International Flavors & Fragrances Inc (IFF) 2008 Q1 法說會逐字稿

Good morning and welcome to the International Flavors and Fragrance first quarter 2008 earnings conference call. Today's call is scheduled to last about one hour, including remarks by IFF's Management and question-and-answer session. Today's conference is being recorded. I will now turn the call over to Yvette Rudich, Director of Corporate Communications. Please go ahead.

Hello and thank you for joining us today. With me are Rob Amen, Chief Executive Officer and Doug Wetmore, Chief Financial Officer . Our earnings release was issued and our 10-Q was filed earlier today . Both are available on our website at isf.com in the investor relations section. As you know, during this call, we may make forward-looking statements about the Company's performance. These statements are based on how we see things today, but they contain elements of uncertainty. These forward-looking statements may be identified by words such as expect, believe, outlook, guidance, may or similar expressions . Actual results may differ materially, due to risks and uncertainties. For a more detailed explanation of the inherent limitations in such forward-looking statements, please refer to the cautionary statement and risk factors contained in today's earnings release and in our 10-K and 10-Q filings available on our website.

Some of today's prepared remarks will exclude those items that affect comparability. These excluded items are captured in our GAAP to non GAAP reconciliations available on our website . For today's call, Rob will begin with some high level comments on the quarter. Then Doug will provide a review of the financial results. Following closing comments from Rob, we will then take your questions. With that, I will now turn the conference

Thanks, Yvette, and good morning. Welcome to the call. I thought I would start with some overview comments on the flavor and fragrance markets and then take a look at the quarter. Demand for flavor and fragrances really reflects both the economic vitality of a country as well as its stage of economic development. For example, in mature economies, we expect flavor and fragrance demand to be in line with GDP. While in a country like India, demand should be far higher than GDP growth, double or even higher. The rising number of middle class consumers fuel rapid growth for our customers's products. Consequently, while the U.S. market demand may be adversely impacted by a weak economy, we're seeing solid growth and demand in China, India and Brazil. Now for the first quarter 2008, IFF reported sales growth of 5% over the first quarter 2007. Excluding currency parity changes, the increase would have been 1%. Sales were driven higher by strong performances in the emerging economies of Asia, Latin America and the Middle East. The european region was up sharply in dollar terms and stable in local currency.

Operating margins improved in fragrance ingredients due to mix and cost recovery, while margins in regions outside of North America benefited from higher sales and good cost control. We had challenges with our business in North America, and with the fine fragrance business globally. These businesses were clearly impacted by the weak retail environment and an inventory correction. As I suggested on our last call, the fragrance business was likely to face a tough quarter. The inventory correction we expected is real and pronounced. I am pleased that the fragrance business activity as measured in new products is up year to year and we are again winning a healthy share of the projects. This will be reflected in sales in late 2008 and in 2009. I will have more to say on how we are working through our challenges and why I remain confident that we will meet our financial goals. However, now, I'd like Doug to take you through the details of the quarter.

Thank you, Rob. Good morning, everyone . Let's begin with an overview of sales. We provided the breakdown of sales and growth. As you can see flavors grew 12% on dollars and fragrance sales were flat in dollars with the 2007 quarter, declining 4% in local currency. The primary drivers of the difference between the local currency growth and the reported dollar performance was the strength of the euro compared to the dollar. The euro was about 11% stronger than the prior year quarter. A basket of other currencies accounted for the remainder of the exchange effect. The fragrance decline resulted from mainly sharp declines in North American fragrance sales in all categories, which I'll touch on in more detail in a few moments. In 2008 we have also begun to realign our portfolio of fragrance ingredients, following the the pricing pressure and margin compression experienced in 2007. During the first quarter we discontinued the sale of certain ingredients, which in total, accounted for about one-half of the fragrance local currency decline in the first quarter. While sales declined as a result of this portfolio realignment, the benefit was improved ingredient profitability.

