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Herman Miller, Inc. (NASDAQ:MLHR)
Q3 2018 Earnings Conference Call
March 21, 2018, 2:00 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good evening, everyone, and welcome to this Herman Miller, Inc. 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 can 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. We will limit today's calls to 60 minutes and ask that callers limit their questions to allow time for all participants. At this time, I would like to begin the presentation by turning the call over to Mr. Walker. Please go ahead.

Brian Walker -- Chief Executive Officer 

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 a view of the current economic backdrop before turning it over to Jeff and Kevin for information on the financial results, including further background on the impact of the new US tax law on our business.

Sales for the quarter demonstrated broad-based growth across each of our business segments with an ELA in consumer businesses leading the way with encouraging double-digit increases. At the consolidated level, sales of $578 million were up 10 percent 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 one-time impact of adopting the new US tax law and a lower statutory US tax rate.

On an adjusted basis, which excludes a 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% of the same quarter last year, driven by a combination of operating performance and a lower normalized US tax rate. New order patterns across the business were more mixed this quarter, coming in 4% ahead of last year at the 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.

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 result this quarter demonstrated an inherited 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 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 US 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 was 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, four, 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 and 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. Second, we are developing technology that fosters a 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 reference-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've often 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 US tax law, this is going to be very interesting because non-architectural products will not qualify for immediate deductibility as capital equipment.

As part of this effort, we recently launched a prospect line of products to help meet the customer's need for expanded enclosure offerings. Our product and business development teams are also working on more offerings within this category. Given all that activity in the area of products and innovation, I'd add that we are looking forward to highlighting our newest editions at the upcoming furniture fairs in Milan and NeoCon. What we'll expect will 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 the contract distribution channel. In workplaces today, the proportion of the average office floor plate dedicated to individual workstations is significantly less than eight to ten years ago when dealers could source 70% to 80% of their product from a single vendor.

The picture today is more complex, with as much as 50% of an office floor plate being furnished with a variety of non-traditional 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 be 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 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 not only want to reduce the costs for our dealers to serve their customers, but also to 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, 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 approving the overall profitability of our consumer business, which is then 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 three and a half years ago. We bought the company we described 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 were 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 has new studios have come online. Today, about 25% to 30% of our revenue is coming from studios that have been open less than three years, helping to increase topline, but putting pressure on profitability, as these studios build toward 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 have spent the last year scoping out how we are going to make this business data-driven and operationally excellent. We believe we are 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 in logistics, pricing 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're 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 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 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 requires 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 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 recall we said that 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 prospect 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 the 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 buildout 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 cost to serve customers. It's impossible to predict these impacts in advance and we are doing everything possible to minimize the impact.

Next, while it was difficult to manage the timing of the initiatives with the rapid changes we've experienced in material costs and a 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 buildings continue to support a positive outlook in the North American contract business.

On the 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 UK still faces uncertainty tied to Brexit, but 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 US 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've moved 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 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 Vice President and Chief Financial Officer

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 are 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 and 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 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 timeframe. 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 with approximately $1.5 million. 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 topline, we continue to experience a tailwind from the weakening of the US 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 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 plan for EO 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 initiative, while a portion of these savings are aimed to offset potential inflation and fund growth investment, 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 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 US tax rate, our effective rate this quarter reflects one-time 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 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 US 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.

Finally, net earnings in the third quarter total $30 million or $0.49 per share on a diluted basis. Excluding the impact of special charts and one-time tax adjustments, adjusted diluted earnings per share this quarter totaled $0.50, an increase of 28% compared to adjusted earnings of 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 -- Vice President, Investor Relations and Treasurer

Thanks, Jeff. Good evening, everyone. We ended the quarter with total cash in equivalence of $193 million, which reflected an increase of $79 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 a 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 trench of that. 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 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.

Jeff Stutz -- Executive Vice President and Chief Financial Officer

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 on 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 of 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 pre-tax 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 US tax legislation.

With that, I'll turn the call back over to Brian before we take your questions.

Brian Walker -- Chief Executive Officer 

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 is 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, let's turn the call over to the operator for your questions.

Questions and Answers:

Operator

Thank you. Ladies and gentlemen, if you have a question at this time, please press * followed by the 1-key on your touchstone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the # key. Once again, if you have a question, press * and 1. Our first question comes from the line of Matt McCall from Seaport Global. Sir, your line is now open.

Matt McCall -- Seaport Global Securities -- Analyst

Thanks. Good afternoon, guys.

Jeff Stutz -- Executive Vice President and Chief Financial Officer

Hey, Matt.

Brian Walker -- Chief Executive Officer 

Hi, Matt.

Matt McCall -- Seaport Global Securities -- Analyst

So, maybe start with the gross margin a little bit. It looks like the Q4 guides got about 150 basis points of pressure on a year over year basis at the midpoint, I guess even with the expectations of faster growth in consumer that has higher gross margins. 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.

Jeff Stutz -- Executive Vice President and Chief Financial Officer

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, but I'll give you some color commentary. I will 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 mainly.

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 magnitude year on year. And then commodities -- I think you'll see an acceleration on 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 things that I think are worth highlighting. I already talked about one of them -- production leverage from higher volumes. We do tend to see that if you look back over history. You tend to see on the order of 100-baiss 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 in 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 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. Those are, I think, the major pieces that I'd call out for you.

