International Flavors & Fragrances Q3 2023 Earnings Call Transcript

Participants

Corporate Executives

• Michael DeVeau, Senior Vice President, Corporate Finance and Investor Relations
• Frank Clyburn, Chief Executive Officer
• Glenn Richter, Chief Financial and Business Transformation Officer

Analysts

• Gunther Zechmann, Sanford C. Bernstein
• Michael Sison, Wells Fargo & Company
• Nicola Tang, Exane BNP Paribas
• John Roberts, Mizuho Securites
• Mark Astrachan, Stifel Nicolaus
• David Begleiter, Deutsche Bank Aktiengesellschaft
• Adam Samuelson, The Goldman Sachs Group, Inc.
• Patrick Cunningham, Smith Barney Citigroup
• Lauren R. Lieberman, Barclays Capital
• Josh Spector, UBS Group AG
• Laurence Alexander, Jefferies Financial Group Inc.
• Silke Kueck, JPMorgan Chase & Co.
• Salvator Tiano, Bank of America Co.
• Andrew Keches, Barclays PLC

Presentation

[Operator]

At this time, I would like to welcome everyone to the IFF Third Quarter 2003 Earnings Conference Call. All participants will be in a listen-only mode until the formal question-and-answer portion of the call. [Operator Instructions]. 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.

[Michael DeVeau, Senior Vice President, Corporate Finance and Investor Relations at International Flavors & Fragrances]

Thank you. Good morning, good afternoon, and good evening, everyone, welcome to IFF's third quarter 2023 conference call. Yesterday afternoon we issued 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.

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 and business outlook. 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, please refer to our cautionary statement and risk factors contained in our 10-K and press release.

Today's presentation will include non-GAAP financial measures, which exclude 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.

With me on the call today is our CEO, Frank Clyburn; and our Executive Vice-President and Chief Financial and Business Transformation Officer Glenn Richter. We will begin with prepared remarks and then take any questions you may have at the end.

With that, I would now like to turn the call over to Frank.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Thank you, Mike, and hello, everyone, and thank you for joining us. On today's call, I will begin by providing an overview of our performance in the third quarter and an update on our strong execution to position IFF for long-term success. I will then turn the call over to Glenn, who will provide a more detailed look at our third quarter financial results by business and discuss our outlook for the remainder of 2023. We will then open the call for questions.

Moving to Slide 6, our third quarter story is one of sequential improvement. As we've discussed, improving volumes has been a top priority and we are pleased with the sequential volume improvements that we have achieved across the majority of our business. On a total company basis, while our volume in the third quarter was down mid-single-digits, it was a marked improvement from our Q2 lows, where we saw a double-digit decline. Similarly, our enhanced productivity initiatives as well as favorable price to inflation led to strong adjusted operating EBITDA results. Sequentially, our adjusted operating EBITDA margin finished at 17.9%, which is a 50 basis-point improvement versus the second quarter of 2023. And our focus on ongoing working capital improvements drove strong free cash flow generation. In particular, the continued execution of our inventory reduction program has resulted in more than a $600 million reduction in inventory since the end of 2022. This was the largest driver of our free cash flow, which improved $320 million versus the second quarter of '23. The net result is that we delivered higher than our expectations on both the top line and bottom line. At the same time, our commercial excellence initiatives and our R&D platform continue to drive improvements in our sales pipeline, in addition and functional ingredients as discussed on our second-quarter call, we are implementing a targeted operational improvement plan to improve sales execution, strengthen our operating model and reshape the portfolio. As we shared previously, we expect this plan for functional ingredients will translate into low-single digit comparable currency-neutral sales growth in line with the market in a mid-teens adjusted operating EBITDA margin over the next three years with a strong improvement in 2024.

And while this will take time, we are seeing improvements in our volume performance where we finished the quarter down mid-teens versus low 20% declines in Q2 of 2023. With this momentum, we have increased confidence in our ability to deliver within our previously announced full-year '23 sales guidance range and we are now targeting the mid-to-high end of our full-year 2023 adjusted operating EBITDA guidance range.