We also undertook a series of price increases in ingredients that had a modest impact on Q-1 results but such impact will increase in the second quarter and as the balance of the year progresses. As you can see on the map, we had solid growth in each geographic region but North America. Europe reported very strong growth, increasing 9% over Q1 '07. Quarterly sales benefited from the strength of the euro as I mentioned. But the reported growth reflected a local currency increase of 1%, led by a 3% increase in flavors. Latin America sales increased 12%. This growth was particularly strong in flavors which grew 37% in the quarter, led by several new wins and strong volume of existing creations. Greater Asia also achieved excellent growth, driven mainly by new wins and improving volumes. Asia sales increased 15% in local currency and 19% in dollars. Fragrances led the Asia performance with an 18% local currency growth, but flavors was not far behind with 13% local currency growth. Growth in Asia was strong in all product categories. Local currency sales to our top product customers, which account for about 56% percent of our sales grew 2% in the quarter, or about twice the rate of our overall local currency growth.

Now let's discuss each of the business units' performance in a little more detail. As you can see, flavors had a very solid start to the year. The wins in volume growth existing business drove improved margin performance. The very strong operating profit leverage results from solid sales performance, enabling excellent absorption of manufacturing costs. All this was enhanced by good -- continued good cost control . The end result was a 27% increase in operating profit. It bears noting that the 2008 performance was against a difficult comparison the first quarter of 2007, when flavors' operating profit increased 20% on an 11% sales increase. Also as discussed in our 10-Q, the 2008 result is inclusive of about $1 million of restructuring costs amicable to flavors, impacting the operating profit comparison with the prior year by about 2%. This chart depicts the percentage growth in flavors sales in both local currency and reported dollars for the last three years. As is evident, the local currency sales performance for flavors continues to excel, driven by the wins in improving volumes.

As we noted in our press release today, we have delivered above market growth for seven consecutive quarters, increasing our market share during that time. And overall, flavors has now grown 11 consecutive quarters in local currency and we are confident that that growth will continue. The fragrance story for 2008 to date is markedly different from flavors. The fragrance operating environment has been more challenging and fragrance profitability has suffered. In the first quarter, as I mentioned, each geographic region other than North America, had a very solid start as we saw in the earlier slides. However, North America sales fell 23%, declining in all categories. The quarter comparison was made more difficult by the 11% increase achieved in the first quarter of last year for North America. But overall, volumes fell sharply in fine, functional and ingredients, driven mainly by overstocked positions at many customers following a weak holiday season in fine fragrance and by destocking efforts at many functional and ingredient customers in view of the weak macroeconomic environment.

This North American weakness, especially the 30% decline in fine fragrance, materially impacted North America and consolidated operating profit in the quarter. Mainly as a result of the sales declines, North America operating profit for the quarter fell $13 million from the prior year quarter. Fragrance operating profit on a consolidated basis also reflects $2.5 million of restructuring costs in the quarter, accounting for 4% of the operating profit decline in comparison to the prior year quarter, also again as discussed in our 10-Q. As you can see in this graph, the local currency sales performance for fragrances had been quite strong throughout 2006 and much of 2007, driven by new wins and a sustained success of existing creations. Comparison with the last year first quarter was particularly difficult, as I noted, especially for North America, as well as for fragrance ingredients overall. But as you'll recall from our last call, we saw a sharp slowdown in Q4 in fine fragrances, most notably in North America and Europe and that North America slowdown continued into 2008. Having said that, at the same time, we have begun to see improvement in functional fragrance performance, supported by new wins and by the launch of the next encapsulation products.

We had a very strong performance in functional in all regions outside North America. Turning to consolidated operating results, the 2008 first quarter summarized on this chart, now note that the chart excludes the impact of the $6.2 million of restructuring charges. Just on that subject for a moment, we have spoken to you in the last several quarters regarding certain initiatives underway to transform our business processes. The principal enabler of this transformation is our single global instance of SAP. In this quarter, these restructuring charges related to employee separation costs, due to the elimination of about 125 positions in administrative functions, mainly accounting and finance, as we moved to outsource these functions to a third party service provider. The first steps in outsourcing will commence in the second quarter, and will proceed over the balance of the year. We will begin to see benefits of these initiatives in the second half of 2008. And there are additional details regarding these charges in our form 10-Q.

