Herman Miller (NASDAQ:MLHR) Q4 2016 Earnings Conference Call June 23, 2016 9:30 AM ET
Brian Walker - President, Chief Executive Officer
Jeffrey Stutz - Executive Vice President, Chief Financial Officer
Greg Bylsma - Chief Operating Officer
Kevin Veltman - Vice President, Investor Relations
Matt McCall - BB&T Capital
Budd Bugatch - Raymond James
Steven Ramsey - Thompson Research Group
Good morning everyone and welcome to the Herman Miller Incorporated Fourth Quarter Fiscal Year 2016 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 report on Forms 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. Greg Bylsma, Executive Vice President and Chief Operating Officer; 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 call to 60 minutes and ask that callers limit their questions to allow time for all participants.
At this time I’d like to begin the presentation by turning the call over to Mr. Walker. Please go ahead.
Good morning everyone. Thank you for joining us. I’ll begin the call today by sharing my thoughts on our performance, highlighting areas of accomplishment, and summarize some of the areas where we still have work to do. Last, I’ll provide some color on industry dynamics as we enter fiscal 2017, then I’ll turn it over to Jeff and Kevin to cover fourth quarter financials in more detail. As the Operator noted, we also have Greg Bylsma, our Chief Operating Officer of our North American contract business joining us for the Q&A portion of the call to offer his perspective on current conditions and opportunities we see for further growth in that segment.
As we announced yesterday, our results for this quarter cap a fiscal year in which we delivered all-time record net sales of $2,260,000,000, representing an increase of approximately 6%. This is despite currency pressures and along with a 19% full-year increase in adjusted earnings per share. We had a high quality of earnings and generated very strong operating cash flow.
We finished the year on a strong note with revenue this quarter of $583 million, coming in above the high end of our expectations for the quarter. Adjusted earnings of $0.56 per share also exceeded our guidance and reflected a 19% improvement over the same quarter of last year. In all, we achieved a return on invested capital of 22% on the full year and generated more than $210 million in cash flow from operations, allowing us to fund strategic investments and reduce outstanding debt levels. Yesterday, we announced a 15% increase in our quarterly dividend payout, a decision that reflects the confidence of our board and management team and the power of our strategy and the strength of our financial position. Importantly, it reflects confidence in our ability to reach even higher, greater heights in the year ahead.
Our performance this year was led by a significant turnaround in our North American segment. Growth in this segment was broad based with notable strength in commercial offices and healthcare. In particular, we had one of our best years in healthcare in recent memory. Our specialty businesses - Geiger, Herman Miller Collection, Maharam - continued to grow nicely and posted improved profitability. In total, our North American commercial interiors business has outpaced the overall industry.
Our Europe, Latin America and Asia team did a great job of overcoming significant economic and currency headwinds to post increased profitability. The relative strength of this business was in Asia where our Posh acquisition has rebounded to be a solid contributor.
Our consumer segment fell short of our goals for the year in terms of both sales and profitability. To be frank, we took a number of actions that we believe are critical to our long-term health in this segment that didn’t play out as expected in the short run, and we’re behind in our conversion to the new studio model. We finished the year with fewer studios and about the same amount of square footage compared to where we were at this time last year. The team has worked very hard to get these issues back on track and we expect improved performance in this segment in 2017.
We believe Herman Miller has a strong foundation to create shareholder value that is built on our high ambition culture, our ecosystem of leading brands, our capacity for innovation, a growth strategy that is catalyzed by an industry-leading multi-channel distribution system, and a proven track record of operational excellence and financial management and stewardship. Over the past five years, we’ve consistently and diligently pursued a strategy to increase the size of our addressable market to position us for faster growth and higher margins. To achieve these objectives, we’ve used a combination of internal development and targeted acquisitions.
This past year, we had a number of accomplishments that furthered implementation of our long-term strategy, solidified our foundation for growth, and improved our operating results, those accomplishments including: we created and delivered a series of bootcamps designed to equip our dealers and our field sales folks with the product knowledge and tools they need to best position our products to win. While we had a number of bootcamp events this past year, this is a long-term capability that is needed to keep our teams up to speed with our fast-evolving offer and the knowledge we’re creating through research.
We refined our sales deployment model to ensure we are best aligned to serve dealers and increase our share of their business and increase our share of the government, healthcare, education customer spend on furnishings. In response, we developed and launched the new channel sales manager role and team. These folks have the responsibility of representing all of our brands for the dealers. We are pleased by the early progress of this team and think it holds great promise.
We also reorganized our sales efforts around healthcare, government, and education. These changes led to better coverage of opportunities and better alignment of skill sets. This enabled us to put additional resources on the largest healthcare and government organizations. This has and will pay great dividends as we offer all of Herman Miller’s expanded capabilities to these large and complex organizations.
We implemented new product commercialization process and structure that ensure we will continue to be the innovation leader in our space. While we still have much work to do, we have clear signs that these changes are making a difference. This year at NeoCon, we launched in excess of 20 new products. This included new products from our R&D studios at Herman Miller, Geiger, the Herman Miller Collection, Nemschoff, Herman Miller UK, and Maharam. The focus of our work over the past year has been to expand the breadth of our offering in new categories where we are currently underpenetrated. The breadth and quality of the work was impressive and we were recognized with a number of awards, and we have a very robust pipeline of new ideas that will continue to propel us forward over the next fiscal year and for years to come.
