KDSKF - Koninklijke DSM N.V. (KDSKF) Q4 2022 Earnings Call Transcript

Koninklijke DSM N.V. (KDSKF)

Q4 2022 Earnings Conference Call

February 16, 2023 8:00 AM ET

Company Participants

Dave Huizing – Head-Investor Relations

Geraldine Matchett – Co-Chief Executive Officer

Dimitri de Vreeze – Co-Chief Executive Officer

Conference Call Participants

Ranulf Orr – Citigroup

Andrew Stott – UBS

Martin Rödiger – Kepler Chevreux

Nicola Tang – BNP Paribas

Matthew Yates – Bank of America

Chetan Udeshi – JP Morgan

Isha Sharma – Stifel

Gunther Zechman – Bernstein

Presentation

Dave Huizing

[Call Starts Abruptly] full year 2020 [ph] results. I'm Dave Huizing and the Head of Investor Relations. I'm with our Co-CEOs, Geraldine Matchett and Dimitri de Vreeze.

Firmenich also published this morning their second quarter 2022 results. Although we are now entering the final phase of the merger process, we are still fully independently operating companies, and we can't take any questions about Firmenich today.

As to our own results, Geraldine will give a short introduction by running you through a few slides of the presentation to investors, which we published this morning together with the full year press release, which you can find on our website. He will also find the disclaimers amongst others about forward-looking statements. After his introduction, we will open the line for questions from sell-side analysts. And with that, Geraldine, you can start.

Geraldine Matchett

Thank you, Dave. And welcome, everyone, from me as well. Thank you for your time and for your interest in DSM.

Now as you can imagine, we are indeed very excited about the merger with shareholders to actively tender their shares in exchange for DSM Firmenich shares. But of course, today, the focus is on our DSM results for 2022, which we published this morning.

So I will start with a few comments on some of the slides of the investor presentation. And then I will be handing over to Dimitri, who will add some color with regards to the business conditions that we are seeing at present and our performance in terms of our ESG [ph] ambitions. And then as Dave just said, we will open for the Q&A.

Now as a reminder, of course, the year 2022 has been a year with a lot of transformation for not only the announcement of the merger with Firmenich, but also finding new homes for DSM Performance Materials and DSM Engineering Materials. Now the disposal of DPM was completed in September 2022 and the divestment of Engineering Materials is now ready for closing and is planned for no later than April 2023. So pretty soon, which is, of course, an important step as well in relation to the merger.

Now reporting-wise, what does that mean? Well, it just means that our Engineering Materials business is reported as asset held for sale in the balance sheet and as discontinued operations in the income statement. So all our comments in the slides here are prepared with reference to the continuing operations as in health, nutrition and bioscience.

Now having said that, then let me indeed go to these continuing operations on Slide 3, to give you the financial highlights for the year. Now as you can see on this slide, we've had actually a very solid performance in 2022. And that is somewhat despite all of the challenges in terms of supply chain volatility as well as the significantly higher costs, be it energy cost, raw materials, et cetera. If I start with the full year performance, you will have seen in the press release in here that we have delivered a full year organic growth of 8%, driven by a strong pricing element to counter, of course, the inflationary environment with up 7% on pricing, but also with solid volumes. Consolidating the fact that last year, we really had extremely high, close to double-digit volume growth. So the plus one is versus a high comp and therefore, really consolidating our performance here.

Now in two words, how did that pan out between the businesses, and I'll come back to that. Well, Health, Nutrition & Care and Food and Beverage had strong pricing and solid volume while our Animal Nutrition & Health business had to contend with a few additional factors such as softer demand, particularly in China, low vitamin prices, towards the end of the year and also in their case, actually a double-digit comparative set of figures.

Now in terms of our EBITDA performance, this has led us for the full year to deliver a 2% increase in EBITDA, which translates into a margin of 17.9%, which is down versus last year by 260 basis points, which is roughly relating if I take big buckets half relating to the time gap between costs going up and our ability to price them through, and the second half related to the mathematical effect of more top line to achieve the same earnings. So about half-half.

Now looking on the right-hand side at the fourth quarter. So in the fourth quarter, we saw overall continued resilient demand. Organic growth, as you see here of 3% was driven by continued good pricing. And the volumes reflect actually high comparative figures for all of the businesses as well as some destocking, which together make it this minus 3%.

