International Flavors & Fragrances Inc IFF CEO Andreas Fibig on Q4 2019 Results

At this time I would like to welcome everyone to the IFF fourth quarter and whole year 2019 earnings conference call. All participants will be in a listen-only mode until the formal question-and-answer portion of the call. To ask a question at that time, please press star 1 on your touch-tone phone. If you would like to remove your name from the queue, please press the pound key. Participants will be announced by their name and company. In order to give all participants an opportunity to ask their questions, we request a limit of one question per person. I would now like to introduce Michael DeVoe, Head of Investor Relations. You may begin.

Thank you. Good morning, good afternoon, and good evening everyone. Welcome to IFF's fourth quarter and full year 2019 conference call. Yesterday evening we distributed a press release announcing our financial results. A copy of the release can be found on our IR website at ir.iff.com. Please note that this call is being recorded live and will be available for replay on our website. Please take a moment to review our forward-looking statements. During the call we will be making forward-looking statements about the company's performance, particularly with regard to the outlook for the first quarter and full year 2020. These statements are based on how we see things today and contain elements of uncertainty. For additional information concerning the factors that can cause actual results to differ materially from our forward-looking statements, please refer to our cautionary statement and risk factors contained in our 10-K filed on February 26, 2019 and in our press release. Today's presentation includes non-GAAP financial measures which exclude those items that we believe affect comparability. Reconciliation of these non-GAAP financial measures to their respective GAAP measures is set forth in our press release that we issued yesterday and is posted on our website. With me on the call today is our Chairman and CEO Andreas Fibig and our Executive Vice President and CFO Rustom. They will begin with prepared remarks and then take any questions that you may have. With that, I would now like to introduce Andreas.

