased $6 million, or 5%, to $164 million -- $134 million in the third quarter compared with $128 million in the third quarter of 2011. Also, our adjusted operating profit margins expanded 100 basis points this quarter to 18.9% compared with 17.9% in the year ago quarter.
In the third quarter, we reported earnings per share of $0.20 per share. The GAAP number includes an $0.88 charge arising from our settlement with the Spanish tax authorities earlier in the quarter. Excluding this charge as well as the $0.01 per share reversal of a restructuring charge in the prior year quarter, our adjusted earnings per share increased 8% to $1.08. This quarter marks the second consecutive quarter in which we were able to deliver solid EPS growth on an adjusted basis despite the challenging economic environment. We are pleased with our performance this quarter and with the favorable trends we are seeing in both our top line and bottom line growth.
I will now turn the call over to Nicolas and Hernan, who will provide you with an update on the progress of our business units, and then to Kevin, our CFO, who will provide an overview of our financial performance. After their respective sections, I will give you some perspective on the outlook for the balance of the year. With that, I'd like to introduce Group President of Fragrances, Nicolas Mirzayantz.
Thank you, Doug, and good morning and afternoon, everyone. We are very pleased with our progress this quarter. We achieved solid results in many areas of the business, and overall trends are improving. Our ability to execute on our plan is illustrated by both our top line growth as well as our recovering profitability.
In terms of our sales performance, we saw accelerating growth in many areas of the business. Local currency sales growth for the Fragrance business was 5% in the third quarter. Fragrance Compounds grew by 9% in local currency, fueled by 10% growth in Fine & Beauty Care and 8% growth in Functional Fragrance. We attribute our success to the strength of our strategic relationships with our customers, our knowledge and insight into consumer preferences and our ability to provide superior product that meet customer needs.
I want to focus on some of the positive trends we are seeing, and there are many. Over the past 3 quarters, Fragrance Compound local currency sales growth has accelerated in every quarter. We grew from the 1% decline in the first quarter to a 6% increase in the second quarter to a 9% increase in the third quarter. This growth in Fragrance Compounds was led by 17% growth in Latin America, 8% growth in North America and 7% growth in EAME. We are very encouraged by the results that we're seeing. In terms of drivers, Fragrances' growth this quarter was driven by a strong pipeline of new wins, continued pricing and lower volume declines on existing business.
On a category basis, Fine & Beauty Care achieved 10% local currency sales growth, led by strong performance in Fine Fragrance and Toiletries. This quarter, new launches in Fine Fragrance included La Vie Est Belle from Lancome; Balenciaga's Florabotanica; Yves Saint Laurent's Manifesto; Taylor Swift by Elizabeth Arden and Donna Karan WOMAN by Estée Lauder. These are just a sampling of the high-profile launches in Fine Fragrance.
Toiletries also performed very well, reflecting major wins with global brands, led by strength in Latin America and EAME.
Functional Fragrance local currency growth of 8% marked the 17th consecutive quarter of positive sales growth in this category. The solid growth was driven by continued strong momentum in Fabric Care and double-digit growth in Personal Wash.
Growth in both end-use categories was driven by strong growth in Latin America and North America, as well as growth in Greater Asia. The growth was also supported by increased sales using our proprietary encapsulation technology.
Given the strong growth we are seeing in the emerging markets, we are adding manufacturing capacity and sales and creative infrastructure to support our growing emerging market footprint. In early September, we announced and celebrated the opening of a new state-of-the-art liquid Fragrances and Flavors manufacturing plant in Jurong, Singapore. This is part of the $100 million investment in Greater Asia and replaces an existing facility.
Turning to Ingredients. As expected, local currency sales declined by 12% due to continued volume losses in commodity products. As we've been communicating, we remain focused on finding ways to revise our participation strategy in Fragrance Ingredients given the new realities of the market and the competitive dynamics. Although year-over-year trends are improving, we expect to see a moderate year-over-year decline in the fourth quarter.
