Overview
We are a leading creator and manufacturer of flavor and fragrance compounds used to impart or improve the flavor or fragrance in a wide variety of consumer products.
IFF is organized into two units that reflect our flavor and fragrance businesses. Flavor compounds are sold to the food and beverage industries for use in consumer products such as prepared foods, beverages, dairy and confectionery products. The fragrance business unit consists of three fragrance categories: functional fragrances, including fragrance compounds for personal care (e.g., soaps) and household products (e.g., detergents and cleaning agents); fine fragrance and beauty care, including perfumes, colognes and toiletries; and ingredients, consisting of natural and synthetic ingredients that can be combined with other materials to create unique functional and fine fragrance compounds. Approximately 55% of our ingredient production is consumed internally; the balance is sold to third party customers.
Changing social habits resulting from such factors as increases in personal income, leisure time, health concerns, urbanization and population growth stimulate demand for consumer products utilizing flavors and fragrances. These developments expand the market for products with finer fragrance quality, as well as the market for colognes and toiletries. Such developments also stimulate demand for convenience foods, soft drinks and low-fat and organic food products that must conform to expected tastes. These developments necessitate the creation and development of flavors and fragrances and ingredients that are compatible with newly introduced materials and methods of application used in consumer products.
Flavors and fragrances are generally:
• created for the exclusive use of a specific customer;

• sold in powder, or liquid form, in amounts ranging from a few pounds to several tons depending on the nature of the end product in which they are used;

• a small percentage of the volume and cost of the end product sold to the consumer; and

• a major factor in consumer selection and acceptance of the product.

The flavors and fragrances industry can be impacted by macroeconomic factors in all product categories and geographic regions. Such factors may include the impact of currency on the price of raw materials, and operating costs, as well as on translation of reported results. In addition, IFF is susceptible to margin pressure due to customers' cost improvement programs and input cost increases. However, these pressures can often be mitigated through a combination of product reformulation, sourcing strategies and material substitution plus internal cost containment efforts, and the development of innovative and streamlined solutions and processes.
STRATEGIC DRIVERS
To increase shareholder value, we pursue three key strategies: investing in research to develop new, innovative materials and delivery systems; developing a deep understanding of consumers' preferences and values; and maintaining superior creative teams to support our flavors and fragrances' customers. Our goal is to deliver differentiated solutions that enable our customers' brands to win in the marketplace.
In order to pursue these strategies, our three key missions are: customers, people and innovation. We are well positioned to achieve success by targeting strategically important global and regional customers in both developed and emerging markets; attracting, developing and retaining top talent; investing in research and development; and fostering a culture of innovation and continuous improvement.

Operations
Second Quarter 2009
Sales Commentary
Second quarter 2009 sales totaled $568 million, down 11% from the prior year period, as flavor sales declined 7% and fragrance sales decreased 14%. Foreign currency parity continued to have a negative impact on year-over-year sales performance, reducing reported sales in the 2009 quarter by $44 million or 7% versus the 2008 period.
Excluding the impact of currency movements, local currency (LC) sales for the Flavors business were up slightly year-over-year for the quarter. All regions except EAME (Europe, Africa and Middle East) delivered LC sales growth for the quarter. Local currency growth in Latin America was driven by new wins, as well as volume growth in dairy and confectionary, combined with modest price realization. In North America, new wins, particularly in savory, and price increases offset lower volumes in several beverage accounts. Greater Asia experienced good growth in savory and price recovery across most categories. These improvements were mostly offset by sales erosion in beverages and confectionary plus the negative effects of a stronger U.S. dollar on local demand.
Fragrance sales were 7% lower than the prior year period, excluding the effects of a stronger dollar. The decline in LC sales is mainly due to lower volumes and product erosion within Fine Fragrance combined with overall weakness in Ingredients demand. These negative factors more than offset very good performance in Functional fragrances which grew 3% in LC in the current quarter. The growth in Functional was driven by new wins in Fabric and Personal Wash. We continue to see solid growth in almost all emerging markets for Fragrance compound sales.
Sales performance by region and product category in comparison to the prior year quarter in both reported dollars and local currency, where applicable, was as follows:

