MillerKnoll Inc

NASDAQ:MLKN

Earnings Call Transcript 2018-Q3

[Operator]

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 would like to begin the presentation by turning the call over to Mr. Walker. Please go ahead.

[Brian Walker, executive]

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 on our strategic priorities. I'll close with the 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 base 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 the onetime impact of adopting the new U.S. tax law and a lower statutory U.S. tax rate. On an adjusted basis, which excludes the onetime 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 level. On the 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.

With 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 an 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 move 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 category we serve, especially the fastest-growing categories in the industry where we are well represented through our collection of brands and portfolios. This is supported by what we continue to see as a generally positive macroeconomic environment bolstered by the recent changes in U.S. tax law, which we believe will ultimately serve as a catalyst for demand in our space through higher employment levels and increase investment spending.

As we reviewed with you before, our strategy for the past 1.5 years is focused on 5 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 2 areas. First, we are targeting new products for the more collaborative areas outside of individual workstations; and second, we are developing technology that fosters a healthier, more delightful end-user experience while, at the same time, gathering actual 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 reference setting technologies as well as product 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 way to open plan office layouts, our customers are increasingly challenged with how to break up workspaces with some form of enclosure 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' needs 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 products and innovation, I'd add that we are looking forward to highlighting our newest additions at the upcoming furniture fairs in Milan and NeoCon in what we'll expect will be a really impactful trade show in both locations.

Another of our 5 priorities is to leverage our dealer ecosystem. Simply put, our goal here is to increase our share of wallet within the contract distribution channel. In workplaces today, the proportion of the average office floorplate 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 floorplate being furnished with a variety of nontraditional ancillary products. Products can be sourced from multiple vendors, creating increased complexity for our dealers and our customers.

In addition to developing products like the enclosures we just discussed, our response to this trend has been to invest in our dealer ecosystem to make it easier for our dealers to select products from across the Herman Miller group of brands to put together compelling proposals. In some ways, you can think about our business as moving from being more about suburban planning where we're building the same thing over and over again to more like urban planning where there's a lot more variety. We do not only want to reduce the cost for our dealers to serve their customers but also to increase our share of their sales.

Last quarter, we continue 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, giving us a 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 designs in a virtual environment. Our enhanced set of tools allows dealers to seamlessly order, specify and visualize our entire product offering across the Herman Miller group of brands.

The third priority I'll expand upon is the goal of scaling and improving the overall profitability of our 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 have been following us for some time will remember that we acquired Design Within Reach around 3.5 years ago. When we bought the company, we described it as being in the early stage of a growth cycle with the key value drivers of larger studios, a greater number of studios and moving from more purchased product to more proprietary designs to drive up margins. Our objective for the Consumer business is to deliver high-single digit operating margins by fiscal 2020. This quarter, we are particularly encouraged to see operating margins move to nearly 5% for the quarter as evidence that our strategy is gaining traction.

Our revenue growth in this business over the past year has been strong as new studios have come online. Today, about 25% to 30% of our revenue is coming from studios that have been opened less than 3 years, helping to increase top line but putting pressure on profitability as these studios built weren't operating at full maturity. As we look to the future, we believe the key to growing profitability in this business will center around 4 key areas. First, we hired a firm, and we have spent the last year scoping out how we are going to make 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, franking changes, supply chain work and how we 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 are going to move some of our investments toward the digital side. This will mean 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 catalogs, you will have seen that we are focused much more around how people live with the products than what the products are. That is having a big impact on our ability to capture not only an entire room but, in some cases, an entire home.

The last big change in our customer and consumer business relates to expanding our target customer audience, which includes the focus on reaching design enthusiasts at an earlier stage of life. Achieving this requires 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 centers on profit optimization. Beyond the work we are 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 million 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 of 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 tariffs have reduced the amount we have 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 initiative 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 disruption and elevated costs to serve customers. It's impossible to predict these impacts in advance, and we are doing everything possible on minimizing impact.

Next, while it is difficult to manage the timing of these initiatives with the rapid changes we have experienced in material cost and the competitive pricing environment, we are continuing to make progress on this priority, and we are keeping it front and center.

Before Jeff reviews the financial results for our business segments, let me provide some brief context on the current backdrop as we see it. In addition to the potential tailwind to the industry from tax reform that I discussed earlier, macroeconomic indicators, including GDP growth, sentiment measures, service sector employment and architectural billings, continue to support a positive outlook in the North American Contract business. On our North American Consumer front, high consumer confidence, low unemployment, historically low interest rates and limited unsold home inventory provide a generally supportive backdrop.

The international picture continues to reflect global economic growth, while pockets of risk exist. The U.K. 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 plans 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 5 strategic priorities will help us continue to create sustainable profitable growth for our shareholders. At the highest level, our global multi-channel business and the greater Herman Miller community remain 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 to provide more detail on the financial results for the quarter.

[Jeff Stutz, executive]

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 American segment orders were up 7% last year on an organic basis for the third quarter, the business experienced a 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 $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 U.K., 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 current 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 $1.5 million. But that said, as Brian noted, the improvement in segment operating margins this quarter to just below 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 a 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're also starting to see increased commodity cost 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 this -- 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 variable 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 to our ultimate goals 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 operating 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.

The 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 a lower ongoing U.S. tax rate, our effective rate this quarter reflects onetime adjustments related to the remeasurement 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 onetime 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 onetime 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.

[Kevin Veltman, executive]

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 rate 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 1:1. 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.

[Jeff Stutz, executive]

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 at the 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 FY '18. 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.

[Brian Walker, executive]

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 to 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 we'll turn the call over to the operator for your questions.