To offset the impact of high raw material costs on our customers, we have been proactively working with some of them to change their product formulas. Due to our vertical integration and expertise, we're able to work with them to find more sustainable alternatives. As a result, we expect to see some volumes transfer from our Fragrance Ingredient business to our Fragrance Compound business beginning next year. This volume transition supports our customers and IFF Compound business, creating a win-win situation. We will provide more insight early next year on the expected top line impacts, which are not expected to be material on a consolidated basis.
As you probably are aware, we report on only the external portion of our Ingredient business, which is roughly 50% of the total Ingredient business. The remaining volume is comprised of internal supply, which are ingredients that we make and use in our Compounds plants. This part of the business continues to grow as we use more IFF ingredients in our internal creations and new wins, and this increased volume is reducing the pressure on absorbing the fixed cost of our Ingredient plants.
Although we achieved local currency sales growth of 5%, our reported net sales declined 1% due to the weakness of the euro and other currencies related to the U.S. dollar versus a year ago. Strong operational performance allowed the Fragrance business to more than offset this foreign exchange pressure, resulting in an 11%, or $7 million, increase in Fragrance segment profit to $65.3 million in the third quarter.
Our continued focus on cost savings initiatives and financial discipline, combined with an improved mix of business and continued pricing to offset higher raw material costs, enabled us to achieve margin recovery this quarter. Fragrance segment operating margin expanded 200 basis points to 17.7%, up from 15.7% a year ago.
Fragrance gross margin recovery supported gross margin expansion at the consolidated level. It should be noted, however, that on a year-to-date basis, margins continue to be pressured by increased input costs, which remain at or near historical highs. To offset this dynamic, we continue to focus on cost savings initiatives, including our Q4 2011 restructuring program, and maintaining a disciplined approach toward cost management.
In the fourth quarter, we expect to see continued momentum in our Fragrance Compound business in both Fine & Beauty Care and Functional Fragrance, supported by growth in every region. We are encouraged by the pipeline of new business wins in our Fine & Beauty Care and Functional categories, as well as the continued traction with our proprietary encapsulation technology.
We continue to closely monitor Ingredient volume trends and believe that we will see improved volume trends in the fourth quarter, although still negative.
With that, I would now like to turn the call over to Hernan Vaisman, our President of Flavors.
Thank you, Nicolas. Good morning and good afternoon. This is our 27th consecutive quarter of local currency sales growth. On a like-for-like basis, over the last 3 quarters, we have delivered local currency sales growth of 6%, 9% and 9% on top of the 9% growth for the third quarter of last year.
We are proud of the -- our results and our ability to consistently deliver strong growth metrics.
This quarter, as expected, the exit of low-margin sales activities accelerated, which had a 3-percentage-point impact on Flavor sales growth, but a favorable impact on segment and company margins.
Once again, we delivered strong growth in every region and every category. Our growth was led by a strong pipeline of new business wins in Beverage and Dairy, both of which achieved double-digit growth. On a like-for-like basis, Savory and Sweet also delivered solid growth in this quarter.
Our results were supported by 10% growth in the emerging markets. Our like-for-like growth in North America was 6%. Beverage and Dairy were once again the 2 best-performing categories and delivered double-digit growth. We also saw solid growth contributions from Savory and Sweet, owing in part to our savory and sweetness modulation tools.
On a like-for-like basis, our EAME region delivered local currency sales growth of 13% led by strong growth in Dairy. EAME was our best-performing region this quarter. Western Europe continued to deliver solid performance with a strong volume growth from wins offsetting volumes declining on existing business. In addition, we are also delivering strong growth in the emerging market of Africa and the Middle East. Greater Asia, our largest region, delivered strong 8% local currency growth. On a like-for-like basis, Greater Asia grew at 9%. This growth was led by double-digit growth in Dairy and high single-digit growth in Beverage, Savory and Sweet. In Latin America, local currency growth on a like-for-like basis was 6%, led by double-digit growth in Savory and positive growth in Dairy and Beverage. Although we have made progress in this region, we continue to work with the customer to improve our sales momentum in Latin America.
