MillerKnoll, Inc. (MLKN) Q3 2018 Earnings Report, Transcript and Summary

Good evening, everyone, and welcome to this Herman Miller Incorporated Third Quarter Fiscal Year 2018 Earnings Results Conference Call. This call is being recorded. This presentation will include forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. These risks and uncertainties include those risk factors discussed in the Company’s reports on Form 10-K and 10-Q and other reports filed with the Securities and Exchange Commission. Today’s presentation will be hosted by Mr. Brian Walker, President and CEO; Mr. Jeff Stutz, Executive Vice President and CFO; and Mr. Kevin Veltman, Vice President, Investor Relations and Treasurer. Mr. Walker will open the call with brief remarks, followed by a more detailed presentation of the financials by Mr. Stutz and Mr. Veltman. We will then open the call to your questions. [Operator Instructions] At this time, I’d like to begin the presentation by turning the call over to Mr. Walker. Please go ahead.

Good evening. Thanks for joining us today. I’ll start with a brief review of our results for the quarter, followed by an update on progress during the quarter and our strategic priorities. I’ll close with a view of the current economic backdrop before turning it over to Jeff and Kevin for more information on the financial results including further background on the impact of the new U.S. tax law on our business. Sales for the quarter demonstrated broad-based growth across each of our business segments with the ELA and Consumer businesses leading the way with encouraging double-digit increases. At the consolidated level, sales of $578 million were up 10% from last year’s level, putting us slightly ahead of our midpoint forecast from back in December. We delivered EPS of $0.49 per share for the quarter which included a one-time impact of adopting the new U.S. tax law and a lower statutory U.S. tax rate. On adjusted basis, which excludes the one-time impact of this adoption and other special charges for the quarter, we reported EPS of $0.50, in line with the expectations we set in December. Adjusted EPS reflected growth of 28% over the same quarter last year, driven by a combination of operating performance and a lower normalized U.S. tax rate. New order patterns across the business were more mixed this quarter coming in 4% ahead of last year’s consolidated levels. On a positive front, our ELA consumer and Specialty segments each delivered impressive increases relative to last year. Notably, our Consumer segment posted its third consecutive quarter of double-digit organic order growth. And our international team delivered among the strongest quarters of growth I’ve ever seen in my career here at Herman Miller. Within our North American segment, the demand pattern was less encouraging this quarter. Following a strong first half of fiscal year marked by above expectation order patterns, our results this quarter demonstrated inherently uneven project-based demand pattern characteristic of our industry at large. As a result, orders within our North American business fell below our expectations, particularly as we moved through the latter weeks of the quarter. This lowered our ending backlog, putting some pressure on our near-term revenue outlook for that segment of the business. While this is a bit disappointing, our overall view of the economic backdrop and our longer term growth prospects remain unchanged. We continue to position ourselves to compete successfully across the product categories we serve, especially the fastest growing categories in the industry where we are all -- where we are well-represented through our collection of brands and portfolio. This is supported by what we continue to see as generally positive macroeconomic environment, bolstered by the recent changes in the U.S. tax law, which we believe will ultimately serve as a catalyst for demand in our space through higher employment levels and increased investment spending. As we reviewed with you before, our strategy for the past year and a half is focused on five priorities. We continue to see these priorities as the key drivers of sustainable growth in terms of both revenue and profitability. As a reminder, these core priorities are, first, realizing our vision for what we call the Living Office; second, delivering on our product innovation agenda; third, leveraging our dealer ecosystem; fourth, scaling our consumer business; and last, driving profit optimization. The organization continues to advance each of these priorities, and I’d like to highlight the progress we have made in certain key areas this past quarter. I’ll begin with progress in new product innovation. A major focal point of our R&D efforts in the workplace today centers on two areas. First, we are targeting new products for the more collaborative areas outside of individual workstations; and second, we are developing technology to foster the healthier, more delightful end-user experience while at the same time gathering actionable data for organizations around utilization and productivity. In addition, we are continuing to invest in a range of new seating products, slated for introduction over the next year. Seating is an area where we hold a leadership position across our industry and we intend to stay in front by introducing new record [ph] setting technologies as well as products aimed at bending the price performance curve. These products include the recently launched Verus task chair, which is pacing well ahead of our expectations today. For some time, we have also explored an area that we are calling enclosures. As the use of private office has given a way to open plan office layouts, our customers are increasingly challenged with how to break up workspaces with some form of enclosures to create topography and places for people to gather. And by the way, we think, especially with the recent change in U.S. tax law, this is going to be very interesting because non-architectural products will now qualify for immediate deductibility of capital equipment. As part of this effort, we recently launched a Prospect line of products, to help meet the customers need for expanded enclosure offerings. Our product and business development teams are also working on more offerings within this category. Given all the activity in the area of product and innovation, I’d add that we are looking forward to highlighting our newest editions at the upcoming furniture fairs in Milan and NeoCon. And what we’ll expect would be a really impactful trade show in both locations. Another of our five priorities is to leverage our dealer ecosystem. Simply put, our goal here is to increase our share of wallet within a contract distribution channel. In workplaces today, the proportion of the average office floor play dedicated to individual workstations is significantly less than 8 to 10 years ago when dealers could source 70%, 80% of their product from a single vendor. The picture today is more complex, with as much as 50% of an office floor play being furnished with a variety of nontraditional ancillary products. Products can be served from multiple vendors creating increased complexity for our dealers and our customers. In addition to developing products like the enclosures we just discussed, our respond to this trend has been to invest in our dealer ecosystem to make it easier for our dealers to select products from across our Herman Miller group of brands to put together compelling proposals. In some way, you can think about our business as moving from being more about suburban planning where we are building the same thing over and over again to more like