Now looking at the P&L for the quarter, as we mentioned, sales increased 5%, resulting in a 4% increase in gross profit. And as I mentioned before, the weakness in North America fragrance impacted gross margin because of poor manufacturing expense absorption, which is accounting for the decline as a percent of sales. While R&D expense increased this quarter in both absolute value terms, as well as a percentage of sales compared to the prior year, exchange was a significant element of the value increase. Excluding exchange, R&D would have increased about 7% versus the prior year quarter. It also bears mentioning, the 2007 first quarter was unusually low as a percentage of sales, 8.2%. And the first quarter of 2008 is more in line with the full year 2007 spending rate. Selling and administrative expenses declined 1% compared to the first quarter last year, and excluding exchange, selling and admin would have declined 4%. The decline reflects continued good cost control, as well as somewhat lower incentive compensation accruals compared to the prior year quarter.

Selling and admin also reflect the benefit of an insurance recovery of $2.6 million relating to a 2005 product contamination matter. The recovery reduced current year selling and admin expense because the related costs were charged to that same caption three years ago. The end result of all the matters I just mentioned was a 7% increase in operating profit compared to a year ago. The evolution of earnings per share from the $0.69 reported in the 2007 first quarter to our current year's quarter is depicted on this slide. As in the past we have not isolated the impact of translation, so other than for shares outstanding, exchange is embedded in each caption. And also, as you would expect, there is some rounding effect in each caption. But having said that, sales growth added $0.04 per share, the operating margin declined, breaking out the insurance recovery separately, reduced the earnings per share by $0.01 and that was mainly due to the gross margin erosion on North American fragrance weakness. As I just mentioned, we recovered $2.6 million related to the 2005 contamination issues. And after tax this recovery accounted for $0.02 per share.

Other income and interest expense combined accounted for a net decrease of $0.09 per share. Most of this change resulted from interest expense which increased about $10 million in connection with a debt taken on to implement the accelerated share repurchase program we undertook last September. We also had somewhat unfavorable exchange results in the current quarter compared to the first quarter of '07, which accounts to much of the remaining difference. There were no sales of assets or related gains in the current quarter. Taxes favorably impacted the current quarter's result as well, adding $0.02 per share. And as we mentioned in our press release, the effective rate for the quarter of 25.4% benefited from favorable tax rulings with respect to prior years. These tax rulings added about $0.03 per share to the first quarter results. And absent these rulings, our effective tax rate for the quarter would have been 28.2%, about the same as the 2007 first quarter . We reduced the number of shares outstanding, adding $0.08 per share and average shares declined 10% from the prior year quarter. And as I just mentioned a moment ago we recorded restructuring costs in the quarter of $0.06 per share . Taking into account all these components our reported EPS for Q1 '08 were $0.069 a share and, excluding those restructuring charges, the EPS would have been $0.75 per share.

The detailed cash flow is available in our 10-Q. Here's a summary on this slide. There were no major fluctuations in cash flow from operations . The first quarter is historically our smallest quarter for operating cash flow. For the full year 2008, I would expect cash flow from operations to have about the same relationship to net income as it did in 2006 and 2007, about 120 to 125% of net income. As you can see, we reduced debt somewhat during the quarter and we also remained pretty tight on capital spending. Having said that, capital spending is expected to scale up somewhat in Q2, as we progress with construction of a new creative center in Brazil, an expansion of our ingredient facilities in China, and a new creative and administrative center in China. The dividend payout reflects the 10% increase announced last year, essentially offset by the reduction in shares outstanding.

And we've continued to buy back shares. In addition to the shares being purchased on our behalf in connection with the ASR. That ASR remains in progress at this time. Year to date we have spent just under $30 million in share repurchase activities, and in so doing, we bought back about 700,000 shares. At quarter end, shares outstanding stood at about 80 million. At quarter end, we also have a remaining authorization of about $269 million. As I just mentioned the ASR remains in progress and we expect completion of the ASR in the second quarter of 2008. Based on current prices and the shares held back at the time we entered the ASR, I would expect to acquire upwards of 1 million more treasury shares some time in the second quarter 2008 on completion of the ASR, but at no further cash cost to the Company.

