At this time, I would like to welcome everyone to the International Flavors & Fragrances second quarter 2018 earnings conference call. All participants will be in a listen-only mode until the formal question and answer portion of the call. 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 DeVeau, Head of Investor Relations. You may begin.
Thank you. Good morning, good afternoon, and good evening, everyone. Welcome to IFF's second quarter 2018 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'll be making forward-looking statements about the company's performance, particularly with regard to the outlook for the third quarter and full year 2018. 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 forward-looking statements, please refer to our cautionary statement and risk factors contained in our 10-K filed on February 22nd, 2018, and our press release that we filed yesterday. Today's presentation will include non-GAAP financial measures, which excludes those items that we believe affect comparability. A reconciliation of these non-GAAP financial measures to their respective GAAP measures is set forth in our press release that we issued yesterday and is available on our website. I would like to also remind everyone that all statements related to future results and events, including the proposed merger are forward-looking statements and are based on current expectations. Actual results and events could differ materially from those discussed here.
Please refer to the information on the disclaimer slide as well as the additional information contained in the regulatory filings of both companies. With me on the call today is our Chairman and CEO, Andreas Fibig, and our Executive Vice President and CFO, Richard O'Leary. We will start with prepared remarks. Then take any questions that you may have. With that, I would now like to introduce Andreas.
Thank you, Mike. On the call today, our plan is to review our financial results for the second quarter and the first half of 2018, provide an update on our financial expectations for the full year, excluding the impact of Frutarom, and give insights into the strong progress we have made relative to the Frutarom transaction. We will be happy to take any questions that you may have as usual. Starting with a recap of our first half 2018 performance, growth was strong across all of our key financial metrics and in line with the objectives we set out for ourselves earlier this year. Currency neutral sales increased 6% in the first half, with both business units growing 6% respectively. New win performance, volume growth on existing business, and price increases to offset rising material costs all contributed to consolidated growth.
From a profitability perspective, currency neutral adjusted operating profit grew 5% as volume improvements and our focus to drive greater efficiencies throughout our business via cost and productivity initiatives continue to support overall profitability. Currency neutral adjusted EPS improved 10%, driven by improvements in adjusted operating profit as well as a more favorable effective tax rate. I'm very pleased to also report that we are making strong progress against our four refreshed strategic priorities. Solidifying our position to drive differentiation, sales of our Sweetness and Savory Modulation portfolio continue to grow strong double digits across all categories, led by Savory and Dairy. PowderPure, our platform for clean label solutions, grew an impressive triple digits as we continue to scale this unique and differentiated technology.
Performance with local and regional customers also remains strong, growing double that of our global customers, and is a trend that we see across both business units. In Flavors, specifically, our midsize go-to-market platform, Tastepoint, continues to deliver strong results, improving strong double digits in the first half of 2018. In terms of maximizing our portfolio, driving growth in our most margin-accretive categories, Cosmetic Active Ingredients continued its robust growth trend by improving very strong double digits in hair care, home care, and toiletries improved high single digits. In Flavors, growth was strong in dairy and beverage, improving double digits and high single digits respectively. We also remain diligent in our focus to drive greater efficiencies in our business, allowing us to reallocate resources to efforts that drive the greatest returns.
This yielded strong results in the first half 2018 as our cost and productivity initiatives, including zero-based budgeting, added approximately five percentage points of growth to currency neutral adjusted operating profit and EPS growth. All in all, we believe our priorities are well positioned and are the strategies to drive long-term value for our shareholders. Our pending transaction with Frutarom, which I will touch on in more detail shortly, will support and accelerate efforts across all of these pillars. With that, I would like to turn the call over to Rich.
Thanks, Andreas. Moving on to our Q2 performance. Currency neutral sales in the second quarter grew 5%. Growth was broad-based as all regions and categories
Across Flavors and Fragrances posted solid results. From a profitability standpoint, currency-neutral adjusted operating profit declined 2% in the second quarter as top line growth and the benefits associated with cost and productivity initiatives were more than offset by the impact of higher raw material costs, including the previously announced BASF citral supply issue. Pricing was up about 1.5 percentage points in the quarter on a consolidated basis. However, as expected, it did not offset raw material pressure in our fragrance business unit. As we move through the back half of the year, we expect the price to raw material cost dynamic to improve as pricing takes hold in fragrances. We are pleased that despite these challenges, we were able to achieve 8% currency neutral adjusted EPS growth as we benefited from a more favorable year-over-year effective tax rate and higher other income.
Looking at our business unit performance for the second quarter, Flavors' currency neutral sales increased 6%, with growth coming in all categories and all regions. It should be noted that on a two-year average basis, growth was very strong at approximately 9%. North American Flavors improved 9% in the second quarter, led by high single-digit growth at Tastepoint and strong new wins in beverage, dairy and sweet. EAME increased 5% on a currency-neutral basis, led by strong double-digit growth in Africa and the Middle East, as well as mid-single-digit growth in Europe. Greater Asia grew 2% in the second quarter on a currency neutral basis. Strong double-digit growth in China and India was largely offset by softness in Indonesia and Thailand. Latin America increased 8% on a currency neutral basis, led by strong double-digit growth in Argentina and Mexico.