Now with regards to earnings for the quarter, we saw an acceleration in the inflation in raw materials. We saw lower prices for some above vitamins. And as you may recall from our Q3 earnings call, we have taken some measures to reduce our inventory. And all of this is reflected in this adjusted EBITDA of €316 million, which is down 11% versus prior year and in the margin of 15.2% for the quarter that, of course, also carries here the mathematical effect that we have seen throughout the year linked to inflation.

Lastly, in terms of cash generation, these measures that we did take in terms of inventory management, did enable us to have a good cash generation in the quarter, which was very helpful in ending the year with some free cash flow.

Maybe last comments and that is more looking a bit into how did we get into 2023, well, we have seen pretty much the same business conditions that I've just described for Q4 going into Q1. Meaning that we continue to see a time gap between inflation and costs with the residual inflation carryover into 2023. We also have those lower vitamin prices and the inventory reduction measures that we initiated in Q4 also are implemented in Q1. So pretty much expecting similar Q1 to Q4 in terms of dynamics momentum. Of course, we navigate this with all of the actions that we've taken in the past, which is continued pricing action but also a focus on our cash generation and on cost management as always.

Now before going into all the three different business groups, let me just pause on the next slide, which is Slide 4. Just briefly to highlight the fact that our businesses have all delivered some good quality organic growth last year, really underpinning the fact that we are serving Brazilian end markets. And this is despite as you know, challenging macro and comps. So just a nice overall picture here, the contribution of all of the three businesses.

Now let me give you a bit more color business by business, and I'll start with Animal Nutrition on Page 5. Now here, let me start actually with Q4. In the fourth quarter, Animal Nutrition saw good pricing momentum particularly in Performance Solutions coming on top of what was already a 7% pricing in Q4 last year. However, this has been partly offset by the lower vitamin prices, which results in this plus two for the whole of the business, so plus two pricing in the fourth quarter. Volumes were down 2%, reflecting here the very high comp of last year, comparative figure. As last year in Q4, we were at plus 11% in volumes. So at the time when, if you recall, a lot of customers were actively building some stock given concerns around supply chain reliability.

Now demand for animal protein remained actually overall resilient. And our Performance Solutions performed particularly well as far as continued to try and increase, particularly their feed efficiency.

Now looking at business conditions and for the full year, so we saw a full year Animal Nutrition, deliver this organic growth of 6% mentioned already and very much related to pricing. Poultry and eggs performed well. And Pork also began – sorry, Pork also began to see a normalization on the swine market in China.

Ruminant and aquaculture had a more challenging set of conditions, owing to the relatively higher price points in an environment of, of course, [indiscernible] consumer environment.

In terms of EBITDA, Animal Nutrition & Health realized an adjusted EBITDA of €546 million in 2022. And with a full year adjusted EBITDA margin of 14.4%, which is approximately down 300 basis points versus prior year, reflecting here the drivers that I've described and of course, the mathematical dilution effect.

Now in Q4, the margin also suffered a bit more given the full quarter impact of the lower prices of some vitamins and the inventory reduction actions that we talked about.

Maybe a few quick words on our key innovations. So if we look here at the logos, let me start with Bovaer. So Bovaer, we saw the launch of many commercial pilots around the world and also, of course, the creation of our strategic alliance with Elanco for the U.S. market. We have gained many regulatory approvals during the year. In fact, I think, we are around more than 45 countries now. So really a great step, including the landmark approval, of course, in the EU at the start of the year. We also, for Bovaer in November, began the construction of the manufacturing facility in Delray in Scotland.

Now when it comes to Veramaris, we saw a strong increase in sales, owing to a continued increased interest in sustainable algae-derived omega-3 in the salmon industry. And we are also seeing continued good interest in the pet food and human nutrition segment.

And when it comes to precision services, one of the news is that we've introduced Sustell, our environmental impact management technology to the aquaculture space. And we also increased nicely our footprint in precision services by doing the acquisition of Prodap, Brazil's leading animal nutrition and technology company. So that was for Animal Nutrition & Health.

Now moving to Health, Nutrition & Care, so HNC. Now for HNC, in quarter four, we saw a good performance with this 6% organic growth supported by a very strong pricing of 11% to, of course, counter rising costs. Volumes were down 5%, against, again, a strong comparative set of figures last year that had the plus 6%. But also with the demand for immune boosting dietary supplements normalizing somewhat versus the elevated level that we had during the peak of COVID, as well as some customer destocking. Probably worth reminding you that, of course, in 2020 and 2021, immunity support in dietary supplements grew significantly well into the double-digit CAGR, and it is not so surprising but now that COVID is better under control, particularly during the winter season, that we see this category take a bit of a breather. But the demand in dietary supplements in the other categories actually has continued to be good.