In looking at a couple of other metrics that we believe are meaningful to investors, our overall return on invested capital for the trailing 12 months ended March 31, 2008 of 14.4% is in line with that achieved for the prior year comparable period. Our return on equity has improved significantly over the prior period, driven by the solid operating results and augmented by the impact of the accelerated share repurchase program. For the comparable prior year period, our return on equity was just under 26%. Finally, in terms of our EBITDA margin, for the trailing 12 months ended March 31, 2008, EBITDA totaled $461 million or 20% of sales compared to $443 million or 20.6% of sales in the prior year comparable period. Now I'd like to turn the

Thanks, Doug. 2008 is and will likely remain a challenging year. The greatest challenge remains to the U.S. I'm not an economist and I'm not making a forecast. But it's hard to see a recovery this year. The next unknown we are dealing with is whether or by how much the U.S. slowdown will impact other economies. We have seen some slowing of growth in several emerging economies, but growth remains in the 7 to 10% range. Fine fragrance business will be a challenge. First quarter sales reflected lower sell through and an inventory correction, which we expected. I can't forecast a turn around in this business until sales enable inventory at our customers to be back at more normal levels.

Lastly, in the past we have reported raw material price increases of about 2 to 3%. In Q1, we saw this tick up slightly to 4%. Now, we continue to work hard to recover these cost increases. However, the inflationary pressures on raw materials is a concern. That being said, I believe I FF is well positioned to deal with the challenges of 2008. IFF is a truly global company with a strong position in every marketplace of importance. Yes, the North American market, which accounts for about 27% of our sales, is currently weak. This is a cyclical issue and we believe in the long-term potential of the U.S. market. Our presence in the emerging markets is a key strength and a key opportunity. I'm very pleased both with our current performance and our future prospects in these fast growing economies. Consequently, we continue to build IFF for the future.

As a result, we remain focused on our strategic priorities, growing our market share by helping our customers win, increasing profitability by improving effectiveness and efficiencies, and the outsourcing initiative Doug mentioned representative of these efforts. We'll continue to invest to meet the needs of the future. For example, we are investing in new and larger creative facilities to drive future growth in China, Brazil and here in the U.S. These are key assets which are integral to winning a new business. Our goal is to build a stronger company based on materials excellence, in-depth understanding of consumers, and superior creativity. I believe by focusing on these strategic imperatives, IFF will deliver on its financial goals. Now Steve, if you could help me, we'll open up the call to take questions.

(OPERATOR INSTRUCTIONS) First question from Douglas Chudy from KeyBanc.

Good morning.

Hi, Doug.

Just wanted to check with you. You noted the inventory corrections in Q1. Do you think this is largely complete? Or should we expect this to flow through into the next quarter? Or next couple of quarters?

Doug, as I indicated, it's really impossible to know whether or not it's complete until after the fact. I think the overhang is -- remains with us. I think it will be an impact in the second quarter and will slowly diminish over the course of the year.

Okay. And secondly, you mentioned that new project activity picked up year over year in the first quarter. Is this on a consolidated basis? Can you maybe break out what you were seeing in flavors versus fragrance? I assume maybe the flavors side was a little bit stronger?

Actually I made the comment referencing fragrance. It's interesting to note we are seeing a pick-up of fragrance projects here in the States, and that's very, very good. And as I said, we are winning a good share of those things. So I feel better about the fragrance business as we move through the year. The flavors business is doing terrifically. Around the world the activity is up, the win rates are up, we are winning in the categories that we said, Doug indicated, but I have to tell you, I am really impress with our flavors team and what they are achieving.

Okay. Finally one other question. I know you don't provide specific guidance but given the current state, do you think that the fragrance, in the tough start to the year, the fragrance segment I guess can get local currency growth positive in 2008 in or do you think that may be a challenge at this point?

I think at this point in time, first of all, we have very difficult comparisons in fragrance for the first half of the year. That will certainly be an element but only an element. I think we are seeing very good growth outside the United States. And while as Rob mentioned, you have to be somewhat cautious about the U.S. market, we are pretty confident that overall we will deliver local currency growth during the segment of 08.

All right. Thank you very much.

(OPERATOR INSTRUCTIONS) Next question from Jeffrey Zekauskas from JPMorgan.

Good morning. This Silke in for Jeff . How are you? Couple of questions. Can you break out the 1% local currency growth by volume and price? Or can you just generally talk about prices in the

There was not a measurable price increase impact in the quarter. As we mentioned, we some passed through some price increases on fragrance ingredients. But that was just an element. But it's -- really overall that 1% is primarily volume-related and driven by the new wins and volume increases on existing creations.

