International Flavors & Fragrances Inc (IFF) 2005 Q4 法說會逐字稿

Good day, everyone, and welcome to the International Flavors & Fragrances fourth quarter 2005 earnings release conference call. This call is being recorded. The speakers for today's call will be Mr. Richard Goldstein, Chairman and Chief Executive Officer, and Mr. Douglas Wetmore, Senior Vice President and Chief Financial Officer.

Thank you. Good morning, everyone. Thank you for joining the conference call. Before I begin, I need to make some cautionary remarks.

This call may contain statements that are considered forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on current expectations And the current economic environment. Forward-looking statements and projections are inherently subject to significant economic, competitive, and other uncertainties and contingencies that are beyond the control of management.

The Company cautions that these statements are not guarantees of future performance. Actual results may differ materially from those expressed or implied in the forward-looking statements. Important assumptions and other important factors that could cause actual results to differ materially from any forward-looking statements and objectives are specified in the Company's 10-K filed with the SEC and IFF's other filings made with the SEC from time to time. IFF does not update forward-looking statements and expressly disclaims any obligation to do so.

Now before I turn the call over to Doug to review the fourth quarter and the full-year results, I would like to make a few opening comments. First, as you are likely aware, we have announced my intention to retiree as Chairman and Chief Executive Officer of IFF at our annual shareholders' meeting on May 9, 2006.

As I have shared with many of you in past conversations, I believe that for a company to remain vibrant, it is important that new ideas and initiatives are constantly evolving, and this is allowed to happen most effectively through a periodic change in leadership.

We can take great pride in our many accomplishments over the past several years, reinforcing our industry leadership. Illustratively, the acquisition and successful integration of Bush Boake Allen, achieving and surpassing all of the business and the financial targets that were established. The creation of one IFF allowing us to collectively focused our attention and initiatives in a unified fashion. The dramatic improvement in customer service levels, resulting in our being restored to the core list of virtually every major global customer.

The successful global implementation of SAP, providing us for the first time a unified set of management systems. The incremental focus on both hard and soft technology, which encompasses both research and creating new molecules, as well as the fusion to the consumer knowledge, brand understanding, coupled with flavor and fragrance expertise. The implementation of human resource initiatives that allowed for management development in the global rewards program based on the achievement of agreed objectives.

I am confident that with the progress we have made, IFF is well positioned to deliver long-term growth and increased shareholder value. Thus, the timing is right to put the succession plan into effect. To assure a smooth transition, the Board has retained an executive search firm to assist in identifying my successor.

Now turning to the year 2005 just completed, I continue to be encouraged by our growth with our large accounts. Growth with the large global, regional and local customers is a key filler of our long-term strategy. For the full year of 2005, sales to our five largest customers grew more than 5% in local currency. This growth is on top of the 7% local currency growth achieved for the full year 2004.

Secondly, we continue to see good growth in key geographic markets we have targeted, such as India, Latin America, Southeast Asia, and China, and Eastern Europe. Most notable among these targeted growth regions are India, which has grown at a compound rate exceeding 12% over the last three years, and Latin America, which has grown at nearly 6% compound rate, despite some difficult economic conditions in the past few years.

We continue to invest for the future in these regions. In November, we opened a new state-of-the-art fragrance creative center in Mumbai, India. I am confident this facility will contribute greatly to our future success in India.

And construction of our new state-of-the-art chemical facility in China is on schedule for completion and commissioning midyear 2006. This new facility will greatly contribute to helping fulfill the needs of our global, regional, and local customers.

Third, we continue to operate in a challenging pricing environment, while at the same time continuing to experience rises in material and operating costs. However, we have taken a series of actions to reduce our costs and restore our profitability. There are additional details regarding these actions in our press release.

Finally, as I have emphasized throughout my time at IFF, we are unequivocally committed to research and development of new and innovative technologies. Our primary objective is to provide our customers with technology and innovation, products and service that will help them win in the marketplace.

By remaining focused on innovation, superior service, and operating discipline, I am confident that we can differentiate ourselves from our competitors and drive market share gains to create value for our shareholders.

Now let me turn it over to Doug to review our financial results for the quarter and for the full year. Afterwards, we will be happy to take your questions.

Thanks, Dick. Good morning, everybody. Before I begin, let me point out that any sales comparisons with 2004 that I make throughout my remarks exclude the results of the European fruit business that we sold in the second half of 2004. All relevant details regarding the fruit business are included in press releases and in filings with the SEC.