Now if we look at from a full year point of view, the performance by segment, so Health Nutrition & Care overall for the year delivered a strong organic growth of 9%, with the 7% price increase. Now demand overall was good, especially actually in the dietary supplements categories of gut health and women health, but we also saw a good performance in Pharma and in Medical Nutrition. Biomedical had a strong year and personal care and aroma as well, while Early Life Nutrition continued its recovery.

When it comes to EBITDA, HNC delivered an adjusted EBITDA for the year of €676 million, we're translating into a margin for the year of 23%, which is approximately 150 basis points down versus 2021 carrying here as well the dilutive effect of the strong pricing that you see here.

Now a couple of news on the innovation front. So maybe I'll start with ampli-D so the ampli-D, which is the faster working form of Vitamin D, continue to receive approvals in countries around the world, really paving the way for customers to include it in their offering. Saw a good progress there.

iHealth launched its first gummy for children under the cultural brand that supports not only immunity but also digestion and vision through combining its lithium-based vision health product, FloraGLO. And Hologram Sciences launched a new customer brand. You see the logo here called Phenology that offers at-home diagnostics, hormone tracking and customer insights for women in menopause.

And now going to food and beverage on Slide 7. That's the one. So, food and beverage in the fourth quarter delivered a good performance with an organic growth of 8%, driven, as you can see here, by an 8% pricing to counter higher costs. Volumes held up against prior year despite the fact that in prior year, we actually had a 14% growth in Q4 which if you remember at the time that was the quarter that benefited from the reopening of out-of-home channels following the lifting of COVID restrictions.

Now on a full year basis, the organic sales growth reached 10%, led by pricing, but also with the volumes up 3%, representing a good performance again, against here a 10% prior year comparator. So the comps were not easy.

Now from a segment point of view, Dairy, Baking and Beverage performed well. Savory was solid, and Hydrocolloids delivered a very strong performance, while Pet Food also had a good performance.

From an EBITDA point of view, the business delivered €266 million of adjusted EBITDA, which translates into a margin of 17.2%, almost 300 basis points below last year, including the dilutive effects of this strong pricing that you see here.

And when it comes to some innovation news in F&B, while we have seen an excellent progress in our plant-based protein capabilities through canola and in – amongst others, the introduction of the textured pea protein, which is the world's first textured vegetable protein containing sufficient levels of all nine essential amino acids to count as a complete protein. So that was actually a big technical step here.

We also launched a new plant-based solution, a combination of the Max Burger vegan fish flavor with the DSM Nutritional lipids, again, a very nice step there. And for Avansya here, we continue to receive good progress in terms of regulatory approvals in different geographies, and we see growing interest from our customers for the fermented stevia sweetener, EverSweet.

Now let me just finish with a couple of short comments on other financials. Going to the next slide. So as you have heard us say throughout the year, we have been actually holding rather high levels of inventory in response to supply chain concerns and to ensure security of supply for our customers. Now towards the end of the year, we took a slightly different approach and decided to take some inventory reduction measures. And this has actually enabled us to create good cash generation in Q4, but of course, for the overall picture, the average capital employed for the year, nonetheless carries these higher levels of inventory, hence, the ROCE performance that you see here.

Now going to the second slide on financial highlights, you see here that we generated an adjusted net operating free cash flow of €310 million. That was predominantly in Q4, thanks to these measures that we took. And if I combine this cash generation with, of course, the proceeds of the divestment of DPM, you see here that we closed the year with a net debt, just net debt of €87 million coming from €1 billion at the end of last year. So, a very solid balance sheet situation.

And maybe just a couple of last words on the dividend. So you may recall that we paid an interim dividend in August of €0.93. And upon the successful completion of the merger of DSM Firmenich it is intended that DSM Firmenich will pay a gross dividend of €423 million, which will be almost €1.6 per share as a sort of final dividend. And this is nonetheless subject to shareholder approval at the general assembly of DSM Firmenich and as described in the offering circular.

And with that, Dimitri, I hand over to you for the latest business conditions and our sustainability performance.