Due to our continued growth, we are making additional investment in the business to support our future growth. As Nicholas mentioned, in September, we opened a new plant in Singapore that manufactures both flavors and fragrances. We are also beginning a new manufacturing facility in Guangzhou, China, which will be exclusively focused on Flavors. This plant is expected to open in the first quarter of 2013. Both the Singapore and China plants are essential to aligning our infrastructure to support our projected capacity requirements in Greater Asia.
Last month, we announced our plans to invest over $50 million in Gebze, Turkey to expand on our existing manufacturing site and build a new leading-edge creative facility. Turkey offers an unparalleled strategic hub into the fast-growing emerging market in the region that will allow us to significantly increase and differentiate our value proposition to our customers. We expect to invest significantly in our Flavors creative and manufacturing capabilities in Turkey, which will provide additional support to key emerging markets.
This quarter, although our Flavors business achieved local currency sales growth of 6% on a reported basis, our net sales were flat due to the weakness of other currencies versus the U.S. dollars versus the year-ago quarter. Importantly, operating performance in our Flavor business more than offset these foreign exchange pressures.
Our gross margin recovery at the segment level supported gross margin expansion at the consolidated level due to volume gains for new business, the accelerated exit of lower-margin sales activities and more favorable category mix, which more than offset higher input costs and investment to support growth initiatives, resulting in 150-basis-point increase in our segment operating margin to 22.4%. This translated into a Flavors third quarter segment profit increase of $5 million, or 7%, to $76.1 million. We continue to make investment in Research & Development to support the future growth of the business and provide our customers with the leading-edge technology and product quality that they expect from us.
Looking ahead, we expect to see continued sales momentum in the fourth quarter of 2012 led by strong growth in the emerging markets, offset in part by the accelerated exit of low-margin sales activities.
Our consistent underlying sales growth remained strong, driven by new business wins using our sweetness and savory modulation tools to make our customers' end products healthier. We are excited about our future growth prospect.
With that, I would like to turn the call over to Kevin Berryman, our CFO.
Kevin C. Berryman
Thank you, Hernan, and good morning and good afternoon, everyone. I would like to put our financial performance into context since it is a direct result of the actions we've taken to improve the profitability of our portfolio, harness the growth of the emerging markets and create innovative and appealing new products that will help our customers to win new business and obtain market share growth.
Reported revenues for the third quarter totaled $709 million. Although sales decreased on a reported basis, on a local currency basis, they increased 5%.
The 600-basis-point foreign currency impact reflects the strong U.S. dollar relative to other currencies versus the year-ago quarter.
On a like-for-like basis, excluding the impact of the exit of lower-margin sales activities, our local currency sales growth was 7%, reflecting strong growth in both businesses, across geographies and categories. Approximately 70% of this growth was volume related with a balanced pricing.
As you've heard from Hernan, Flavors continued their steady cadence of positive growth, which speaks to the consistency and stability of the Flavors business. This quarter, Flavors delivered 6% local currency growth. And excluding the impact of the exit of lower-margin sales activities, they delivered growth of 9%.
Our Fragrance business delivered overall local currency sales growth of 5%, reflecting strong underlying trends in many areas of the business. Importantly, Fragrance Compounds delivered local currency sales growth of 9% and increased segment profitability, reflecting cost savings initiatives, improved category mix and the net impact of increased prices and lower increases in raw material costs.
Overall, our strategic priority of leveraging the growth in the emerging markets is producing favorable results. We're seeing continued double-digit local currency sales growth in the emerging markets, which has made significant contributions to the top line of both businesses, with a growing global middle class and the desire for, and availability of, products that consumers use in their everyday lives. We are very encouraged by the growth we are seeing and have made targeted investments in various areas of the globe in order to be able to continue to participate in this growth for the foreseeable future.