In addition to internal development, we recently announced a strategic partnership with United Kingdom-based naughtone. This partnership will augment our internal development of furnishings for those work points on the floor play that are beyond our historical focus on individual work stations, and naughtone will add to our operational capabilities needed to serve the EMEA region.
We made a number of steps which will enhance our ability for us to deliver on the promise of the living office. At NeoCon, we began to roll out a number of case studies which provide evidence of how the application of the living office can improve our customers’ businesses and the lives of their people. We also began the introduction of a number of new products and partnerships that will enable us to deliver our three-part strategy for the connected and quantified office: smart furnishings, smart settings, and smart places. These capabilities combined with our growing breadth of solutions beyond the work station significantly enhanced our ability to deliver on the promise of the living office introduced four years ago.
Enriching the ways customers experience Herman Miller and our ecosystem of the brand is a long-term objective. Starting in the fourth quarter of last year, we reset all of our global showrooms to better serve our customers and dealers. This past year, we opened new showrooms in Washington DC and New York. The New York showroom is our first flagship location that unites our Herman Miller Geiger collection and Maharam brands. This location will serve as the home for our talented folks in this region and create a unique experience for both our contract and consumer customers. We fell short of our goal this year of opening six new DWR studios; however, we did open or expand DWR studios in Arizona and California, and we enter 2017 with a strong pipeline of nine new studios that are under contract and in our plans.
Last, we invested in new capabilities to enhance our ability to serve our dealers, corporate customers and consumers. Our Made to Measure program significantly improved our ability to respond to our customers’ needs for customized solutions. We implemented new information technology systems at Design Within Reach and Nemschoff at a number of international locations. These systems will enhance the operation of the business and make us easier to do business with.
At the close of the fourth quarter, we launched a new and improved ecommerce store for Design Within Reach. In this coming year, we’ll upgrade the Herman Miller ecommerce store with the same technology. This year, we also completed the opening of our new manufacturing and logistics facilities in the United Kingdom and India. In North America, we invested in new manufacturing process equipment that improves our quality and cost.
To be frank, we experienced some growing pains in our consumer segment this year, and there is more work to do. That said, we continue to believe the strategic drivers that led us to invest in this segment are intact. As a reminder, those remain the convergence of work and home environments, the power of having a multi-channel capability for increasing the size of our addressable market, and last the permission the Herman Miller brand has to play in this segment of the furnishing space.
The recent NeoCon event further confirmed the convergence we predicted with the launch of The Living Office is Happening. More specifically, we remain confident that Design Within Reach was a great fit with Herman Miller as it contained the capabilities needed for us to make this strategic move, a brand that’s congruent with Herman Miller, and they have a talented leadership team.
While we’re disappointed with the results of the quarter and year, I’m pleased to report that we made significant progress on a number of fronts this year and we’re well positioned for future growth and improved profitability. As a part of our real estate transformation, we closed a number of smaller legacy retail studios during the year and developed an exciting pipeline of new and expanded studios for the next year. We’re beginning to see the impact of our investments in brand awareness and channel initiatives, and we expect to realize further benefits over the next couple of quarters. These efforts included a mobile optimized web platform rolling out a new sourcebook to highlight the breadth of the offer from our trade partners. We also implemented a new ERP system during the section quarter of the year that brings significantly improved capabilities. In the fourth quarter, we reached an agreement with Amazon.com that expands our wholesale market coverage. Finally, our growing contract business continues to be a bright spot as we expand volumes to the Herman Miller dealer network, a great example of the potential that exists with our multi-channel strategy.
The negative operating results this quarter in the segment were driven by increased investments in marketing, an unfavorable mix of trade and contract business, and year-end accounting adjustments and pre-opening studio costs. Looking to next year, we’re confident we have the right foundation in place for executing on our consumer growth strategy. Our plan for fiscal 2017 includes ramping up our DWR studio footprint by approximately 100,000 square feet by the end of next year and launching several exclusive product designs. We’ve recently implemented changes to our catalog program which we believe will significantly improve the efficiency of new customer prospects, and later this fall we have exciting plans for the launch of a new retail store to anchor our New York flagship showroom, the first Herman Miller-branded retail store in North America.
Let me close with a few comments about the macro environment. While pressure in the energy sector and political uncertainty persist as headwinds, the core industry metrics for the North American contract business remain generally supportive. In particular, service sector employment, non-residential construction activity, and the Architecture Billings Index have all been positive and form a [indecipherable] forecast for low to mid-single digit annual growth through 2017. There is a good deal of construction activity in the healthcare space which augurs well for this sector.
On the consumer front in North America, a recent dip in consumer confidence has been offset by strong housing activity, low interest rates, and rising household income. As you might expect, regions impacted by the energy sector have been challenging.
Outside of North America, the economic picture remains mixed. While the impact of strong dollar headwinds has lessened, uncertainty in Europe in various oil-producing regions persists. That said, our confidence in the long-term growth potential of our business in key global regions has not wavered.
On the commodity front, we’re starting to see some increases in input costs, such as steel, so in addition to our ongoing lean manufacturing emphasis on identifying operational improvements, we’re moving ahead with plans for a price increase later in fiscal 2017.
On balance, while there are challenges and risks to the global economy, we believe the current cycle of growth should continue through fiscal 2017, and we believe the accomplishments from 2016 and the plans we have for 2017 should enable us to stay on pace for the long-term objectives.
