International Flavors & Fragrances Inc (IFF) 2007 Q3 法說會逐字稿

Good day everyone and welcome to the International Flavors & Fragrances third-quarter 2007 earnings conference. Just as a reminder, today's call is being recorded. All participants' lines will be muted until the question and answer portion of this call and instructions will be given at that time.

The speakers for today's call will the Mr. Robert Amen, Chairman and Chief Executive Officer; Mr. Douglas Wetmore, Senior Vice President and Chief Financial Officer and Yvette Rudich, Director of Corporate Communications. Please go ahead.

Hello and thank you for joining us today. During the course of this web cast, we may make certain forward-looking comments. The complete text regarding our forward-looking statement is included in our press release and in our filings with the Securities and Exchange Commission. In addition, during this web cast we may refer to certain non-GAAP financial measures in order to supplement our GAAP financial results. Examples of such measures include our discussion of local currency sales performance and applicable geographic regions and earnings per share, excluding restructuring charges and other nonrecurring items.

We will leave this slide up for a moment to ensure that everyone has an opportunity to review it.

Now here's what we will cover on today's call. Rob will speak about market dynamics, third quarter highlights and the business unit overviews. Doug will then provide a third quarter financial review. Following some closing comments from Rob, we will then take your questions. And with that, I will now turn it over to Rob.

Good morning, everyone thanks for joining us. Before we discuss our Q3 results, I wanted to share with you our view of the marketplace which is part of what makes us particularly optimistic about our future. The global economy continues to show healthy growth. Both the developed and the developing markets are expected to grow through 2008 with China and India driving increases in growth.

We believe the flavor and fragrance markets are growing as well, which is due in part to the increasing purchasing power of consumers in the developing markets. This is good news for our customers and for IFF because our customers are among the most prominent global enterprises who are growing those regions.

In addition, their customers in the developed markets, they are reaching a growing middle class that stretches from Indonesia to China to Russia, Brazil and beyond. Our data indicates that as entry-level consumers' disposable income increases, they spend a disproportionate amount of their new income on better consumer products, and that is good for our future.

Such a snapshot of the external environment as we see it. Now, let's take a look at our third quarter results. As we told you in our second-quarter call, our key priorities continue to be developing our customer relationships, developing our product innovations, top-line growth and improving our operational performance. Focusing on these elements enabled us to deliver in the third quarter results that equaled or exceeded our long-term financial goals.

Looking at the third quarter highlights adjusted to exclude unusual items which Doug will cover in more detail later, our revenue grew 8%. Excluding the foreign exchange impact, our growth was 5%. We believe that is faster than the market's growth. Operating margins were 16.5%, up slightly from last year's 16.3%, and earnings per share increased 13% from a year-ago period. We're very pleased with these results and clearly we are moving forward in all areas because of the successful implementation of our business plan.

Turning to the individual businesses, the Flavor business had another very strong quarter. This is the third quarter in a row of double-digit sales growth for the business. The growth was in all categories and in each market. Operating margins improved, growing 14%, driven by new wins, improved cost and richer product mix. The business unit strategy is clearly paying off and I am pleased with the momentum that we are building in this business.

The Fragrance business sales were up 6% versus the third quarter of 2006. Results in this business were weighted down due to lower pricing for fragrance ingredient sales and a weak year-over-year performance in our Fabric Care segment. I believe we have bottomed out in these areas and expect improvement in coming quarters as encapsulation launches take hold.

Fine Fragrance had another strong quarter. The Fine Fragrance business has now grown I believe 15 quarters in a row. The Fragrance business overall is performing well, except in Fabric Care volume and ingredients pricing. I believe this business has the right initiatives underway to deliver stronger results in the coming quarters. Now Doug will provide you some more details on the financials.

Thanks, Rob, good morning everyone. Let's begin with an overview of sales. This slide provides a breakdown of sales and growth by our two business units. Flavors achieved a 12% growth in reported dollars on a 9% increase in local currency sales, while Fragrance sales grew 6% for the quarter in dollars on a 3% local currency increase. The difference between the local currency growth and the dollar performance was mainly due to the strength of the euro and the pound. The euro was 6% stronger than the prior-year quarter while the pound was nearly 8% stronger. A basket of other currencies accounted for the remainder of the exchange effect.