Fourth quarter 2005 sales totaled 461.6 million, decreasing 1% in comparison to the prior-year quarter. Sales for the quarter were moderately impacted by currency, mainly the dollar/euro relationship. In local currency, flavor and fragrance sales both increased 1%.

Our fragrance sales were led by fine fragrance, which increased 12% in dollars and 16% in local currency, mainly driven by new wins. It also bears mentioning that fine fragrances had a somewhat difficult growth comparison versus the prior-year fourth quarter, when fine fragrance sales grew 6% in local currency and 11% in dollars. Functional fragrance products were down 6% in dollars and 4% in local currency and aroma chemical sales declined 7% in local currency, 11% in dollars.

Flavor sales, most notably in North America and Europe, continued to be unfavorably impacted by lower selling prices for naturals, most notably vanilla. As we have noted in the past, the selling price for vanilla flavors generally move in line with the cost of the underlying raw materials. However, moving forward into 2006, we do not expect any further impact on sales because of major movements in the underlying cost of the raw material for vanilla.

Sales growth for the quarter by region is detailed in our press release issued earlier this morning. As had been the case for the past several quarters, our sales performance was strongest in India and Latin America.

Net income for the quarter decreased 63% in comparison to the prior year as reported, and let me briefly touch on the various aspects that impacted earnings in the current quarter and the corresponding comparison to the 2004 quarter.

In the current quarter, gross profit as a percentage of sales was 40.5%, compared to 42.6% reported in the prior-year quarter. This was somewhat lower than had been anticipated. As has been the case in the past quarters in 2005, the margin decline was mainly attributable to higher raw material costs, which we have not as yet been able to fully recover through increased selling prices. Energy costs, most notably at our chemical plants, and higher freight costs also contributed to the declining margin. Adding to that, the weak performance in functional fragrance and in chemicals impacted margin through poorer than anticipated manufacturing expense absorption.

On the subject of pricing, we have made progress in terms of the price increases, but more progress is required. While the pace of raw material price increases abated somewhat as the year 2005 progressed, material costs as well as energy costs continue to rise.

We continue with our many research and development efforts. For the full year, R&D expense totaled 10% of sales. Excuse me -- for the quarter totaled 10% of sales, but came in at 9.1% of sales for the full year. The increase as a percentage of sales in the fourth quarter was more a factor of the sales performance than R&D spending.

Selling, general and administrative expenses as a percentage of sales were 18.6%, compared to 18.1% in the prior-year quarter. As we mentioned in our press release, the SG&A increase is primarily the result of additional costs associated with product contamination matters that we have talked about in previous quarters, partially offset by lower accruals under the Company's incentive plans. We do not anticipate any further costs associated with the product contamination as we move into 2006.

During the quarter, we repurchased approximately 425,000 Treasury shares, and at December 31, 2005, we had remaining authorization under our latest program of about $177 million.

With respect to capital spending, we spent about $93 million for the full year, pretty much in line with our expectations, and we expect in 2006 to be spending somewhere along the lines of $70 million. Again, we think that over the three-year period '05/'06/'07, we will spend roughly in line with depreciation, which would average about $75 million a year.

Turning briefly to 2006, our press release includes initial guidance for the full year 2006, and we will, consistent with past practice, update this guidance as appropriate as the year unfolds.

In brief, our current guidance is as follows. We expect local currency sales to increase in the low single digits in comparison to 2005, and based on current exchange rates, this translates into a low single digit increase in reported dollars. The expected growth is pretty consistent between flavors and fragrance, and as was the case in 2005, the fragrance growth is expected to be led by fine fragrance and toiletries.

Let me give you some preliminary guidance or initial guidance in terms of where we expect the sales to be for each of the geographic regions. Both North American fragrances and flavors are expected to increase in the low to mid single digits. Europe fragrances are expect to be flat to up in the low single digits in local currency. Europe flavors are expected to increase in the low to mid single digits in local currency.

Latin America is expected to increase in the mid single digits -- Latin America fragrances are expected to increase in the mid single digits, while Latin America flavors are expected to increase in the mid to the high single digits, continuing the strong growth achieved in 2005.

Asia-Pacific fragrances are expected to increase in the low single digits in local currency, while Asian flavors are expected to increase in the low to mid single digits in local currency.