With that, I’ll turn the call over to Jeff, who will provide more detail on the financials.
All right, thank you, Brian, and good morning everyone. Consolidated net sales in the fourth quarter of $583 million were 6% higher than the same quarter last year. Orders in the period of $606 million were 9% above the prior year level. These amounts reflect a strong finish to the year as they represent our highest quarterly sales and order levels in the past 15 years.
As I mentioned last quarter as well with respect to our year-over-year order comparisons, one important point to consider is the relative impact of general price increases that went into effect during the third quarter of last fiscal year. Our best estimate is that this had the effect of shifting upwards to $20 million of orders into the third quarter that would have otherwise been entered in the fourth quarter of last year. By contrast, we made no significant price changes in the third quarter this year, and accordingly saw no comparable shift in the timing of order entry. Net, this had the impact of limiting our reported order levels in the fourth quarter of last year. To be clear, given the level of estimation required to quantify this, we have not adjusted for it in our calculation of organic order growth for the period. Still, we do believe it’s a factor worth considering as you evaluate our numbers.
Sequentially, net sales in the fourth quarter increased approximately 9% from the third quarter level, while orders increased 19%. These sequential improvements are slightly above the average seasonal trends we’ve seen in the business over the past five fiscal years. Within our North America segment, sales were $333 million in the fourth quarter, representing an increase of 8% from the same quarter last year. New orders in this segment totaled $359 million in the fourth quarter, reflecting an increase of nearly 12% from last year. Project sizes above $1 million were particularly robust during the quarter, and order growth by industry sector was fairly broad-based led by healthcare, business services, and state and local governments. The energy sector continues to be a notable exception as that industry grapples with a difficult economic climate.
Our ELA segment reported sales of $111 million in the fourth quarter, reflecting an increase of 7% compared to last year. New orders totaled $102 million, an amount 9% higher than the same quarter a year ago. This year-over-year order growth was led by strong demand in continental Europe, South Africa and China. These areas of relative strength were partially offset by softer demand in the U.K. and in Latin America, both of which are regions facing acute political and economic uncertainty.
Sales in the fourth quarter within our specialty segment were $62 million, an increase of almost 4% from the same quarter last year. New orders in the quarter of $62 million were 7% higher than the year-ago period. Consistent with what we’ve seen throughout the fiscal year, our growth within this segment was led by strong momentum at both Geiger and the Herman Miller Collection.
The consumer business reported sales in the quarter of $78 million, a decrease of 2% compared to a year ago. On a comparable brand basis, revenues for the quarter were up approximately 1%. I would note that we have revised the comparable sales measure that is provided in our supplemental materials this quarter, moving from a comparable studio measure to a comparable brand sales metric. We believe this better reflects sales results across the multiple channels that DWR serves.
New orders for the consumer segment in the quarter were $84 million, slightly ahead of the same quarter last year. Relative to the fourth quarter, operating results were unfavorably impacted by a number of year-end closing adjustments primarily around inventory and accounts receivable. In addition, we ramped up our marketing spend in the quarter in the areas of catalog and digital, and we were encouraged to see order demand accelerate in the consumer segment in the month of May.
Our consolidated gross margin in the fourth quarter was 38.7%, a 60 basis point improvement over a gross margin of 38.1% in the fourth quarter last year. The year-over-year improvement was fueled by favorable commodity costs, production leverage, and ongoing operational improvements. We had a relatively high mix of large projects this quarter both in the U.S. and abroad, and consequently our gross margins reflected the impact of deeper average discounting versus where we ran last quarter. Additionally, with the recent uptick in steel and oil prices, we began to feel moderation in the comparative year-on-year favorability in commodity costs. These factors aside, the relative strength of our gross margin performance remained a highlight in our consolidated results for the quarter and for the full fiscal year.
I’ll now cover operating expenses and earnings for the period. In total, operating expenses in the fourth quarter were $169 million compared to $162 million in the same quarter a year ago. Our current quarter expenses reflect the impact of pre-tax gains totaling approximately $6 million associated with the sale of a former manufacturing facility in the U.K. as well as the divestiture of Living Edge Furniture, our dealership in Australia. Excluding these gains, operating expenses in the fourth quarter were approximately $13 million higher than the same quarter last fiscal year. The majority of this increase relates to spending on new product launch and marketing initiatives, higher incentive accruals, product warranty expenses, and general variability on higher revenue.
Operating income in the quarter was $57 million or 9.7% of sales compared to $37 million or 6.7% of sales in the prior year period. Excluding the impact of the gains that I just described, adjusted operating income was $51 million or 8.7% of sales, and by comparison we reported adjusted operating income of $48 million or 8.7% of sales in the fourth quarter last year.
The GAAP basis effective tax rate for the fourth quarter was 24.9%. The rate for the quarter was lower than previously forecast due principally to the impact of a favorable transfer pricing adjustment totaling $2 million recorded in the quarter. As this transfer pricing benefit reflected the full-year benefit for FY16, approximately $1.5 million or $0.02 per share of the benefit was not attributable to the fourth quarter. This compares to an effective tax rate of 29.5% reported in the same quarter last year. Excluding the impact of the transfer pricing adjustment, the effective tax rate within the fourth quarter was within the range we provided at the beginning of the quarter.