As Glenn will highlight, we are seeing signs of green shoots in the fourth quarter with stabilization and improvements across several parts of our business. Lastly, we've made important progress against our portfolio optimization initiatives as we are rapidly addressing our capital structure. Most notably, aligned with our best owner mindset, we announced an agreement to sell Lucas Meyer Cosmetics to specialty chemical company, Clariant for $810 million which is equivalent to a high-teens multiple based on our projections. We expect to complete the transaction in the early part of the first-quarter of 2024 and all proceeds will support our deleveraging priorities. Moving forward, we continue to pursue strategic non-core divestitures that will drive further deleverage and enable us to further prioritize our fastest-growing margin-accretive businesses and deliver long-term value for shareholders.

Moving to Slide 7. In the third quarter, IFF generated $2.8 billion in sales, representing a 3% decline on a comparable currency-neutral basis. A strong performance in Scent and Health and Biosciences was more than offset by softness in Nourish and Pharma Solutions. As I mentioned, volumes improved sequentially across nearly all businesses with restricted particularly strong performance in Scent and Health and Biosciences. Excluding functional Ingredients, which continues to disproportionately impact our results, overall volume decline, and low-single digits in the third quarter.

Adjusted operating EBITDA for the quarter was $5.6 million, down 10% year-over-year. On a comparable currency-neutral basis. Our favorable net price to inflation, as well as enhanced productivity gains, were more than offset by lower volumes, due primarily to temporary customer destocking and unfavorable manufacturing cost absorption. Adjusted EPS, excluding amortization, was $0.89, primarily impacted by lower profitability.

Now, I will turn it over to Glenn to provide more detail on profitability and our performance by business segment.

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

Thank you, Frank, and good morning, good afternoon, and good evening, everyone. Taking a closer look at our profitability performance on Slide 8. As Frank mentioned, we delivered a higher-than-expected EBITDA of $506 million in the third quarter. While we continue to benefit from favorable price to inflation and productivity gains. As you can see from this slide, ongoing volume pressures impacted our profitability in the quarter. While we are encouraged by the sequential volume improvement we have seen across most of our portfolio, it remains the primary pressure in Q3.

If we look at our profitability performance. Absolutely unfavorable manufacturing absorption related to our inventory improvement program, adjusted operating EBITDA would have declined 6% year-over-year on a comparable currency-neutral basis. Note that our negative absorption in the quarter was less than expected as our inventory reduction program for the year has run its course and volumes have improved. We've done a good job at driving working capital improvements to our inventory reduction program driving more than $600 million reduction in inventory since the end of '22. As a result. At this time, we are now expecting approximately a $165 million impact from negative absorption to profitability for the full year, down from $180 million. This could also flex further as the fourth quarter unfolds. To reiterate, this is a one-time transitory impact of the P&L in order to maximize cash flow moving forward.

Turning to Slide 9, I'll provide a closer look at our Q3 performance by business segment. In Nourish sales declined 7% on a comparable currency-neutral basis, driven mainly by the continued weakness in functional ingredients. While functional ingredients remained a main driver of weakness in Nourish in the third quarter, we did see sequential improvement and expect this to continue as we move into the fourth quarter. Good growth in our Flavors business and the positive impact of IFF's ongoing pricing actions and productivity initiatives were more than offset by lower volumes and unfavorable manufacturing absorption. Together, this led to a 26% year-over-year decrease in comparable currency-neutral adjusted operating EBITDA.

Health and Bioscience continued to deliver strong results in Q3 led by meaningful growth in Cultures and Food Enzymes, Grain Processing. Home and Personal Care and Animal Nutrition, leading to comparable currency-neutral growth of 2% year-over-year. Price increases, and productivity gains led to a 12% year-over-year increase in comparable currency-neutral adjusted operating EBITDA.

Scent was once again our strongest performer, delivering 7% growth in comparable currency-neutral sales, driven by double-digit growth in Consumer Fragrance and high-single-digit growth in Fine Fragrance. Like Health and Biosciences, Scent also saw strong 19% growth in comparable currency-neutral adjusted operating EBITDA with profitability driven by favorable net pricing and productivity gains.

Pharma Solutions growth rate was pressured this quarter in large part to a very strong prior year comparison with a 28%, 2022 sales growth comparison and a 76% '22 adjusted operating EBITDA comparison. Price increases and productivity gains for this business were more than offset by lower volumes in comparable currency-neutral sales declined to 9% and comparable currency-neutral adjusted operating EBITDA declined 34% in the quarter.