As we have mentioned in the past, we operate in a global environment that has seen varying degrees of economic momentum. Over the course of the year, we've spoken about slowing economic growth in Western Europe and China, and we've been closely monitoring our progress in both regions. This quarter, on a consolidated level, we saw improving trends in Western Europe driven by our Flavors business. But we continue to see some softness in Fragrances driven by Fragrance Ingredients. Both Flavors and Fragrances showed solid growth in China.
From a top line perspective, we are pleased with our underlying growth, which led to increased margin recovery and profitability. Our gross margins expanded to 350 basis points that has been alluded to previously, to 42.5%. The improvement was primarily due to an improved mix of business in both Flavors and Fragrances, increased volume from both businesses, the exit of lower-margin sales activities in Flavors and ongoing manufacturing efficiencies. These gains, along with pricing actions, more than offset increased raw material costs.
Research, selling and administrative costs increased 11% or $17 million this quarter. The increase was primarily due to increased incentive compensation accruals this quarter versus the year-ago quarter, when provisions were lower than target. In addition, we also had increased pension costs and investments behind growth initiatives. Importantly, our strong gross margin recovery more than offset these increased RSA expenses, resulting in a $6 million or 5% increase in adjusted operating profit to $134 million.
Interest expense declined $400,000 in the quarter, reflecting lower levels of outstanding debt. And other expenses decreased $3.4 million year-over-year due to gains associated with the company's deferred compensation plan assets.
As we've explained, this quarter, we took a $72.4 million charge, or $0.88 per share, to net income, arising from our Spanish tax settlement that we announced on August 2. Excluding the impact of this charge, our adjusted effective tax rate in the third quarter of 2012 was 27.2% versus 26.9% in the year-ago quarter. The 30-basis-point increase primarily reflects the absence of an R&D tax credit in the U.S. during the third quarter of 2012.
Adjusted EPS increased 8% to $1.08, up from $1 in the third quarter of 2011, excluding the reversal of a restructuring charge of $0.01 per share in the prior year quarter.
I would like to comment briefly on the top line trends we are seeing in our business. On a total company basis, our local currency sales growth has increased every quarter: from 1% in the first quarter to 4% in the second, to 5% this quarter. These trends are more pronounced if we exclude the impact of the exit of lower-margin sales activities, which has been putting incremental pressure on our top line growth. On a like-for-like basis, our growth increased from 1% and 5% in Q1 and Q2 to 7% in Q3. We assume the industry continues to grow at 2% to 3% overall. On a like-for-like basis, our year-to-date growth is 4%.
Looking at the business units, Flavors has shown consistent growth every quarter with 5% growth in the first quarter followed by 8% in the second and 6% in the third quarter. However, excluding the impact of the exit of low-margin business, the like-for-like sales growth has increased from 6% to 9% and 9% in the first 3 quarters of the year. On a year-to-date basis, they have achieved 8% like-for-like growth.
Nicolas spoke of Fragrance Compounds' accelerating growth. The third quarter was a robust quarter for Fragrance Compounds, and growth has improved every quarter this year to 9% in the third quarter, resulting in a 5% growth year-to-date. All areas of the Compound business are showing continued momentum. The only area that remains challenged is the external portion of our Fragrance Ingredients business. However, the strength of the rest of the portfolio is more than offsetting this weakness.
Overall, we are seeing better momentum in the business. While we are cautiously optimistic, trends are improving, and underlying volumes remain strong.
I'd like to provide you with an update of our raw material costs. Although they are still increasing, they are increasing at a lower rate, as we expected. Compared to the prior year quarter, raw material costs increased 2%. That said, the third quarter of last year was the highest increase of last year at 13%. So even though raw material costs only increased by 2% this quarter, on a 2-year basis, they are up 15%, which has continued to pressure our margins.
Year-over-year pricing benefits this quarter, while reduced versus previous quarters, have helped to somewhat reduce the margin pressure, while raw material costs remain as a significant headwind on a year-to-date basis.
Our continued margin recovery this quarter reflects strong innovations, improved product mix, cost savings initiatives and the exit of lower-margin sales activities in Flavors. As we mentioned last quarter, we believe we have reached an inflection point in our gross margins, and we are seeing this play out.