urban planning, where there’s a lot of variety. We do not only want to reduce the cost for dealers to serve their customers but also increase our share of their sales. Last quarter, we continued to make great progress expanding our digital tools to help make doing business with us as easy as possible for our dealers. We successfully launched our new visualization and specification tool in Asia, single global platform for this important capability. We also launched a virtual-reality program for our North American sales team to help customers see their potential workplace designed in a virtual environment. Our enhanced set of tools allows dealers to seamlessly order, specify and visualize our entire product offering across our Herman Miller group of brands. The third priority I will expand upon is the goal of scaling and improving the overall profitability or consumer business, which has been growing very fast from a revenue perspective but to be frank, without the profitability we need. Those of you who’ve been following us for something will remember that we acquired Design Within Reach around 3.5 years ago. We bought the company, we describe it as being an early stage of the growth cycle with the key value drivers of larger studios, a greater number of studios and moving from more purchased product to more proprietary design to drive up margins. Our objective for the consumer business is to deliver high single digit operating margins by fiscal 2020. This quarter, we’re particularly encouraged to see operating margins move nearly 5% for the quarter as evidenced that our strategy is gaining traction. Our revenue growth in this business over the past year has been strong as new studios have come on line. Today about 25% to 30% of our revenue is coming from studios that have been open less than three years, helping to increase top line but putting pressure on profitability as these studios built for operating at full maturity. As we look to the future, we believe the key to growing profitability in this business will center around four key areas. First, we hired a firm and we’ve spent the last year scoping out how we are making this business data driven and operationally excellent. We believe we’re going to be able to improve segment operating margins by somewhere between $10 million and $20 million through this work. Through a combination of improvements on logistics, pricing changes, supply chain work and how we could schedule and administer promotions, we should start to see some benefits next quarter. Next fiscal year, we will continue to see this work ramp up. Based on our work here over the past quarter, our confidence around this program is growing. The second big objective is to shift our marketing investments within this business from physical to digital transformation. We are seeing faster growth online than we are in studios, and we’re going to move some of our investments toward the digital side. This means slowing our rate of new studio openings from the pace of openings over the past few years. Third, we’re working to shift the brand from being more about individual items to a focus on lifestyle. If you follow the catalog, you will have seen that we are focused much more around how people live with the product than what products are. That is having a big impact on our ability to capture not only the entire room, but in some cases an entire home. The last big change in our consumer business relates to expanding our target customer audience, which includes a focus on reaching design enthusiasts at an earlier stage of life. Achieving this required the introduction of new more, accessible products as well as an expanded focus on digital marketing. Finally, the last strategic priority with notable progress last quarter centered on profit optimization. Beyond the work we’re doing within the Consumer business to improve profitability, we continue to focus on profit optimization as a broader corporate priority. A year ago we announced an initiative targeting gross annual savings of 25 to $35 million by fiscal 2020. You’ll recall, we said the savings will be used to enable us to achieve our operating margin goal of 10%, offset by expected inflation and to provide funds needed to invest in our strategic priorities. We estimate our annual run rate from this initiative as at the end of this quarter sits at nearly $22 million. While we’re making good progress on the gross annual savings, to be frank, the recent increases in material costs and the expected continued increases resulting from a strong economy and the prospects for tariff, have reduced the amount we’ve dropped through to the operating line. As a result, we recently engaged the firm assisting our profit optimization efforts in the Consumer business to develop a similar plan for our North American contract business. It’s too early to talk about specific goals but we believe this work combined with our previous initiatives and future price increases will keep us on track for our long-term goal. One of our more recently announced cost actions will involve the consolidation of our Chinese manufacturing operations into a single campus in southern China. This will involve the build out of facilities and the relocation of people, inventory and equipment. We’ll begin this process in the fourth quarter. While we are confident this is the right long-term direction, there will be some short-term disruptions and elevated costs to serve customers. It’s impossible to predict these impacts in advance and we’re doing everything possible to minimize the impact. Next, while it is difficult to manage the timing of these initiatives with the rapid changes we’ve experienced in material cost and competitive pricing environment, we’re continuing to make progress on this priority and we are keeping it front and center. Before Jeff reviews the financial results for our business segment, let me provide some brief context on the current backdrop as we see it. In addition to the potential tailwind for the industry from tax reform that I discussed earlier, macroeconomic indicators including GDP growth, sentiment measures, service sector employment and architectural building -- billings continue to support a positive outlook in the North American contract business. On a North American consumer front, high consumer confidence, low unemployment, historically low interest rates and limited unsold home inventory provide a generally supportive backdrop. International picture continues to reflect global economic growth while pockets of risk exist. UK still faces uncertainty tied to Brexit, while economic and political pressures in oil-producing regions including the Middle East contribute to ongoing uncertainty there. The current geopolitical situation with North Korea remains an obvious threat. The recently announced plan for U.S. tariffs on imported steel and aluminum and the potential response from other nations is a new development. We are actively developing contingency plan to help navigate this environment. While we do not import any raw steel into North America, we have not been surprised to see the recent increases in domestic steel prices in response to potential tariffs on imported steel. As we move forward, we are confident our five strategic priorities will help us continue to create sustainable, profitable growth for our shareholders. At the highest level, our global multichannel business in the greater Herman Miller community remains focused on our mission to deliver inspiring designs to help people do great things. With that overview, I’ll turn the call over to Jeff provide more detail on the financial results for the quarter.