Now I will discuss the sales performance in a little bit more detail later by business unit. This chart depicts the percentage growth in our consolidated sales in both local currency and reported dollars since the first quarter 2005. As you can see, we've been delivering local currency growth since the fourth quarter of that year, and moreover, since the second quarter of 2006, we have been achieving local currency growth in line or better than our stated goal of at least 4%.

Also as is evidenced in the graph, we went up against some challenging comparisons from a growth perspective in the third quarter this year, having grown 7% in local currency in the third quarter 2006.

Turning to sales performance by geography, in this slide, we summarize sales performance in local currency by the geographic regions and full details regarding that sales growth are in our 10-Q, which was filed this morning. North America sales overall were flat, weighed down by volume decreases in Functional Fragrances, partially offset by continued strong performances in Fine Fragrance and in Fragrance ingredients. Flavors continued its strong 2007 performance in North America, growing 5% in the quarter, driven mainly by new wins. Growth in Europe, Africa and the Middle East came in all product categories, led by increases of 15% in ingredients and 7% in Fine Fragrances. Flavors delivered another solid quarter of 4% local currency growth. Latin America sales were particularly strong, most notably in Flavors, which increased 31% in the quarter and is up 21% year-to-date. The Flavors performance year-to-date follows an 11% increase for the full year 2006 and a 21% increase in 2005, so we've really been doing well in Flavors in that market. Latin America Fine Fragrance also continued its strong growth, increasing 14% in the quarter. Both Functional Fragrance and ingredients were impacted by volume declines, and in the case of ingredients, pricing also added some impact.

Greater Asia achieved significant growth, driven by new wins and improved volumes, most notably in Flavors, which increased 10% in local currency. Fine Fragrance performance was also very solid, driven mainly by new wins.

Local currency sales to our top 30 customers, which currently account for about 57% of our sales, grew in line with the growth for the quarter at 5% and are up over 6% for the first nine months this year, continuing the pace of growth achieved for the full year 2006.

Turning in some detail to Flavors, this chart depicts the percentage growth in Flavor sales in both local currency, the yellow line, and reported dollars for the last three years, or since January 1, 2005. As is evident, the local currency sales performance for Flavors continues to strength, driven by increased wins and improving volume. Flavors has now grown nine consecutive quarters in local currency and we are confident that growth will continue. Flavors sales growth has led to equally strong improvements in flavor profitability, as Rob discussed a few moments ago. The new wins and volume growth of existing business drove improved gross margin performance. Product mix and expense absorption have also contributed to the improved profitability. Operating profit depicted on this slide is as adjusted to exclude a $3 million insurance recovery related to the 2005 product contamination issue. We realized that insurance recovery in the third quarter of 2006. Including the insurance recovery from the prior-year operating result, the 12% sales growth would have resulted in an 8% increase in operating profit on a GAAP reported basis.

Turning to Fragrances, the percentage growth in fragrance sales in both local currency and dollars since the first quarter of 2005 is depicted on this chart. The local currency sales performance has been quite strong for the past several quarters, driven by new wins and the sustained success of existing creations. That strength over this period has been most evident in Fine Fragrance and Beauty Care. More recently, sales of ingredients have also begun to pick up. Ingredient sales increased in the third quarter and have increased 7% in local currency year-to-date. As Rob mentioned earlier in the call, Functional Fragrances had been weak, most notably in fabric care. However, we expect that weakness to begin turning around soon, enabled mainly by the new encapsulation product launches, which we expect.

Now looking at Fragrance profitability. The Fragrance operating environment has been somewhat more challenging than Flavors has experienced and Fragrance profitability has not grown in the same manner that it has for Flavors this quarter. It is fair to note that Fragrance has the more difficult comparisons with prior-year periods. The Fragrance margins continue to be impacted by lower selling prices on Fragrance ingredients. Having said that, though, the selling prices have stabilized at these lower levels.