Dimitri de Vreeze

Thank you. Thank you for that, Geraldine. All right. Thank you for that. I hope everybody can hear me. I still see the green line around you Geraldine so I don't know if you can hear me. But…

Geraldine Matchett

I can hear you fine Dimitri, I think.

Dimitri de Vreeze

Will give it a leap of faith off we go. So you see on this enormously busy slide, which you're normally used to us, our proposition on what we expect for business condition. And I think as you have seen from our press release and once again on this slide, given the proposed merger process is advanced. It is intended that we as DSM Firemenich will provide an outlook for 2023 once DSM Firemenich have been consolidated and the combined business plan is approved.

We expect similar conditions in Q1 as we saw in Q4 for DSM with EBITDA being impacted by continued price cost gap, lower vitamin prices and the effects of inventory reductions, as already indicated by Geraldine in the beginning. And we are navigating this volatility through pricing actions partly to mitigate residual inflammation, inflation for predominantly the first half but also improve cash flow further through reducing inventories and focusing on the operational cost.

The first half of 2023 will be weak given the residual inflation, softer demand and continued impact from vitamin prices. But we expect a stronger second half of the year as the inflation overhang eases and volumes will pick up again after a period of destocking in the first half. The big question mark for all of us in 2023 will be how inflation will develop, and there is still a wide range of possible outcomes and let me not speculate on that outcome.

Looking beyond the next quarters, while we expect near-term conditions to remain challenging, we are confident and confirm our midterm targets for DSM given our strong pipeline of innovations and the positive structural long-term drivers for our business, which is geared around health for people and health for planet.

Let me go to the next slide. As you are used to for DSM, we are a PPP company, people, planet and profit. Let me use the last two slides to give you a bit of an update on progress made on the planet perspective first. So here you see the slides with the three key targets around our ESG ambitions. As a leader in sustainability, we value or what we can do based on progress made. And I'm very happy to say that we have increased our target for cutting greenhouse gas emissions from our own operations, Scope 1 and Scope 2 for the second successive year. The new target of an absolute reduction of 59% from 2016 levels by 2030 has been independently validated by sign-based targets and is aligned with limiting global warning with 1.5 degrees. Partly possible because a huge progress on our renewable energy. You can see that here 78% fully committed to the 100% renewal by 2030. And having these two coupled, it is creating a road map to our commitment to be net zero by 2050.

Also proud to say, you can see it on the slide as a fourth bulletin, we have, again, be acknowledged by CDP, a leading evaluator of corporate environmental disclosures which awarded the company's climate change strategy and water stewardship M&A rating, making DSM one of only a handful of companies in its sector worldwide to achieve such recognition.

Now let's move to health for people. Let me start with safety. If you can move this slide, let me start with safety which we normally always do within DSM. We start presentations with safety because it's a foundation we are built as a company. We're not happy with the frequency index of recordable injuries, you've seen 0.28, which is a deterioration from prior year, where we basically have taken actions to make sure that we continue to also create a safe environment and a safe working place for all our employees, but also all our contractors on our sites.

In wellness, DSM implemented various initiatives throughout the year to support our employees and their families from nutrition, immunity care to mental health. And I'm also very happy to say that we also made good progress on our diversity, equity and inclusion efforts and you can see that here with the representation of women at executive level that improved again this year.

Overall, very happy to say that our people demonstrated a fantastic perseverance in 2022. And I also have to say, I'm very proud of how all our employees reacted to the nation initiative we started with our partner Wolfoo program, Turkish series to battle the earthquake and rehab.

And with that, Dave, I think, now time to open the floor for questions.

Dave Huizing

Yes. Indeed, I think it's time. So let's do that. Let me remind you that the sell-side analysts who want to ask questions have to register via audio conference link, which they can find on the website like we always do. And I think we are ready when I look at the route. So operator, please, let's start the Q&A Session.

Question-and-Answer Session

Operator

Thank you, Mr. Huizing. [Operator Instructions] The first question is from Ranulf Orr [Citigroup]. Orr, please go ahead.

Ranulf Orr

Hi there. Thank you very much for taking the question. Firstly, please, could you just help us slightly better understand the trajectory of volume growth for the three Nutrition segment into Q1 and what your customers are taking about destocking there?

And secondly, please could I just ask about the opportunity from China reopening. I think back in the first half results last year, you said it was a 3% drag on, on EBITDA. Is that the kind of magnitude in recovery we could expect if we do have reopening? Or given the level of destocking and low inventory levels in the country, we could see a much bigger uplift? Thank you very much.