Finally, net earnings in the fourth quarter totaled $41 million or $0.67 per share on a diluted basis. Excluding the partial year of tax transfer pricing benefit and gains associated with the dealership and U.K. property sales, adjusted diluted earnings per share in the quarter totaled $0.56. This compares to adjusted earnings of $0.47 per share in the fourth quarter of last year and reflects a 19% year-over-year increase in earnings per share.
With that, I’ll turn the call over to Kevin to give us an update on cash flow and our balance sheet.
Thanks Jeff. We ended the quarter with total cash and cash equivalents of $85 million, which reflected an increase of $30 million from last quarter. Cash flows from operations in the period were $85 million, representing an increase of 46% from the fourth quarter of last year. The primary contributors to the increase in operating cash flows for the quarter were higher net income as well as working capital inflows from higher accounts payable and lower inventory levels, offset by higher accounts receivable. For the full fiscal year, cash flows from operations were $210 million, reflecting an increase of 25% over the prior year.
Capital expenditures were $30 million in the quarter, bringing the year-to-date total to $85 million. Looking ahead to next fiscal year, we anticipate capital expenditures of $80 million to $90 million for the full fiscal year. Cash dividends paid in the quarter were $9 million and $35 million for the full year. The dividend increase we announced yesterday increases our expected annual payout level to approximately $41 million. The new quarterly payout level also brings the dividend in line with our yield target and is in keeping with our commitment to balance our capital structure priorities, including funding internal growth investments, reducing outstanding debt levels, and enhancing cash returns to our shareholders.
We also continued a share repurchase program during the quarter at a level aimed at offsetting dilution from share-based compensation programs. In total, we made repurchases of $6 million during the quarter and $14 million for the full year.
We remain in compliance with all debt covenants and as at quarter end, our gross debt to EBITDA ratio was approximately 0.8 to 1. The available capacity on our bank credit facility stands at $219 million. Given our current cash balance, ongoing cash flows from operations and 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 first quarter of fiscal 2017.
Okay, let me begin with two important factors that you should consider in developing your models for our first quarter. First, you should bear in mind that our 2017 fiscal year will include 53 weeks of operations. The addition of this extra week is required approximately every five years to realign our fiscal periods with the calendar months. As a result, our first quarter will include 14 weeks of operations, though the relative timing of scheduled summer holidays will reduce the impact of this extra week to four incremental shipping days relative to the first quarter of last year.
The second factor relates to the relative impact of the Australian dealership divestiture which occurred at the end of the fourth quarter as the culmination of a long-term plan to transition ownership to the local management team. This will of course impact our year-over-year revenue and order comparisons in the first quarter. Net of intercompany eliminations, that dealership contributed approximately $9 million of revenue in the first quarter of last fiscal year. Considering these factors, we anticipate sales in the first quarter to range between $600 million and $620 million. On an organic basis, adjusted for the extra week and dealership divestiture, this forecast implies revenue growth of approximately 3% at the midpoint of the range.
Consolidated gross margin in the first quarter is expected to range between 38% and 39%, and this forecast incorporates the expected impact from a recent uptick in market prices for key commodity inputs. The extra week of operations in Q1 will add incremental expenses of $9 million to $10 million partially offset by the elimination of operating expenses from the dealer sale. In total, operating expenses in the first quarter are expected to range between $174 million and $177 million.
We anticipate earnings per share to between $0.60 and $0.64 in the period, and this assumes an effective tax rate of between 32% and 33%.
With that overview, I’ll turn the call back over to the operator and we’ll take your questions.
Our first question will come from Matt McCall from BB&T Capital. Your line is open.
Thank you. Good morning everybody. So maybe Brian, start with--you made some cyclical comments there. I wonder if you could give more detail. I think that Jeff talked about project strength in Q4, but maybe Brian talk about your outlook for projects, what kind of visibility you have, and what kind of comfort you have with BIFMA. I know you referenced it, but I just want to get more detail there.
You know, Matt, overall if you look at -- you’ve almost got to take this by segment. If you take the North American contract segment, activity levels were really good with customers in the fourth quarter, in fact a good size increase over last year in terms of visits, not that that necessarily is a perfect correlation, but I would say that gives you some indication of activity levels. Certainly NeoCon - I think you were there - NeoCon activity was pretty darn good. From what we can see in terms of project activity in the fourth quarter, large projects were at a fairly good level of big projects that we saw coming through in order entry in the fourth quarter. So from all I can see right now, activity levels look generally good. I would say healthcare continues to be very hot, at least compared to where it’s been the last few years. It’s not obviously gotten back to its peak, but that area in particular has been good.
You know, there is certainly in the North American contract market, there are some headwinds. I know some folks have talked about what’s going on in areas that are petroleum-based. We’ve certainly seen that not only domestically but globally. That part of the country, at least in our data is--you know, it’s virtually almost gone away at one level when you look at activity levels compared to where we were a year ago or two years ago. It’s a pretty big drag on the overall numbers for us, and I’m sure it’s a pretty good sized drag on the overall industry, both in North America--both in the U.S. and in Canada in fact.
If you shift gears internationally, Asia has been pretty darn strong for us overall, and I would say fairly broad-based with the one exception really being Japan has not been that great, but that’s not surprising given the longer term economic malaise that they’ve been in. It’s not a bad business for us, it just has not been a big grower whereas the remainder of Asia has actually been pretty good, including China despite all of the news around China. We’ve actually felt pretty good about China, at least over the last year or so.
