Herman Miller's (MLHR) CEO, Brian Walker on Q1 2017 Results – Earnings Call Transcript

Herman Miller, Inc. (NASDAQ:MLHR)

Q1 2017 Earnings Conference Call

September 22, 2016, 09:30 AM ET

Executives

Kevin Veltman – VP, IR

Brian Walker – President & CEO

Jeffrey Stutz – EVP & CFO

Analysts

David Vargas – Raymond James

Kathryn Thompson – Thompson Research Group

Good morning everyone and welcome to the Herman Miller Incorporated First Quarter Fiscal Year 2017 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. 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 to participate.

At this time I’d like to begin the presentation by turning the call over to Mr. Walker. Please go ahead.

Brian Walker

Good morning, everyone and thank you for joining us today. Yesterday we announced our financial results for the first quarter of fiscal 2017. Our consolidated sales and orders for the quarter were $599 million and $596 million respectively and earnings per share were $0.60 per share.

As a reminder, our Q1 results include an extra week of operations. Adjusted for this impact as well as foreign currency in the dealer divestiture organic sales and order gross rates were in the low single digits. Having a diversified business that saves multiple audiences means that each of our business segments has different rhythm.

While our overall sales this quarter were slightly below our expectations, I am very encouraged by the order momentum within the ELA, specialty and consumer business. In North America, while orders levels were just below last year, we continue to view industry dynamics as largely supportive of continued growth and our internal indicators reflect the same conclusion.

Jeff and Kevin will provide a more detailed breakdown of our financial results by business segment, but as I normally do, first I would like to share my thoughts on the current economic backdrop and the overall direction of the business.

Over the past five years, we’ve been diligent in our pursuit to expand our addressable market and building multichannel business, which provides us the platform to deliver our leading designs and innovations and new audiences virtually anywhere in the world.

Its approach and infrastructure is a differentiator for us and as we continue to execute on our key strategic initiative. We believe we are well positioned for sustainable sales and profit growth. While the macroeconomic backdrop of the business is generally positive there are areas of challenges in the U.S. and abroad.

Pressures in the energy sector, rising steel prices and general uncertainty surrounding the upcoming presidential election persist as headwind in the U.S. With that said, unbalanced industry metric we track, remain largely supportive for the North American contract business. In particular, service sector employment, non-residential construction activity and the architectural billings data have continue to trend positive.

Consumer confidence has also picked up and low interest rates remain a catalyst for the housing market, supporting generally positive trends in existing home sales and housing starts.

Outside of North America, the economic picture is more mixed. The economies in Latin America have continued to be wracked by political turmoil and commodity price pressures, particularly centered on oil producing regions. The Brexit referendum in June took markets by surprise and created a major source of uncertainty in the economic future of the U.K. and Europe.

While the near term impact of Brexit has been less dramatic than we initially fear, the longer term implication for the region and beyond are very unclear. Conversely, we continue to foresee favorable long-term demographic trends in the Asia Pacific region, which remains a key area of growth for international business. As we’ve expanded our business to new channels and markets, we deliberately coupled this effort with our hallmark excellence and designer innovation.

This powerful combination provides a real differentiation from our traditional competition and uniquely positions us to serve customer audiences that would have been missed opportunity had we not embarked on the strategic shift. As I mentioned at the outfit, our diversity of offering means that the different businesses often move at different rhythms.

Let me spend a few minutes providing some color on the results for the quarter. In North America we felt the project-based nature of the contract industry this quarter. Total levels were softer than expected throughout the first two months of the quarter, which showed a marked improvement toward the end of the period.

Weaknesses in the energy sector continue to pose a notable challenge, particularly in certain regions of the U.S. and Canada. More positively, the healthcare sector remain an area of strength this quarter.

Overall, we remain encouraged by level of project opportunities and customer interest we are seeing. Despite the relative softness we experienced at the start of this quarter, we feel generally good about the macro backdrop and our team’s ability to compete — compete effectively for new business.