Geraldine Matchett

Thank you very much for your questions. Appreciate it. Dimitri, do you want to start on the volume developments, I was just taking our technology was working.

Dimitri de Vreeze

Yes. It is working indeed. I couldn't or the full question, but it was what we see in terms of volume development from last year into this year, certainly is what I understood. So first of all what we have seen is overall conditions for quarter four, we see continue in quarter one and that has to do with the vitamin prices. It has to do with the time gap, and it has to do with some of the destocking we see. So that is overall what we see going into 2023. We also indicated that maybe the first half will see a different setup in the second half based on some of the ranges of Adcom on inflation, but we need to see how that looks at.

For volumes on animal nutrition, there is an interesting piece there. There are lots of people who say, "Hey, do you don't see any changes on your resilient demand in terms of volumes." You've seen that we have pretty resilient demand in 2022, but it has to do with different species. What we have seen is down trading in that segment. We've seen that poultry and eggs have grown faster than for instance, ruminants. And that is something which is linked to the inflationary context.

Secondly, I'm bridging to your second question on China. Indeed, China is a key element for animal nutrition and protein demand for two reasons. One is China is the biggest country in terms of protein consumption. So if China is opening up, and we see some signs of China opening up, although slowly in itself. So we still need to see how that evolves. And secondly, if China is opening up, you also know that China is the biggest producer of vitamins.

And I've clearly indicated last time also in our calls, that there is a cost comparison where we are lacking compared to China, if you look at the energy pricing. So China could have two positive effects, but we don't see that as we speak. We see some bits and pieces, but certainly not consistently. So I would move this more into the second half than in the first but hey, this is something which will evolve throughout the next coming months. So let me pause here.

Ranulf Orr

Very cleat. Thank you.

Operator

Your next question will come from Andrew Stott with UBS. Please go ahead.

Andrew Stott

Hey. Good afternoon, Geraldine and Dimitri. Thanks for taking the question. So first one was just a bit more granularity on your Q1 commentary, just given your – there's the absence of guidance for the year as well. Geraldine, I'm just requoting what you said. You said that you expect a similar Q1 to Q4 in terms of dynamics; but can we talk absolute EBITDA? Because if you look at the last three or four years, you've typically made 30 million-ish extra EBITDA, I guess, because of selling days just normal seasonality. Is the comment you're making specific to normal seasonality? Or are you really sort of suggesting that absolute EBITDA will be similar to Q4? So that's the first question.

The second question is around cash conversion. I see, obviously, the work you've done has improved the cash release in Q4, as you mentioned. But what do you think is a normal level of working capital to sales for the Nutrition business. I guess we just don't have a lot of historical data to go on. So how would you put that 12 months in a sort of longer-term framework?

Geraldine Matchett

Thank you, Andrew, and thanks for your questions. So let me start indeed with what we're seeing in Q1. And here, we also realize that given the circumstances can give you a full year outlook. We also normally don't talk to the quarter. But here, I think it's fair that we are in a position to sort of be quite clear that basically the elements that brought down the EBITDA, both absolute and margin in Q4 are going to be similar in Q1. So we're looking – if you remember, the Vitamin A, for example, on a full quarter basis, has currently an impact of 20 million, 25 million. You can expect to see that happen in Q1.

As you can imagine, the prices actually are not yet coming back up. We have the time lag, which is the second important element that we have been running after inflation. We see a time lag of a similar sort of amount going into Q1 and the inventory measures are also – we've started in Q4, but actually a lot of the measures are in Q1. So when you put that together these are the elements that you can expect to be – that we're picking up in Q1.

So it is going to be from, if you think a margin evolution point of view, as we saw maybe in 2022, we saw our margin sort of go down as the year progressed. We will be starting from the low base and then progressing upwards out of the momentum that we take – we took out of Q4. So that's really what I can share at this point. So a gentle start to the year would be the best way of describing it.

Now when it comes to cash conversion, you're absolutely right that we have not had a clear picture for quite a while now, because if you think of all of the COVID disruptions for two years and then all the supply chain issues last year, we are now in the motion of bringing down the working capital bit by bit. I don't – it will take us a bit more time. Maybe in terms of figures, I do want to point out the fact that our DSO is actually pretty normal currently. It's in the 60s. So it's actually 66 days. Our payables are in the 80s. So that's also pretty normal. What is on the high side is inventory. So we closed the year with 145 days of inventory.