Europe is, I would say for us--you know, if we look at it by region, EMEA as a region for us that has been pretty good, but I would say is kind of moving all over the place. So the U.K. is difficult for sure. It seems like a lot of people have pulled back with some anticipation of what might happen with Brexit. Middle East is, I would say, moderate. I think people are trying to read which way oil goes, and I think if we see some continued improvement in oil, that area should get better. But we’ve been able to move around in that region to offset the negative with some positive. The overall tone of the EMEA, if you backed up and looked at it from 100,000 feet, Matt, I would say it is sort of flat to down, is the way I would describe it.
The most difficult region of the world for us has been Latin America, particularly everything in South America. Mexico has not been too bad - activity levels there are reasonable, but I think when you get down to places like Brazil and others, it’s pretty darn quiet. So I’d say mixed bag globally. U.S. still feels like it’s leading the pack in terms of economic activity for us, followed by probably Asia.
On the consumer front, as you know, I think that’s also been a little mixed overall in terms of trying to read the signals. Certainly, the one over-arching trend in the consumer furnishings market and our belief is that the promotional activity is still a big driver of that business and an area that we’ve got to do work on.
And maybe that actually leads to my next question, DWR profitability a little bit weaker than we expected, 3% for the year was the EBIT. As we look out in the next year, can you talk about the outlook for profitability, how much is dependent upon the top line, how much is dependent upon some of the issues getting behind you, and what kind of visibility do you have into DWR next year?
Yes, and by the way, let me just make sure that we’re--you know, while at one level it’s DWR, so you’ve got to look at the consumer business as a full segment rather than just--in just that, because it’s meaning between the two.
But let me say from a broad view, certainly the profitability we saw in the fourth quarter was not only disappointing, it’s just unacceptable - we can’t be there for long. It will take a bit of a ramp, I think Matt, before we get back to the levels that we would--you know, where we would expect and get back to the kind of plans that we had from the beginning. It certainly has a heavy dependence on -- we have to get some revenue growth, particularly on the consumer, direct to consumer part of that business. What I feel good about in terms of getting back to growth is we know we have a number of store openings and we have a lot of those that are under contract, so it’s not like a year ago - we’re hoping to get the contract, we’re hoping to get planning approval. This year, we got really hung up in a lot of those areas. We have a number of the studios we’ll open. Of the nine that I mentioned, a good number will open in the second quarter - I think it’s seven, six of the nine? Six of the nine will open in Q2. The timing of that, beginning or end, is a little bit harder to predict, but I would say by the time we roll out of Q2, we should have those in line, so that feels good. We know where we’re going there, but I think we at least have that element is well within our control. That certainly is a big help.
I would also say that we had a number of flesh wounds this year, if you will, not only from the ERP system, from the quarter-end adjustments which--or year-end adjustments to inventory that should not hit us again. They weren’t really operating things; they were much more things that got caught up in accounting systems and that kind of stuff as we got to our new ERP system. So I think we’ll have a lot of those things.
You know, my gut is we ought to be able to see--if we were at 3% this year, I’d like to come out of next year at least double that kind of number, up in the 6% range. I don’t think you’ll see that in the first quarter, though. I think it’ll take a bit of a ramp as those new studios come on.
One of the other keys, Matt, is going to be increased productivity prospecting with catalog. That’s a big deal, and we think the trend line, Matt, while you can’t really see it in the revenue numbers yet, the returns we’re starting to see are getting better and we’re not fully implemented. We’ll implement over the next two months the final few steps, so I think we’ve got the right things in place and we’ll know as we get through the business next quarter.
Okay, let’s see. Let me ask some more questions here. So the SG&A was also higher than we thought. I believe it was you, Jeff, or maybe it was you, Brian, that went through some of the realignment, sales force realignment, [indecipherable] realignment. I know that some of that’s been ongoing, but can you talk about what really drove the delta? I think it was even outside of your guided range. And then as you look out into the next year, I know you’ve got some spending. How should we think about the SG&A outlook in general?
So Matt, let me take the first part of your question here. For the quarter, yes, we were a bit higher. When you adjust for the gains, obviously, that I called out, we came in a bit above the guide, a bit above our own internal expectations for operating expenses. Really, two primary drivers - obviously we beat on the top line, so we had some variability that just is natural with that higher revenue versus the midpoint of the guide that we gave at the start of the quarter, so that’s one factor.
The other probably bigger factor is warranty costs, and I want to be clear on this one - this is a calculated warranty cost related to our lag schedule process that we do, that we have as any company that has a long-term warranty program. We factor in, you know, recent quarter data into your lag calculations, and out of that came an identified need to increase some warranty accruals in the business, so that was the other major driver in the quarter.
Hey Jeff, it’s important, Matt, to know that this is a little bit of the impact of the change we made midyear this year on how we--how the accounts were requiring us to account for warranty between goodwill and hardcore warranty costs. We traditionally booked goodwill as a period cost, and we didn’t accrue it with the belief that it was related to future sales [indecipherable] warranty. If you remember, midyear they required us to move to goodwill the part of our general warranty. What happens is now even that goodwill decision, so if it’s a customer that we want to do something for maybe that’s even outside of warranty, because we think it’s the right thing to do to retain them and treat them like we want to, that falls into this lag schedule now that Jeff was talking about. So you not only book what you’ve spent today, but then you have to--it essentially changes the prediction of how much you’re going to do into the future. So that’s a little bit of a new factor we’re going to have to watch over time, and it could go either way. I don’t think it’s a big move, but it’s one that we’ll have to pay attention to.