Flavors' currency neutral segment profit grew approximately 6%, led primarily by volume growth and the benefits from our ongoing cost and productivity initiatives. In terms of currency neutral segment profit margin, we achieved margin expansion year-over-year of approximately 10 basis points to 24.3%. Fragrances' currency neutral sales improved 5%, driven by broad-based region and category growth. From a category perspective, Consumer Fragrances grew 5% on a currency neutral basis, as growth was achieved in all categories, led by double-digit growth in hair care, as well as mid-single-digit increases in toiletries, home care and fabric care. Fine Fragrances improved 1% on a currency neutral basis against a very strong 11% comparison in the prior year period. Growth was led by a double-digit increase in Latin America and low single-digit growth in North America. It should be noted that EAME and Greater Asia were soft.
However, it was due to a strong year-over-year comparison of 19% and 25%, respectively. Fragrance ingredient sales were up 10% on a currency neutral basis, with growth in three of our four regions, driven by improvements in volume and higher pricing related to raw material costs. From a profit perspective, fragrance currency neutral segment profits decreased 9% on a currency neutral basis as volume growth and cost and productivity benefits were more than offset by higher price to input costs, including the BASF citral issue. As I mentioned, as we move through the back half of the year, we expect the price to raw material cost dynamic to improve as pricing takes effect. In terms of currency neutral segment profit margin, our profit profile remains solid, yet was under pressure year-over-year. Before I move on, I want to provide some more commentary on the raw material environment.
Coming into the year, we expected mid-single digit raw material inflation in 2018, inclusive of the impact of the citral situation. With that heavier based in the fragrance business unit. Since that time, cost inflation has picked up following a series of disruptions in the supply chain. There have been fires at several ingredient suppliers, increased environmental actions on suppliers in China, and to a lesser extent, rising oil prices. Based on what we're seeing today, we expect incremental inflationary pressure as we exit 2018 and head into 2019. It remains imperative that we achieve incremental price increases or identify other actions in unison with our customers to ensure we cover our raw material cost exposure over time. Operating cash flow was $55 million compared to $58 million for the first half of the year.
Performance was primarily impacted by a product recall payment as we previously disclosed, as well as costs associated with the bridge loan commitment fees, the combination of which was approximately $40 million. In addition, there was an increased level of working capital. Working capital was primarily impacted by high inventory due to rising raw material costs, increased volume associated with the pre-building of inventory related to the citral issue, and higher than anticipated sales volumes. Over the course of the year, we expect all elements of working capital to improve. From a capital allocation standpoint, we spent approximately $67 million in capital expenditures or about 3.6% of sales. We continually will spend approximately 4%-5% of sales in 2018 on CapEx. Regarding cash return to shareholders, in the first half, we spent approximately $109 million on dividend payouts and $15 million on share repurchases.
As part of the Frutarom combination, we have paused our share repurchase program as we prepare for the financing of the transaction and prioritize debt repayments going forward. Last week, our board of directors authorized a 6% increase in the quarterly dividend to $0.73 per share on the company's common stock. The increased dividend reflects the board's confidence in the cash generation potential and financial strength of the company. We will maintain a disciplined approach to capital allocation as we continue to accelerate growth through organic investments and strategic acquisitions, while returning significant capital to shareholders. As we look towards the balance of the year, I want to provide some commentary on our financial expectations, excluding the Frutarom transaction. All of our currency-neutral metrics have not changed.
Based on our strong year-to-date performance and our current outlook for the second half of the year, we are reconfirming our previously stated full-year currency-neutral guidance. As world currencies versus the dollar continue to fluctuate, we do expect to see an impact in terms of our top line. Based on current rates, we believe that we will have a 2 percentage-point benefit on consolidated sales growth versus 3% previously indicated. While many currencies have an impact, the largest is the euro to U.S. dollar exchange rate. On an adjusted profit and adjusted EPS basis, we anticipate the benefit of FX to be the same as previously communicated, due primarily to our 12 to 18-month rolling hedging program and movements of various other currencies.
For your reference, please note that we remain hedged at approximately 80% on the euro profit exposure at EUR 1.15 for 2018, and are approximately hedged at 35% at EUR 1.23 for 2019. With that, I'd like to turn the call back over to Andreas, who will walk you through an update on Frutarom transaction.
Thank you, Rich. First, I would like to reiterate that we continue to be very excited about the combination, and it will create a global leader in natural taste, scent, and nutrition, with an expected 2018 pro forma sales of $5.3 billion, and is a win for both companies' shareholders. Together, IFF and Frutarom will have a broader customer base, more diversified product offerings, and an increased market penetration. We will instantly become a leader in natural solutions. We will also strengthen our exposure to fast-growing small and mid-sized customer accounts, gain new opportunities in attractive and fast-growing adjacencies, and enhance our global reach. We also anticipate cost synergies through raw material harmonization, footprint optimization, and streamlining overhead expenses. Additional cross-selling opportunities and integrated solutions are expected to provide revenue synergies to our shareholders over time. Both organizations have a strong talent base comprising thousands of extraordinary employees globally.
Through our integration planning work, we continue to be confident in the opportunities that lie ahead and the ability of the combination to accelerate profitable growth, enhance free cash flow, and generate greater returns for our IFF shareholders. Since the announcement of the deal on May 7th, we really have made strong advancements towards the deal close, I would like to give you an update on a few. On Monday, Frutarom received shareholder approval for the transaction. Of the votes cast at the special general meeting, about 95% were in favor of the proposed merger, representing approximately 75% of all outstanding shares. We are pleased that Frutarom shareholders have approved the combination with IFF, marking another milestone on our path to unlock the value creation potential of the combined company.