The priorities we communicated last year, remain our focus this fiscal year. In particular we’re committed to the continued evaluation of the Living Office framework, which includes the launch of new product and smart solutions, research to quantify the results of applying these concepts and the extensive training of our sales force and dealers.

As further proof of the power of this framework and the innovation leadership of Herman Miller, Wallpaper Magazine recently named The Living Office one of the finest design innovations of the past 20 years.

Outside of North America, while the initial impact of Brexit on our ELA segment has been less than we originally anticipated we’re continuing to monitor the situation closely to ascertain the long-term impact and determine where new opportunities and challenges may exist as a result of the change.

For the quarter, organic quarter growth for ELA was led by continued strength throughout Asia and improved demand in Continental Europe. We also have a robust pipeline of new product launches across the POSH and Herman Miller brands to fuel future growth.

Our new partnership with U.K. based naughtone is also very promising as it will increase our global collaborative furnishings offer and extend our operational capabilities to better serve the EMEA region.

The specialty business with a strong connection to architect and design specifiers delivered order growth led by Geiger and Herman Miller Collection. This segment continue to benefit from a consisting cadence of new products as well as the trend towards the convergence of work in home.

On the consumer front, while we’re not declaring victory yet, we’re encouraged by the positive momentum we saw on the topline this quarter. The channel and brand initiative we outlined last quarter, including changes to our catalogue prospecting approach are gaining traction and as such, we continue investing in promotional activities to drive business through our consumer channels.

We also remain focused on the growth drivers of this business including expansion of our real estate footprint and an ongoing cadence for exclusive new product launches.

This quarter we opened studios in Manhattan, New York, Austin Texas and Washington DC and we have another six studies under contract to open this year. Austin and Washington DC we’re repositioning existing locations to the new model. So our store count increased by one in the quarter. In Q2 we will also open our first Herman Miller retail store in North America inside the Park Avenue flagship showroom in the New York City.

Consolidated gross margin was slightly lower this last quarter in large part due to the rising cost of steel. So it will offset the fluctuation of the commodity cost, we’ve continue to implement a number of lean initiatives to drive operational improvements across the business.

And as we noted last quarter, we intend to implement a price increase during our typical timeframe this year. On the operating expense front we aim to sink to our spending levels with the demand patterns that we see across our business.

At the same time, it’s necessary to ensure appropriate levels of investment to support key long-term initiatives, such as Design Within Reach studio openings and new product launches. We have a robust pipeline of new product under development a number of which we will launch over the coming three to six months. And our longer-term pipeline is very strong with a particular focus on expanding our leadership in seating.

Finally, we continue to focus on maintaining an efficient capital structure. In addition to the 15% increase in our dividend last quarter and ongoing share repurchases, we recently refinanced our revolving credit facility, which will both lower our cost and create financing capacity for the future.

I’d like to close by emphasizing our unique value proposition. At its heart, Herman Miller is a company driven by culture centered around its employees, a sense of purpose and a motivation to create inspiring designs to help people do great things. That’s why we have been and will continue to be the center of every game changing innovation in the office furniture industry.

Our value proposition is anchored by a powerful combination of world renowned design brands, industry-leading R&D and unreliable multichannel capability. As we look to the future, we are the only company in our space that is positioned to seize opportunities across a broad range of addressable markets and deliver a complete set of solutions to consumers and organizations across the globe.

With that as a background, I turn the call over to Jeff who will provide more detail on the financial results for the quarter.

Jeffrey Stutz

Thanks Brian and good morning, everyone. When we spoke with you in June we pointed to a couple of important factors to consider when modeling our first quarter numbers. These included the extra week of operations and the impact of the divestiture of our dealership in Australia at the end of the fourth quarter of last fiscal year.

As a reminder our first quarter results reflect 14 weeks of operations rather than the normal 13 weeks, though the relative timing of schedule summer holidays reduced the impact of this extra week to four incremental shipping days relative to the first quarter of last year.