Secondly, related to the restructuring that you had taking and cost savings that may flow through the income statement the second half of the year, what benefit should we be looking for? Could it be $1 million for $1.5 million a quarter in savings beginning in the second half or is that too large a number?

I would prefer at this point in time not to quantify. As I said, we expect some savings to begin in the second half of the year. But at this point in time, it's probably a bit premature to quantify that. But it does bear mentioning, though, that these are one of the things that we have talked about in the past as a contributor toward our getting to that 18% plus operating profit as we exit 2009.

And maybe a last question I'll go back into the queue. On the -- you had some very strong growth on the flavor side. Can you at all aggregate what amount is due to share gain, market share gains, what portion is due to new product introduction and at what rate the base business has grown?

Great question. If we had really good market data we'd be able to give you good analysis. We think there is a decent market share gain. And the market share gain comes from new wins. You either have growth in existing business -- growth or erosion in existing business and then the new wins. So, Doug, I would imagine it's about half and half.

Pretty close to that. We do have some disclosures in the MDA portion of the Q. Which depending on how you print it off, I have it on page 14 in mine. But it provides a breakdown of some of the new wins. And then the balance of the growth in those region was volume-related.

Okay. That's helpful. Thanks very much. I'll get back into queue.

(OPERATOR INSTRUCTIONS) We have a follow-up question from Jeffrey Zekauskas of JPMorgan.

I guess I'll just stay on the call. I had a question related to the encapsulation technology. That is you mentioned that you launched a new product on the functional side related to encapsulation technology. In which region was it launched and if I could know, how many products are in the market today on the functional fragrance side that use the encapsulation technology?

We had two major launches. We had one major launch in Europe and one major launch in this quarter in Latin America. I am very pleased with the response in the marketplace. Both products have gained meaningful amount of market share against their competitor products. Our customers are happy and it's a demonstration of the technology. So where we remain very, very optimistic about the potential of encapsulation to help our customers.

Maybe to follow-up on that, if I look at the functional, if I look at a local currency growth on the functional fragrance side of 3% this quarter, is that something you think may be sustainable throughout the year? Like a similar rate, given like the success with encapsulation and maybe other products?

I think the 3% is definitely sustainable. If you take a look at what's gone on in North America, if we just get North America stabilized a little bit, you could envision numbers well above the 3%. This was really a tale of two cities in fragrance. I mean, you had all other and then you had North America. And if we understood North America was going to be weak, we are working and that will improve. Not quickly, not dramatically, but it will improve and to the extent that the inventory correction starts to be behind us, we'll see much better numbers. Outside of North America we are seeing really excellent growth in functional fragrance and certainly flavors on a global basis.

So if I had to summarize, to me it sounds that some of the -- on the fragrance side that local currency growth in functional may be improved throughout the year. Fine fragrances may be a bit challenging just because it's been weak demand, it is not really clear what the inventory levels are on the retail level. Ingredients business may have a little bit of a head wind because of probably lower margin that you chose to exit, which over time should improve the margin. And flavors has a good win rate and a good rate of growth, which it seems to expect to continue throughout the year.

I think you have summarized the quarter very effectively.

Okay. Thanks very much and I'll stay on for the call.

Steve, any more questions?

Next question from [Eric Shorgen] from Morgan Stanley.

Good morning.

Good afternoon, Eric.

Good afternoon. Just two quick questions. First the on the -- a bit more color on the North American fragrance market, could you talk a little bit more about which category is it which is driving this weakness? Is it really just the perfumes? Or is it across all the different ones? And also within the fragrance ingredients, is this continued price pressure here or is it actual volumes which are falling off? And then secondly, just on the margin, nice seeing the SG&A coming down so much as a percentage of sales. Is this kind of leverage sustainable during the rest of the year do you think or was it mainly related to the compensation expenses during the first quarter?

I will try to answer each of them and if I overlook them help me back because that's a lot. First of all I would encourage to you take a look at the table in the 10-Q, because we explode the sales by area, by region, by product category by region. And North America was most pronounced in fine, but functional ingredients following that, because ingredients follows the functional and we think that, as I said, some decline in consumption, but certainly in inventory correction.