                                                                   % Change in Sales-Second Quarter 2009 vs Second Quarter 2008
                                                    Fine &
                                                  Beauty Care        Functional        Ingredients        Total Frag.        Flavors        Total
North America            Reported                       -26 %              -3 %               -9 %              -13 %             1 %         -6 %

EAME                     Reported                       -37 %             -12 %              -29 %              -26 %           -18 %        -23 %
                         Local Currency                 -26 %               1 %              -18 %              -14 %            -5 %        -11 %

Latin America            Reported                         8 %               2 %               -5 %                3 %            -1 %          2 %
                         Local Currency                  10 %               3 %               -4 %                4 %             8 %          6 %

Greater Asia             Reported                         7 %              11 %              -14 %                4 %            -4 %         -1 %
                         Local Currency                  10 %              13 %              -14 %                6 %             1 %          3 %

Total                    Reported                       -23 %              -3 %              -19 %              -14 %            -7 %        -11 %
                         Local Currency                 -16 %               3 %              -13 %               -7 %             0 %         -4 %

† North American sales declines were driven primarily by weak economic conditions and continued efforts on the part of our customers to maintain low inventory levels, notably within Fine Fragrances.

† EAME sales continue to be the hardest hit by overall weakness in demand across almost every category. There was some improvement in LC sales, on a relative basis, over the course of the quarter.

† Latin America saw solid LC sales growth across all segments, except Ingredients. We continue to experience good penetration with key regional accounts for Fragrances and news wins for Flavors.

† Greater Asia LC sales growth was driven by new product introductions in Fragrances partially offset by volume declines and the effects of a stronger U.S. Dollar (USD) on local demand for Flavors. The decrease in ingredients sales was driven by volume declines consistent with the overall market weakness.

Consolidated Operating Results
   The percentage relationship of cost of goods sold and other operating
expenses to reported sales is as follows:

                                                        Second Quarter
                                                       2009        2008
               Cost of goods sold                       59.9 %     58.5 %
               Research and development expenses         8.6 %      8.8 %
               Selling and administrative expenses      16.4 %     16.5 %

Cost of goods sold includes the cost of materials and manufacturing expenses; raw materials generally constitute 70% of the total. Research and development expenses are for the development of new and improved products, technical product support, compliance with governmental regulations, and help in maintaining relationships with customers who are often dependent on technological advances. Selling and administrative expenses support our sales and operating efforts.
Cost of goods sold, as a percentage of sales, was 59.9% compared with 58.5% in 2008. This increase was mainly the result of higher input costs plus lower absorption and volume, as well as weaker product mix that was partially offset by cost recovery efforts.
Research and development (R&D) expenses were down approximately $7 million from the prior year as tight cost control on applied research and development and the effects of a stronger U.S. dollar more than offset somewhat higher spending on basic R&D.
Selling and administrative expenses (S&A), as a percentage of sales, decreased to 16.4% as compared to 16.5% in the second quarter 2008. The current year quarter includes $0.9 million related to employee separation costs versus $3.4 million in the 2008 period. Excluding employee separation costs in each period, S&A expenses in 2009 increased approximately 30 basis points as a percentage of sales. The increase is mainly attributable to higher pension costs, bad debt provisions and product claims. Interest Expense
In the second quarter 2009, interest expense totaled $14.0 million as compared to $18.5 million in 2008. The reduction during the 2009 period reflects the elimination of cross-currency interest rate swaps during the second half of 2008 and during the first quarter 2009, and lower average borrowing costs. Average cost of debt was 4.6% for 2009 compared to 6.0% in 2008. Other (Income) Expense, Net
Other expense in 2009 of $1.6 million versus other income of $4 million during the 2008 period was mainly due to losses on foreign exchange transactions, compared to gains in the prior year. Income Taxes
The effective tax rate was 26.1% as compared to a rate of 23.2% in the prior year quarter. The 2008 effective tax rate was 27.6% excluding a $3.9 million benefit from favorable tax rulings related to prior periods. Excluding this effect, the decline in the effective tax rate in 2009 reflects the mix of earnings in countries in which we operate, ongoing savings associated with an increase in non-U.S. investment tax credits, as well as favorable provision-to-return adjustments.
Operating Results by Business Unit
We evaluate the performance of business units based on operating profit before interest expense, other income (expense), net and income taxes. See Note 10 to our Consolidated Financial Statements for the reconciliation to Income before taxes.
Flavors
In the second quarter 2009, Flavors operating profit totaled $55 million, or 20.2%, as a percentage of sales, compared to $57 million or 19.6% of sales in 2008. The improvement in profitability reflects margin and cost recovery efforts combined with lower overhead expenses that more than offset the effects of higher input costs, weaker mix and unfavorable foreign exchange impacts.