Thank you, Andreas. First, let me say how delighted I am to have joined IFF at this exciting time. With the integration of Frutarom, the combination with DuPont's N&B business, and the many opportunities and challenges this will bring, for my part I expect to focus on: first, improving execution and accountability; second, enhancing effective collaboration across the business – that's legacy IFF, Frutarom, and soon N&B; third, strengthening our financial discipline; and finally, delivering solid ROI. Now on to the numbers. Reported sales increased by 29% in 2019, with three additional months of Frutarom being the major driver. Excluding Frutarom, currency neutral sales grew 3% with the 2019 53rd week contributing 1%. I'll provide more color on sales by segments as we go through those slides. Fully adjusted operating profit margin excluding amortization rose by 30 basis points, driven by productivity initiatives, acquisition-related synergies, and a Brazilian tax recovery. It's also worth noting that in our fourth quarter, our currency neutral EPS excluding amortization grew a robust 23%, driven mostly by acquisition-related synergies, volume growth, low incentive compensation, a Brazilian tax recovery, and a lower effective tax rate, which more than offset headwinds from higher raw material costs. As the IFF team has done in previous quarters, I would like to highlight the impact of emerging market pricing on our growth rate to better compare to peers. As a reminder, for a variety of reasons, many of our sales transactions in the emerging markets occur either in US dollars or other hard currencies or are indexed to hard currencies when we have to invoice in local market currencies. So when reporting our currency neutral sales growth, we exclude foreign exchange related price changes in emerging markets. But this is different from our peers. We believe that our reporting standard provides investors with the true assessment of underlying currency neutral growth, especially when there are large emerging market devaluations relative to the US dollar or euro. However, it's important to help all of you understand performance relative to competition. For the fourth quarter of 2019, the stronger US dollar environment plus emerging market devaluations year-over-year in several key markets had approximately a 1% currency impact on growth if we include emerging market pricing. For the full year, this impact represented approximately a 2% currency impact on growth rate. Let's dig a little further. Let's move on to slide 11. In the fourth quarter, currency neutral sales increased year-over-year by 6% to $478.3 million. Fourth quarter performance was strongest in Consumer Fragrance, increasing in the high single digits from the prior year, driven by growth in home fabric and hair care. Fine fragrance grew in the mid single digits, led by double-digit growth in both Greater Asia and Latin America. At the same time, Fragrance Ingredients declined in the low single digits from last year as price increases were offset by volume declines mainly as a result of industry destocking. For the full year, currency neutral sales increased by 4% from 2018 to $1.9 billion, with growth across all regions and all categories, especially those that are a strategic focus. Both Fine Fragrance with record new win contribution and Consumer Fragrance grew in the mid single digits from 2018. Our performance in Fine Fragrance was driven by double-digit growth in EMEA and Greater Asia, while as in the fourth quarter, Consumer Fragrance was led by strong improvements in home and fabric care. For the full year, Fragrance Ingredients improved by low double to mid single digits driven by price increases. For the full year, currency neutral segment profit grew 6% and margin expanded 30 basis points to 17.3%. Drivers included raw material driven price increases as well as benefits from productivity initiatives that ran the gamut from manufacturing, procurement, and make versus buy to innovation. Moving on to Taste on slide 12. In the fourth quarter, currency neutral sales increased year-over-year by 8% to $429.9 million. This performance was led by double-digit growth in Greater Asia and high single digit growth in North America. Sales to multinationals, which had been under pressure in the last few quarters, grew mid-single digits, indicating an inflection point in Q4. We also saw much stronger growth from regional and local customers. From a category perspective, we were strongest in beverage and savory, helped greatly by strong new win performance. For the full year, currency neutral sales increased by approximately 2% to $1.7 billion, driven by high single digit growth in Greater Asia and low single digit growth in EMEA. As discussed during the year, we had some challenges in North America and Latin America related to volume declines with multinational customers. As in the fourth quarter, full year 2019 growth was strongest in beverage and savory. For the full year, Taste posted an industry-leading 22.1% segment profit margin with $383 million in segment profit, which was supported by productivity increases, integration-related synergies, and lower incentive compensation expense. Now let's move on to Frutarom's performance on slide 13. In the fourth quarter, Frutarom currency neutral sales increased year-over-year by 6% including the net contribution of acquisitions and divested businesses, which is a sequential improvement in underlying performance. Organic currency neutral growth for the quarter was 2%, essentially led by taste and savory businesses. As discussed in past calls, Frutarom experienced compliance and portfolio related transitory headwinds. Excluding these, organic currency neutral growth would have been 6%. For the full year, sales were $1.5 billion for the segment, up 3% on a currency neutral basis from the prior year including the net contribution of acquisitions and divested businesses. In 2019, organic sales growth was flat, and if you exclude the transitory issues, organic currency neutral sales growth was 3%, driven by solid growth in taste and savory solutions, the fastest-growing category. Future growth includes double-digit increases in food protection inclusions and algae. For the full year, Frutarom segment profit was $127 million or $286 million excluding amortization, and we finished the year with a strong quarterly segment profit increase of 24% led by acquisition-related synergies. The Frutarom operating margin excluding amortization was 19.2%, supported by delivering on our acquisition-related synergies and by disciplined cost management. Slide 14 provides some additional color on cash flow. As you will see, operating cash flow for the full year was up significantly from $438 million in 2018 to $699 million this year, a $261 million or 60% increase. This was driven primarily by higher cash earnings from Frutarom, which was included for the entire year. Working capital, defined as inventories, accounts receivables, and accounts payables, improved year-over-year with progress in all three metrics. Inventories still remain at elevated levels primarily due to raw material cost increases and safety stocks within the scent division. However, in the fourth quarter we saw continued positive trends. For 2019, capex as a percentage of sales is approximately 4.6%, which is a significant investment in the future. Throughout the year, we made new capital investments with new plants and capacity investments mainly in Greater Asia as well as creative centers, and we invested in high return integration-related synergy projects such as manufacturing optimization. Bringing all this together, we had a strong $95 million increase in free cash flow for 2019, representing a 73% increase year over year. Moving on to slide 15, we expect full year 2020 sales of between $5.15 and $5.35 billion, with adjusted EPS excluding amortization between $6.20 and $6.45. At this point in time, we expect a modest impact on sales from the recent coronavirus outbreak, but we are unable to quantify this as there are just too many variables and uncertainties. In addition, we have already incurred some relatively modest costs related to the outbreak as we acted to mitigate the impact to our supply chain. Right now it's too early to quantify the impact on our results, but we did widen both our sales and adjusted EPS excluding amortization guidance ranges to make some allowance for this as well as for continued volatile operating environment. The next slide provides some additional color about what we expect to drive our core sales growth for the year. Looking into our 2020 sales growth expectations and given the several moving parts, we felt it was important to give you an overview of the drivers. As you see from this slide, sales growth for 2020 is expected to be approximately 1% to 5% on a currency neutral basis. This includes a headwind of about 0.5 percentage point impact from portfolio adjustments, namely the carryover impacts from compliance and citrus sourcing, and an estimated one percentage point impact related to the 53rd week in the prior year period. Excluding these impacts, our core currency neutral sales growth is expected to be approximately 2.5% to 6.5%, which includes approximately 2% to 5.5% from the organic business, 0.5% to 1% from cross-selling, and little to no impact from M&A. Now let's move to slide 17 for some additional color on what is driving our EPS growth. Adjusted EPS excluding amortization growth for 2020 is expected to be approximately 3.5% to 7.5% on a currency neutral basis. This includes a headwind of approximately five percentage points related to an incentive compensation reset which is usual performance versus internal budget in 2019, an anticipated 0.5% impact due to the portfolio adjustments, and an estimated one percentage point impact related to the 53rd week in the prior year. Excluding those impacts, core currency neutral adjusted EPS excluding amortization is expected to grow in a range of 4% to 8%. We also expect to have a 6% positive contribution from integration synergies, which when added to our core growth puts us in the double-digit growth rate. We are the delevering team and pleased to tell you that we remain on track to deliver on our commitments of getting down to below 3 times net debt to EBITDA by the end of 2020 while maintaining an investment grade rating. We are already down to approximately 3.2 times, down from 3.6 times a year ago, and we will continue to focus on improving working capital, tightly managing our capex while making the necessary investments, and of course growing our cash flow to further support achieving this goal. Management incentives are aligned to support repayment. With that, let me turn the call back to Andreas.