We continue to have comprehensive pre-close meetings and discussions on talent, R&D, adjacencies, and business and functional integration to ensure that when this transaction closes, we are ready to execute and drive profitable growth by capitalizing on the best of both organizations. We also want to take a moment to reiterate our intention to remain listed on the Tel Aviv Stock Exchange upon completion of the transaction. Given the progress to date, we now expect to close in the fourth quarter of 2018, earlier than our previously communicated timeline of six to nine months from the May 7th announcement. This timing continues to be driven primarily by the completion of the remaining antitrust reviews. To ensure the most successful integration, we have structured our approach in a very disciplined manner with strong and dedicated teams. Foundational in our approach are four guiding principles.
The first includes establishment of a cross-functional team across both organizations, directly involving about 75 people committed 30%-100% of their time to the integration, depending on the nature of their role. To complement and support this team, we have engaged external advisors such as leading consulting firm across a variety of specialties. Our second core principle is to protect the core business and deliver the plan. As both organizations are entering the transaction as a position of strength, it's very important that we do not lose focus and continue to deliver strong financial performance. At the same time, the integration team is responsible for realizing our targeted cost synergies and capture cross-selling opportunities. Leading the integration for us is Francisco Fortanet and Amos Anatot for Frutarom.
Francisco is the EVP of operations for IFF and has extensive experience leading manufacturing, procurement, plus strong cross-functional leadership, robust commercial support expertise, bringing innovation to market. Amos is the EVP of global supply chain and operations for Frutarom and has a robust knowledge of the day-to-day operations at Frutarom, and is actively involved in all business aspects. Together, both are excited and very engaged to ensure the successful completion and integration of our two great companies. Aligned with our second core principle to protect growth trajectory of both businesses, we are structuring our day one model to ensure that once the transaction closes, Frutarom will remain as a standalone unit for now and will maintain their current go-to- market strategy. Given they are very customer-centric organization, it is critical that we limit the changes on the front end of the business.
We want to ensure that there are zero disruption to customers, and they continue to provide their products as effectively and efficiently as they have done in the past. To drive cost synergy realization, which I will cover in more details in a moment, we plan to leverage IFF's global expertise and shared service model. As time progresses, we will slowly centralize various group functions to further unlock value. Simultaneously, we intend to drive cross-selling through sharing our vast technologies and categories expertise across the organization. While going through the integration process, there will be areas where we selectively lift and shift as appropriate based on the long-term strategy of the business. One example is the Cosmetic Active Ingredients where we are moving Frutarom's business into our LMR infrastructure. As we outlined on May 7th, we plan to unlock significant cost synergies related to the Frutarom acquisitions.
I'd now like to give you a bit more clarity on where the $145 million cost synergies target will come from and the estimated timing of this. We expect approximately 40% of the cost synergies targeted to come from procurement as we accelerate the rationalization and harmonization of raw materials across both organizations. Activities include make versus buy, vendor consolidation, centralization of spend, which will all contribute to the savings. Approximately 30% will come from operations as we optimize the global footprint. Given the large infrastructure of both organizations, approximately 110 sites on a combined basis, there are a lot of potential options to optimize our combined footprint. Out of the anticipated $145 million of our run rate cost synergies, we estimate approximately 20%-30% to come from streamlining of overhead expenses.
It should be noted that less than 10% will come from business development as we are taking steps to ensure the preservation of the customer service levels at both companies. In terms of timing, we anticipate $145 million of run rate cost synergies by the third full year after closing, with approximately 25% achieved in 2019, 17% in 2020, and the remainder in 2021. In addition to the cost synergies, and that's where I'm most excited about, we believe there's a strong potential to drive accelerated growth by capitalizing on revenue synergies. Stepping back, not only does this combination create a global leader in taste, scent, and nutrition, the combined organization will have the broadest customer base and strongest product offering and deepest market penetration in our industry. With respect to customers, we at IFF are extremely well-positioned with global multinationals.
Out of our approximately 3,000 customers, 50% of our sales are global customers, where we are participant on nearly all global core lists. The balance, our sales are with local and regional customers, strategic focus for us, where we are utilizing mid-tier customer go-to-market model like Tastepoint. Frutarom, on the other hand, has approximately 30,000 customers, of which 70% are small, mid-size, and private label accounts. By putting us together, we will have a very strong distribution network, ranging from the largest global customers to startups and private label accounts. In terms of products, we pride ourselves on our ability to bring differentiating and unique innovation to the market. With approximately 8% of our sales spent in R&D, we have developed industry-leading technologies across various areas, including modulation, delivery, natural cosmetics, and so on.
Our pipeline right now is as well-filled as it was never in the history of IFF. Frutarom has a leading natural portfolio. 75% of their consolidated sales, as well as access to adjacent technologies such as natural savory solutions, natural colors, natural food protection, and health ingredients. The combination will create a comprehensive portfolio with a potential for integrated solutions to offer our customers one of the strongest portfolios in the industry. Together, both organizations will further penetrate key markets around the world. IFF has a leading market share in Greater Asia and Latin America, as well as strong positions in North America and Western Europe. Frutarom is a great complement as they have very strong exposure to key emerging markets and a complementary position in developed markets.