Okay.

And I'm -- I certainly don't anticipate that we are going to see that continue. I expect that will improve over the course of the year. Not -- don't look for an enormous bounce in the second quarter, but certainly in the latter part of the year, this should be strong. Now fragrance ingredients, there is a lot of good things going on there. Last year, we saw pricing pressure. I said we were in, on our December call, we were addressing it, we have gone to the market on these materials and increased prices. We saw a very modest amount of that in the first quarter. Those will be, those increases will be more evident as we move through the remaining quarters of this year. So you did see an improvement in margins in the first quarter and they will be further improvement in margins as we progress through the course of the year. And then fine fragrance, what was your -- ?

You know, Eric, if you look in the Q, as Rob said, we break out the category performance by geographic region. I think that, we talked about it a bit, but I think your second question was on the selling and admin, and can we continue at that current level? As we mentioned, the lower incentive compensation accruals, we had a very strong first quarter in 2007, which drove higher incentive accruals and they were not quite as high this quarter because our performance was not quite as good. And they are very much performance driven incentive accruals. But our goal is to continue to reduce the selling and admin expenses and that's really why we have undertaken some of the initiatives, such as the outsourcing that I mentioned on the call, and those will benefit selling and admin, basically, admin expense in this case. And I think Rob mentioned in his comments that this is just an example of what we are undertaking, which means that there are other initiatives that we have to undertake to further take non value-added costs out of our business. And the primary tool for that is to leverage this wonderful tool that we have in SAP.

Okay. That's great. Thanks very much.

Okay.

Next question will come from John Roberts from Buckingham Research.

Good morning, Bob. Good morning, Doug.

Good morning.

Could you compare/contrast the current economic cycle impacts on your business, the (inaudible) cycles? Is this divergence between flavors and fragrance in North America kind of unprecedented?

I guess I'm the closet historian, John, so let me address that. You know there's a couple differences between this one and the last let's say 2001 dating back to the early 90s. I think that's probably, you can argue all you want about the disconnect between the global economies now or the delinking of the global economies. I think that is certainly an element, because the growth in India and Brazil and China and Indonesia as examples are -- they might be affected a little bit by the U.S. but I don't think it's going to cause those economies to come to a screeching halt, because they have acquired so much momentum on their own. Only the fullness of time will prove whether that assessment is correct. The second thing for us, typically, in an economic slow down, it's always been the flavor business that has perhaps that's been a little bit more impacted, which is, I think, a surprising change for this one. Because flavors, typically the food companies would really slow down new product launches, would curtail marketing expenditures, all with the focus on driving or maintaining their earnings. And I think now they are continuing launch new products and they are really focusing on growth. And so that's probably a difference from the last two cycles that I have experienced here in North America.

Are there substantial supply chain differences down the fragrance customer applications versus the food one? So that you wouldn't expect inventory effects in flavors that you are seeing over in the fragrance side?

I think the one key difference in flavors from fragrances, you have a much shorter shelf life for the -- for our flavor and fragrance compounds. Food has a shelf life, whereas fragrance, as long as it's properly stored, really has a very long shelf life . So that may suggest that there could conceivably more inventory of a detergent product or a fine fragrance product than of a snack or a beverage

That's what I was trying to get at, because you've really got the same consumer at the end of the day buying either a food product or a household cleaning and personal care product.

But there's a different dynamic if you think, too, John on the product development and introduction. Flavor product development is much quicker . I mean we can see things as rapidly as three or four months going from development to being in the market, where in fine fragrance it's always, it seems to me, close to a year. And sometimes longer. So they are the end consumer, but how they develop the product, the intricacies of the customer supply chain and the supply chain complexity cause there to be a

I think the other thing past experience has shown is that the phenomenon of destocking is pretty much contained within North America. We have never seen the European or Lat Am or greater Asia companies accumulate the inventory in their distribution chain, as we have seen in North America. So that, when the destocking effect happens or the pendulum swings the other way, that impact is most pronounced no North America.