At this time, if you would like to ask a question, please press the star and 1 on your touch-tone telephone. You may withdraw your question at any time by pressing the pound key. Once again, to ask a question, please press the star and 1 on your touch-tone phone. We'll take our first question today from Mark Oestereich with Stifel. Your line is open.

Thanks and morning, everybody.

Great, thanks. So two questions for me. First, on the sales forecast range, it's a bit wider than we're accustomed to seeing, I think, relative to some of your peers. I'm curious why you're giving a wider range. I hear the China commentary, but that's not a particularly large percentage of business. So is there something from a macro standpoint or a customer standpoint that you're hearing or worried about? And then the second question is from... So I get organic growth for 4Q was down about 4% if you back out the acquisition contribution and the two pieces of business from the closing of the prior year that you didn't have for the full quarter. So that gets a full year number down about 1%. I guess the question there is, you've owned Frutarom now for a little over a year. What's a reasonable run rate of growth? You've talked about 6% as a target longer term, but it just seems like that's not the case anymore. So maybe you're still thinking 6%? Please kind of walk through how you're thinking about it if that's the case, or what are the moving parts today? That'd be helpful.

Sure, thanks. Thank you, Andreas. Hi, Mark. Very little to add there except typically we didn't quantify on the coronavirus because it's too early, just too early to tell and understand it. But what we did do was widen the ranges, and we can come back at some point subsequent in the year as we know more.

Okay, thank you. We'll take our next question from Mike with Wells Fargo. Your line is open.

Hey, guys. Um, my gosh, you didn't want to get a little bit of color in terms of what's driving the growth of 2.5% to 6.5%? I know you have nice little color columns there, but in terms of the organic business, can you maybe walk through? I think you've won some business in taste or maybe in scent, I can't remember. And you know, what gives you confidence that you can actually grow organically in 2020?

Just one thing probably in pricing and scent, lighting, and fragrance ingredients, but otherwise I think it's all good. Okay, great.

We will take our next question from John Roberts with UBS. Your line is open.

Um, thank you and welcome, Rustom. That was a good presentation for somebody only on the job a couple of weeks. Thank you. Now that the year one guarantees have expired for the Frutarom employees, are you seeing any increase in turnover?

Do you have any update on the timing of filing for the DuPont deal? And just remind us what are the key long lead-time critical items on the path to closing in first quarter 2021?

Take our next question from PJ Ju of Citigroup. Your line is open.

Yes, good morning. You know, one question is on taste. North America was challenged due to volume erosion from large multinational companies. I thought that destocking in packaged foods was mostly done by end of third quarter. So is that incremental destocking, or is this an issue with underlying demand with these multinational companies? Thank you.

And my second question is, you know, one of your priorities was getting IFF's technology into Frutarom and the cross-selling you talked about. Can you give us an update on that and if that's happening to this point? Thank you.