Fragrances
Fragrance operating profit for the second quarter of 2009 was $35 million, or 11.7%, as a percentage of sales, compared to $56 million or 16.3% of sales during 2008. The decline in profit was driven by lower volumes and unfavorable mix, higher input costs and negative currency parity impacts that were partially offset by reduced overhead expenses and cost recovery efforts. The 2009 results include $5 million related to the restructuring charge. Global Expenses
Global expenses represent corporate and headquarters-related expenses which include legal, finance, human resources and other administrative expenses that are not allocated to an individual business unit. In 2009, Global expenses for the second quarter were $9 million compared to $12 million during 2008. The 2009 and 2008 Global expenses included $1 and $3 million of employee separation expenses, respectively. In addition, the 2009 quarter includes a net reversal of $0.4 million pertaining to the restructuring plans. First Six Months 2009
Sales Commentary
Sales for the first six months of 2009 totaled $1.1 billion, decreasing 9% from the prior year period of $1.2 billion, as Flavor sales declined 5% and Fragrance sales decreased 12%. Foreign exchange had a 6% negative impact on reported sales for the first half of 2009 as the U.S. dollar strengthened against most currencies; at comparable exchange rates, sales would have decreased 3% year-over-year.
On a local currency (LC) basis, Flavor sales increased 1% year-over-year. North America and Latin America delivered solid growth despite weak economic conditions whereas sales in EAME were down 3% as a result of the economic slowdown and ongoing inventory reductions by our customers. Greater Asia sales in LC were up 1% for the six month period, despite the effects of a stronger USD on local demand.
Fragrance sales declined 12% including 6% attributable to exchange rates. Fine & Beauty Care sales declined 14%, reflecting weak consumer demand and excess inventories through the supply chain primarily in North America and EAME. Functional Fragrance sales grew 2% globally due to new wins in the fabric care and personal wash categories combined with good growth in emerging markets. Ingredients sales declined 9% on a LC basis primarily due to significant erosion in the fine fragrance category.
Sales performance by region and product category in comparison to the prior year period in both reported dollars and local currency, where applicable, was as follows:

                                                                                   % Change in Sales-Six Months 2009 vs Six Months 2008
                                                          Fine &
                                                        Beauty Care           Functional           Ingredients           Total Frag.          Flavors         Total
North America               Reported                             -21 %                  3 %                   1 %                  -6 %              3 %          -1 %

EAME                        Reported                             -35 %                -12 %                 -28 %                 -25 %            -15 %         -21 %
                            Local Currency                       -26 %                 -1 %                 -19 %                 -15 %             -3 %         -11 %

Latin America               Reported                              10 %                  2 %                   5 %                   5 %             -1 %           3 %
                            Local Currency                        13 %                  2 %                   5 %                   6 %              8 %           7 %

Greater Asia                Reported                               9 %                  3 %                  -5 %                   3 %             -3 %          -1 %
                            Local Currency                        12 %                  4 %                  -6 %                   4 %              1 %           2 %

Total                       Reported                             -20 %                 -3 %                 -14 %                 -12 %             -5 %          -9 %
                            Local Currency                       -14 %                  2 %                  -9 %                  -6 %              1 %          -3 %

† North America sales declined slightly, driven by erosion and volume declines in fine fragrance compounds that more than offset the benefits from new wins in our savory, fabric care and personal care categories, as well as some price recovery. Ingredient sales growth was mainly attributable to price increases and mix.

† EAME sales declines in LC were driven by de-stocking and weak economic conditions across all product categories. Functional fragrance sales in LC were aided by good growth in fabric care.