While we haven't quantified the contribution of revenue synergies yet, we look forward to driving incremental growth by capitalizing on these three uniquely beneficial positions. I would like to provide an update on the antitrust approval process. We are currently on track as all applications have been submitted to the 8 countries that we needed to file in. In June, we have already received approval in the U.S. and have recently received approval in Israel. The rest, we are awaiting feedback, and under normal circumstances, expect to conclude the process in the fourth quarter. Rich, can you please take us through deal financing considerations?
Thank you, Andreas. Given our progress to date, and as we prepare for financing the transaction, we want to briefly give an update on the sources and uses of funds. From a source of funds perspective, we are providing approximately $2 billion of new equity to Frutarom shareholders at closing of the deal. We'll be issuing about $2.2 billion of new equity issuance to the market. Of the $2.2 billion, approximately 67% is expected to become an equity and approximately 33% tangible equity units. From a debt standpoint, we'll be taking on approximately $3.1 billion of new debt financing. Within this debt financing, we'll be using a combination of 10 and 30-year U.S. dollar bonds, as well as EUR public bonds with maturities. The remainder will be cash on hand from the balance sheet.
In terms of uses of funds, we will be delivering approximately $2 billion of equity and $4.3 billion of cash to Frutarom shareholders. We will be retiring approximately $900 million of debt on both sides, on both the IFF side as well as Frutarom. All this was done while maintaining our focus on keeping an investment-grade rating. Back to you, Andreas.
Thanks, Rich. Let's summarize. We're very pleased with our performance for the first half of 2018. Sales growth was robust at 6%, with growth across both business units. We also have achieved strong improvement in currency neutral adjusted operating profit and currency neutral adjusted EPS. Based on our year-to-date performance and our current outlook for the second half of the year, we have reconfirmed our previously stated full-year currency neutral guidance. On this strong foundation, we are pleased to have made great advancements towards the Frutarom deal close faster than our original expectations. We are very excited that together, the combination of IFF and Frutarom will have a broader customer base, more diversified product offerings, and an increased market penetration.
It will create a global leader in natural taste, scent and nutrition, with a very attractive financial profile in terms of growth, profit, and cash flow, which is expected to unlock significant value for our shareholders. With that, we would now like to open up the call for questions.
At this time, if you would like to ask a question, please press star, then the number 1 on your telephone keypad. Again, to ask a question, please press star, then the number 1 on your telephone keypad. Your first question comes from the line of Mark Astrachan with Stifel Nicolaus.
Yeah. Thanks, morning, everybody.
Morning, Mark.
Morning, Mark.
Hey. Wanted to ask first just on a logistics standpoint, sales growth expectations for the back half of the year. There's a pretty large implied range from guidance. There's obviously a much tougher comparison. I guess any sort of broader strokes you can give on how to think about that, including how much pricing should we expect given the commentary about incremental input cost pressures and the underlying volumes as well as new wins?
Sure, Mark. I think a couple of things for me as I think about it. We've been talking since the end of last year, certainly in the first two quarters, that a big component of the higher growth in the first half of this year was the volume on existing business. We've expressed, and I certainly have expressed, an expectation that that will soften. I think overall, on a two-year basis, the numbers are fairly consistent first half, second half. I do think the mix is gonna change where I think our win performance is pretty consistent. Our good rates or our commercial performance are good, I think in the second half of the year, we're expecting a decrease in the impact associated with volume in existing business and an increase in the pricing impact.
As I said, in the second quarter, we were about a point and a half of pricing impact in Q2. I would expect that to be higher than that in the second half of this year.
I guess kind of putting that together then, it sounds like you're expecting basically the two year to weaken somewhat, but maybe not as much as I guess I would've thought given incremental pricing. Is that fair?
Yes. Very fair.
Just switching more to a strategic question, Andreas, I guess I wanna understand a bit more what gives you conviction in commentary you've had before about sustainability of Frutarom's about 6% core sales growth, in the context of what seems like some increasing competition within the natural space from competitors, not just Givaudan or Firmenich, but just sort of broader strokes as customers out there move towards cleaner labels and more healthful products?
I think that's a very fair question and an important question for us as well as we are redoing now our strategy. Let me answer in a way that, first of all, we have now probably the broadest customer base in the industry. A lot of business is done with the mid-size and smaller customers, where we expect to have higher growth rates going forward than our core business. Secondly, if you look at the categories, we have now a portfolio as a combined company, or we will have, let's put it, after closing, which gives us the ability to move categories which have good and high growth rates like natural colors, for example.
We mentioned that natural color, that's still a trend where we have, let's say, the exchange from synthetic to natural colors in the U.S. just in front of us, where we will see high growth rates going forward. For the customer base and the categories give us good confidence that the growth rate will be really good despite the competition in some of these areas. The market is so big that we believe that will not hamper our ability to have a fast-growing business in front of us. If we're combining both, I believe we can see a good uptake in the growth rate here.
Thank you.
Your next question comes from the line of Lauren Lieberman with Barclays.
Thanks. Good morning.
Good morning, Lauren.
First thing I wanted to ask about was just the commentary on the incremental inflation. It sounded like both there's incremental inflation versus the outlook 6 months ago for the second half of the year and also very much heading into 2019. I just wanted to be clear on expectations for the back half. Is there incremental pricing going in? Do you have visibility? I mean, it sounds that way from you've said you're reiterating, but how you're going to be covering that incremental inflation that's close in. Also as you're looking into 2019, just to maybe try to help us square the kind of rate of inflation we're talking about. Because if you're discussing needing to work with customers on solutions outside of pricing, it suggests it's a pretty severe rate. Thanks.