I hope it helps, PJ. Thank you. We'll take our next question from Anton with Deutsche Bank. Your line is open.

Anton, thanks. Good morning. So I have two questions. One is just on gross margin. It looks like you took a step back this quarter, and I was expecting an improvement. So maybe if you could share with us what the puts and takes were there and how we should think about raw materials and gross margin in 2020. And then my second question is just if you could give us a sense of how we should think about cash flow and capex in 2020. Thank you.

Sure, so it's Rustom. So let me take this. In the fourth quarter, gross margin was negatively impacted by higher raw material costs and unfavorable mix. Right? So who have learns in my first couple of weeks, raw material costs can fluctuate monthly, quarterly. Usually inventories increased in Q4. That's really very solid. They were primarily impacted by the timing of raw material costs for the balance sheet and the P&L, and that's not much different from what happened in the second quarter where raw materials came in much more favorable. And if you want to think about specific commodities, in taste it was primarily vanilla, and in scent it continues to be turpentine and China tariffs. You wanted to quick cash flow? Yes, roughly about 4.5% next year as well, 4% of sales. Sorry, 4% of sales on capital. And then the final part of your question, at least into the intermediate value pressure, was about raw materials and how that would flow through into next year. Right. Looking at 2020, we believe that raw material costs will stabilize, specifically in the scent division where we have the largest raw material increases. The current purchases... amazing. And look, it's important to note there still remain elevated levels, and that we will, as we always have, worked with our customers and actions including price increases to cover that exposure. And I think those are your questions right now.

Thank you. We'll take our next question today from Adam Samuelson with Goldman Sachs. Your line is open.

Yes, thanks. Good morning, everyone. So just thinking about the 2020 plan a little bit. And maybe first, just to clarify on the coronavirus impact. I know the guidance doesn't officially contemplate an impact, but it also kind of you've put a wider range to give some best-case, some room there. Could you just contextualize for us the China sales exposure and also just fine fragrance, as far as you can tell, how much you think that actually goes through global duty-free and travel channels? It's probably the two areas most at risk. And similarly, on the production side, how much of your raw material production do you source from China? Thanks.

Okay, and then just maybe following up on the prior question on the gross margin performance in the fourth quarter. Clearly it came in below your plan. And I just want to be clear: if it was raw material cost and inventory, I presume you would have had more visibility to it. Was there a sharp kind of divergence in sales mix and the decline in fragrance ingredients? I would have thought that would have been a tailwind to the margin performance. Just want to clarify a little bit if it was a surprise relative to your own plan a couple of months ago. It seems like a bigger variance than I thought.

We'll take our next question today from Lauren Lieberman with Barclays. Your line is open.

Great, thanks. Good morning. I just want to follow up again just a bit on Frutarom. So a few things here. One is that with Frutarom being folded into taste, to what degree do we really get visibility into this inflection you're expecting in 2020? Because when I look at Frutarom in the fourth quarter, even if I concede and say the four points that you're calling transitory are in fact transitory, organic was still down 2% even excluding those things in the fourth quarter. So I'm just struggling with why mid-single digits is comfortable and how we'll kind of get visibility into that with it again being folded into taste as we get into 2020. Thanks.

So, Lauren, it's Rustom. Let me have a crack first at how we track it and how we manage it. So yes, maybe our weather report is two segments, but what we are going to do over the course of the year in 2020 is we are going to, as much as possible, track the Frutarom elements separately. Now remember, as we continue to integrate, there will be some sales that come from Frutarom that now show up that naturally migrate over into the legacy taste part of the business, right? So it won't be perfect, but we are going to do our absolute best for ourselves as much as anything else to protect and control that.

I hope it helps, Lauren. Thank you. We'll go next to Jessica Costas with JPMorgan. Your line is open.

Hi, good morning. In your remarks, you said that you knocked out $20 million in costs at Frutarom, but the year-over-year increase in operating income is about $5 million. And even if you compare it to the first quarter of 2019, maybe you're up $3 million. So why isn't Frutarom earning $45 million if you've lowered your cost structure by that much? What are the numbers so low?

That's so sorry, I was gonna cut in there. That number is the right number, but it's going to be spread across the three businesses, the business units, as we go into next year.

We have no further questions at this time. We'll turn the call back to Andreas Fibig for any final closing remarks.

This does conclude today's program. Thank you for your participation. You may disconnect at any time.