Profitability in the current quarter was also impacted by weak Functional Fragrance sales, as well as some increases in raw material costs. The raw material increases were in line with our expectations, about 2% to 3% year-over-year. The cost of scaling up of the new ingredient facility in China, which I noted in the past couple of quarters has diminished in the third quarter of 2007 as that plant is close to operating at a normal capacity level.

Now turning to consolidated operating results. This chart reflects as-adjusted numbers for 2006. The sole adjustment is the exclusion of the $3 million insurance recovery, which was included in selling and admin expenses in the 2006 third quarter. Sales increased 8% in dollars on the underlying 5% local currency increase. Gross margin eroded somewhat compared to the prior year for the reasons already mentioned, namely the lower selling prices for Fragrance ingredients. We continue to tightly control expenses in both research and development and selling an admin. Currency translation added about 3% to each category compared to the prior-year quarter, but as a percent of sales, R&D is 10 basis points below the prior-year quarter and is down about 30 basis points year-to-date. Selling and admin expenses declined 70 basis points in the 2007 quarter in comparison to the prior-year, excluding that insurance recovery.

Including the insurance recovery in the 2006 results, selling and admin expense for the '06 quarter would have been 16.3% of sales compared to the 16.2% that we had reported in the current year. Selling and admin expense for the current quarter also include about $1.5 million of expense incurred in connection with initiatives currently underway to transform our business processes along the lines of what we have talked about in prior calls. I would expect a similar amount of expense in the fourth quarter this year as well as the first quarter next year.

The principal enabler of these transformation initiatives is our single global instance of SAP, which we've talked about for a long period of time. We'll begin to see benefits of these initiatives in the second half of 2008. It's premature to share additional details on this call, but we will keep you updated as progress is made.

Operating profit as a percentage of sales on this as-adjusted basis totaled 16.5% in the third quarter this year compared to the as-adjusted figure of 16.2% reported in the prior-year quarter.

Looking at reconciliation of earnings per share, before we walk you through the growth components of earnings per share for the third quarter this year, it's important to revisit the 2006 results for a moment. Third quarter 2006 earnings as reported were $0.70 per share. However, the $0.70 per share included the impact of a couple of items that were nonrecurring in nature and which should be fully considered in evaluating our performance in the current quarter. First, the insurance recovery, which represented about $0.03 per share. Secondly, other income for the third quarter last year was unusually high, mainly as a result of gains on disposal of some fixed assets. In our third quarter call last year, we highlighted these elements as having accounted for a net swing in other income expense of $0.04 per share.

So, adjusting for these items, we arrive at what I consider to be adjusted earnings per share for the third quarter 2006 of $0.63 per share, and that is the basis on which we will measure our performance in the current quarter. So turning to 2007, the evolution of earnings per share from the $0.63 we just talked about to our current year result is depicted on the slide. And as in the past, we have not attempted to isolate exchange effects in the chart, so the impact of the weaker dollar is embedded in each of the elements discussed, except the number of shares outstanding. Also, the amounts are approximate as they are subject to rounding. But having said that, sales growth added $0.06 per share and efficiencies added $0.01 per share. The strong sales growth facilitated efficiency improvements, an element of which is capacity utilization and absorption, and expense control also contributed to the profitability improvement. However offsetting this to a certain extent was the somewhat weaker gross margin.

Other income and interest expense combined after taking into account the adjustments I just discussed on the preceding slide accounted for a decline of $0.03 per share. An increase in interest expense represented the biggest source of change for which the primary reason is the increase in the average interest rate on debt. In the 2006 quarter, our average interest rate was 3.2%, and this year, it averaged 4.4%. The debt we took on in connection with accelerated share repurchase program executed in this quarter and which I will talk about in a few moments had a fairly nominal impact on interest expense in the third quarter.

Taxes favorably impacted the current quarter's result. The effective tax rate was 27% compared to 29.8% in the prior-year quarter, adding $0.02 per share, and there were no unusual tax adjustments in the current quarter. We reduced the number of shares outstanding by 3% compared to the '06 period, adding $0.02 per share, and I will talk about the share repurchase in a moment.