† Latin America LC sales saw good growth and new wins across all product categories. Flavor sales were up 8% in LC as compared to very strong performance during 2008.

† Greater Asia LC sales growth was driven by new product introductions and wins across most product categories and price realization. Flavor sales performance was good, despite the negative effects of a stronger USD on demand.

Consolidated Operating Results
   The percentage relationship of cost of goods sold and other operating
expenses to reported sales is as follows:

                                                       First Six Months
                                                       2009         2008
              Cost of goods sold                        60.1 %      58.7 %
              Research and development expenses          8.8 %       8.8 %
              Selling and administrative expenses       16.2 %      15.8 %

Cost of goods sold includes the cost of materials and manufacturing expenses; raw materials generally constitute 70% of the total. Research and development expenses are for the development of new and improved products, technical product support, compliance with governmental regulations, and help in maintaining relationships with customers who are often dependent on technological advances. Selling and administrative expenses support our sales and operating levels.
Cost of goods sold, as a percentage of sales, was 60.1% compared with 58.7% in 2008. This increase was mainly the result of higher input costs, lower absorption and volumes, plus weaker sales mix that were partially offset by cost recovery and margin improvement efforts.
Research and development (R&D) expenses were down approximately $9 million from the prior year as tight cost control on applied research and development plus the effects of a stronger dollar more than offset increased spending on materials research.
Selling and administrative expenses (S&A), as a percentage of sales, increased slightly to 16.2% of sales as compared to 15.8% in the first half of 2008. The 2008 amount includes the benefit of a $2.6 million insurance recovery related to a prior period product liability claim offset by $3.4 million for employee separation costs. The 2009 amount includes $0.9 million pertaining to employee separation costs. Excluding these items, S&A as a percentage of sales was 16.1% and 15.7%, respectively, for the 2009 and 2008 periods. The reduction in S&A dollars reflects a stronger U.S. dollar, cost reduction efforts and lower incentive compensation expense that more than offset higher pension expense and provisions for bad debts and product claims. Restructuring and Other Charges
Restructuring and other charges consist primarily of separation costs for employees, including severance, outplacement and other benefit costs.
The Company recorded a net pre-tax charge of $4.1 million during the three months ended June 30, 2009. This amount includes $6.6 million for severance and related costs associated with the elimination of approximately 70 positions globally, less a $2.5 million reduction to previously recorded provisions. The reduction in prior reserves is attributable to lower estimated benefit costs on severance paid as well as fewer position eliminations requiring severance. The position eliminations in the current quarter are expected to generate approximately $9 million in annual savings once completed during the third quarter. The reductions were primarily related to our Fragrance business reflecting the weak economic conditions affecting this segment.

The 2008 charges primarily related to employee separation expenses in connection with the implementation of a global shared service center and a performance improvement plan. Positions eliminated and charges, net of reversal by business segment are detailed in the table below.

                           Restructuring Charges
                              ( In Thousands)             Positions Eliminated
                            2009             2008         2009             2008
            Flavors      $      (363 )     $    925             7              17
            Fragrances         4,849          2,480            60              19
            Global              (382 )        3,455             5              91