Now on Slide 10, I'll discuss our cash flow and leverage position. Cash flow from operations totaled $795 million, a significant increase reflecting a strong improvement in inventory levels. Capex year-to-date was $390 million or approximately 4.4% of sales. Our inventory reduction program and working capital improvements have also greatly contributed to IFF's improved free cash flow performance, which totaled $405 million, a significant increase of $320 million from the second quarter. Year-to-date, we also distributed $619 million in dividends to our shareholders. Our cash-and-cash equivalents totaled $652 million, which includes $23 million in assets held for sale.

Additionally, gross debt for the quarter totaled approximately $10.3 billion with a net debt-to-credit adjusted EBITDA of 4.6 times. Our trailing 12-month credit-adjusted EBITDA totaled approximately $2.1 billion. We are making good progress on working down our debt levels. And as Frank mentioned earlier, portfolio optimization remains a near-term priority as we work to reduce our leverage position and ensure our resources are focused on the businesses that will carry our success into the future. The sale of our cosmetic ingredients business, which is expected to close in the early part of the first quarter of 2024 will further support our strength and capital structure as we pay down debt in line with our net debt to credit adjusted EBITDA targets.

Now on Slide 11, I would like to focus on our consolidated outlook for the rest of the year. First, we are reaffirming our full-year revenue guidance range of 11.3% to 11.6 billion, which reflects the improved momentum we are seeing across the majority of our business. That accounts for the macroeconomic environment and foreign exchange impact, which we expect will persist through the end of the year. On the bottom line, we are now expecting to deliver full-year 2023 adjusted operating EBITDA at the mid-to-high end of our previously-announced guidance of $1.85 billion to $2 billion, driven primarily by favorable price to inflation and improved productivity. We also now expect full-year interest expense to be slightly higher at approximately $450 million. Our projected effective tax rate for the year is expected to be approximately 21%, the same estimate we provided last quarter.

Finally, as we look to the fourth quarter, we continue to expect an improving trend in a majority of our businesses as we navigate the macroeconomic challenges impacting our industry, we are seeing signs of green shoots in the fourth quarter, the stabilization and improvements across several parts of our business. As we near the end of the year, I know many of you have questions on 2024. While the macroeconomic environment remains volatile with low visibility, we are optimistic heading into the New Year. We have several known one-off items that we have high level of confidence will be tailwinds including significant negative absorption related to our successful inventory reduction program and one-time Lucas Meyer inventory write-down.

Also, we will continue to execute on our cost and productivity initiatives and have a carryover benefit from this year's restructuring program. These of course will be partially offset by a reset of our annual incentive compensation program where we have reduced payments in 2023 related to our performance versus target. In the end, improved volume performance will be critical to our success and we believe that destocking will largely be done as we exit the year and we also believe we will benefit from the acceleration of our strategic transformation initiatives. We will provide our 2024 guidance with our fourth quarter results, which we expect to be towards the end of February.

With that, I'll turn the call-back over to Frank for closing remarks.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Thank you, Glenn. Let me start by saying that I am tremendously proud of what our teams have accomplished in the last quarter. To advance our focus strategic initiatives and build a stronger more resilient IFF. Our improved performance, productivity gains, and reaffirmed financial guidance reflect the hard work of our global teams that continue to support our long-term vision. We executed against our strategic priorities in Q3, and we'll continue to take action in Q4 to build a stronger IFF better positioned to accelerate growth, expand margins, and deliver value for shareholders.

Finally, looking at our business more broadly, we will continue to pursue portfolio optimization initiatives to strengthen our capital structure. As we've discussed previously, we are laser-focused on investing in our highest-return businesses while positioning our less margin-accretive businesses for success, either through new ownership or through focused improvement plans, such as those we are pursuing for functional ingredients. Our goal as we move through the end of 2023 and beyond is to ensure that each of our businesses has the resources and where appropriate, the ownership most conducive to accelerating our growth, expanding our margins, and maximizing our long-term returns as we continue to innovate for customers worldwide.

With that, I will now open up the call for questions.