This is a change we make every five years in order to realign our fiscal cut-off days with the calendar month. So as I talk through the details, I would note that our organic sales and order rates considering the impact of both the extra week and the dealer divestiture along with the impact of changes in foreign exchange rates.

So to begin, consolidated net sales in the first quarter of $599 million were 6% higher than the same quarter last year. On an organic basis, sales increased 1.5% from the prior year. Orders in the period of $596 million were also 6% higher than last year and on an organic basis, orders increased 2.5% from the first quarter a year ago.

Sequentially net sales in the first quarter increased approximately 3% from the fourth quarter level, while orders were 2% below the previous quarter. Excluding the impact of the extra week and dealer divestiture, sales decreased by 2% while orders were 7% below the fourth quarter. These organic sequential declines are below the average seasonal trends we’ve seen in the business over the past five years.

In addition to the inherently project-based nature of the business, we believe the softness in orders we experienced at the start of the quarter particularly in July, reflected an initial pause in activity as company’s digested complexity surrounding uncertain interest rate policies, Brexit results and the pending U.S. Presidential election.

Within our North American segment, sales were $365 million in the first quarter, representing an increase of 8% from the same quarter last year. Adjusting for the impact of foreign currency translation and the extra week, segment sales were up 1% on a year-over-year basis. New orders for this segment totaled $348 million in the first quarter, reflecting an increase of 5% from last year, while decreasing 1% on an organic basis.

Orders from project sizes above $1 million were down compared to last year, primarily driven by large project activity last year in the energy sector. Overall order, growth by industry sector was mix, we saw strong growth in healthcare, business services and electronics, while the energy sector continued to be particularly challenging environment.

We also saw lower order levels in a few other sectors this quarter including wholesale and retail utilities and financial services. Our ELA segment reported sales $97 million in the first quarter, reflecting a decrease of 5% from last year. New orders totaled $110 million an amount 1% higher than the same quarter last year.

Although on an organic basis, which excludes the impact of the dealer divesture, the extra weekend foreign currency, segment sales were slightly above last year and orders were up an impressive 12%.

This year-over-year order grown was lead by strong demand across Asia, through China, India and Japan along with growth in Continental Europe. This growth was partially offset by softer year-over-year demand in the U.K. tied to their region’s challenging economic backdrop made all the more uncertain following the Brexit Referendum in June.

Sales in the first quarter within our specialty segment were $61 million, an increase of 5% from the same quarter a year ago. New orders in the quarter of $67 million were 15% higher than the year ago period. And on an organic basis, segment sales declined slightly while orders were 8% higher than the first quarter of last year.

Order growth within this segment was lead by double-digit organic growth from both Geiger and Herman Miller Collection. The consumer business reported sales in the quarter of $75 million, an increase of nearly 13% compared to last year. New orders for the quarter were $71 million which is 10% ahead of the same quarter a year ago.

On an organic basis, segment sales increased almost 6% and orders were nearly 4% higher than the first quarter of last year. On a comparable brand basis, revenues for the quarter were up just over 1% for DWR. We were encouraged to see order demand accelerate for the second quarter in a row and our marketing investments particularly in the area of catalogue and digital began to gain traction.

Our consolidated gross margin in the first quarter was 38.4% which is slightly higher than the first quarter of last year. As expected the recent increase in steel prices had an unfavorable impact on us compared to the same quarter last year, and we also felt the impact of comparatively deeper discounting this quarter. These factors were offset however by continued operational improvements.

I’ll now move on to operating expenses and earnings for the period. In total, operating expenses in the first quarter were $174 million compared to $162 million in the same quarter last year. The majority of this increase relates to the extra week of operations; however there was also additional spending on new product development and marketing initiatives and preopening cost related to new DWR studios.

Operating income for the quarter was $56 million or 9.4% of sales, compared to the $55 million or 9.7% of sales in the prior year period. The effective tax rate in the first quarter was 32%. This compares to an effective rate of 33.6% reported last year and finally, net earnings in the first quarter totaled $36 million or $0.60 per share on a diluted basis which is 7% higher than earning to $0.56 per share in the first quarter of last year.