Good morning, Lauren. It's Rich. I think, look, as I indicated in my comments, I think we ended last year, started this year, we expected inclusive of citral, the BASF issue to be mid-single-digits. It's now above that given the other dynamics. I think what we feel good about is that the vast majority of our discussions and pricing negotiations with our customers have been completed. It's a matter of phasing those in. We've talked about that in the past. These things don't happen overnight, but we're confident in our ability to recover those increases over time. As I think about next year, our current view of what we're seeing today, obviously we expect the BASF situation to normalize in the second half of this year, so that will relieve some of the pressure.
I think that as we see it today, input costs next year are probably going to be in the low to mid-single-digit level.
Okay, great. I'm not sure if you'll be able to comment on this yet, but the Frutarom outlook, I think sort of implies that they are baking in some incremental M&A before year-end. To what degree do you have visibility on that? Because that's one piece that's sort of the forward look that's left me a little bit less comfortable, is assuming M&A for something that's about to be bought is sort of a bit of a funny dynamic. Anything you can offer there would be great.
Look, in general, what we said when we announced the deal is that we certainly want to go ahead with a model of good acquisitions on this business and particularly on the adjacent businesses. Probably not at the same rate as Frutarom is doing it because some of them were just geographic expansions where we probably don't need it because we are, as a combined company, are very well covering the globe. We know and we have visibility of their pipeline in terms of deals. I can't give you any details, but there are certainly a good pipeline and there are deals to be happen over time, and that's what I can say for now. Yeah, and we have planned in our business model for money to be spent on M&A on this side as well. That's what I probably can announce today.
Okay. Thank you.
Your next question comes from the line of Heidi Vesterinen with Exane BNP Paribas.
Hi. Good morning. A question on the pro forma business as well. You talked about increasing profitability through the combination. If you know, there's a debate on the market about how high margins can go. Some people are saying there's a cap. Do you still see significant margin potential for yourself and more broadly in the industry, please? Thank you.
Yes, Heidi. In particular, when you look at the change in product portfolio and customer portfolio going forward, what we certainly see is that in some of the adjacent businesses, you have good margins and probably better margins than in the core F&F business. Now it's up for us actually to manage our portfolio in a way that we see a margin increase over time for the total corporation. I'll give you just one example. You might remember when we moved three years ago into the Active Cosmetics, that's a very high margin business, at least the piece or part where we are playing in. We see now some of these businesses coming to us as well with Frutarom. Now we are right now in the middle of the discussion in terms of strategy.
What are the product categories we really want to push? To move ahead on that time. Certainly, it's true on the core F&F business, it's not easy to push the margins up and up. With, let's say, the acceleration of the different portfolios, I think don't forget that we have the cost synergies for us as well, and they will help us on the margin side, in particular when you look at procurement and at the manufacturing footprint, because that's another driver for us for margin. It was probably a little bit of a long-winded answer, but I wanted to give you some details. The answer is yes, we can move it up.
Thanks. If I could squeeze in a very quick short one. On the citral issue, is there any scope to get compensated after this disruption, perhaps from the supplier? Thank you.
Yeah. Heidi, we're looking at every possibility there in terms of obviously working with our customers. Our number one priority has been to maintain surety of supply with our customers, and figure out the best way to work with them. From there, we'll look at any other option out there.
Thank you.
Your next question comes from the line of Michael Sison with KeyBanc Capital Markets.
Hey, guys. Nice quarter.
Hey, Mike. Thank you.
Good morning, Mike.
When you think about slides 20 and 21, appreciate the update on the integration approach and such. I understand you're keeping Frutarom separate, makes a lot of sense. Could you give us a little bit of color how you plan to change the culture within Frutarom? A lot of different businesses that have bought over the years. What's sort of the plan inside that box to integrate that and make that more efficient?
Mike, that's certainly something where we look into it right now to look what really makes sense to change or what makes sense to keep. We have to say that there's certainly some elements like the nimbleness and the customer focus we like a lot. We certainly will not change that. There are a couple of elements actually within the culture where we have to take to consideration whether we make them even bigger within the combined company. We are in the middle of the assessment to do it. We will also, day one, integrate some business already. As I said, we lift and shift, it has to make sense and we can't jeopardize the top-line growth, because that's so important for both businesses.
That's the reason why we have also kept our business people really focused on our core business and doing the integration basically and the back office work. Okay? We can give you certainly more details over the next couple of months when we are coming closer to closing, and after closing certainly as well.
Sure. Then in terms of revenue synergies, you have three buckets that you talked about. Is it going to be quicker to see the synergies in either the three buckets or three buckets? Just sort of want a feel for where and how soon some of these little areas can come in.
Look, it's actually an easy answer, but maybe not always as easy done. It's basically, we give them access to our technology. What we have seen so far when we disclose some of the technology to them, there's a lot of excitement around that, what they can do with it, with their own customer base. Usually, you know they have small and mid-size customers, so I expect actually a pretty quick uptake of this kind of business or top-line synergy on this side. On the other hand, they have all the adjacent businesses, which we can sell into our bigger customers as well. There's actually a lot of excitement on our bigger customer side as well, what they can do. There, for example, an interesting company, it's called PowderPure. They have a technology which is very complementary to our PowderPure technology, which goes into natural solutions.