And here, you have a component of volume, which is about a third in terms of the growth versus previous position and two-third is actually the inflation that's in the balance sheet value of inventory and the FX. So to give you an absolute sort of what would be the right number is a bit difficult. What we do expect though is to have a limited outflow on working capital as we unwind this position during the year 2023. So from a cash generation, we should be seeing, hopefully, not a big – probably still a bit of an outflow because of growth, but a small one for the year 2020.

Andrew Stott

Thank you.

Operator

We'll take our next question from Martin Rödiger with Kepler Chevreux. Please go ahead.

Martin Rödiger

Thank you. Coming back to the guidance. Assuming there is no merger with Firmenich, would you say that the current consensus estimates by [indiscernible] Research for DSM on a stand-alone basis for 2023, are accurate? And does your answer refer to all levels of the P&L or solely on EBITDA?

And the second question is on the depreciation charges, which were in the second half 2022, 10% up year-over-year and 12% up versus the first half. What was the reason for that? Is that driven by depreciation or by amortization? Thanks.

Geraldine Matchett

Hi Martin, and thanks for your questions. So I have to say, we very seldom comment on the great work done by the sell side when it comes to consensus. It is a dangerous thing to do, and you can imagine we didn't give an outlook for the year. So me commenting on how we appreciate the consensus would be a similar kind of thing. So let me not do that. But what I can say is, of course, answer your question on depreciation and amortization. So what we are seeing is actually a combination of both, and if we look we actually closed, I think with 165 million per quarter depreciation and amortization. And here, you have both included the increase has come from the amortization of acquired intangibles through the acquisitions. So that also fits in there and to some extent, kind of a sustained depreciation level. So on a stand-alone, this is broadly what we would expect to see going forward as well.

Martin Rödiger

Thank you.

Operator

We'll take our next question from Nicola Tang with BNP Paribas. Please go ahead.

Nicola Tang

Hi everyone. Thanks for taking the question. And the first one, talk a little bit about destocking in human health and Geraldine, you mentioned in your provided remarks. Can you just clarify, is that just in directory settlements? Or is that also in other markets in humans? And would you expect within the kind of comments you've made around guide to the extent you've given comments on guidance outlook. Do you expect to see destocking sort of expand into other markets as well?

And then the second question on pricing with the 7% price mix in 2022. Was there any sort of surcharges in staff within that number? I'm just thinking about into this year, how confident are you in terms of still implementing pricing, assuming I guess, against this backdrop of weaker bitumen prices and maybe sort of destocking environment? Thanks.

Geraldine Matchett

Yes. Thank you for joining, and thanks for your two questions. I think both, of course, critical in looking into how the market will develop going forward.

Dimitri, do you want to comment?

Dimitri de Vreeze

Yes. Thanks for those questions. In the Health Nutrition & Care, your destocking question. Let's look at what are the segments of Health Nutrition & Care. So we've got Medical Pharma, Personal Care & Aroma, Early Life Nutrition, Biomedical that sense they have their own dynamics of the destocking part and the softening demand is predominantly in dietary supplements as a segment and predominantly in North America, where there is some softening in the retail chains in North America.

Remember that dietary supplement has sort of three categories. So we have dietary supplement, which is iHealth which is B2C which is strong. We have probiotic sales for the good health, which is strong. And then we have the third segment within the dietitians, which is called multivitamins. And obviously we've seen a huge step-up in multivitamin sales during the COVID period that is normalizing still at a higher total turnover versus 2019.

But you do see within inflation and inflation pressure also on the purchasing. You do see some impact on that piece of our business, and we do see a bit of destocking in that retail chain. So that to your question. And we need to see how that further continues going forward also depending a bit on the multimillion-dollar question on how inflation corrects itself throughout the year.

Then your question on pricing. Indeed, very good pricing momentum. You also see that we will continue to do so. And we've also kind of started further price increases because of the residual inflation we see predominantly in the first half. Part of that 7% is and has been surcharges – energy surcharges, freight surcharges but that already – freight surcharges were already partly lifted in Q3 and Q4 when the container and transport prices went down. And I'm very confident that those prices will continue to increase because we now not only take surcharges, but we make more fundamental inflation valid contract prices in. So it has been part of surcharges, but now being part of the structural price increase going forward into 2024 [ph].

Nicola Tang

And maybe if you wouldn't mind us follow up in terms of on that question around your expectations for input inflecting this year?