In the long run--by the way, the cash doesn’t change. This is much more of a balance sheet kind of true-up issue.
So Matt, to the second part of your question, going forward in our Q1 guide, I don’t know if you recall earlier in the fiscal year, this question came up on operating expense run rate when we were giving, I think, our outlook for the third quarter. We had talked about expecting to see operating expenses to gear back around in line with that 29% of revenue run rate, and that’s about the expectation moving forward. I think that’s reflected in the guidance for Q1.
Okay, all right. Apologies to [indecipherable] but I’ve got to get one in for Greg, since he’s there. How are you, Greg?
Good Matt, thanks.
So can you talk about the North American manufacturing footprint a little bit? I know there was some initial opportunities when you moved into your new role, but can you just update us there? Is there anything that can offer some margin visibility in the bigger part of your business over the next 12 to 18 months?
Sure, Matt. So I think if you step back, and our strategy over the last kind of two or three years has been to say, what are our core competencies, and to really drive those competencies. So we have taken about--taken a look at the things that have been done on the outside, and maybe we had a core competency in driving those internally as we have product mix shifts away from maybe old legacy products to newer products. So I think if we were sitting here today and steel was still sitting at $580 a ton, we’d be talking about maybe margin improvements going forward. Right now, we’re working hard to accelerate some of the in-sourcing stuff we’re working on to try to offset some of the big increases in steel.
So as I look forward, our prediction is that the current increase in steel is not a demand-driven increase. It’s more of steel folks trying to get higher prices because they didn’t make very much money at $580 a ton. So I think they’re working hard to get that price up. I don’t personally think it’s going to sustain at this level. Hard to predict how far, if it falls or it goes up - it’s always hard to predict, but we’re working hard on the footprint to try to offset some of the costs that are coming. But I think the margin percentage that you see out of North America reflects the work we’ve done over the last couple years, so I think there’s more to be done. We think we have more opportunity, but it’s not something I can promise you next quarter.
Matt, the other thing Greg’s been doing that I think has been helpful on this front is we’ve been looking at the total footprint, not only within what we would think of as Herman Miller but also Nemschoff and Geiger, and making sort of choices around centers of excellence that we could use so that we can--as we continue to expand the breadth of the product line, how do we use some of those other plants and align them, which as an example Geiger is producing a number of products now that actually are the North American contract segment, where they have an expertise in North Carolina in upholstery and we produce it in that plant, even though from a segment reporting standpoint that shows up really on Greg’s side. We’ve been looking at that more and more to make sure we get the right balance and therefore in the total company are we getting the best cost and utilization of assets. I think there are some--as we look forward, there are some additional opportunities there, as well as the other thing Greg has begun to really start to think about is how are the leaps that are going forward in things like robotics, how are they going to play longer term. That’s not a tomorrow thing or next four quarters, but how do we begin to look at that, especially--like, anybody who is in manufacturing in the midwest is struggling with getting labor, and while labor costs per hour are going up crazy, there is a difficulty just finding people today.
Okay, perfect. Thank you all.
Thank you. Our next question will come from the line of Budd Bugatch from Raymond James. Your line is open.
Good morning Brian, good morning Jeff, good morning Kevin, and good morning Greg. I guess a couple of questions from me. First for Herman Miller and just composition of sales, over the last year it’s changed. It changed in your--I think one of your most profitable areas, seating, last year it had a 300 basis point increase as a percentage of its composition of total revenues to, I think, 38%. Can you give us a little bit of color on the composition of revenues this year by product line?
Budd, I don’t actually have that data in front of us. We can come back to you on it. Let me say--let me say, I’ll give you my gut feeling. You guys chime in if you think I’m in the wrong place. I don’t think we’ve seen a major change this year, year-over-year. What you are continuing to see over time is as we continue to build out products for the broader floor play, there is no doubt that you are seeing increases in seating, and I would say that a lot of that is not just task seating now, where in the past we would have played very heavily in task seating and not as much in those other areas. In fact if you even went to--if you looked around NeoCon and saw the number of products we were launching of seating, related seating that were in the non-individual work station area, I think a lot of the increases we felt on the seating side are starting to come in those, what some people call ancillary areas, so it’s a little bit of both of those in my mind.
Yes, I mean, that’s kind of where I’m trying to go to, because I was trying to look at the wins you’ve had. You talked about the projects over a million dollars being particularly strong. I think that’s notable, and I’m just trying to understand the competencies, what’s getting you those wins in the marketplace.
Well, I think the--I think on one level, Budd, the ability to help customers--I do think The Living Office has had an impact. If you listen to dealers and you listen to folks in the E&D community, our ability to help and envision a whole space has been very, very helpful. I think historically we didn’t really have a sales force that was focused on winning in those additional areas outside of the work station, so having people focused on that has really helped.
I would say the one thing we’ve started to feel the benefits of, although I think it’s early days, is this channel sales manager role that we created, I think, in the long run is going to really help us not necessarily a big change against [indecipherable] competitors, but in places like at the dealer where, you know, we may be 60% of their sales, 70% of their sales, there are literally hundreds of companies in this industry that are going after those other areas. Our ability to have someone at the dealer every day who is helping them understand what’s in our total offer, I think is critical. In the past, we didn’t really have to think about that because if we just won systems and seating and filing, we were in the main of the project. But as the floor play has shifted, if we don’t have the ability to capture the areas around it, you’ve got a shrinking part of the pie that you’re planning. I think those things have helped us, and in the work business that certainly has helped.