Questions and Answers

[Operator]

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from the line of Gunther Zechmann with Bernstein. Your line is now open.

[Gunther Zechmann, Analyst at Sanford C. Bernstein]

Hi, good morning, everyone. Frank, my question to you is, could you please talk about the development in the Functional Ingredients part of the business? It looks like a V-shaped recovery, but any color you could give around the moving parts within that business on the topline and the ramp of what you mentioned around the fixed-cost measures that you're taking, would be great. Thank you.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Hey, Gunther, it's Frank, good afternoon, good morning. A couple of things, one with regards to Functional Ingredients. The business clearly across all of the ingredients is stabilizing, Gunther and we saw a good sequential improvement when I look at Q2 to Q3, in particular and through the various business lines, core texturants, emulsifiers, sweeteners, and Protein Solutions, good sequential improvement. So that's a very positive sign for us and obviously, those products are going into some of our key dairy and bakery end-market categories.

As far as the Functional Ingredient plan overall. We're focused in three areas, one to enhance our go-to-market approach; two, drive operational efficiencies; and three, really reshaping the product portfolio. And since we've announced, we've added targeted commercial professionals to pursue incremental opportunities with our customers. We've also reviewed our organization and we're in the process of adjusting our operating model, Gunther to drive greater efficiencies throughout. And at the same time, we have completed a full review of our product lines and we're in the process of investing behind our strongest products as well as rationalizing those that are underperforming. The team is urgently acting to drive better performance across Functional Ingredients and the net result of this, Gunther will be, we're very confident we can grow sales in line with the market and deliver mid-teens adjusted operating EBITDA margin over the next three years. Thanks for the question.

[Operator]

Thank you. Our next question comes from the line of Mike Sison with Wells Fargo. Your line is now open.

[Michael Sison, Analyst at Wells Fargo & Company]

Hey, good morning, guys, nice quarter. Frank, deleveraging is an important part of your thesis going forward and can you maybe provide an update on your divestiture process? I think there is press out there that pharma is potentially up for sale and how that fits into your strategy.

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

Hey Mike, it's Glenn why don't I attempt to start it and then Frank and sort of add into it? Good morning to you. So just, we have been very transparent for many-many quarters that continue to enhance the portfolio, i.e., refine it is the key enabler of getting to our future leverage goals. We were pleased to announce in the quarter the sale of Lucas Meyer Cosmetics for $810 million gross proceeds that should net about $730 million net. All of that will be used for divestitures. And the company went for a circa 18 multiple based on this year's forecast earnings. So we're pleased by that.

We have a number of other additional portfolio actions underway. We have not publicly mentioned Pharma that as you noted, it's in the press from that standpoint. We are confident that these actions will get us to where we need to which is a three times or less leverage ratio. Relative to your question around pharma. Pharma is a very good business, it's a sticky business. It's in a very healthy sector in terms of the pharma business, but candidly, it has relatively limited overlap in terms of end customers. For the rest of IFF, there are eliminated revenue or other synergies across the complex with Pharma and to answer your question regarding how Pharma fits into our overall framework.

As a reminder, Pharma was sort of in the middle of the pack in terms of ROIC. It has a relatively high-return business, which is the excipients that 75%, and then has a lower return more industrial business on that. So, I think that, Frank you want to add anything else to that.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

I think we can go. Thank you.

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

Thanks, Mike.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Thanks, Mike.

[Michael Sison, Analyst at Wells Fargo & Company]

Thank you.

[Operator]

Thank you. Our next question comes from the line of Nicola Tang with BNP Paribas. Your line is now open.

[Nicola Tang, Analyst at Exane BNP Paribas]

Hi, everyone, thanks for taking the question. Frank, actually, Frank and Glenn, you guys commented volume performance improved sequentially through Q3 and you pointed to signs of green shoots. So I was wondering if you could give some more color either by division or by specific end-markets in terms of why you're seeing that improvement. And what's your latest assessment of customer inventory levels overall, do you think that destocking is now behind us? Thanks for the question.