[Operator]

[Operator Instructions] And our first question comes from the line of Matt McCall from Seaport Global.

[Matthew McCall, analyst]

So maybe start with the gross margin a little bit, it looks like the Q4 guide has got about 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 the next fiscal year.

[Jeff Stutz, executive]

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, but I'll give you some color commentary. I would tell you as a starting point, our expectation for 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 already 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 see on the order of 100 basis point improvement in gross margins between Q3 and Q4, and production leverage tends to be a major factor there. 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. We'll have a full quarter, if you will, of price increase benefit. Although I 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.

[Matthew McCall, analyst]

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 has gone higher still and discounting is 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?

[Jeff Stutz, executive]

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 in 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 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.

[Brian Walker, executive]

I certainly think the work we're doing around Nemschoff, we should start 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 yet, 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 just 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'll -- 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 reversed is we are -- there's 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 are today, if it didn't move any further, by the price increases as Jeff mentioned that will layer in. So we'll capture some there. Obviously, there is currently a longer downside risk because of the lag of prices, and there's 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 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 projects. Now that's -- obviously, we've been on a strong or a difficult pricing environment, I think most of the industry is showing some of that. But as steel moves, it's 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 that will also be done at the sort of project-by-project, negotiations-by-negotiation piece, which we will have to be better at. And we are going to set our sights to at least making sure we don't let further deterioration happen.

[Jeff Stutz, executive]

And Matt, let me just -- this is Jeff again, let me just add one more thing. I think we should be really clear on this point. We've been -- we have been marching our way toward a goal of achieving operating income at the consolidated level at or near that 10% level by FY '20. We are not walking away from that as a goal. We've typically described our, if you will, kind of leverage capability or our 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 our goal of growing operating income at 2 to 2.5x 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 a 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 weeks, it's anyone's guess right now as to how long it lingers there, if it goes up or if it moderates a bit, but right now that's our point of view.

[Brian Walker, executive]

I'd also say, Matt, it sounds like we're adding a lot to this question, this is probably the most important thing to think about right now beyond what's happened 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 that 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 that -- those numbers look to us like they're 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 to 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 possibilities. 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 4 weeks into the work right now, so it's a little early. We think we'll 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 we -- but we think we'll get some in the first quarter. So it takes -- if that's a bogey, it will take us about a year to get there. If we get started now in the fourth quarter like we are or start it at 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 going to get impacted heavily by inflationary pressures and discounting, we got to start 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 had already started to see this as a pattern and early in the quarter made the decision we are 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.

[Matthew McCall, analyst]

Okay, that was great. And I was actually going to ask a question about the consultant moving over into the -- and looking at the New York -- the North American office business, but you kind of answered there. I just want to get some clarification. So it sounds like this is more gross margin focused than SGA-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 just it's interesting to me that, that would be the area, the next area of focus given that it's 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, Jeff's comment around 2x the rate of sales growth in '18 will get me to my answer but just trying to put all these things together.

[Brian Walker, executive]

Yes, Matt, let me try to string those together because I think that's a -- it's a very good question. First of all, while the -- the good news is we have a very profitable North American Contract business. It also has -- a fair part of that business, as 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 on that business to ask what can we do to be more effective. I don't think you should assume it's 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 looked at. So it is not a limited engagement where we said look at one thing, we said come in, take a deep look with our folks, help us look across the spectrum of things that you think we should be paying attention to. This is not, I would say, a cost-cutting exercise though, it is an optimization exercise. And if it -- if the Consumer business is any guide, much of the work began -- became about understanding and utilizing our own data to better guide decision-making. It involved 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 -- it's 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 a 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 ways 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 say, until the end of the fourth quarter, what that looks like. So I guess, it's one of those things. There'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 got, in 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, that growth rates will come from new areas. In that business, we got to figure how to grow profitability while we don't have as fast of a top line. At the same time, I think we have felt cost pressures greater in that business from these inflationary things and others. So I think you can dovetail the 2. I would tell you, 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. In fact, 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 to another and then asking is there other areas we should look at. And that's really what I think this is. It's more of a continuation of something we started last year than it is a whole new thought. I think now we're just more -- it's clearer to us that if we're going to get to the drop-through goal we had of that 25 to 35, we got to go do more work than what we are going to do.

[Operator]

And our next question comes from the line of Kathryn Thompson from Thompson Research.

[Steven Ramsey, analyst]

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?

[Brian Walker, executive]

No. I mean, I think right now, the biggest move you've seen has been in steel, and you're starting to see some of it in lumber which more impact the contract business. Certainly, you'll see -- if 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 tariff 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 a benefit in many -- in some cases, where it drives 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.

[Jeff Stutz, executive]

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 not seeing the level of increases that we are in the U.S. So, so far it's been tilted more toward North America.

[Steven Ramsey, analyst]

Excellent. And then on the 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?

[Brian Walker, executive]

Steven, yes, look, I think the pattern typically is you capture around 30% of the list price increase fall-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 could 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 do -- 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 tends to be within a range of project size. And often, you are on larger projects, even 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 look 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 can perfectly predict it, but I can tell you 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 in 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 cost and 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.

[Steven Ramsey, analyst]

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 view, even the competitors view the lower tax rate giving them room to lower prices to be competitive in the contract business?

[Brian Walker, executive]

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'll continue to see the global economy move along, that at least we're in a period of growth and you're not dealing with inflation in a nongrowth period. I mean, 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 your goal has to be move as much of 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, particularly in the U.S.

[Operator]

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

[Brian Walker, executive]

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.

[Operator]

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