I think it’s also helped in healthcare, and our healthcare team, I think has done a better job this year than ever of not just trying to win business at the hospital but at the entire organization that’s delivering healthcare, which as you know includes everything from an insurance company to a doc practice to outpatient clinics to the hospital. That certainly gets a different kind of mix, right, because you end up being--you know, our historical healthcare business had a lot of material handling carts, nurses’ stations, and certainly we won workstations. But actually if you looked at healthcare over time, our share on the admin side was lower than our overall share of office business, so that certainly is one of the areas that we think longer term has got some potential for us.
I hope that helps give you some color on it, at least.
Yeah, and it’s the channel sales that I also wanted to explore, because I thought for a long time that you’re a line dealer unit. As you correctly mentioned, you get where you are the competitive--nobody can sell into your competitive set and to your aligned office dealers, but there was a significant amount of that share of wallet that was selling through others, through the huge diversified composition of the industry. So maybe you can give us a feel of share of wallet of your aligned dealers - how has that moved year-over-year, and what’s the opportunity there? How much of that revenue, of that 40%--where was that 40% two years ago, and where it will be in three years?
Budd, this is Greg. Obviously it varies by dealer allotment. Normally that number probably has moved up a little bit. It was probably in the high 50s; I think this year it’s running at about 60. I think we’ve done a nice job, the development team has done a nice job to queue up things that maybe don’t hit the radar screen of NeoCon to fit in those areas. So Brian mentioned Made to Measure, which I think goes a long ways towards helping dealers meet the demand of the customer, that maybe they served in a different way in the past. So things in the laminate world, which is really--we had talked to you earlier, about a year ago about dealer blitzes, which was one of the big feedbacks from the dealer community, and the other bit would be our options group who’s doing specials all the time. It’s the way we approach pricing, I think has made a big difference.
So I think that that number has moved up primarily in the last 12 months related to those two areas, but I think with the allotment you saw at NeoCon, with the launch of Plex and some of the other seating that you saw, that is very specifically targeted at growing that number.
[Indecipherable] I think if you looked at it historically, a lot of people would say if you looked at a typical job, 70% to 80% was probably the individual workstation, and that number, depending on who you talk to, has certainly been driving down. So the hard work in some ways has been not only to grow but to make sure we’re not losing share of wallet with the dealers over time in areas that we used to say were competitive were really those big three areas. Now, the areas that we want to be competitive in are much, more broader sets, so in some ways it’s us. You know, this I think has been a core part of the strategy from the beginning, is asking how do we increase the addressable market, and for sure past the addressable market within the contract world.
If there has been a positive, and you and I talked about this a little bit in February during the conference, one of the positives on the DWR side is we just really haven’t been--we haven’t been able to get fast enough after the dealers’ request to be connected to DWR. We’ve certainly seen the contract side of DWR grow. There is more potential there for us to do--make that easier for them to connect with, and that’s one of the things we’ve got on our objective list for this next year, is there are areas that those guys could get after that are not in our core offer, like areas for dining where they have a much bigger variety. As you know, typically on a corporate campus, they’re not going to pick just one dining outfit and do it across. They’re going to be much more varied around that, so the ability to have variety there becomes a big deal.
Yeah, I was trying to understand what the opportunity is in 2017. That’s kind of a--exactly, and DWR was a disappointment this year, I believe, or at least ran into challenges. Maybe disappointment is too hard a word, but ran into challenges, and you said you’re going to open up six, as I get that, in the second quarter, six of the new studios?
That’s right, Budd, by end of Q2. That’s the plan.
So how are you organizationally going to handle that crossover between DWR and Greg’s area, and does it have any impact on ELA at all? I don’t suspect it does, but you’ll help frame that.
Well, so let me give you--I think you’re--this is almost in some ways a three-part strategy in my mind to make sure we can fill out those other areas in the contract world. The first is then what can we do with internal development at both Geiger, the Collection and core Herman Miller? You saw at NeoCon products from all of them there. That has been sort of job one, and we knew we could get our arms around the easiest ones that fit into all our current sales [indecipherable].
The second one is how do we make DWR available? Now, what a lot of people don’t know who don’t see the inner workings, we have a separate division within DWR that has 3D acquisition for contracts. It was relatively small for them - they really focused on trade and direct to consumer, but they had a small contract business which in many ways served a lot of times hospitality, or hospitality within a corporate setting, i.e. dining areas and the like.
What--the guy who runs that is a really experienced guy on the contract side. He doesn’t come really from the retail business; he was a contract guy on outdoor contract. His focus has been to develop the connection with the dealers. What we believe we’ll do over time is, first, we have to develop a sourcebook and some marketing materials to make it easy for the dealers to know when they can apply DWR product and what is an appropriate application. We think that will start with--starting with our settings logic from The Living Office, to say what are those settings that are typical for a planner to do, and then how do they know when to reach for Herman Miller, Geiger or the Collection, or DWR, which all will have appropriate times. That’s important.