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

Yeah. good morning or good afternoon, Nicolas. Thanks for the question. It was interesting to see literally essentially every single sub-business within Nourish, H&B, and Scent had a sequential improvement in volumes from Q2 to Q3. So it was very broad-based in terms of the performance improvements we saw. I say, in general, the H&B categories were stronger from an absolute volume standpoint in the food and bev which is not surprising, given what's happening from a consumer demand standpoint. Pharma was the one exception, pharma actually had volumes down. I would note though, they had an incredibly strong third quarter of last year they had a plus 12% in terms of volume. So there's a bit of an overlap. We had converted a system in Q2 of last year. So there was a bit of a backlog of orders, which was cleared up in Q3. So a little bit of a normalization from a standpoint.

Relative to your question on destocking, it's very difficult to say per se. However our feedback from our businesses, we would say that the majority of the customers at this point are either done or expected to be winding down by the end of the the fourth quarter. I think the one segment, that's a little bit of a laggard is Pharma. The Pharma business in terms of the customers started destocking a little bit later. It has a meaningful distributor component of the business as well and also the industrial side and I think that's also been reflected very clearly in the competitive set for the Pharma business as well. So knock on wood, things are sort of moving fairly broad-based across the entire business. Thank you.

[Operator]

Thank you. Our next question comes from the line of John Roberts with Mizuho. Your line is now open.

[John Roberts, Analyst at Mizuho Securites]

Thank you. Scent benefited from a favorable price versus raws. Was that both sequential and year-over-year? Are you getting more price sequentially? And how are you thinking about 2024?

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

Hey, John, this is Glenn. Hey, by the way, welcome to your new home. So relative to Scent, sequentially, it's relatively neutral, Q2 to Q3 in terms of the net price versus cost. Although it is less moving less price and more costs. So, we're now seeing the effect of the deflation basically moving through more so and year-over-year, slightly higher in the third quarter versus the second quarter. As a reminder, in our core markets, being the consumer in Fine Fragrance, our final pricing actions were implemented at the beginning of this year. So really what we're now beginning to do it and there was some implementation in the second quarter of last year. So we're now sort of fully over that from last year's from a neutrality standpoint and what we'll be seeing more the cost reduction.

One important asterisk, we have a percent of our business as you know, that's that basically sells ingredients. About 50% of production is used for our own products and 50% sold. There is a commodity component such as turpentine as an example, Galaxolide, which is somewhat commoditized. The pricing dynamic is a little bit more on a downward cycle given these categories. But in general, the net price. Cost is generally very stable in the Scent business. So thanks for the question.

[Operator]

Thank you. Our next question comes from the line of Mark Astrachan with Stifel. Your line is now open.

[Mark Astrachan, Analyst at Stifel Nicolaus]

Thanks, good morning, everybody. So just curious about how you think about your volume performance relative to peers. It appears that there still outgrowing you all. I suppose somewhat related to maybe to the last question, the bigger picture. It looks like pricing was a much smaller contributor. Sequentially, does that factor into how you think about volumes? And then just lastly, tied together when do you think your sales can go back to the long-term algorithm? Thank you.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Hey, Mark, it's Frank. Let me take that one. There are a couple of things that I really wanted to highlight on this question. So first, we spent a lot of time obviously with our teams throughout the quarter and at the end of the quarter looking at our competitive dynamics and how we're positioned.

And to highlight, maybe if you could give me a minute just to walk through some of our key business lines, so Flavors, for instance, Mark, we actually grew the business this quarter and feel very good about our performance, in particular, in North America and Greater Asia, and very well-positioned against our competitive set.

Health and Biosciences, you actually saw growth versus the prior year. Market was very encouraging and in fact, you saw growth in Cultures and Food Enzymes, Animal Nutrition, Home and Personal Care was a good growth quarter for us. Grain processing has good growth from a sales perspective as well. And then if I look at our Scent business, our Scent business actually grew above-market, Mark; Consumer Fragrance above-market. So clearly growing market share there. And then also our Fine Fragrance business had a good performance. So I feel really good about the Scent performance versus prior year. And then also as we've already highlighted across just about all of our business lines good sequential improvement.

So when I look at our overall business, I feel really good about the sequential improvement. The one area that we do have disproportionate volume declines versus our competitors as we've highlighted is Functional Ingredients. If you were to exclude functional ingredients, Mark our volume would be down low single digits. So we feel as though we're well within our peer set there and like I said, we feel very good about the majority of our business and how we're performing.