With that overview, I’ll turn the call over to Kevin to give us an update on the cash flow and balance sheet.

Kevin Veltman

Thanks Jeff. As Brian mentioned, we refinanced our revolving credit facility shortly after the end of this quarter and I thought I would start by presiding a few more details of the transaction. We put two components of financing in place. First we upsized our revolver by $150 million from $250 million to $400 million and extended the maturity of the facility to September 2021.

Second we took advantage of this current low interest rate environment by putting in place a 10-year interest rates swap arrangement. This swap carries a notional amount of $150 million and will become effective in January 2018 when we pay off our current private placement debt that matures at that time by borrowing on the revolver.

The interest rate swap will fix the interest rate on that $150 million at approximately 2.8%, a level substantially lower than our current private placement rate of 6.42%. While this transaction does not impact fiscal 2017 interest rate expense, starting in January 2018, we expect our annual interest expense run rate to be approximately $5 million lower than current levels as a result of this transaction. With that background on the refinancing transaction, let me move to the commentary on the first quartet.

We ended the quarter with total cash and cash equivalents of $65 million, which reflected a decrease of $20 million for the last quarter. Cash flows from operations in the period were $30 million compared to $33 million in the same quarter of last year, primarily due to higher cash outflows from working capital resulting from higher inventory levels and lower reliabilities partially offset by lower accounts receivables.

Capital expenditures were $22 million in the quarter. We anticipate capital expenditures of $80 million to $90 million for the full fiscal year. Cash dividends paid in the quarter were $9 million. As a reminder, last quarter we announced an increase of 15% in our quarterly dividend rate that will be paid beginning in October. This increase brings our expected annual payout level to approximately $41 million.

We also continued a share repurchase program at a level currently in that offsetting dilution from share-based compensation programs making repurchases of $7 million during the quarter.

We remain in compliance with all debt covenants and as of quarter end our gross debt-to-EBITDA ratio was approximately 0.9 to 1. The available capacity on our bank credit facilities stood at $208 million at the end of the quarter. Given our current cash balance, ongoing cash flows from operations and our total borrowing capacity, we believe 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 second quarter of fiscal 2017.

Jeffrey Stutz

Okay, with respect to the forecast, we anticipate sales in the second quarter to range between $580 million and $600 million. On an organic basis adjusted for the dealership divestiture, this forecast implies revenue growth of approximately 2.5% of the midpoint of the range.

As with any forecast, we base our estimates on a few important inputs including the level of new contract activations, our assessment of opportunities in the funnel and perhaps most importantly, recent order trends. As we’ve stated, we saw significant improvement in average order rates moving from July to August. Our Q2 revenue forecast reflect average invoicing levels roughly in line with the order facing we saw in the month of August.

Consolidated gross margin in the second quarter is expected to range between 37.5% and 38.5%. This forecast incorporates the expected impact from the uptick and market prices for key commodity inputs namely steel. Operating expenses in the second quarter are expected to range between $171 million and $174 million and we anticipate earnings per share to be between $0.52 and $0.56 for the period. This also assumes an effective tax rate of 31% to 33%.

And with that, I will turn the call back over to the operator and we’ll take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Budd Bugatch with Raymond James. Your line is now open.

David Vargas

Good morning, this is David Vargas on for Budd. I was hoping that if you could talk a little bit about where in particular you saw the strength in order growth in the ELA segment?

Brian Walker

David right?

David Vargas

Yes.

Brian Walker

David, primarily the biggest growth we saw was actually in Asia and I would say it was pretty broad based throughout Asia. As we mentioned, we had pretty good activity levels on Continental Europe. Middle East was a little back end of the quarter where we saw a better period, but that’s always difficult to predict as you’re going through some of the holidays that happen over there that time of year.