Thanks, Brian, and good evening, everyone. Consolidated net sales in the third quarter of $578 million were 10% above the same quarter last year. Orders in the period of $563 million were nearly 4% above the same quarter a year ago. Within our North American segment, sales were $316 million in the third quarter, representing a year-over-year increase of 7%. New orders were $295 million in the quarter, reflecting a decrease of 7% from last year. On an organic basis, we posted year-over-year revenue growth of 8% while order levels were 6% lower than the same quarter last year. In addition to a rather challenging prior year comparison, our North America segment orders were up 7% last year on an organic basis for the third quarter, the business experienced the relative softening in large and medium project activity this quarter. Sector results for the quarter showed lower order demand in business services and utilities, partially offset by growth in energy and state and local government. Our ELA segment reported sales of $103 million in the third quarter, an increase of 17% compared to last year on a GAAP basis and up 11% organically. New orders totaled $114 million, which is 33% higher than last year on a reported basis and up 27% organically. The strong year-over-year order growth was broad based across all international regions with notable strength in the UK, Continental Europe, Australia, Mexico and the Middle East. Sales in the third quarter within our Specialty segment were $73 million, an increase of 5% from the year-ago period. New orders in the quarter of $71 million were up 7% over the same time frame. The increase in orders for this segment was driven principally by strong project activity for Geiger and the Herman Miller Collection. The Consumer business reported sales in the quarter of $87 million, an increase of 19% compared to last year, driven by strong growth across our studio, catalog, e-commerce and contract channels. New orders for the quarter of $83 million were 14% ahead of the same quarter last year. While operating earnings for the Consumer segment remain constrained in the near term by the rollout of new studio locations that take time to fully mature, we see a path to operating margins near double digits for this business over the long run. During the quarter, we estimate the unfavorable impact to operating earnings related to the drag from new studios that have not yet reached full maturity was approximately at $1.5 million. With that said as Brian noted the improvement in segment operating margins this quarter to just above 5% represented a meaningful acceleration toward our goal for the consumer business. Related to the impact of foreign exchange rates on our top line, we continue to experience the tailwind from the weakening of the U.S. dollar. We estimate the translation impact from changes in currency exchange rates had a favorable impact on consolidated net sales of approximately $6 million in the quarter. Consolidated gross margins in the third quarter totaled 35.6%, which was 160 basis points below the same quarter last year. As we’ve noted in recent quarters, we continue to experience unfavorable product mix, increased levels of discounting and costs associated with outsourcing certain high demand products. We are also have starting to see increased commodity costs in the area such as steel, aluminum and plastics. Operating expenses in the third quarter were $168 million compared to $158 million in the same quarter last year. This amount includes approximately $4 million in the current quarter in special charges, primarily associated with the planned CEO transition that we announced in February and consulting fees supporting our profit enhancement initiatives. Excluding these special items, the increase of $6 million was driven primarily by higher variables selling costs and incentive compensation levels, as well as higher occupancy and staffing costs related to new DWR studios. Helping offset these expenses or these increases, we continue to make good progress on our cost savings initiatives. While a portion of these savings are aimed to offset potential inflation and fund growth investments, we continue to believe this initiative will be a key contributor to our overall target of achieving operating margins at or near 10% at the consolidated level by fiscal 2020. As a reminder, the walk toward our ultimate goal for profitability won’t be an even one, as required investments for growth are not necessarily linear with our cost reduction plans. On a GAAP basis, we reported earnings of $38 million this quarter. Excluding special charges, adjusted operating earnings were $42 million or 7.3% of sales. By comparison, we reported adjusted operating income of $37 million or 7% of sales in the third quarter of last year. Effective tax rate in the third quarter was 19%. This rate includes the impact of the recently enacted Tax Cuts and Jobs Act. In addition to the impact of the lower ongoing U.S. tax rate, our effective rate this quarter reflects one-time adjustments related to the re-measurement of current and deferred tax liabilities. This rate benefit was partially offset by a charge related to the deemed repatriation of accumulated foreign earnings. Excluding these one-time items, our adjusted effective tax rate for the quarter was 25.8%. Looking ahead to next year, we expect our full-year rate in fiscal 2019 to be between 21% and 23%, which reflects a full-year of the lower U.S. federal tax rate, anticipated mix of domestic and foreign earnings and the impact of state income taxes. From a cash flow perspective, we expect cash tax savings of approximately $25 million in fiscal 2019, driven by the lower base rate as well as savings associated with immediate deductibility for some of our planned capital investments. And finally, net earnings in the third quarter totaled $30 million, or $0.49 per share on a diluted basis. Excluding the impact of special charges and one-time tax adjustments, adjusted diluted earnings per share this quarter totaled $0.50, an increase of 28% compared to adjusted earnings of $0.39 per share in the third quarter of last year. So, with that, I’ll now turn the call over to Kevin to give us an update on our cash flow and balance sheet.