And then the other one that we have highlighted, Mark was with regards to Pharma but Pharma as we've mentioned had a very strong competitive quarter last year. So that's more of a competitive issue for us in this quarter compared to last quarter of last year. But all-in-all, Mark, we feel as though the overall business is sequentially improving and is in a really good position as we head into 2024.

[Operator]

Thank you. Our next question comes from the line of David Begleiter with Deutsche Bank. Your line is now open.

[David Begleiter, Analyst at Deutsche Bank Aktiengesellschaft]

Thank you, good morning. Frank on the -- on Pharma Solutions, can you comment on the sequential margin decline? Was it more mix or more-and-more costs and what does this mean for you, do you think for margins in Q4 and next year for Pharma? Thank you.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Yeah, David, so Pharma as we mentioned the comparison versus the prior year as we highlighted was a 28% growth. Last year, with a lot of shipment catch-up, as we implemented in some SAP shipments that went into Q3 of '22 and then EBITDA growth last year was 76%, so that was the comparator versus last year and obviously, you can see that were down 9% on the topline this year because of the comparator. If you look sequentially, you do see some choppiness as Glenn highlighted earlier. There are some distributors that are starting to rightsize inventory in this business. That is something that we see more of a destocking as we ended kind of Q3 and as we go into Q4 we anticipate that the inventory destocking will continue. With that said, we think it's temporary in nature. I have no concerns about the overall outlook for the Pharma business, very sticky business, our core pharma position is as well I should say, our core pharma business is well-positioned with our customers. So destocking by our distributors, rightsizing inventory are temporary in nature and we feel good about the growth potential performance for Pharma as we go into '24 and beyond.

[Operator]

Thank you. Our next question comes from the line of Adam Samuelson with Goldman Sachs. Your line is now open.

[Adam Samuelson, Analyst at The Goldman Sachs Group]

Yes, thank you. Good morning, everyone. So, Glenn, in your prepared remarks hoping you could just maybe elaborate a little bit around some of the high-level puts and takes as they stand today for 2024 EBITDA versus 2023. Obviously, there is the absence of the inventory absorption charges, the inventory write-off in the second quarter. You've got headwinds on incentive comp, and if you can quantify that. It doesn't sound like there's a lot of this point, we should be thinking about a lot of price-cost tailwinds. You're going to have a divestiture kind of impact, but can you help us think about when productivity kind of savings that we should be kind of thinking about going into 2024 on a year-over-year basis? And then from there, is the major swing, really just volumes and the operating leverage associated with that or is there anything else that you would highlight? Thanks.

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

Thank you, Adam, and good morning. So let me kind of break that down into two components, one just normalizing, I'll say the one-time items from this year into next year, and then talk a little bit about 2024. In terms of normalizing this year, the first thing you do is you have to take out $75 million of EBITDA related to divestitures. So that's roughly six months of Savory Solutions and then FSI or Fragrance Specialty Ingredients business and then basically a full-year directionally for LMC, that's about $75 million in earnings. In addition, you have to add back the impact of absorption, which goes away, that absorption is related to the inventory reduction. So as we've mentioned, we've taken out nearly $600 million of volume-related inventory this year, that's about $165 million benefits.

On top of that, the LVK write-off in the second quarter was $44 million. And then lastly, in terms of sort of abnormal items, I would add about $25 million of additional benefit associated with the annualization of our headcount reduction program this year. Offsetting that, as you mentioned, is roughly $70 million-ish of basically truing up our incentive plans back to a 100% given this is a challenging year will pay out at a lower percentage. So those are the normalized items, I would take this sort of baseline of the 2023 results.

Candidly, relative to '24, we are -- we will be prepared to have a very fulsome discussion at the February call. We're in mid planning process right now, we're working with all the businesses in terms of their plans from volume, net price procurement on deflation, productivity programs, etc. So it's a little early to talk about those components at this point, but we promise we will have a very detailed discussion in February.

[Operator]

Thank you. Our next question comes from the line of Patrick Cunningham with Citi. Your line is now open.