And finally, as discussed in the press release and in our Q, the Company reported a pension curtailment loss of $6 million, or $0.04 per share. Effective at the end of this year, the Company froze the defined benefit for the vast majority of its U.S.-based employees and introduced an enhanced defined contribution plan for those employees. As a result of these actions, the Company expects to realize net annual cost savings of approximately $4 million beginning in 2008. As I mentioned, additional details regarding the pension change are included in our 10-Q.

Taking into account all of these components, our reported earnings per share for the third quarter this year was $0.67 per share. But for purposes of measuring our future performance, specifically the third quarter 2008 performance, we would exclude the impact of the curtailment loss. We consider the adjusted earnings per share of $0.71 per share, adding back the pension cost, to be the basis against which our future growth should be measured.

It's useful to put into context our quarterly earnings per share performance this year compared to the last several years. When excluding the restructuring charges and other nonrecurring items, such as the tax benefit of homeland, gains on sale of assets and the 2007 pension curtailment, earnings per share this quarter represents the second-highest earnings per share achieved in the Company's history. The chart also serves to highlight the element of cyclicality in our business with the fourth quarter being noticeably and consistently smaller in terms of earnings than the other quarters of the year. Bear in mind in the fourth quarter of 2006, the Company reported GAAP earnings per share of $0.53, which included restructuring charges of $0.02 per share as well as gains on the sale of land of $0.06 per share and a credit to tax expense of $0.04 per share for reversal of tax reserves following a tax ruling. Adjusting for these items for purposes of measuring the fourth quarter 2007 performance, our base line for performance in the fourth quarter 2006 was an adjusted per-share result of $0.45. If you're modeling our fourth quarter performance for this year, we believe it is the $0.45 that you should be measuring us against.

Turning to cash flows, the '07 cash flows from operations declined compared to the prior-year result, and that was not unexpected. I discussed the contributing factors before, but let me briefly repeat those for someone that may not be familiar. The main driver for the decline was about $55 million of payments and incentive in deferred compensation made in the first quarter of '07 with respect to 2006. In 2006, there were about $9 million of such payments. For the full year 2007, I continue to expect cash flows from operations to have about the same relationship to net income as it did in 2006. A principal enabler of that in the fourth quarter will be sharply lower pension contributions this year compared to the roughly $60 million we contributed in the fourth quarter of 2006.

We remain pretty tight on capital spending with about $37 million gross spending year-to-date compared to $31 million in the prior-year period, and capital spending is expected to scale up somewhat in the last quarter of the year. We currently expect spending to be close to $60 million for the full year 2007. Our gross debt at September 30 was $1.187 billion -- $1.2 billion -- compared to just a little bit over $800 million at June 30 and December 31. The debt increased in connection with our increased share buyback activities. You can also see the impact of the increase of dividends reflecting the increases in October last year and July of this year, partially offset by somewhat lower shares outstanding.

This slide outlines the share repurchase activity undertaken this year. You will note that following our announcement in July of the accelerated program, the Company terminated the remaining $125 million authorization that had been in effect and which was replaced by the new $750 million program. We executed the accelerated share repurchase program in September, and prior to that, during the third quarter, we repurchase just under 1 million shares in the open market. Year-to-date, we have accounted for the repurchase of 10.2 million shares at an average price of $52. Full details regarding the ASR are included in our 10-Q.

As you can see, our average shares outstanding in the third quarter this year compared to last year are down 3%. The full impact of the ASR will be evident in the fourth quarter. As you can see, our shares outstanding at September 30, 2007 stand at just below 81 million shares, down 10% from the 89.4 million outstanding at December 31, 2006.

In connection with the ASR, we completed a private placement of debt in September, issuing $500 million. You can see the various terms and value for those terms in the chart. The ASR funding accounted for $450 million of funds and the remainder was used to pay off current bank borrowings. We were very pleased with the overall interest in the IFF debt placement, and as you can see we were able to term out the debt over a 10- to 20-year period at a weighted average interest rate on debt of 6.37%. Taking into account this debt, along with all other debt on our books, at September 30, 2007, our weighted average interest rate was about 5.5%.