Thanks, Jeff. Good evening, everyone. We ended the quarter with total cash and equivalents of $193 million, which reflected an increase of $78 million from last quarter. This increase is primarily a result of borrowing an additional $75 million on our bank revolving credit facility in January, as part of our long-term capital structure. As discussed in prior quarters, we utilized the 10-year interest rate swap to fix our interest rate at 3.2% on this borrowing through January 2028. This transaction was in addition to borrowing $150 million on the revolver to repay private placement notes that matured in January. We also used a 10-year interest rate swap to fix our interest at 2.8% for this tranche of debt. In both cases, we were able to take advantage of the low interest environment when we entered into these interest rate swap transactions. Cash flows from operations in the period were $29 million, comparable to $28 million generated in the same quarter of last year. Capital expenditures were $11 million in the quarter and $51 million year-to-date. We anticipate capital expenditures of $75 million to $85 million for the full fiscal year. Cash dividends paid in the quarter were $11 million and we repurchased $13 million of shares during the quarter. We remain in compliance with all debt covenants and as of quarter end our gross debt to EBITDA ratio was approximately 1 to 1. The available capacity on our bank credit facility stood at $167 million at the end of the quarter. Given our current cash balance, ongoing cash flows from operations and our total borrowing capacity, we continue to be well-positioned to meet the financing needs of the business, moving forward. With that, I’ll turn the call back over to Jeff to cover our sales and earnings guidance for the fourth quarter of fiscal 2018.