[Patrick Cunningham, Analyst at Smith Barney Citigroup]

Hi, good morning. Just a follow-up on positive absorption or just absorption coming off next year? What percentage of the portfolio is built to order versus built to stock and are there any specific businesses, where that split is skewed towards one or the other?

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Yeah, and I wouldn't say that those that are built to order don't have an absorption impact as they do. But to answer your question, we're roughly 55 built to stock; 45 built to order in terms of the overall portfolio. So the built stock is more of the legacy DuPont N&B portfolio versus the legacy F&F for the build-to-order. So as a result that Nourish is split, probably slightly more build-to-stock and build-to-order but a combination of the ingredients business, the food systems, and then obviously the Flavors business. The Asian B and Pharma businesses are largely built to stock. And the Scent business is largely built to order.

[Operator]

Thank you. Our next question comes from the line of Lauren Lieberman with Barclays. Your line is now open.

[Lauren R. Lieberman, Analyst at Barclays Capital]

Great, thanks, good morning. I was curious if you guys could talk a little bit about pricing, pricing in the quarter came through a bit stronger. I think, than we had anticipated. And so just curious what didn't think that there was any incremental pricing going through. So maybe it was just sort of stickiness, but would love some detail on that. Thank you.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Yeah, it's more related to deflation than price per se. Pricing, actually all of our pricing was implemented earlier this year, we really have not been implementing any more pricing actions this year. So it's really been the favorability associated with deflation that enhances our earnings versus expectations.

[Operator]

Thank you. Our next question comes from the line of Josh Spector with UBS. Your line is now open.

[Josh Spector, Analyst at UBS Group]

Yeah, hi sir, thanks. So I was just wondering if you could give an update on free-cash flow, what your expectations are for this year now. And just given you scaled back your inventory, I guess your manufacturing headwinds from inventory investments. Does that mean you're done or is there more opportunistic inventory reduction to do to shore up the cash flow further? Thanks.

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

Yeah, hey. So the second part. Josh, this is Glenn. The second part of your question, we are largely done with the inventory reductions, we're basically going to be largely flat-lined for the balance of the year. Relative to our free cash flow estimates for the year they are unchanged versus our previous quarter. We will be call it circa $450 million on a reported free cash flow for the year. I will note, once again, that includes about $440 million of Reg G items. So we're right around $900 million of adjusted free cash flow for the year. Just as a reminder, of those Reg G items. They're broken down into about a little over half of them, call it about $240 million are literally associated with our divestitures. A big portion of those are taxes, not surprisingly, we also have another roughly $80 million of the final integration costs that are associated with systems conversion and legal entity changes from DuPont. Those will be complete this year. And then there's about $75 million related to restructure that's from the implementation of this year. And then, call it $50 million to ship sort of all other related expenses. So that's sort of a breakdown of the Reg G items. Thanks, Josh.

[Operator]

Thank you. The next question, we'll go to the line of Laurence Alexander with Jefferies. Your line is now open.

[Laurence Alexander, Analyst at Jefferies Financial Group]

Good morning, can you update, how much of your business ex-Pharma is in the fix or shift category and how much it needs to improve in aggregate where on average for you to be happy with that, I mean, like, not just like a minimum threshold, but what's your like three-year to five-year target might be.

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

When you referenced fix or shift, I'm assuming you're talking about the ingredients business.

[Laurence Alexander, Analyst at Jefferies Financial Group]

Yeah. So that's correct. Most of it, but I guess I'm fishing for if you have anything else that you're now putting in that category.

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

That's largely it's 90% of it. And as we mentioned, that business is of our total business, it is about 20% to 25% of the total portfolio. And Frank outlined on the call previously, the major initiatives. It will take some time to fully implement those initiatives. So we are seeing some progression and improvement in the business. But we're a ways away from sort of getting back to sort of the full historical level of both earnings profile and growth. Our target is to go from largely a high-single-digit EBITDA margin level to mid-teens and to basically get the business basically growing in line with the industry, which historically has been sort of on a volume basis, 1% to 2% a year.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

Another thing, this is Frank, what I would add is on that 20%, Glenn mentioned, it's a number of those have our assets have been disposed and we continue down the path of optimizing our portfolio as we've highlighted. And then within Functional Ingredients, as we've mentioned, we are making good progress as I highlighted earlier and that's really where the majority of the improvement area needs to be, but I don't want to lose also site of the 80% or so of the business, as we've been highlighting today that has seen a good sequential improvement in a number of businesses that actually grew versus prior year.