In terms of maturities, this slide depicts the maturities of debt over the next several years. You can see, we have a very good ladder of maturities with no major tranches maturing in any one period. The 2012 maturity reflects the scheduled end of our current bank facility, and while we show it as being paid off for purposes of this slide, it would be our intention to enter into a new credit facility.

As expected, the rating agencies adjusted their ratings on the IFF debt but kept our outlook overall as stable. We're very comfortable with these ratings.

So, in summary, before I turn the call back over to Rob, we continued to see strong growth in our industry and we are very encouraged with our performance to date. We continue to grow sales, improve profitability and deliver on our near-term goals, all while focusing on the initiatives necessary to strengthen our business for the long-term. With that, I will turn back over to Rob.

Thanks, Doug, that was great. In closing, just a few comments. First, we are pleased that we delivered another good quarter for our share owners and our customers. It was a very, very good performance. As we look ahead, we remain confident in our ability to continue to perform consistent with our strategic goals which we outlined for you this time last year. The combination of the positive external environment and IFF's continued focus on winning with our customers, developing our people and innovation will enable us to continue to deliver on our commitments.

And with that, Doug and I would be happy to respond to your questions.

(OPERATOR INSTRUCTIONS) Mike Sison, KeyBanc.

Nice quarter. Rob, when you assess the organic sales growth this year for 2007, one of the things that you noted in the long-term goals was you felt that market growth would be about 2%. So you are tracking more on the plus side of the 4 plus. Is that more of what you have done internally in terms of new product wins, or is the market actually growing faster than the two?

That's a great question, Mike. Clearly, our expectation is we're going to grow relative to the market, first and foremost. We believe we have the tools in place to enable our customers to succeed, and consequently we will be rewarded with faster organic growth. Our understanding of the markets were, when we set those goals, that on balance our markets were growing at 2%. I think there is increasing evidence that perhaps growth is more than that, but I am not prepared yet today to give you a hard number. We're evaluating our data, our customers' data, and we will update that number. If that number goes up, my expectation is that we will again expect to grow faster than the market. But stay tuned, and we will come back when we have more analysis there.

Okay. Then when you think about the momentum heading into 2008, I know it's a little bit early, but can you give us a little sense on sort of the new project wins, sort of the momentum there? Do you see it carrying over into 2008? It looks like Flavors has done a wonderful job this year picking up a lot of business.

I tried to indicate that. As I said, looking ahead, I continue to believe we're going to be able to sustain the growth in sales and earnings that we outlined in our financial goals. Flavors has had a great year and they are on a great trend, as you saw from the charts Doug shared with you. Do I expect they're going to continue to grow at 9% in local currency terms? I think that's a bit of a stretch, but I think they're going to continue to grow. They have some terrific new products in the market and we're winning in a number of areas. So I expect them to continue to advance. Flavors, as we have indicated, has sort of -- pardon me, Fragrances -- has labored under the dilemma with the pricing on fragrance ingredients, which really dates back to a decline in pricing we saw early in the year (technical difficulty) no further deterioration. And I would anticipate not a lot of deterioration from here either.

Fabric Care has been a disappointment. That occurred because we had a loss in certain products, they came off the market, and there was a lag before the new products came back in. These new products are now coming in the market. They're scheduled in the first quarter and beyond. So I think Fragrance is going to pick up from where they are today.

So I remain very optimistic because we've got great internal initiatives. And, to be honest with you, we are dealing with a buoyant global economy and an improving global consumer. That's our market.

In terms of the profitability in Fragrances, you talked about the margin pressures, primarily pricing in Fragrance ingredients, higher raws and sort of the volumes there in Functional. Are those sort of weighted equally? And then going forward, how do you make up some of those pressures heading into 2008?

The pricing represented about 40% of the impact. Material cost represented about 30% of the impact. And then, the volume declines in Functional Fragrances, which as you see if you look in the 10-Q, were most pronounced in North America, accounted for about 30% of the decline in the margin. So it was spread fairly evenly between those three elements.

And do you think those pressures will persist into 2008?