Okay. With respect to the forecast, we anticipate sales in the fourth quarter to range between $590 million and $610 million. We estimate the year-over-year favorable impact of foreign exchange on sales for the quarter to be approximately $6 million. On an organic basis, adjusted for a dealer divestiture and the impact of foreign exchange translation, this forecast implies a revenue increase of 4% compared to last year as a midpoint of the range. We expect consolidated gross margin in the fourth quarter to range between 36.25% and 37.25%, reflecting a sequential quarter improvement from production leverage on expected higher sales volume and channel mix. This estimate also reflects our latest view on commodities including the recent uptick in steel pricing. Adjusted operating expenses in the fourth quarter are expected to range between $169 million and $173 million. On a GAAP basis diluted earnings per share for the fourth quarter of fiscal 2018 are expected to range between $0.49 and $0.53. We anticipate adjusted earnings per share to be between $0.56 and $0.60 for the period. Adjusted EPS excludes an estimated $6 million to $7 million of pretax restructuring and other charges expected in the fourth quarter of FY18. Also this assumes an effective tax rate in the quarter of 23% to 25%, reflecting the lower tax rate from the new U.S tax legislation. With that, I’ll now turn the call back over to Brian before we take your questions.

Thanks, Jeff. I thought I would close on a brief update on our planned CEO transition. As you know, in February, we announced my plan retire in the first quarter of fiscal 2019. The Board has formed a committee to evaluate internal and external succession candidates. To help with this work, we retained a global search firm. While we are early in the process, we continue to believe the successor will be identified early in the first quarter of fiscal 2019. This will leave ample time for an orderly transition. For now, it’s business as usual. We are focused on the strategic priorities we discussed earlier and serving our customers. Now, I’ll will turn the call over to the operator for your questions.

[Operator Instructions] Our first question comes from line of Matt McCall from Seaport Global. Sir, your line is now open.

So, maybe start with the gross margin little bit. It looks like the Q4 guide, got about a 150 basis points of pressure on a year-over-year basis at the midpoint. And I guess, that’s even with the expectations of faster growth in Consumer that has higher gross margin. So, maybe take us through some of the puts and takes there. And then, if you could, give us an initial view about how some of those puts and takes can trend as we move out in the next fiscal year.

Hey, Matt, this is Jeff. Let me take a stab. I’m not sure I’m going to be able to quantify every line item for you for, but I will give you some color commentary. I would tell you, as a starting point, our expectation gross margins, absent what I mentioned earlier, which would be an improvement in margins due to higher production leverage. I would expect them to be the same factors that we just walked through on a year-over-year basis for Q3. Namely, the discounting pressure that we’re feeling, we certainly expect to continue to feel some of that as we move forward; product mix, I would say on the same order of magnitude year on year. We do -- and then commodities. And I think you’ll see an acceleration of some of the commodity pressure from steel prices. If I had to quantify that for you, it’s probably on the order of an incremental $1 million of year-over-year impact just related to steel by itself. The positive factors are a couple of things that I think are worth highlighting. I talked about one of them. Production leverage from higher volumes and we do tend to see that if you look back over history, you tend to us on the order of a 100 basis-point improvement in gross margins between Q3 and Q4. And production leverage tends to be a major factor that we did do a price increase in February, the beginning of February. So, we didn’t feel much of the impact of that in the third quarter, and we’ll have a full quarter, if you will, of price increase benefit, although I’d have to qualify that and say as you know from history in our business that layers in over time. The other thing, I’d point out is we have a higher expectation in terms of channel mix within our businesses, namely a higher mix of revenue coming from our consumer business expected in the fourth quarter relative to Q3. So, those are I think the major pieces that I’d call out for you.

Okay. I mean, I know it’s hard to look that far out. I’m not necessarily trying to get guidance for next fiscal year. But, when you talk about some of the trends for those items, I mean, anything that’s going to reverse or until we comp some of the difficulties, we’ll see the trends continue. I know, steel’s going higher still and discounting likely to continue. But any important call-outs for next fiscal year as we start to think about modeling gross margin relative to some of the weakness we’ve seen recently?