We are right now talking how we can bring this together and make sure that this gives a great offering to our customers. There are a lot of discussions. It means basically our technology into their customer base, and it means their adjacency into our customer base. That's what we are working on it. We haven't put too much of these revenue synergies already into our plan because we said we want to be really diligent to go over it and then make really good plans how to do it in the best way. When we have our, let's say, first investor conference after the closure, we certainly will disclose some of it. Okay?
Great. Thank you.
Your next question comes from the line of Jeff Zekauskas with J.P. Morgan.
Thanks very much. When you calculate currency neutral operating profit growth, is the base what you actually reported last year, or is it a different base that's currency neutral, that's not immediately visible?
Yeah. Mike. No, Jeff, sorry.
It's all right.
Excuse me.
You see, Rich still has a little bit of a summer cold but you will get
Perfect timing for this.
Yeah.
Yeah, we take the prior year, then we're adjusting prior year results to current year exchange rates. Keep in mind though, that when you're looking at last year's reported numbers, the pension accounting change, which is a pretty significant number, where the pension income is no longer reflected in operating profits, now in other income and expense.
Okay. I just say that since your analysis of your own results relies so much on currency-neutral values, you might simply supply those values so that your financial statements are somewhat more transparent. Since it's simply a translation to currency-neutral, I don't think it would give away anything competitive. Just secondly, can you describe what the tangible equity units are in a little bit more detail, and what's the timing of your equity financing?
Sure. In terms of the financing, we expect to do the debt and equity raise, equity first, debt second, in the middle of September. The exact dates, we're still working through that. In terms of the tangible equity units, they're issued at a premium, they convert from a tangible equity unit into common shares at the future. They have an interest component to that.
Yes.
The premium allows the company to benefit up to a cap on growth in our share price over the three-year period that gets the upside in terms of as we deliver upon the plan, the shares reflect that we'll have a lower dilution effect.
Okay, good. Thank you so much.
Your next question comes from the line of Gunther Zechmann with Bernstein.
Hi. Good morning, everyone. From what you said about pricing versus raw material costs, I found that very interesting. Do you expect higher gross margins in the second half this year compared to last?
Compared to last year?
Second half last year.
No. I think what we expect to see is that if you look at the year-over-year pressure that we saw in the second quarter, I would expect the second half of the year to be better than that, or less year-over-year pressure.
Pressure from raw materials, less pressure, but also better pricing from what you said. Higher gross margins in the second half 2018 versus 2017.
Yeah. If you look at the second quarter numbers, we were down about 200 basis points year-over-year in Q2. As we get the pricing in the second half of this year, I would expect that decline to decrease in the second half of the year.
Okay. That's very clear. Thanks. Then just on the second quarter itself, on the gross margin, can you help me split out how big the effects were between the ongoing raw material cost inflation and the citral impact? I think you already mentioned the 1.5% price in Q2, if I heard that right.
Pricing was about 1.5%.
You don't provide that bridge anymore that you used to.
Yes. Let me give you the background. As I said, 1.5% price increases. As I just mentioned, we were down about 200 basis points year-over-year on gross margins. Actually, most likely more than that, but all that can be attributed to net price to input cost, the dynamic. As best as we can estimate it's split roughly 50/50 between the citral issue and the other price increases. As I said, it's a timing issue that we expect to normalize over the balance of the year and into early next year.
That's great. Thanks very much.
Your next question comes from the line of John Roberts with UBS.
Thank you. Your mysterious largest shareholder, Winder, increased their position in your stock again recently. That surprised me a little bit, given they'll be able to buy all they want on the secondary offering in a month or so. Have you talked to them about participating in the secondary?
Hey, John, it's Mike. From a largest shareholder perspective, look, we've had pretty lengthy conversations with them with respect to every ongoing institutional investor we have. They remain passive, evident with their filing of their 13G, there's no change there. With respect to secondary offering, unfortunately, we don't disclose the process, but what I can say is that there's technical rules that they have to abide by, given their size. It's ongoing conversations as we move forward. More to come.
Okay. Secondly, are you concerned at all about the persistent low growth in the greater Asian flavors business? You had an easy comp this quarter. It was against -2% a year ago, and you haven't had a comp above 2% in over a year.
No, actually not, because we are happy that finally we are turning around the situation in China with good growth in China in the flavors business.
What is in, let's say, an issue for us was Indonesia, because we have a big business in Indonesia and the market is pretty soft. That what's taking the growth rate down. Eventually that will come back. The rest of the Asian business is performing very well. As I said, particularly, John, China, we are happy to be back. Interesting enough is, you might recall that the whole thing goes back to our factory issue we had in 2015. It took us longer to recover. We have now a second manufacturing plant actually in place, and we will open it in the fourth quarter of this year. We have a backup plan, and we believe that China will be, for us, a good growth country going forward.
Now even we see the consolidation of Frutarom even better because we will get some of their volume basically into our factories as well.
Okay. Thank you.
Your next question comes from the line of Adam Samuelson with Goldman Sachs.
Yes, thanks. Morning, everyone. Maybe just a clarification on the guidance and a lot of ground covered today. There is a pretty sharp deceleration implied in second half currency neutral sales growth and understanding the comps get considerably tougher, especially in Fragrance. You've got better pricing expected to flow through. Is it such that you think volumes are actually down year-on-year in the back half, either company-wide or at least in Fragrance? Is it just comps? Is there anything on win rates or customer order patterns that would make you think that? I just want to make sure I understand some of the moving pieces in there.