Geraldine Matchett

Sorry, the line was not great. Could you just repeat?

Nicola Tang

The question was what are your expectations for input inflation this year?

Geraldine Matchett

Oh, input inflation? Yes. So if you remember, we had about 10%, 11% inflation in our cost base in 2022. Now we see the carryover to be about 5% into 2023. With, of course all of the disclaimers that one has to put on this subject in terms of how things are going to develop. But of course, when you have the sort of inventory rollover that we have, we know that we have at least 5% inflation, and that's why we expect to continue to see pricing required in order to close the price gap – the price cost gap in a couple of quarters coming still, yes.

Nicola Tang

Yes. Thank you.

Operator

And we'll take our next question from Matthew Yates with Bank of America. Please go ahead.

Matthew Yates

Hi. Good afternoon everyone. I'd like to follow up on Andrew's question earlier, Geraldine, you mentioned you're obviously trying to reduce inventory towards year-end, but we are struggling a bit by not having sort of pro forma balance sheet here, excluding the materials business. So that 145 days of inventory you mentioned, can you just clarify what you think a normal level is?

And then perhaps for Dimitri, since we last spoke, we had the announcement from Novozymes and Chr. Hansen about a combination. You've got various relationships with those two companies. Do you anticipate any disruption from change of control clauses in particular is there any concern about your sourcing of LGG probiotic for iHealth? Thank you.

Geraldine Matchett

Okay. Thanks, Matthew. Let me start with inventory. So, what we've managed to do is reduce the inventory day count from Q3 to Q4 and about 10 days. That brought us to 145. Now if I look at versus prior year, we're closing, last year it was 135, so that's a 10-day up versus 2021. But of course, what we are still living against is that this was the COVID years. So there was also a lot of uncertainty on supply chain, and that's why the big question about levels of stock in the chain and including our own levels of inventory and supply.

So to give a firm number as to what would be a healthy one, difficult at this point, but what I can say is that one should at least be able to come in – to bring it back, and remember in there it's not just volume, it's inflation. So it's the cost per unit on the balance sheet. So we have an inflationary aspect that's sitting there. But we should be able to bring it back down to at least prior year 135 and then take it from there. So that's the sort of granularity that I can provide on inventory.

And Dimi?

Dimitri de Vreeze

Yes. Novozymes, Chr. Hansen let me not comment on the deal other than the combination will make a very strong technology player. And there, where we partner with either Chr. Hansen and Novozymes, I think the combination will make the partnership only stronger. On your spec request on change of control in all legal environment, let me not go into that. We will touch base when that will be on the table. We cross that bridge when we're there.

Matthew Yates

Thank you, guys.

Operator

And we'll take our next question from Chetan Udeshi with JP Morgan. Please go ahead.

Chetan Udeshi

Yes. Hi. Thanks. I just wanted to follow up on some of the other comments you made earlier in the call. But I think the first question I wanted to maybe touch upon was DSM has been sort of cutting production since Q4 you've seen some of the other participants in the vitamins chain cutting production, but yet the prices are still sinking lower and lower. So I'm just curious in your thought process, what is driving the weakening trend that we still see in the pricing? Because clearly the demand for feed ingredients to some extent has been weaker in some parts of the world or from second half. So I'm just curious, despite production cuts why are we not seeing prices stabilize?

And the second associated question is do you think there is a sort of a structural element now for DSM and the production capacities that you have in Europe in this high-cost environment that you might have to reconsider whether you need to be producing some of these ingredients necessarily in Europe? Or you think the profitability at the moment is still healthy enough for DSM to sustain the production in Europe, especially in Switzerland? Thank you.

Geraldine Matchett

Thanks for those questions. Appreciate it. Dimi?

Dimitri de Vreeze

Yes. Thanks for those. So first of all, the vitamin you're referring to, which is been under pressure Vitamin A for the rest of the vitamins we see stabilization, and I'll come back to your question on Europe versus the rest of the world. So on the Vitamin A, this is clearly an area where at current prices nobody is making money to your point. Secondly, what you have seen is that there is Vitamin A in the market, which is running out of shelf life. And then you have a choice whether you sell the product or whether you impair and depreciate on it.