Matt, I’ve got one that comes to mind that I probably should have -- I should mention that will be a contributor to what we hope to be an improvement in Q4, but this will continue to next year on a year-over-year basis. And that is we’ve been talking the last few quarters about outsourcing, the impact of outsourcing certain production. We’ve been capacity constrained in a couple of areas. That will abate in the fourth quarter a bit for us. And certainly as we move into next year, we have some new capacity coming online. We won’t feel that the same degree of negative impact of that as we have the last few quarters. So, that certainly is one that will be an offset.

Certainly think of work we’re doing around Nemschoff, we just try to see some benefit. That’s pretty minor in the big scheme of things, Matt, but that’s been a negative drag. While that business isn’t I would say healthy, we are starting to see early signs of the work that the team is doing that are going to be positive. As Jeff mentioned, in addition to the -- in addition to the mix side of the consumer business, a good deal of the work we’ve done on profit optimization will actually hit the margin line, because a lot of that was both sourcing, pricing and the way we do promotion. So, I think we believe we’ll continue to see better margins in the consumer business, gross margins as well as operating margins. Look, I think the key right now to getting these trends revere, we are -- there is no doubt if the tariff pressure continues to come, we’re going to continue to see at least the steel prices that are already in front of us, those are going to get implemented. We will get some offset from where we’re today, if it didn’t move any further. But the price increase, as Jeff mentioned, it will layer in. So, we’ll capture some there. Obviously, there is currently longer downside risk because of the lag of prices and there has certainly been movement recently that are not yet into the steel prices. Having said that, our job as managers is not to sit and just for wait for that to happen, but to go do something about it. So, we are working on things around that like what can we do as we look at individual project pricing to maximize pricing on project. Now that’s -- obviously, we’ve been in a strong or difficult pricing environment. I think most of the industry is showing some of that. But as steel moves, it is going to be difficult to do that simply through list price increases. So, at the same time, we’re going to have to be good at what you might call, situational pricing. And I think, our team is spending a lot of time asking that question where can we optimize it that is by doing some of the work I think we’ve already done around products but I think there will also to be done at the sort of project-by-project, negotiation-by-negotiation piece, which we will have to be better at it. And we are going to set our sights to at least making sure we don’t let further deterioration happen.

Let me just add one more thing. I think, we should be really clear on this point. We have been marching our way toward a goal of achieving operating income at the consolidated level, adding that 10% level by FY20. We are not walking away from that as a goal. We’ve typically described our, if you will, leverage capability or contribution margin over the long-run as a ratio of operating income growth to sales growth. And we’ve tended to talk about that as you know, as a goal of growing operating income at 2 to 2.5 times the rate of sales. We still believe that’s the right range. Now, admittedly the recent inflationary pressures around steel in particular, that makes -- that tougher climb, and I would tell you, we’re still believers of that range. It probably points us toward the lower end of that range as we move into next year, based on everything we know now. And steel prices have really spiked up in recent week. It’s anyone’s guess right now as to how long it lingers there or goes up a bit, moderates a bit. But, right now, that’s our point of view.

I’d also say, Matt, it’s something we’re adding a lot to this question, this is probably the most important thing to think about right now beyond what’s happening in demand patterns. The other thing I noted in my comments is while we have really generated a good deal of work towards our gross savings we expected to get, the net hasn’t been there. So, this quarter we began an engagement with the same group of folks have been helping us on the consumer business, which we have growing confidence in. We’ll know more as we get through the fourth quarter, but those numbers look to us like they are very likely in the range that we’ve given you. We are starting a similar program with them right now within the North American contract business. It’s too early to talk numbers but that is really targeted saying how do we get the capture rate we needed to get to that 10%. And that is one of the objectives we have there. We’ll know more when we get to the fourth quarter. We’ll know more what we are starting to look at in terms of a range of possibility just like we did with the consumer business. It takes us about a quarter to get that work really fully scoped out. We’re about four weeks into the work right now. So, it’s a little early. We think we will have a good picture as we get to the end of the fourth quarter and begin to implement. The question will be can we capture any of that next year. And that’s going to be a question mark as we get. Right now, we think -- if you look back at the consumer business, we didn’t really begin that work until the start of the second quarter. We think we’re going to capture some in the fourth quarter, although not a great deal. And so -- but we think we’ll get some in the first quarter. So, it takes -- if that is a bogie, it will take us about a year to get there. If we get started now in the fourth quarter, like we are, start the third quarter, there’s a chance we could get a quarter of that work into next year. And that’s kind of our push is while we may not be seeing it right now, we’re getting impacted heavily by inflationary pressures and discounting, we got us moving and we are moving. We didn’t wait until now, even though to be frank it was a little deeper in the last month of the quarter than we expected with some of the commodity moves and other things. We already started to see this, as a pattern, and early in the quarter made the decision we’re going to get going on that work. So, fortunately, the team is already at least in front of it as far as we can be, given what’s happening.