            Total        $     4,104       $  6,860            72             127

Interest Expense
In the first six months of 2009, interest expense totaled $34 million as compared to $37 million in 2008. The 2009 decrease reflects a lower average borrowing cost and the elimination of a cross-currency interest rate swap during the second half of 2008. The 2009 amount includes $4 million of interest paid on the close-out of a cross-currency interest rate swap classified as a net investment hedge. Average cost of debt was 5.2% for 2009 compared to 6.0% in 2008.
Other (Income) Expense, Net
Other expense in 2009 of $0.4 million as compared to other income of $1.8 million in 2008 was mainly due to losses on foreign exchange transactions, compared to gains in the prior year, and lower interest income in 2009. Income Taxes
The effective tax rate was 25.3% as compared to a rate of 24.2% in the prior year period. The 2008 effective tax rate was 27.9% excluding $6 million of benefits pertaining to favorable tax rulings from prior periods. The decline in the effective tax rate in 2009 is mainly attributable to an increase in non-U.S. investment tax credits and the mix of earnings across the countries in which we operate.
Operating Results by Business Unit
We evaluate the performance of business units based on operating profit before interest expense, other income (expense), net and income taxes. See Note 10 to our Consolidated Financial Statements for the reconciliation to Income before taxes.
Flavors
For the first six months of 2009, Flavors operating profit totaled $107 million, or 20.0% of sales, compared to $114 million or 20.2% of sales in 2008. The 2008 amount includes $0.9 million of restructuring expenses. The decline in profitability was primarily the result of unfavorable currency parity, higher input costs and lower volumes and absorption. These were partially offset by cost recovery and margin improvement efforts. Fragrances
Fragrance operating profit for the first six months of 2009 was $71 million, or 12.0% of sales, compared to $103 million or 15.4% during 2008. The 2008 amount includes $2 million of restructuring expenses compared to $5 million during 2009. The decline in profit was driven by significantly lower volumes in Fine Fragrances and Ingredients, higher input costs and unfavorable mix partially offset by pricing, margin recovery efforts and lower overhead expenses.

Global Expenses
Global expenses represent corporate and headquarters-related expenses which include legal, finance, human resources and other administrative expenses that are not allocated to an individual business unit. In 2009, Global expenses for the first six months were $17 million compared to $20 million during the 2008 period. The 2009 period included $1 million of employee separation costs. The 2008 period included approximately $3 million of restructuring charges and $3 million of employee separation costs, partially offset by a $3 million insurance recovery related to prior period product liability claim. Excluding these items, the improvement is attributable to cost control and reduced incentive compensation expense.
Financial Condition
Cash and cash equivalents totaled $164 million at June 30, 2009 compared to $178 million at December 31, 2008. Working capital was $779 million at June 30, 2009 compared to the $710 million at December 31, 2008. Additions to property, plant and equipment for the six-month period ended June 30, 2009 totaled $19 million. Gross additions to property, plant and equipment are expected to approximate $70 million for the full year 2009.
Operating cash flows in 2009 were an inflow of $88 million versus $79 million in the prior year period. The improvement in operating cash flows was led by the reduction of our inventories, which was driven by our internal process improvement initiatives. The inventory reduction was partially offset by lower other payables and long-term liabilities. Operating cash flows in 2008 benefited from the receipt of $18 million on termination of an interest rate swap.
At June 30, 2009, we had $1,214 million of debt outstanding comparable to $1,216 million outstanding at June 30, 2008.
In February 2009, we closed out the $300 million USD London InterBank Offer Rate (LIBOR) to European InterBank Offer Rate (EURIBOR) interest rate swap for $16 million, of which a $12 million loss was deferred in AOCI where it will remain until the Euro net investment is divested and $4 million was included currently in earnings as a component of interest expense.
In January 2009, April 2009 and July 2009 we funded a quarterly cash dividend of $0.25 per share to shareholders, a 9% increase from the prior year quarterly dividend payment.
During the six months ended June 30, 2009, we repurchased 75,000 shares on the open market at a cost of $2 million or $26.22 per share. In the comparable period ended June 30, 2008, we repurchased approximately 700,000 shares at a cost of $30 million on the open market.
We continue to generate strong operating cash flows and our revolving credit facility (the "Facility") remains in place. As of June 30, 2009, the drawdown capacity on the multi-year revolver is approximately $300 million. Cash flows from operations and availability under our existing credit facilities are expected to be sufficient to fund our currently anticipated normal capital spending and other expected cash requirements for at least the next eighteen months.
The Facility and 2008 Japanese Yen loan contain the most restrictive covenants requiring us to maintain, at the end of each fiscal quarter, a ratio of net debt for borrowed money to adjusted EBITDA in respect of the previous 12-month period of not more than 3.25 to 1. At June 30, 2009, we were in compliance with all financial and other covenants. At June 30, 2009 our Net Debt/ adjusted EBITDA(1) was 2.51 to 1 as defined by the debt agreements.
Failure to comply with the financial and other covenants under these agreements would constitute default and would allow the lenders to accelerate the maturity of all indebtedness under the related agreement. If such . . .