From an overhead cost standpoint, RSA expense as a percent of sales increased 250 basis points this quarter to 23.6%, up from 21.1% of sales last year. The year-over-year change primarily reflects increased incentive compensation accruals in the third quarter of 2012 versus the third quarter of 2011. As you may recall, last year's RSA spend was favorably impacted by lower incentive compensation accruals due to the challenging economic environment. The level of incentive compensation we are now accruing for this year reflects our improved performance versus expectations and is more consistent with normalized levels of incentive compensation provisions. Other cost increases reflect continued R&D spend on innovation and on commercial activities and other customer-facing activities to support our growth in the emerging markets. Finally, we also incurred higher pension costs and increased our provision adjustments for allowance for doubtful accounts.
The dollar remained stronger versus the euro in the third quarter versus a year ago. And as a result, foreign exchange, as we have discussed, had an approximate 600-basis-point impact on the top line. However, there was limited impact on the third quarter year-over-year operating profit margin, largely due to our cash flow hedging activities. These activities, combined with our other operating improvements, more than offset the negative impact of foreign exchange.
Looking ahead to the balance of the year, over 70% of our euro-dollar exposure in 2012 remains hedged at the rate near $1.39. With current rates at around $1.28, the euro had strengthened versus where it was in the third quarter. We therefore expect that any headwinds from foreign exchange in the fourth quarter will be negligible. For 2013, we are nearly 70% hedged against the euro at levels that approximate $1.29.
From a cash flow perspective, for the first 9 months of the year, cash flows from operations were $143 million, or 6.7% of sales, compared with $117 million for the first 9 months of 2011. Importantly, the cash flow in 2012 includes a cash payment of $105.5 million this quarter related to the Spanish tax settlement and a $240 million -- $248 million cash inflow from ongoing operations.
This increased cash flow from ongoing operations in 2012 reflects the impact of lower year-over-year incentive compensation and income tax payments in 2012 versus 2011, as well as an improved earnings position.
As anticipated, capital expenditures are increasing, in line with our guidance, due to the investments we've made in Singapore and China. And we expect capital spending to approach 5% of sales for the full year 2012. The Singapore plant, which opened in early September, manufactures both Flavors and Fragrances liquid compounds. The Guangzhou, China plant will open early next year and will be exclusively Flavors focused.
And as noted by Hernan, in addition, last month, we announced a $50 million-plus investment in expanding Flavors' manufacturing facility and building a creative center in Gebze, Turkey.
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, Nicolas, Hernan, and Kevin. We are pleased with the progress we've made over the past few quarters. The diverse and stable nature of our business, combined with our customer intimacy and consumer insights, enabled us to deliver strong results in a challenged environment.
Although we are mindful of economic volatility in various parts of the world, we are confident that, based on our diversification, we will be able to offset softness in one part of our business with strengths in another part of the business world.
The accelerated momentum we see in the Flavor and Fragrance Compounds business is fueled by the strategic investments we have made in the emerging markets over many years, combined with our ability to provide customers with products that meet and surpass consumer expectation and lead to market share growth for both our customers and for us.
We are committed to driving the business for the long term and executing on our growth plans.
IFF's operations were impacted by Hurricane Sandy, resulting in short-term disruptions in power, manufacturing and in our information technology systems. I am pleased to say that most of these disruptions have now been resolved due to the rapid reaction of our employees in implementing our disaster recovery plans. We are currently in the process of estimating the impact of the storm on our business. We do not expect it to have a material impact on our fourth quarter financial results.
For the fourth quarter, we expect to see continued strong local currency sales growth in Flavors, offset in part by the continued acceleration and exit of low-margin sales activities. In Fragrances, we expect momentum to continue in Fine & Beauty Care, while also maintaining solid growth in Functional. We expect to see improving volume trends in Ingredients business in the fourth quarter, although we still expect year-over-year moderate volume declines.