And I was actually going to ask the question about the consultant moving over into the -- and looking at the New York -- North American office business, but you kind of answered it. I just wanted to get some clarification. So, it sounds like this is more gross margin focused than SG&A focused. And when you broke out the new segment profitability, one thing that jumped out to us was how profitable that business was. So, is it -- is the idea to focus on your most profitable business? Is it kind of a result of some of the inflationary pressures that we’ve seen? It’s interesting to me that that would be the area, the next area of focus given that it is so profitable. So, clearly you see incremental opportunity. And I guess related to it, the continued investments, you’re doing a good job on SG&A, but you’re also talking about continuing to invest. So, I’m trying to balance all those things as we look out in the next year. And maybe the answer is just comment around 2 times, the rate of sales growth in ‘18 will get me to my answer. But just trying to put all these things together?

Let me try to string those together. I think that’s a very good question. First of all, the good news is we have a very profitable North American contract business. It also has -- a fair part of that business is, you might imagine is fairly mature where many of the other businesses are younger, if you will or been in a state of rapid growth. So, they’ve taken a little bit more to get where they need to be. At the same time, I think you have to look at what’s happening in the contract business or the traditional business. That business is changing rapidly in terms of the complexity of the products and therefore what it takes to manage that business. And what we don’t want to do is be behind on making sure that we have looked at everything in that business to ask what can we do to be more effective? I don’t think you should assume its cost of goods sold because we don’t know that yet. To be honest, when we started this work in the consumer business, what we ended up working on, to be frank, was probably not what I would have predicted from the beginning, neither magnitude of the work nor the areas that they look at. So, it is not a limited engagement where you said, look at one thing. We said, come in, take a deep look with our folks, help us look across the spectrum at things that you think we should be paying attention to. This is not, I would say, a cost cutting exercise though. It is a optimization exercise. And if the consumer business is any guide, much of the work became about understanding and utilizing our own data to better guide decision-making. It involves relearning and teaching new ways of doing things that resulted in better profitability. Some of that was pricing, some of that was marketing strategy, some of that was product strategy. It was a wide range of things. And to be frank, no one item singularly was very large. So, I think we’re going to this with our eyes open that this is in some ways, if you want to think of it is, it’s akin to an HMPS exercise that we’re not going in assuming we’ve got an answer. We’re going in assuming we’re open to rethinking things that could involve changes in the way that we think about pricing, the way that we think about marketing products. So, it will be broad-based, to be frank. Although I can’t really predict for you right now what the impact is going to be and I think we won’t know for some time, like I said, until the end of the fourth quarter what that looks like. So, I guess, it’s one of those things, it’s an old adage that the best time to be working on getting better is when things are good, not when things are bad because you’ve gotten some ways more opportunities to improve. And so, that’s a good business. It hasn’t had great growth rates as you know. And so, we’ve said, well, we’re not going to probably grow that one by having growth rates like we want to have overall. The growth rates will come from new areas. In that business, we’ve got to figure out how to grow profitability while we don’t have as fast of a top line. At the same time, I think, we have some several cost pressures greater in that business from these inflationary things than others. So, I think you can dovetail the two. I would say, if we hadn’t seen a move in steel, we’d still be doing this work though. So, I don’t want to say it’s in response to what’s happened. We were already going down the trail back when we started this work a year ago. We decided we would look at it, sort of business by business so that we could learn as we went along. And as we saw things in one business we’re quickly applying them another and then asking is there other areas we should look at. And that that’s really what I think this is. It is more of a continuation of something we started last year than it is a whole new thought. I think now we are just more -- it’s clearer to us that if we’re going to get to the drop through goal, we had that 25 to 35, we got to go do more work than what we’re going to do.

And our next question comes from the line of Kathryn Thompson from Thompson Research. Your line is now open.