Has there been a shift over the past couple of cycles and a difference between flavors and fragrance, between say discretionary applications -- I'm thinking about a candle being discretionary versus a shampoo scent or cleaner scent being a basic need. I don't know if you're more exposed these days or the industry is more exposed to a lot of new things that have been introduced that are viewed as discretionary purchases by customers. So that some of the functional business has become kind of like the fine fragrance business.

Yes. We have not seen enough evidence to suggest there is any change in consumption in the functional area to date. Now, maybe in a year's time we'll have some different insights on that.

Okay.

And certainly, I mean, let's all be open and honest on this. The American consumer, the working class family is going to face some real tough challenges over the course of 2008. They are going to be making trade-offs. How they are going to make it, we don't think we understand yet nor is it evident. But so far, we have not seen a significant shift. We are seeing in the functional fragrance area more supply chain adjustments and more sort of adjustment and some push back on some of the ingredients price increases to some degree. But that's now sort of returning to more normal levels.

Okay. Because I was -- my concern was that in the food side, I think a lot of the new product introductions by your customers have been new drinks, things that might be discretionary purchases by customers on the food side, even not basic foods but more of these alternative new age beverages and so forth. You are saying you aren't seeing really a pullback in functional on discretionary type products. You don't think you would see it on the food side, either.

No good data with which to draw conclusions yet, John.

Lastly, I thought R&D as the percent of sales might gradually trend down a bit, because you are going to the center of excellence model globally and R&D and that there would be some savings in that function as well? There wasn't really any evidence of that in the quarter.

Well you know, John, to be fair, I think you you would have seen that come down, it was that 8.7%. Had North America sales just stayed flat, it probably would have been been down to about 8.5%. Long-term, you can't just look at an individual quarter. You have to look at it long-term. I think that long-term because of a higher rate of sales growth and a very tight focus on certain R&D initiatives, that the R&D expenditure will trend down closer to 8% than to 9% over the course of the next couple of years. And that's really what we have been saying all along. We are committed to spending between 8 and 9% on R&D, because ultimately, we've got to develop unique materials to help our customers. They may be more powerful materials, they may be materials that enable a customer's product to be lower cost. But we will -- we see enormous potential for new products and new materials and we're going to continue to invest. So that's in our strategic plan to be in the 8 to 9% range.

Thank you.

(Operator instructions) Next question from [Chris Lashok] from Perkins Wolf.

Good morning, Rob and Doug. Have you guys put any numbers around the impact of the inventory destocking? During the quarter?

Well, it's hard -- I think there's a couple of things you can do. First of all, we know we haven't lost a significant amount of business in terms of just being replaced. And certainly that's the case in fine fragrance, where you just don't -- you are not replaced. So it really is an element of destocking or just a slowdown in order activity, a slowdown in the restocking activity. But I think, if my experience over the last decade has been any indication, it typically takes a couple quarters after the destocking effect passes before you really come to grips with what the impact was. I think back to the fourth quarter of -- it's either '03 or '04, where we suddenly had a surge in functional fragrance activity in North America and sales for functional jumped 20%, give or take, in that quarter. But we knew we didn't have any wins that would drive that order of magnitude. But it was more along the lines of the restocking because, at some point in time, the customer was concerned that they were going to lose a sale because they didn't have sufficient inventory in their pipeline. So it's really 20/20 hindsight that would only allow us to really analyze that.

Okay. Next question I guess is probably the bigger one in my mind. You have mentioned you've seen the raw material inflation rate tick up here. We are now looking at about, I guess, around 4%. And yet pricing is more or less flat. How you do you tackle that 4% cost inflation, which in my opinion is probably only going to get worse here in the next quarter or two or three? How do you go about getting that back?

Well there is two ways of going about it . First of all, we have to go to our customers on some materials and get cost relief . And there's a big part of it . The other part is you design the higher costs into new products. And every time we are developing a new product, we understand the new cost and we are developing those new products with those costs in place. So in effect, you are capturing that on a go-forward basis. We are out, and we have been seeking cost relief and achieving it. So, we'll get a little bit more of that. But as the portfolio turns, you are effectively

Great. Thank you.

And at this point, we have no further questions.

Thank you all for joining us. And we look forward to speaking with you in future quarters.

Thank you very much.

And this concludes the teleconference. We thank you for your participation. Have a great day.