With regard to margin trends, we expect that raw material costs will continue to stabilize at the current rates, which, as Kevin has pointed out, when combined with last year's trends still results in historically high levels of input costs. Given our progress on a number of initiatives, we expect our gross margins will continue to trend above year-ago levels.
We have a committed and dedicated group of people whose mission is to see the company succeed. We are pushing ahead to meet our internal profit objectives despite the headwinds mentioned. Excluding the costs related to the impact of the hurricane, we expect our adjusted earnings per share to be in line with current market consensus for the fourth quarter.
In conclusion, our strong performance at IFF 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 help shape the industry and delight consumers.
Going forward, we expect continued momentum and growth. We will continue to proactively manage our performance and calibrate costs in line with our top line growth as we continue to execute against our business plans.
With that, we would be happy to take any questions you may have. Thank you for your participation.
[Operator Instructions] Your first question comes from the line of Mark Astrachan with Stifel, Nicolaus.
Mark S. Astrachan - Stifel, Nicolaus & Co., Inc., Research Division
I guess first question, Kevin, just housekeeping. 2013 input costs, if you could give us an update there, that'd be helpful. And then second question, you commented in the press release that the new facility in Singapore replaces an existing plant in the same area. Could you talk maybe more broadly about an opportunity for more of the same happening, meaning this year, spending 5% of sales on CapEx this year, next year, last year, and so new facilities are coming. I understand some of that is for demand. But also, new facilities are probably more efficient than existing facilities. So what is the opportunity longer term to do a better job of getting efficiencies and costs out of some of these new facilities coming online?
Kevin C. Berryman
Okay, Mark, nice to hear from you. Look, I think that it is a little bit early for us to discuss what's been -- or what our expectations are for 2013 input costs. I think we've said in the past that we don't consider there to be a great level of variability as we look forward into 2013. And I'll leave it at that at this particular point in time. But certainly, it's a much more stable environment than we've seen in the past. So I'll leave it at that at this particular point in time. In terms of the investments in our factories, clearly these are investments that are capacity oriented and supporting our future growth initiatives largely in Greater Asia. The recent Turkey announcement is supporting other parts of the emerging market portfolio that we have. But clearly, they're about increasing our capacities. There are efficiencies embedded into those plants. But at the same token, there will be some incremental depreciation that we have at this particular point in time as well. Having said all of that, we will continue to try and drive incremental efficiencies into our business. And as you see through the initiatives that we have in recognizing the third quarter gross margin progression, it's a wide swath of efforts, including some pricing but also new wins, good margins on those new wins and working on price and cost efficiencies with our factories. And that will continue to be a focus as we go forward.
Our next question comes from the line of Edward Aaron with RBC Capital.
Edward Aaron - RBC Capital Markets, LLC, Research Division
And so I wanted to clarify your comments in your prepared remarks about what sounds like an expected volume transfer from Fragrance Ingredients into Compounds. Are you essentially saying that you've been able to kind of negotiate to transition some of your external ingredients supply into kind of sales of higher value-added compounds? And then if that's the case, were you able to do that without making a trade-off on your Compounds margins?
It's Nicolas. What we did is that we really built upon our vertical integration in some parts of our portfolio and unique expertise to be able to provide solutions to our customers and build upon that expertise to go from a single ingredient to really a creation. And this is really creating a win-win situation for both our customers and really eliminating some of the volatility in the feedstock of the ingredients. So we're providing a more stable solution, which is providing stability to the brand of our customers.
Edward Aaron - RBC Capital Markets, LLC, Research Division
And then just a follow-up. Kevin, I think relative to most Street estimates, your gross margin this quarter came in better, and the RSA expenses were a little bit higher to offset that. Was that the case versus your internal expectation as well kind of coming into the quarter? I'm just trying to kind of better understand this. Maybe you had more flexibility than you expected to have to spend back against the business in Q3.
Kevin C. Berryman
I would say that the results are pretty much in line with kind of what our expectations were at. And I think that, as we've talked about, we will continue to evaluate investments in customer-facing initiatives and innovation long term, and in the short term when we think those opportunities are warranted and value enhancing. We certainly did some of that in the third quarter, and that will continue to be the case as we see opportunities and continued margin progression and growth at the top line.