So that market – that stock, which is running towards the end of the shelf life still needs to be sold first before normalization takes place. We've mentioned that earlier. We don't see that normalization yet in Q1. We don't expect it in Q2. So we'll need to see how that works out throughout the rest of 2023. Then specifically on your infrastructure. We are a global company with global infrastructure. So we, on a continuous basis look at where we need to produce and where it's produced to be best.

But at the energy prices, predominantly in the beginning of the year, we obviously have seen that Europe has a disadvantage. However, it's not only input prices in energy what counts. You also need to look at your whole infrastructure where there's technology optimization, there a technology advantage going forward. So this is something which is continuously on our mind, which we have indicated we have reviewed.

For the vitamin where we've seen that there is a very high input price, we have reduced some of our production lines in Vitamin C and also on Vitamin A in Sisseln [ph] temporarily where we look at how the impact will also look on Vitamin E. So this is not an overall change of approach, it is basically waiting for shelf life, which is pulling the market going forward is normalizing and then I expect we can be having a normalized level where we can look at global infrastructure going forward.

Chetan Udeshi

Thank you.

Operator

We'll take our next question from Isha Sharma with Stifel. Please go ahead.

Isha Sharma

Hi. Good afternoon. Thank you for taking my question. I just have one left, please. Could you talk a little bit about your hedges in terms of energy? Do you have any hedges into 2023 already? Or do you see a relief from lower energy costs already starting in Q1.

Geraldine Matchett

Yes. Thank you, Isha. Yes, I can comment on that. So as you know, of course, we saw energy costs go up a lot in 2022. Just to give you an order of magnitude, in 2021 we're at about 200 million, 2022, 350 million, and we expect for 2023 about 100 million more, so about 450 million. Now 80% of that is hedged. So with hedging, it's good and it's bad. It's good because it provides some certainty. Of course, should there be a good development on AAG cost, we will not benefit from it in the short-term. It's also important to remember that in 2022, we also had some hedging that protected us a bit. So that's why you see the delta from 2022 to 2023.

Isha Sharma

Thank you very much.

Dave Huizing

And I think we have time for one last question. So maybe you can put the last question through.

Operator

Certainly. We'll take our last question from Gunther Zechman with Bernstein. Please go ahead.

Gunther Zechman

All right. Thanks for squeezing me in. Can I just follow up on the destocking point, please? What's your visibility then? And what gives you the comfort and the confidence to say that the volume effects you've seen towards the end of last quarter and into the beginning of the new year is destocking versus demand reaches please?

Geraldine Matchett

Dimi, do you want to comment?

Dimitri de Vreeze

Yes, that's a good question because in all fairness it is obviously also a bit fuzzy for our customers. So at the moment that we discussed with them and they say, "Hey, there's some demand softness, and we asked them, well, is it destocking? Or is it demand softness? Yes, i.e., that's almost like a theoretical component, right? But there is some destocking because of the inflationary context. There is some destocking because of the uncertainty in that segment.

However, the demand itself has shown to be very resilient going forward. So we also see also in other segments that if China is opening up that will create an additional demand going forward for the animal space. So it is a bit of a theoretical discussion. Let's face it that people will say, this is only because of destocking or this is demand softness I find that difficult. I mean, in the market for a long time. It is sometimes linked and sometimes it's also self-filling prophecy, right? And people are uncertain and their post itself.

But there is some destocking going on because you can look at your own stock levels, look at our stock levels, and we are part of that value chain, and we deliberately decided to destock because customers don't want to pay for additional reliability as we had during the COVID time. So I think everybody is reviewing that strategy a little bit. So there's definitely some destocking ongoing. Whether the soft demand is part of the stocking or not, I think that's a theoretical question, and we will see if we follow the path throughout 2023.

Dave Huizing

Yes, I think with that, I think we are at the end of the Q&A, we're also approaching the full hour. Dimitri, maybe a short time for a few closing questions before we close off.

Dimitri de Vreeze

A few closing questions perhaps. I think we have had a very good solid 22022 with conditions, which we saw in Q4 going into Q1. We have made progress on people, planet and profit. And we also made progress on the merger towards DSM-Firmenich.

And with that, I'm going to hand back to you, Dave, so you can officially close.

Dave Huizing

Okay. Thank you. By the way, also thank you, Geraldine. Thank you all, all the audience for attending today. And with that, we're concluding today's webcast. And as usual, if you have any further questions, please don't reach out to my team and myself. And with that, thank you, and I give it back to the operator.

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Koninklijke DSM N.V. (KDSKF) Q4 2022 Earnings Call Transcript