David Vargas

Got it. And any color on maybe the size of the orders that you are seeing within that segment and also if you expect that trend, how do you — how are you viewing that trend given some of the macro uncertainty in Europe right now, it’s not just in the U.K., but it’s also on the continent?

Brian Walker

Yeah nothing stood out in terms of any one large order or anything like that to drove it. So it was pretty balanced. Last year actually we had one very large order in Australia that’s backed out of the organic numbers. So it was actually the dealer that we saw but they had one large unusual order last year during the quarter, but nothing this year stood out as a specifically very, very large order.

So I would say a pretty typical balance there. How we’re viewing it, I would say we’re watching what’s going on in Europe and in the U.K. very closely. At one level we think there could be some additional opportunities for us because as the U.K. has dropped in value versus the Euro, it creates some capability for us because we produce in the U.K. So that actually probably one level makes us more attractive if you will or makes us more competitive in Continental Europe.

In the short run, we haven’t seen as much impact as we expected from Brexit although I would say one of the things we wonder is when we saw a little bit of an air pocket in July was that somewhat related to all the news it was out both here in the U.S. as well as with Brexit and wondering whether those two things cause some business people to pause, I can’t really prove that, that’s a gut unsure. It seems like that was pretty broad based at least across our industry from what I’m seeing from others.

But after we got through that period, things I would say appear to have returned a bit to normal. I would say that at the same time, it’s a big change and so you’re not going to see that happen overnight. I think the question is going to be what happens as they sort out all the implications around trade deals and those kind of things.

David Vargas

Okay. Thanks and regarding North America, the weakness you saw early in the quarter, can you give a little bit more color on that, was that maybe a push out or a lengthening of the purchasing cycle or was there something else involved there that you saw you can point to that cause some of that weakness?

Brian Walker

We didn’t see anything about things being pushed out, I guess from — we didn’t have any cases where folks calling us up and saying hey you’ve won this project and we’re going to delay it. So we didn’t see any delaying type things or at least none that I’m aware of other than the typical things you get with you’re kind of a bit in the construction business that you do from time to time see that, but I would say nothing unusual there.

Maybe the thing that is most interesting to us is activity levels as reported by our sales people, what we looked at as Jeff mentioned in terms of contract activations, which is really how many times that we have a new contract that we’re putting place as either a long standing contract or particular order, those actually stayed quite good and the funnel look pretty healthy.

So I guess from a delay standpoint, it would certainly seem that the other signals that we would typically be tracking to see get a pulse of the business did not seem to match fully what we were seeing in terms of day-to-day, week-by-week order entry.

So maybe a delay in that sense, but certainly nothing that was telegraphed by customers that they were making a decision to delay. Again you can’t really tell with all those other events that are going on like Brexit to say that that have an impact on the business.

Typically, I would say you don’t tend to see that signal strength in our industry that fast because if you’re already building a building signed a lease, you are going to move forward. So that would seem to be a little unusual although certainly something we’re paying attention to.

The other thing was a little bit difficult to read this quarter is our healthcare order entry was very strong in the early part of the quarter and then cooled and I would say the non-healthcare part actually played exactly the opposite pattern.

So we had some different patterns by industry sector also playing amongst all that. Of course the one that I think everybody is talking about those of us who played there significantly, the most difficult sector overall from an industry perspective was clearly the oil and gas sector, which if you’ve been watching what’s going on in Texas and in Calgary and those kind of markets, it’s pretty quiet in terms of project activity.

David Vargas

Okay. And then — thank you, and then the last question for me, when you were referencing people discounting, was that just in the consumer segment or was that also across all the office furniture in the North America segment and also can you give a comment on what you’re seeing in residential demand? Is there a change going on there? Is that softening a little bit or does it remain strong?

Brian Walker

First I think the primary comment around pricing or discounting in particular was related primarily to the contract business in North America that would cover both healthcare and office. That’s what we’re primarily talking about there.