[Operator]

Thank you. Our next question comes from the line of Silke Kueck with JPMorgan. Your line is now open.

[Silke Kueck, Analyst at JPMorgan Chase & Co.]

Hi, good morning. There's a $70 million SG&A benefit this year from the compensation changes and most of that occurred in the third quarter. And secondly, if there is a $160 million headwind from unfavorable manufacturing absorption, which is a 150 basis point headwind to gross margin. Do you expect as a base case, your gross margin to be up by 150 basis points next year? And do you have volume growth in order to keep that?

[Glenn Richter, Chief Financial and Business Transformation Officer at International Flavors & Fragrances]

I think, to the second question, you should definitely normalize the absorption as a starting point. The ultimate margin dynamics for next year, which we'll discuss in more detail in February will be a combination of mix, volume growth, and ultimately any additional sort of price inflationary pressures. So it is a complex, you can say just straight-line the improvement. I think you can reset the baseline. But then you have to sort of think through all the variables of what's driving the gross margin rate for next year. So, the part that comes back to that in February. The $70 million that we've referenced really are the savings from headcount reductions we implemented this year. So as a reminder, there was a program that we targeted $100 million of annualized cost reductions. So roughly $70 million, $75 million of that this year, and then about $25 million will be the annualized impact, it's all been implemented. So it is all done. So it's really just a timing element of that.

And then lastly, there's always some choppiness quarter-to-quarter because of accruals around variable incentives, so depending on the up-and-down, things can get trued up and can be a little bit choppy. So that does affect the support of quarter-to-quarter RSA as well. Thank you.

[Operator]

Thank you. Our next question comes from the line of Salvator Tiano with Bank of America. Your line is now open.

[Salvator Tiano, Analyst at Bank of America]

Yes, thank you. I wanted to ask if you can remind us a little bit your exposure to some of the key soybean, well to to the soybean price as well as to key oilseeds, vegetable oils, and whether the recent pretty steep declines in some of these edible oils. It can be a meaningful contributor to 2024 EBITDA.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

I would say two things. We have a very-very large basket of roles. So there's a lots of things moving in either direction. In general, the fixed-cost trends, the deflation trends are working in our favor. So that's a general statement. Relative to soy. We do actually lock in. Over time, we typically hedge out for a period. So we don't necessarily always capture either the immediate upside or downside, but over the longer arc, obviously, as those prices decline, we capture it.

[Operator]

Thank you. Our next question comes from the line of Andrew Keches with Barclays. Your line is now open.

[Andrew Keches, Analyst at Barclays]

Yeah, thanks. Congrats on the quarter. Just to confirm. In the past, you've mentioned that the 3.0 times net debt to EBITDA as a level you plan to hit in 2024. So I guess just based on where you are in the asset-held discussions, do you still have confidence and visibility into achieving that level next year or is there some risk that gets extended? I know the covenant horizon was pushed out about a year to early '26, so any help on the timeline would be great. Thanks.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

We are. Great question. We're very confident that relative to our current M&A activity in the market it will allow us to accomplish our goal of 3x or less. And it should be -- we should be able to accomplish that by the end of next year, this is always a, there's always a, and I'll say a timing element relative to closing transactions given separation legal entity changes, those sort of things but barring sort of a normal path we should be in good shape by the end of next year.

[Operator]

Thank you. That will conclude the question-and-answer session. I will now turn the call over to Frank for closing remarks.

[Frank Clyburn, Chief Executive Officer at International Flavors & Fragrances]

So, first. I want to start by thanking all of our IFF colleagues around the world and all of the tremendous work that they are focused on to really help our customers and to continue to innovate. Our vision as a company is truly to be the innovative leader in essential solutions and we're very proud of the progress that we're making through this quarter. And I also want to thank everyone for joining our call. We look forward to our fourth quarter update and full-year guidance for the '24 update in February and I wish everyone well and thanks for joining our call.

[Operator]

[Operator Closing Remarks]