Mike, in today's world with oil trading above $90 and various commodities inflating fairly rapidly, historically we've said our raw materials are increasing on the order of 2% to 3%, and that is what we have seen. But I think we have to be cautionary that there could be increases. We have had -- they're not big items, because in the context of the 2% to 3% overall increase, we've had some declines and we've had some increases of substantially more than that.

Last question and I will get back in queue. In terms of cost savings, pluses heading into 2008 or the fourth quarter, you sort of had a plus [paying] efficiency mix. If you can accelerate that, maintain sales growth, would your margins expect to improve in Fragrances year-over-year going forward?

I think I would be one of the enablers, Mike. The second one is, as Rob mentioned earlier on the call, the acceleration of the launches in connection with encapsulation technology will, one, give us a little bit strengthening in Functional Fragrances. And those two elements, along with just continued sales growth will further improve the profitability in 2008.

(OPERATOR INSTRUCTIONS). Vito Menza, Sandler Capital.

Nice quarter. Just wanted to re-highlight something and make sure I understand it properly. If we exclude a $3 million gain that happened in Q3 of '06 regarding the insurance settlement, we kind of wipe that out of our Q3 '06 EBIT numbers. We're really showing your EBIT margin kind of pre-amortization of 17.1% this year versus 17% last year, and post the amortization of 16.5% versus 16.2%. So we did expand EBIT margin when you wiped out that $3 million gain. Is that right?

And we think it's appropriate to wipe that out, because we had to explain all that because that impacted both '05 and '06, but that is a one-off item that had to go through the selling and admin. But you really have to exclude it for purposes of analysis.

It wasn't a period item, really.

I agree. I read a sell-side note this morning that didn't exclude it, that made it look like your EBIT margin was down 40 basis points year-over-year. So I (MULTIPLE SPEAKERS) sure that (MULTIPLE SPEAKERS) .

I think that's a very good point. We tried to highlight it in both the 10-Q and in the press release, and it's certainly evident in the slides that we've reviewed just a few moments ago. So we try to provide as much information as we can, and then the reader has to progress from there.

Understand. And just a couple of bookkeeping things. Doug, what was the share account you ended -- how about this -- what was the share count you began Q4 with?

It's whatever we announced. We bought back 900,000 shares in the open market and we retired 7.6, so 7 -- I've got to work the math.

Alright, but it seems to be about 80 million or so.

The shares outstanding at the end at September 30 are 80.9.

Got it. Thank you very much, guys, I appreciate it.

(OPERATOR INSTRUCTIONS). John Roberts, Buckingham Research.

The margin pressure in the Fragrance ingredients, was that concentrated in Asia where the sales were down so much? Is that where you weren't able to pass through raw material costs?

John, think of it more as sort of the Fragrance ingredient equivalent of pharmaceuticals going generic. It was isolated in items where people could (technical difficulty) on some of these smaller commodities and they could (technical difficulty) down.

The decline, John, in Asia was primarily volume-driven, but in each of these regions, there was an element of pricing.

And is there excess capacity, or what's preventing you through from passing through the raw material cost increases?

Well, like any commodity, it's supply and demand, and these are still profitable. Prices have come down.

Then in the Functional Fragrance decline in North America, that minus 14% from a reported basis, is there any one thing or a couple of things that account for that?

There's a beeping going on in the back which kind of interrupts. I think you've said -- asking about North America. But that was a couple different things. No individual product accounted for that? But as Rob mentioned and I think I mentioned that there was some transition from old fragrances or existing fragrances, and there was a delay in the launching of the replacement.

Was it in the fabric softener area where you're -- that's where you're kind of hoping to make it up?

Yes, primarily in Fabric Care. And as you know, that's the area where the first launches of the encapsulation technology have been and will continue to take place. So we view it as more of a temporary aberration.

So is this North American fabric care customers flushing inventory of all product?

That's an element of it.

Okay, thank you.

It appears we have no further questions at this time.

Well, thank you. Again, we're pleased with the quarter, we're excited with the momentum. We think we have three solid quarters growing, and we look forward to future results. Thank you for joining us.

Thank you very much.

That concludes today's conference. We thank you all for joining us.