Certainly and I would say by the way that is — that tends to move around geography by geography within the U.S. you’ll see different competitors at different times being more aggressive based on a particular project and certainly we get more aggressive from time to time in our geography or particular customer that we’re interesting in cracking.

So I wouldn’t say that was consistent pattern as much as certainly there was some deeper pricing in the quarter and that’s bounced around over the last year or so. I don’t know if that’s an unusual pattern, but one that we are in a very competitive space and I’m sure when business activity level look lower you will see competitors be more aggressive on how to deal with that.

On the consumer side from a pricing standpoint, we did note that margins were little bit lower. Certainly we had more promotional activity this quarter. So we were on sale I believe more days this quarter than we were last year. So that would have been part of the drive in that business as well as we made a decision to do some price down and some things that we wanted to move out of — out of our inventory, which we felt really good about.

So that’s one that I wouldn’t say is necessarily directly tied to competitive pressure other than fact that one of the things we noted last year is that we had really attempted to back off on a number of promotional days. Our view is that that was not a successful move and that in fact it’s still true that much home furniture is sold really on sale and so you have to play the promotional gain on a regular basis.

So we are doing other things that we believe will longer term bring margins back up in that business to more proprietary products that certainly helps the more that — and as we try to get a broader spread across price points, it takes a little bit of pressure off of discounting product bound to hit price points without the same margin levels.

So those couple of things are certainly within our grabs, but things that we are looking at. In terms of demand, I think that sounds from what I have read around across the space of home furnishings. It looks like demand patterns have been I would describe it as mix, some people are up, some people are down it doesn’t look like there is a very clear picture.

I suppose for us we believe most of what we are doing right now while certainly we were impacted by the reduction in the number of folks that are coming over to set up second homes in United States as the dollar get stronger, that’s more difficult and there was a very big pattern to that a couple a years ago particularly out of South America as an example and out of Europe where people starting second home either in vacation areas in the U.S. like Miami in South East Florida and/or New York City. So there was a big pattern towards that. That kind of business certainly is not as strong as it was two years ago.

On the other hand for us a lot of what we did this quarter and believe we’ll see next quarter was putting in place the things that we need to drive our demand regardless of the state of the overall industry and those things this quarter included getting back to a positive studio growth, which we really haven’t had over the last 18 months.

We’ve been treading water or down, generally down. We knew that we talked a lot about last year that the catalogue efficiency had dropped significantly due to a change we made. We have found a new partner and move back to model we had used previously.

We saw significant improvements in the efficiency and effectiveness of our catalogue drop this quarter. We think that’s a sign of the third thing that was on our agenda was to improve our overall service and delivery, which last year was really impacted by ERP that hit really more in the second quarter, but we know that that’s started then and continue to affect consumers’ willingness to give us a try if you will.

We have now seen six months or so of much better customer service scores back up by the way levels higher than what we had historically pre-ERP change. So we’ve been systemically making those improvements to guys who run the consumer business and their team has done a great job of staying on task with those things and I think that’s what’s really playing into our order patterns in that business.

Jeff Stutz

Yes and this is Jeff. I’d add one thing to this and this is kind of — this is an aside to your question on consumer demand, but the other area that our consumer business at least have been focused on is investing in putting in place the kind of infrastructure they need to grow their contracts on their business and so while that is still — we’re growing off a small base, we feel very good about all through last year.

That was one of the bright spots in the business and team continues to feel very excited about the growth they’re seeing and the potential we see for that business moving forward. That’s another area that we put some investment in here of late.

Brian Walker

That’s a good point Jeff too because that will also affect longer term the way that we report gross margins in that consumer business. The stuff that we do that is more contract related or B2B whether that’s in the hospitality area or with office customers. That will tend to be at lower gross margins, but of course we don’t have the load in that business that we need — that we do in the retail side of stores and/or the same level of marketing spend that we’ve got in that traditional retail business.

David Vargas

Okay. Thank you very much for taking my questions.

Operator

Our next question comes from Kathryn Thompson with Thompson Research Group. Your line is now open.