No, again, I think as I mentioned earlier, overall when we look at it on a two-year basis, there's not any significant change. What we do see happening is that the first half of this year, lower comps, but a bigger chunk of the improvement was volume on existing business. The volume on existing business were above, let's call it five-year norms. Our win rates and impact of new wins was consistent with the five long-term trends. We're not seeing anything slowing or increasing there. We expect to see a slowdown in the volume on existing business that'll be offset by pricing.
Okay. Just below the line, tax rate has come in, I think below the expectations at the beginning of the year. Is there an expectation that you see a notable pickup in tax in the back half, or what's the full year expected rate?
Yeah. For the first half of the year, we're between 18 and 19. I would expect we're going to end the year between 19 and 20.
Okay. The financing for Frutarom is not embedded in the EPS outlook for the year. Is that correct?
No. Well, everything related to that is excluded at this point.
Okay, perfect. Thank you.
Your next question comes from the line of Fintan Ryan with Berenberg.
Good morning, gentlemen. Two questions from me, please.
Thank you.
In terms of the integration with the Frutarom deal from the Frutarom side, given that we are a few months further down the line, have you thought about or have you seen any impact so far in terms of some Frutarom employee turnover? Would you be confident that most of the core management team there will remain with IFF and help that integration process post-acquisition, particularly given that I saw that the Frutarom shareholders rejected the $20 million bonus proposed for the CEO of Frutarom. How does IFF intend to keep him compensated or interested in the business? In terms of the regulatory approvals, would you anticipate any issues in terms of some of the larger markets where Frutarom operates, in terms like Russia and the European Union?
Is there potential for any divestments that you can see at this stage, or do you think it's just merely box-ticking exercise to get the regulatory approvals? Thank you.
Thank you, Fintan. Let me start with the last one first. On the regulatory side, we don't see any issues, and we don't expect to have to divest any business before we get regulatory approval, which is positive, and that made us actually believe that the fourth quarter is good for closing, which is ahead of the initial timeline we have given ourselves. We're very happy about that. On the talent side for the integration, we haven't seen any significant departures. We believe that many of the senior leaders will have a good position within IFF and will stay. We are very happy with many of the talented people who will join the new IFF in the new makeup of the company and help us driving growth.
From my standpoint, Fintan, I think we're also obviously, we have a completely separate work stream around talent management and the people. As Andreas' previous comments in his prepared remarks, very strong talent base. Part of that work stream is identifying who those key people are and reaching out to them and having discussions before closing in terms of what the vision is for the future.
Your next question comes from the line of Faiza Alwy with Deutsche Bank.
Hi, good morning.
Good morning, Faiza.
Hi. I just wanted to go back first to pricing in the quarter. If you could just update us on or give us more color around where the pricing is coming from. My sense is that it's coming maybe more from the smaller customers, and then you expect in the back half to get more pricing from your more global customers. Maybe if you could disaggregate how much of it is coming from fragrances versus flavors and within fragrances, how much is fragrance ingredients versus the other components.
Sure, Faiza. In general, I would say that the pricing is skewed towards fragrances versus flavors. Within that, it's a balance between compounds and the ingredients business. As you know, we've talked in the past, the fragrance ingredient business generally works off a 6-month contract, so generally, the impact is seen sooner on the ingredient side. On the fragrance compound side, the timing is often driven by, one, the process to identify where and when the choices are made about the adjustments, and in some cases can be driven by the indices or the contract on when the windows open up. The details on global versus local and regional, it's hard to say. I think it's more around those three businesses, more fragrances than flavors, and more of what we see today is on ingredients versus compounds.
Okay, understood. Unless I missed it, I don't think you reiterated your previous outlook around double-digit EPS cash accretion in year two post the deal. I was just wondering if that still stands, and if it does, maybe you could walk through some of the components of that. I know we understand the synergy phasing, but maybe if you could just update us on what type of underlying growth you're expecting and maybe if you've baked in anything for incremental acquisitions there.
Sorry, Faiza. Mike, I'm sorry. I can't control that.
Yeah. It still stands. That's clear, and Rich can explain.
Yeah. We reiterated the guidance today around our core business. We were not talking about the Frutarom deal that we'll cover, as Mike said earlier and Andreas talked about, we'll cover that after the deal closes. Overall, a big part of the year-over-year on a cash basis accretion is driven by the synergies. When we go from 25% to 70%, the cash flow generation of the business is quite significant and we expect it to pay down the debt quite significantly very quickly. We get both the operating profit gain as well as the interest expense reductions that are driving it.
Your next question comes from the line of Patrick Lambert with Raymond James.
Hi, good morning, everybody. Thanks for taking a few questions. Brief one. Just going back on citral. Every company has a different timing of impact, apparently. Do you think that actually for you guys, the bulk of impact, and I think it was last year, about $45 million for the year total without any mitigation. Is it more in Q2 versus the rest of the year, or there's still more to come in terms just for citral impact? That's question number 1.
Yeah, I think for that first part, as we talked about on the last call, the impact was small in Q1. As I talked about at the time, most of the higher costs were sitting in inventory. I think when you think about the overall impact, Q2, Q3 are the pressure points. Then on the input cost side, we expect the purchasing cost to come down as the citral line stabilizes. Then on the other side, we get the pricing takes hold, and that'll further mitigate the impacts.