This is Steven on for Kathryn. I guess, first, looking at gross margin, do you believe gross margins will be pressured to an equal degree in all segments from inflation, taking into account that Consumer segment showed expansion this quarter?

No. I mean, I think right now, the biggest move you’ve seen has been in steel, and you are starting to see some of it in lumber, which more impacted contract business. Certainly, you will see and we continue to see overall inflation, you’re going to see that I think across the economy, although I don’t think it’s runaway yet. I think this tariffs stuff is moving it. Certainly, the U.S. dollar movement makes some parts of the business have cost increases, especially stuff you’re bringing in from Europe. On the other hand, it also provides benefits in many -- in some cases will drive higher margins and higher realization in places like Canada. So, on balance, right now that looks like actually it’s a net positive to a degree. So, I think, we’ll feel it primarily right now in the North American contract and probably the international business where we have more content of those commodities.

Yes. Steven, this is Jeff. Though, I would point out in our international business in talking with our supply management folks, they’re not currently seeing the same level of inflationary pressure on steel specifically as we are in the U.S. Now, I can’t predict exactly where that’s going to go here over the next few quarters, but particularly, in China as an example, they’re are not seeing the level of increases that we are in the U.S. So, so far it’s been tilted more toward North America.

Excellent. And then on price increases, was the February price increase a business as usual kind of increase. And at this point, are you confident if it came to the situation you could increase prices further in the next 12 months?

Steven, yes, look at -- I think, the pattern typically, as you capture, around 30% of the list price increase falls through. To be frank, if we could have predicted the tariffs perfectly, we probably would have done a bigger price increase at the time. It’s difficult in the contract business to do a price increase more than once a year. It’s possible. It is more difficult because you have contracts that often have clauses in them that limit how often you can do one. Now, we are exploring what are the things we can do because there are some ways to do that. I think, for sure, a year-out we would certainly feel like we would -- we could do one and we would capture some. On the other hand, we have multiple levers to pull right now. While we have standard discounting for customers on contracts that tend to be within a range of project size, and often you are on larger projects, either midsized projects, you are competitively bidding. And so, I think those are places where you can also manage around the edges by being better at your pricing, both not only looking at discounting but looking at how you value engineer solutions that don’t require you to pull the price lever. So, we will look at the full gambit of ways to manage it. We can’t tell you going forward that we get it perfectly predicted. But, I can say that we are talking about and looking at all of those levers to see what we can do, at least to make sure that we can ameliorate any further difficulty there. But, I think it’s going to be -- we’re going to have to be great at cost; we’re going to work on making costs, making the business more efficient. I think, the work we’re doing on the outside will help us with that. We’re going to have to be better at situational pricing and over time we’ll look to where we can do price increases.

All right. And then last question being about discounting. Do you expect discounting in the market to ease up as everybody starts to encounter these inflationary headwinds or do you even that competitors view the lower tax rate giving them room to lower prices to be competitive in the contract business?

Well, to be frank that’s somewhat unknowable at this point because we don’t know what their thoughts are. You certainly would hope that as folks see price inflation or cost inflation that everybody would look at what do we do with pricing overall. But that’s one that’s very difficult to predict. And I think that somewhat will depend on what demand levels look like. If demand strengthens as a result of the tax change, I think it’s more likely, folks will feel less pressure to discount to get the business that is out there. So, I think it’s going to really depend on what the mix of the situation is. And hopefully, we don’t see any economic slowdown from tariffs and all of those things that we continue to see the global economy move along. But, at least we’re in a period of growth and you are not dealing with inflation in a non-growth period. As you know, the industry has been a little bit up and down over the last year. There are certainly categories that are growing very rapidly and there are categories that aren’t growing so rapidly. So, I think you are goal has to be move as much as your mix to the areas that are growing rapidly and get much smarter and more efficient in the areas that aren’t, so that you can play as effectively there as possible. And then again hope that we don’t see any slowdown in the global economy or particularly in the U.S.

And I’m currently seeing no further questions. I would now like to turn the call back Mr. Brian Walker for any further remarks.

Thanks for joining us on the call today. We appreciate your continued interest in Herman Miller and look forward to updating you next quarter. Have a great evening.

Ladies and gentlemen, thank you for participating in today’s conference. This concludes today’s program and you may now disconnect. Everyone have a great day.