Your next question comes from Jeff Zekauskas from JPMorgan.
Silke Kueck-Valdes - JP Morgan Chase & Co, Research Division
This is Silke Kueck for Jeff. In -- so it looks like your sales performance on a year-over-year basis was lower due to currencies. So maybe you lost $5 million in sales year-over-year. And your gross profits moved up quite significantly. And what you indicated is that your raw material costs are still up 2%, but you also got about 2% pricing. So you probably more than offset all of your raw material costs but, it seems also, other cost benefits that you're picking up. So I wanted to just see like what's the benefit of restructuring savings and other cost efficiencies may have been to your gross margin line, if you can quantify it. And secondly, I also have a question regarding -- just I wanted to get an update as to what has been done on the Ingredients side to better match the costs with the lower sales base of the business.
Kevin C. Berryman
Sure, Silke. Let me take a stab and then I'll turn it over to any my colleagues who want to add any additional color. I think that again, as outlined in the prepared comments and some earlier comments, there was a wide swath of things that were driving our gross margin. While certainly, pricing helped to offset the incremental input costs that we talked about, it really wasn't the primary driver. The net pricing versus input costs was not the driver to our margins. Volume and mix certainly was a key determinant of that, and that certainly helped provide a big chunk of the benefits. And I think also, the cost savings initiatives were also important, and that is just the blocking and tackling of running the business where we saw some good progress again in Fragrance, where they were able to reduce some costs in their business. Hernan and their team, obviously, have been managing through the exit of some of the lower margin, and that benefit approached 50 basis points for the company as well. So there certainly was a wide range of issues that were executed, or opportunities that were executed against, which allowed us to deliver the strong margin profile. So it just wasn't about the pricing even though that continued to be an important element to help reduce some of the pressure from input costs.
Silke, it's Nicolas. Regarding Ingredients, as we have been saying in the past, I mean, following the strategic review of the portfolio, we concluded that the Ingredients business was and still continue to be of strategic and financial importance to us, and the #1 priority of the business is to provide cost-advantage ingredients to our Compound business. And that's why we're really driving higher consumption of IFF ingredients in our new wins, in our creation, in order to have a better absorption. It is also fair to say that the Ingredient part of our business has been probably one of the most efficient in terms of manufacturing. So we're constantly looking at opportunities to reduce costs and to bring it in line with some of the challenge. But we'll also continue to develop solution and -- that we will be sharing with the Board as we move forward and develop alternatives to adapt to our costs, to the new reality of the market. One thing that I wanted to add and I want to make sure also following the question from Edward, is that with the transfer of some of the Ingredients into Compounds, we will see a lower Ingredients top line sales in the future in 2013 as we're migrating business from Ingredients to Compounds.
Your next question comes from line of John Roberts with Buckingham Research Group.
John E. Roberts - The Buckingham Research Group Incorporated
I have a question on the Flavors business. How much of the business now is in products where customers have either a health label or an all-natural label?
It's Hernan speaking. We don't have available this information. But what we can say, that we -- we've seen a, I would say, material growth on these health and wellness trends. So while I cannot be precise, I could say that it's really gaining territory in almost all parts of the world.
John E. Roberts - The Buckingham Research Group Incorporated
Well, I asked that question because the developed markets growth continues to be quite good. And I would assume it's a big factor in the developed markets?
Definitely. In developed markets, it's one of the key factors. I mean, not only the health and wellness but also naturals are the key drivers. And since we have, I would say, very suitable tools, it's helping us to grow the business there.
John E. Roberts - The Buckingham Research Group Incorporated
But would it be maybe 1/3 of the developed market Flavors applications?
I could not say at this point in time 1/3 because I don't have this information. But I think that they're growing very fast and, at one point in time, probably will get there.
Your next question comes from Mike Sison with KeyBanc.