Both India fragrances and flavors are expected to increase in the high single to low double digits in both local currency and dollars, continuing the pattern of strong growth that we have achieved in that region for the past several years.

Gross profit as a percentage of sales is expected to improve somewhat from the 2005 performance, mainly due to improved sales performance, improved product mix, the implementation of the price increases that we've talked about throughout 2005 -- the final stages of the '05 price increases, as well as additional increases in 2006 as necessary, and savings resulting from the restructuring actions that we announced on January 10. At this time, for your models, I'd suggest the improvement is expected to be about 100 basis points over the full year 2005 achieved.

R&D expenses are expected to approximate 9% of sales. SG&A expenses as a percentage of sales are expected to decrease somewhat from 2005 levels, mainly as a result of the restructuring activities and the absence of costs associated with product contamination. Partially offsetting these savings will be the inclusion of about 14 to $16 million in equity compensation expense in 2006, compared to about $7 million of such expense in 2005. The actual expense will depend upon the value of the Company's stock and the number of restricted stock units granted.

This guidance excludes the impact of adoption of Statement of Financial Accounting Standards Number 123 regarding share based payments, which we expect to adopt in the first quarter of 2006. We are currently in the final stages of evaluating the impact of adoption of that standard and will discuss this in more detail at the time we release first-quarter earnings and will also include the expected impact of adopting the Standard in our annual report for 2005, which is currently being worked on.

In 2006, we currently expect interest expense to decrease about 10% from 2005 levels, mainly based on anticipated lower levels of debt. As you may know, the $500 million of notes mature May 2006. The effective tax rate in 2006 is expected to approximate 31%, pretty much in line with 2005, when excluding the benefit we realized on homeland repatriation. However, the rate will fluctuate somewhat depending on earnings mix in the various geographic regions in which we operate.

In taking into account all the foregoing, we currently expect earnings per share for 2006 to be in the range of $2.23 per share to $2.31 per share. As I mentioned before and as in the past, we will continue to update full-year guidance as the year progresses and as we announce the individual quarterly results.

With that, we will now open the call to questions. Operator, I'll turn it over to you.

(OPERATOR INSTRUCTIONS) Jeffrey Zekauskas, JPMorgan.

Good morning. This is Silke Kueck for Jeff. I have a couple of questions. Can you discuss the impact of the additional costs related to the [indiscernible] issue in the fourth quarter and how much did you spend on it for the year? And what is the benefit to SG&A from your restructuring initiatives?

Well, on a full-year basis, SG&A was impacted by between 7 and $8 million for customer claims associated with the product contamination, and that was mainly in the third and fourth quarter. We had roughly $3 million in the second quarter of the year associated with product testing, as well as disposal of certain affected product -- raw material product. And while we are still pursuing insurance recovery on both those fronts, we have not anticipated insurance recovery in recognizing expense in 2005, nor in providing guidance for 2006.

In terms of the savings that we mentioned in the press release, 16 to $18 million of annualized savings, the savings is roughly broken down about 25% in manufacturing expense, 25% in R&D expense, and then about 50% in the SG&A line. So you can split that out in your model as you deem appropriate.

In addition to that, there's roughly 10 million in [indiscernible] related costs that you won't see in 2006?

Yes, that's true. We are not anticipating any further claims at this point in time.

Fine fragrance sales were again exceptionally strong in the fourth quarter and for the year, and local currency growth in flavors is beginning to rebound. How do we think about growth in 2006? I know you've laid it out by region, but how do we generally think about it?

Well, I think we have given you some guidance already on that. We had truly an outstanding year in fine fragrance in 2005, and we are hopeful that we are going to be able to continue the momentum in 2006. But to get into specifics in terms of what that is going to look like in terms of the win rates and whether or not it parallels completely 2005 performance, it would be premature.

But we are encouraged by the performance of fine fragrance and, similarly, the performance in the flavor side of the business with many of our customers in several regions also shows us that we are gaining momentum in those areas where we had not before.

As I mentioned, the growth between flavors and fragrances, as we currently expect it and as incorporated in our guidance, is pretty much the same for both between flavors and fragrances. The only distinction I drew is that, again, as with 2005, fine fragrance is expected to lead fragrances in terms of overall increase. We are expecting some growth in functional fragrance, but fine will be the leader in terms of growth.