The second thing that Greg has started to work on with John Edelman, John McPhee, and the gentleman that runs their contract business is could we make it easier around order entry. So one of the things we’re going to try to get done this year - I say try because it’s not simple to do - is to make it easy for a dealer to actually order the products that are more simple, if you will, and are probably the bulk of the opportunity, can we actually put those into the Herman Miller order entry system so when a dealer is processing their order to the Herman Miller, they can include some of those DWR proprietary products or products that they have the rights to for contract, and they only have to go to one place to go do it. That would just make it simpler, we can then get better control of the total logistics for them.
The third element of this is really the partnership with naughtone, which in the case of naughtone we are going to make that easy for the dealers as well, at least Herman Miller dealers, so that they can order directly--those products through Herman Miller as well. So we’re essentially going to create, if you will, sort of a marketplace between Herman Miller, naughtone, DWR, and even in fact we’ll have--at the end of this year, we’ll have Geiger on the same order entry system, which will make all of that stuff get to be more streamlined from the dealers’ perspective, if that makes sense.
Okay. I’ve taken much longer than I planned to. Thank you. We’ll talk about some of this offline as well. Thanks.
Thank you. Our final question will come from the line of Kathryn Thompson from Thompson Research Group. Your line is open.
Good morning, guys. This is Steven on for Kathryn. I was wondering if you could--sticking with DWR, a couple questions here. Can you talk a little bit more about your--or give a little more color on your partnership with Amazon and how--kind of the logic behind it?
Yes, it’s really not a DWR partnership. It’s actually Herman Miller consumer, so we are selling some Herman Miller products on Amazon.com. Today, it’s pretty much limited to some task seating. We have always had some form of representation on Amazon, often through one of our other wholesale customers who had stores on Amazon. We believe that the idea of going to Amazon just was another addition to our overarching multi-channel strategy. We think you want to be able to meet the customer where they want to shop, and Amazon is a place that a lot of people go to shop. Task seating happens to be one of those things that is often known - people know what they're buying, so it seemed like it made some sense to work with them. Certainly they have an outstanding logistics capability, so it looked good from that angle.
We also know that increasingly consumers start often on places like Amazon.com when they’re doing a search, so in fact some people would say that maybe searches start more on Amazon than they do on a Google search now. So you’re spending a lot of money to do Google Adwords on search, yet if you’re not in the place that they’re searching, they don’t even find your brand there, so the idea was that we’d get the Herman Miller brand represented on Amazon in a way that if people are doing a search, if the products weren’t on Amazon that they were looking for but they found them from another brand, maybe they found a chair but they wanted another option, that also leads them hopefully back to the DWR site or HermanMiller.com, or one of our other great retail or wholesale customers, so that they can see a more expanded offer if there’s additional things that they want.
So we saw it as a two-pronged benefit - we think people will buy from that channel, but we also thought it was a great marketing step. To be frank, there’s also a third benefit, and that is that often when you buy on Amazon, and sometimes if you’re not represented there you see replicas or knock-offs of your product, and having the real thing there, we think actually helps a bit discourage the folks that are trying to play off of our brand and the designs of our products.
Great, very interesting. My last question, just capital allocation internally for the upcoming year, I think you said capex for this past year was $85 million. Just how do you think of that, just total dollar basis for the full year, and then what segments will you be investing the most capital behind? Thank you.
Well, if you look at it--you guys might have to give percentages, Kevin or Jeff, but it’s always going to heavily be weighted towards the North American contract business in total, because it’s still the biggest part of our revenue, and I would say this next year we have a very heavy product development schedule, particularly in areas like seating which tend to be larger capital outflows in terms of capital development. So I would guess the majority is still heavily weighted towards the North American business.
Last year, we have a fairly heavy weighting towards international because we built two new facilities in international, so I would guess that segment will slide back a little bit this year.
Yeah, I think the consumer segment, you’ve got to bear in mind if we can get through our anticipated studio opening schedule, those new studios run typically a million to a million and a half or thereabouts or capital per, so that’s probably $9 million or $10 million of capex tied to consumer this year, and that’s in the number.
So the weighting will actually move, I think overall this year, from the international business, ELA, to consumer, and that’s kind of the shift, and the remainder remains about the same with a big good deal of that balance being really in the North American work business, largely around new products, some new equipment that Greg talked about where we’re working on efficiencies, and I’m sure we’ll have some facilities as well on that side.
This is Jeff. I’d just tag onto that, I guess from a balance sheet standpoint, we’ve done a good job paying down our line of credit. I think we had $22 million or so outstanding at quarter end. We’ll continue to focus on that. We increased the dividend and that will put probably another $5 million of run rate annual for the dividend. And we’ve been pretty consistent, but we started to buy some shares back this year really aimed at offsetting benefit plan dilution, but we don’t have any intention of--I mean, we’ve generated great cash. We have terrific cash generation, as Brian called out and as Kevin described on the call, and we anticipate we’ll continue to generate good amounts of cash, but we do not intend to build a big cash balance, right, so we will balance that with continued returns of cash to shareholders as well. So that--I think in that order of priority, that’s our intention.
That’s all for me. Thank you.
Thank you. That looks like all of our questions. I would like to turn the conference back over to management for any closing remarks.
Thank you all for joining us on the call today. We appreciate your continued interest in Herman Miller and we look forward to updating you next quarter. Hope you guys have a great day. Thank you.
Ladies and gentlemen, thank you for participating on today’s conference. This concludes the program. You may now disconnect. Everyone have a great day.
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