Michael J. Sison - KeyBanc Capital Markets Inc., Research Division
And Nicolas, in terms of new launches in Fine & Beauty, you talked about that and I was impressed with the recovery in growth there. Does that suggest that Fine & Beauty should show pretty steady organic sales growth for the next several quarters? And then one for Doug. In terms of the $50 million in EBIT that you can get for product rationalization, can you give us an update roughly where you're at on that through year end?
Mike, regarding Fine, as you mentioned, we have a good momentum and a good string of new wins that have already been launched or are in the pipe. As we all know, one of the most critical seasons for our customers is the one in which we're entering right now until Christmas. So I believe that the Christmas season will be driving a lot of the market trends. And from that, we will be able to project our performance. So I think it's too early in the season. What is important is that where we participate, we have a strong momentum, and we've been able to secure and to win significant new launches.
Douglas D. Tough
We pick up the next part of your question going -- and it's really flowing out of the Investor Day discussion. And while we haven't disclosed the number, I'll take you through the 3 planks that we had then and we have now. And it's been an interesting evolution. That maximization of the portfolio is both -- that's really where the concept flowed from. It was to really focus as much on growing where we could. And you can see in both the Fine discussion Nicolas has had and some of the categories that Hernan discussed, we've got some priority categories, and they're broadly doing well and contributing to that goal. The third plank was that if we couldn't fix things, we would exit businesses. And that was -- there was a little bit of that in Fragrances in previous quarters. The focus really for the company in the last few quarters has been on Flavors. And Hernan touched upon that, and Kevin has just mentioned the benefit of margin we get from exiting. Exiting was a last resort. But nevertheless, you can see the company's positive traction in margin recovery from having exited the business and still having some good top line growth. The second plank, and really the most interesting one and where we've candidly been treading water, and while that's disappointing in the absolute, I think the particulars around the facts are important. But treading water was really around some categories in Functional Fragrance in the Fragrance businesses. And the treading water was the identification of the need to fix some businesses. And candidly, the team have really taken some excellent actions to move the progress ahead, but we have been hit by significant raw material cost increases over the last couple of years. So it's a function of taking some pricing with customers, revising some formulas, doing some things we inside the company call "some value creation," which is streamlining the business. We've done a number of things, all of which have been positive in terms of margin recovery, but they've been offset by the, if you will, the tsunami of the raw material cost increases in the last couple of years. So since that meeting, we've probably made very little traction despite some really strong actions. But if this grow-the-categories, we're still doing that, we will exit some low margin. But that fixed Functional, we've made some -- little progress. We've still got more to do, but it's been a great experience. And had we not, frankly, been able to engender some of the successes I just talked about in the light of the cost increases, the margin would have been extremely negative.
Your next question comes from Erik Sjogren from Morgan Stanley.
Erik Sjogren - Morgan Stanley, Research Division
Yes, [indiscernible], it's Erik Sjogren at Morgan Stanley. The only question remaining for me is really on the Flavors business. I mean, a 3% impact from the portfolio rationalization in the third quarter, is this a run rate now? Or are you adding significantly more to the products you're considering here for the next couple of quarters going forward?
It's Hernan. So this is the run rate. I mean, just to give more -- I mean, Flavors some more information, this is -- what you've seen this quarter is what we expect to have in the next few quarters. So in other words, after, I mean, the second half -- or in the second half of the next year, we will not see any more business discontinued. Of course, we are always reviewing our portfolio, but I would say that we can say that we are largely done by half of next year.
And there are no further questions. Do you have closing remarks?
Douglas D. Tough
Yes. Thanks. I'd like to thank all the participants on the call for their support today. Particularly with the federal election, there's many potential distractions for all of us. For those IFF employees on the call, I would like to reiterate my thanks and appreciation for all you've done during the last week in keeping the business going strongly. And for all the people on the call, we look forward to our Q4 and final year results, which we expect to be positive. Thank you for your participation today. Have a good day.
Thank you for joining today's International Flavors & Fragrance conference call. You may now disconnect.
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