And lastly, in your last Q, I think the stock compensation expense was laid out at roughly $0.02 a share. Is that just like the ballpark magnitude of SFAS 123 that we should think about, or could it be lower because of accelerated vesting?

There is no move for accelerated vesting. As you know, we're kind of in a transitional period because we stopped issuing options except to a limited number of overseas employees, where options are better for their purposes from a tax perspective. And so we're adding in the expense of the restricted stock units.

As a result of that, we're still evaluating the impact of the adoption of 123, which is why I included in our press release the caveat that the guidance does not contemplate the impact of 123.

I think that the overriding thought at the end of the day was when we shifted from options to restricted stock units, which was in May of 2004, the Board of Directors and the compensation committee target was that the earnings per share impact of the RSUs would be pretty much similar to what the impact of the pro forma information in our annual report would be regarding stock options. If you look in our 2004 report, I think it's between $0.16 and $0.17 per share when we are at a full run rate.

But we'll get that information. It will be included in the 10-K, which we anticipate the filing sometime before March 15, which is when the deadline is. We will include the anticipated impact of that and we will talk about it in much more detail when we release first-quarter earnings.

Thanks very much.

(OPERATOR INSTRUCTIONS) Mike Sison, KeyBanc.

Nice run there, Rich. Sorry to have you go. I guess my first question is what type of person do you think are you looking for or do you think the Board is looking for it to sort of take IFF to the next level?

Well, my hope and expectation is that someone comes in that has vision, that has experience in relevant background in order to be able to come up to speed very, very quickly. And will provide the type of direction and continued leadership that has enabled IFF to accomplish many of the things that we have talked about over the last 5.5 years.

We are at a stage now where we can take great pride in the accomplishments which we have achieved, but there is considerably more that we can do. And therefore, it is a question of somebody who can build on those accomplishments and indeed lead with providing incremental ideas, just as we have been pleased to have been able to do over the last period of time.

Okay, fair enough. Doug, the impact on materials for 2005 in total, is it still about 3% impact to gross margin?

I think the impact on gross margin was roughly 300 basis points. As many of you know, the raw materials represent historically about 70% of our overall cost of goods sold. In 2005, it is a little bit over 72%. And we saw in the first half of the year overall weighted average increase in raw material cost of between 5 and 6%.

As I've mentioned in the third-quarter and the fourth-quarter calls, the pace of those increases abated as the year progressed, but overall, underlying raw material costs, I would say for the full year 5 to 6%.

Remember, we used the weighted average cost of accounting, so even if some of the materials declined later on the year, just because of the use of the weighted average you don't necessarily get that flowing in. And we will still feel some of the impact of that in 2006.

Raw materials, they should be up again to a degree in '06?

I think you'll see just a modest increase. And obviously, I wish I had a crystal ball in terms of what was going to go up and what was going to go down. But I think you won't see any order of magnitude based on what we know today of the likes of the increase that we saw in the first half of 2005.

Rich, you commented that the pricing environment remains challenging. Could you give us a little feel for that? Is competition looking to raise prices or is it just pressure from customers? Maybe give us a feel for what level of pricing you think you could attain in '06?

We continue to believe that we are going to have some measure of success with respect to our customers accepting and recognizing the raw material increases, particularly when they are petrochemical based. And the situation in the Middle East is so unsettled that who is to say where oil is going to go?

But the discussions that we have had with many of our customers is that they are understanding. Having said that, they are also looking to control and contain their own costs as much as possible.

As for competition, one never knows how the competition is going to react. We do know that the only other public company, Givaudan, did indicate that they were not going to be pressing for price increases, and therefore, that obviously has a competitive impact within the marketplace. But I will tell you from IFF's perspective, we believe the responsible thing to do is to continue to press for price increases, and it is our job to be able to effectively explain to our customers the basis for the need and the willingness on their part to accept what is clearly demonstrable within the marketplace.

So far, I am pleased to say that we have found levels of receptivity. But I do not in any way suggest, Mike, that this is an easy road to travel. It is going to continue to be one where or we're going to have to dialog with our customers and clearly explain each necessity as it materializes.

Remember, some of the price increases that we achieve are actually either reformulation of the product that we're shipping to the customer, where we are able to reengineer the formula and arguably reduce the cost. That takes a little bit longer than just passing on a price increase.

There is an element of price increase in our anticipated growth for the coming year, but the prime driver for anticipated growth in 2006 is really volume and winning new business.