Matt McCall -- Seaport Global Securities -- Analyst

Okay. 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, 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 Vice President and Chief Financial Officer

Matt, I've got one that comes to mind that I probably 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. 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. Certainly, as we move into next year and 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 -- Chief Executive Officer 

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 that the work the team is doing that are going to be positive.

As Jeff mentioned, in addition to the mixed 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, we believe we'll continue to see better margins in the consumer business, gross margins, as well as operating margins.

I think the key right now to getting these trends reversed, 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 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'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, 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'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. 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 project by project, negotiation by negotiation piece, which will have to be better at. We are going to set our sites to at least making sure we don't let further deterioration happen.

Jeff Stutz -- Executive Vice President and Chief Financial Officer

And Matt -- this is Jeff again -- 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 at or near that 10% level by FY20. We are not walking away from that as a goal. We've typically described our, if you will, leveraged capability or contribution margin over the long run as a ratio of operating income growth to sales growth. 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 a tougher climb and I will 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. Steel prices have really spiked up in recent weeks. It's anyone's guess right now 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 -- Chief Executive Officer 

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 toward are 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 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 the capture rate we needed to get to that 10%?" That is the objective we have there. We'll know more when we get to the fourth quarter. We'll know more what we're 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 four 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? That's going to be a question mark as we get -- right now, we think, as 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, but we think we'll get some in the first quarter. 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 of the third quarter, there's a chance we could get a quarter of that work into next year. 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've got to start moving. 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 to see this as a pattern and early in the quarter, made the decision we were 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.

Matt McCall -- Seaport Global Securities -- Analyst

Okay. That was great. I was actually going to ask the question about the consultant moving over and looking at the North American office business, but you kind of answered it there. I just wanted to get some clarification. It sounds like this is more gross margin-focused and SG&A-focused.

When you broke out the new segment profitability, one thing that jumped out at us was how profitable that business was. So, is the idea to focus on your most profitable business? Is it kind of a result of some of the inflationary pressures 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 into next year. Maybe the answer is just comment around two times the rate of sales growth in '18 will get me to my answer, but just trying to put all these things together.

Brian Walker -- Chief Executive Officer 

Yeah, Matt. Let me try to string those together. 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, 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. What we don't want to do is be behind on making sire 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 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, is 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 at things you think we should be paying attention to."

This is not, I would say, a cost cutting exercise, though. It is an optimization exercise. 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 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 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 as it's akin to an HMPS exercise that we're not going in assuming we've got an answer. We're going and 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 product. 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 until, like I say, 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 got, in some ways, more opportunities to improve. So, that's a good business. It hasn't had great growth rates, as you know, and so we said, "We're not going to grow that one by having growth rates like we want to have overall. Growth rates will come from new areas." 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 felt cost-pressures greater in that business from these inflationary things than others. So, I think you can dovetail the two. I would tell you, if we hadn't seen a move in steel, we'd still be doing this work, though. 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 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, "Are there other areas we should look at?" 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 at that 25 to 35, we've got to go do more work than what we're going to do.

Matt McCall -- Seaport Global Securities -- Analyst

Alright. Thank you, Brian. Great detail.

Operator

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

Steven Ramsey -- Thompson Research Group -- Analyst

Good morning or good afternoon, I should say. 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 the consumer segment showed expansion this quarter?

Brian Walker -- Chief Executive Officer 

No. 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 impacts the contract business. Certainly, you'll see as we continue to see overall inflation, you're going to see that across the economy, although I don't think it's run away yet. I think this tariff stuff is moving it.

Certainly, the US dollar movement makes some parts of the business have cost increases, especially stuff you're bringing from Europe. On the other hand, it also provides a benefit, 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 on those commodities.

Jeff Stutz -- Executive Vice President and Chief Financial Officer

Yeah, Steven. This is Jeff. I would point out in our international business and 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 US. Now, I can't predict exactly where that's going to go here in the next few quarters, but particularly in China, as an example, they're not seeing the level of increases that we are in the US. So, so far, it's been tilted more toward North America.

Steven Ramsey -- Thompson Research Group -- Analyst

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

Brian Walker -- Chief Executive Officer 

Steven, yeah. I think the pattern typically is 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 could do one and we could 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 midsize projects, you are competitively bidding. So, I think those are places where you can also manage around the edges by being better at your pricing, not only looking at discounting but looking at 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 there. 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 -- Thompson Research Group -- Analyst

Alright. 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 that competitors view the lower tax rate, giving them room to lower prices to be competitive in the contract business.

Brian Walker -- Chief Executive Officer 

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. 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, that at least we're in a period of growth and you're 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 your goal has to be move as much of your mix to the areas that are growing rapidly and get much smarter in more efficient in the areas that aren't so that you can play as effectively there as possible. Then, again, hope that we don't see any slowdown in the global economy or particularly in the US.

Steven Ramsey -- Thompson Research Group -- Analyst

Great. Thank you.

Operator

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

Brian Walker -- Chief Executive Officer 

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

Operator

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

Duration: 50 minutes

Call participants:

Brian Walker -- Chief Executive Officer 

Jeff Stutz -- Executive Vice President and Chief Financial Officer

Kevin Veltman -- Vice President, Investor Relations and Treasurer

Matt McCall -- Seaport Global Securities -- Analyst

Steven Ramsey -- Thompson Research Group -- Analyst

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