You still believe you can, out of the 7%, recover about 5% of impact? You know the percentage points of your breakthrough.
Yeah. We still believe that currently the impact in the year, this year, will be about a 2% headwind, so somewhere between $10 million and $15 million on operating profit.
Your next question comes from Jonathan Feeney with Consumer Edge.
Good morning. Thanks very much. When you think about your sales forecast, maybe this is a question more for Rich or maybe Andreas, do you have implicit in that an assumption about acceleration or deceleration in your end customer markets? How much visibility do you have into that? Finally, could you characterize the growth in your portfolio, in your customers right now between either small or local or both kinds of customers versus global customers? I ask because it seems like persistently, your growth rate is so much better than if I put together just a sloppily put an index together of what appear to be all your major CPG customers. You've been growing a lot faster for a long time on an organic basis. Just trying to get my hands around that and how you think about that as you forecast. Thank you.
Sure, John Roberts. First of all, what we see certainly is that the small and mid-size customers are providing us with better growth than the big ones. Now with some of the moves we have done in our own core business, like Tastepoint, for example, we are covering better these small and mid-size customers, which gives us some good growth here. That's good. Actually, this is one of the reasons for the Frutarom deal, because it will give us even more exposure towards these customers, and we feel very excited about this. In general, if you look at the volume trends, they are pretty robust. I would say also with our end customers. Since, I would say probably third quarter last year. We see still pretty robust volume trends.
We saw it in our first quarter, for example, where we were circling through our inventory much faster than we saw it, in particular on the fragrance side. We don't see a deceleration of these trends, but you never know. That's certainly for something we have to see, and we are in constant dialogue with our customers all the time to figure out where they stand and how much growth they see going forward. So far, the volume trend is intact for our customers, which is actually good news for us.
Your next question comes from the line of Brett Hundley with The Vertical Group.
Hey, thanks for fitting me in, guys. I just have one question. I'm trying to think more about the ability of your fragrance segment margins to rebound in 2019. Rich, I thought you had an interesting comment on pricing when you talked about raw material inflation continuing into fiscal 2019. I don't know, I'm just reading your comment as very public and signaling and talking about how it's imperative that you get pricing through or look at other actions. If I'm not reading too much into that comment, as you guys have pricing discussions, ongoing pricing discussions with customers, do you feel like you're getting to any type of price ceiling on the synthetic side? Or do you feel like you're running into any challenges on taking pricing higher?
Maybe related to that, if it's not pricing, do you guys believe that you can deliver another round of cost savings following what you've done over 2017 and 2018? Are you feeling better about maybe walking your synergy number from Frutarom higher or maybe walking it faster? Can you just talk about the other ways that if you don't go out and get pricing, that you might be able to offset further oncoming inflation? Thank you.
Sure. Thanks. Look, I'm never gonna sit here in my role and tell you that getting the price increase is easy. It's not. It's a long process. I think we have better tools available to us today to help our teams have fact-based conversations with our customers at a very detailed level that we hadn't had six or seven years ago. That's imperative to our ability to get those price increases. Would I like them to come sooner? Absolutely. We have to manage our business, and these are long-term relationships with our customers, and we have to work together. In some cases, we can come quicker. In other cases, we have to make a choice and work with them around formula optimization or opening up the formulas and reformulating. Sometimes we have to look at options around phasing in the price increases.
I think both businesses have shown the ability to recover the price increases. Again, sometimes the timing was probably not what Andreas and I would like, but I think we're able to do that. Now, from a margin standpoint, obviously it's dilutive because what we don't do is try to mark up the cost increases. I think those will continue. We'll continue to work that next year. I think what's important to me, I think when I look at the trajectory on the input cost increases, again, we're not sitting here saying, or we're expecting it to be double-digit increases across 80% of the portfolio, which is what we faced back in 2010, 2011, and 2012, and that took us two or three years to recover that. I think we will continue to do that.
In terms of your questions around cost savings and what we do as a business, that's part of what we're constantly doing is managing productivity programs. The product productivity programs that Francisco's led over the last 11 years that I've been with the company have been dramatic in terms of what they've delivered to the bottom line and helped give us flexibility. I'm not gonna sit here and tell you we have the same ability to achieve those that we've had in the last 10 years over the next 10 years because we've done all the easy stuff. It's a constant part of our agenda. We will obviously look to accelerate the synergies and turn over every possible stone to have as much flexibility in our operating model. I think we will then look at how much do we reinvest in the business.
That becomes, to me, the variable of terms of, okay, if we're ahead of schedule, we can potentially reinvest quicker. If we're behind, we'll be more restrictive in terms of where we make incremental investments.
Actually, on the cost side, particularly on manufacturing, as Rich said, the easy stuff is done. Now, in front of the fourth industrial revolution, we see much more of a drive into artificial intelligence and robotics, which will help us actually significantly to decrease some of the costs we are having in that area. That's actually very helpful. Our profitability and potential savings agenda is still on for the core business. Then on top of it, certainly the savings we get through the Frutarom deal. That's where we are, and we feel actually very good about it.
We have reached the allotted time for Q&A. I would now like to turn the call back over to Andreas for closing remarks.
Yeah. Thank you for all the great questions. It was a good session. I hope you got the answers you needed, and as usual, we follow up with the one-on-one calls for more detailed information. Thank you very much, guys. Have a good day. Bye-bye.
Thanks.
Thank you for participating in today's conference. You may now disconnect.