All right. Last question. I just wanted to get a better deal for flavors. You are looking for growth. I think if you exclude the divestiture, volumes were up 1% last year, right? If you -- what is going to drive that growth higher?

We were actually flat excluding the fruit, but pretty close to --. I think the key is we had the two impacts in '05. One was the divestiture, which we provided an as-adjusted comparison, so on a like-to-like basis, you can tell the impact there. The second thing was the pricing of vanilla, which as I mentioned, we've passed that now. We don't expect any further impact.

The key really for us moving forward is to get some growth in the big markets, which is Europe and North America, and we are pretty confident about getting the growth in North America. I think the growth in Europe is a little bit less than that expected in the United States. And that is where the challenge is, because the underlying macroeconomic environment in Europe is still a bit of a challenge in many of the major countries that we operate in.

But the early signals in North America are that we are getting growth on the flavor side of the business. If you couple that with performance in Latin America and in Asia-Pacific and in India on the flavor side, I am encouraged. We do not in any way expect that we are going to be sluggish. We have had very good wins in North America on the flavors side.

I think Doug properly signals that Western Europe in general continues to be a challenging business environment, not only for us, but for our customers as well.

Great. Thanks, guys.

(OPERATOR INSTRUCTIONS) John Roberts, Buckingham Research.

I believe in your [10-K] you provide an R&D breakdown between fragrances and flavors. I didn't know if you might break that out for '05. And that 9% of sales in '06, is that like 11% R&D to sales for fragrances and then a single digit number in flavors?

The precise breakdown is pretty much the same as -- we approximated in the discussion of R&D initiatives in the forepart to the 10-K. That relationship has stayed fairly static -- I mean, it moves a little bit, obviously. And I think for the sake of your model right now, you should assume that the relationships stay pretty much the way it was in 2004. And then we will update that when we prepare our 2005 10-K.

So you're spending about 11% of sales in fragrances on R&D. Do you think that is the primary cause of the acceleration you're seeing in fine fragrances and as a follow-up to it, you're finally getting the benefit in the R&D?

Well, I think the clear sequence of success, as we have said repeatedly, is going to come from Capital R, which is new molecules. We're seeing very good results in both the fragrance and the flavor side with respect to the development of some of those technologies. And some of them have been coming through more rapidly on the fragrance side than the flavors side, but we are very, very encouraged about the future with respect to new technologies on the flavors side as well.

Is their trickle-down effect between fine fragrance and functional fragrance? That is, if you have a couple years of acceleration here in fine fragrance, we should see, as those products move to more personal care --?

There is definitely a trickle-down with respect to fine. And if you take a look at virtually all of our major customers involved in functional fragrances, they are looking for that trickle-down from fine, and it takes a few years. The molecules first start in fine and then they find their way down into functional.

Also, remember that the adaptation of those molecules to functional fragrances takes some time because when you're using them in fine fragrance, you are really talking about mixing them in a solution of alcohol and water. When you start incorporating them in functional fragrances, the [bases] are much more sophisticated and, therefore, the compatibility issues need to be worked through much more carefully, and that can take time, too, John.

Lastly, could you just update us on the sustained fragrance product launches that you're expecting from your customers in '06?

Yes. I think that we're going to see the encapsulation technology in the marketplace early this year, and we will update you with specifics at an appropriate time.

And that will show up in functional fragrances?

Yes.

Great. Thank you.

(OPERATOR INSTRUCTIONS) Gentlemen, that concludes our question-and-answer session for today -- wait -- we do have a follow up from Jeffrey Zekauskas.

This is Silke again. If I look at your guidance range, based on the cost savings that you should achieve this year from restructuring and various costs related to [indiscernible] going away, if volumes were just to grow slower than you currently expect, shouldn't you be able to easily hit the bottom number of your EPS guidance range?

You know, Silke, it is always subject to a degree of impact because of currency as well as product mix. I wish I was wise enough to be able to give you a more precise measure, but that is the best guidance we have at this point in time, and we are very confident in achieving the cost savings. And we will just continue to update as the year progresses. And it would be nice to be able to tell you that we're trending towards the higher end of that range, but it would certainly be premature at this point in time.

I understand. Thanks very much.

Okay. Thank you all very much. Talk to you at the next quarter.

Thank you. That does conclude our call. We do appreciate your participation. At this time, you may disconnect. Thank you.