Kathryn Thompson

Hi. Thank you for taking my questions today. First focusing on gross margin performance in the quarter and digging a little bit deeper into leverage that you talked high level about a few of them, but I wanted to just dig a little bit deeper, first remind us how much raw material consist of cost that’s still consolidated for the company or you can at least do it at consumer?

And then how much of steel was a drag in the quarter and what are your expectations in upcoming quarters? And then finally, once again related to margins, how much was volume or mix an impact in the quarter? So really what we’re trying to understand are just the various puts and takes and in particular how to think about raw materials as we move forward? Thank you.

Jeffrey Stutz

Kathryn, this is Jeff. Let me take a shot at it. I may need you to kind of guide me along your questions as we go. But let me start with the raw material question. So when we think of it as direct materials, tend to run about 40% of revenue is a raw, so you know our average margins, so that can get you to the mix within cost of goods sold.

I would — I’d go one step further than that. Steel is an important input cost of our total materials. Now bear in mind, when I give you — when we talk about materials, keep in mind we not only purchase raw steel, but we purchase a lot of value added component parts of that steel.

We also aside from steel in our direct material number, we have a lot of purchase complete products as well, through the mix of our business. So I just wanted to give that as context.

But in terms of steel, the steel buy and this is primarily a North American answer, but that tends to run about 7% or 8% of our total cost of goods sold in the North American business just the steel by itself. That would be the single largest category of material. Perhaps a little lower that you might think, but bear in mind we do have a lot of other purchase complete type cost in our material line. So that just gives you a little background.

Brian Walker

So Jeff that is just steel that we buy raw…

Jeffrey Stutz

That’s raw and component parts. Yeah. So let me pause there, Kathryn keep walking me through your questions, so I don’t miss anything.

Kathryn Thompson

Yeah, very helpful on that. The next just practically speaking as we think and look forward in modeling, particularly as we look at a little bit lower gross margin guidance for Q2, how much was steel a component of that versus just pure lower order rate?

Jeffrey Stutz

So we expect the pressure from steel pricing, when you go sequentially from Q1 to Q2 to be on the order of $5 million.

Kathryn Thompson

Okay.

Brian Walker

Lower.

Jeffrey Stutz

Yeah, lower, let me check. So does that give you what you’re asking there.

Kathryn Thompson

Yes.

Brian Walker

So Kathryn one of the things that happened this quarter, Jeff, I think this is the accurate way to think about it, because we have locked in pricing for periods of time, it tends to be that both cost roll in over a period of time. So we started to see some of the steel prices obviously were moving in the late spring or early summer. We didn’t feel the full impact of where it landed in the quarter. So we’ll continue to see a bit of a build as we get into this quarter.

Now from a pricing perspective of steel, steel was at very low level most of last fiscal year. It peak in about June or July, I think it hit its peak. It’s come back down like most people predicted. The question from here is where it will trend back down to? I think the low point was 550 ton, if that’s right. And then it got as high as 800 to 850 and its back down to I think around 750 today maybe a tad lower.

And so the question is going to be, does it trend back down below 750? Most people would expect that to cool a bit, but not go back to where it was at 550. So the levers that we are actively pulling are what can we do about lean initiatives? What can we do to in-source and then third, where can we and how can we pull the price levers to try to offset some of that and it’s bundle of those three items.

Jeff Stutz

Yes, Kathryn let me — this is Jeff again. Let me make sure I clarify some to avoid confusion. So when we look at our Q2 guide, our gross margin impact from steel on a year-over-year basis, not a sequential basis, we think is about $5 million. Sequentially, we think between Q1 and Q2 it’s probably closer to $1.5 million or $2 million, okay.

Kathryn Thompson

Okay. That makes more sense. That makes lot more sense simply because we’ve been tracking steel pricing with the tariffs being implemented this spring, but prices certainly have come back a bit.

Looking just at more on the contract business and I know you gave some helpful color earlier in the Q&A regarding discounting, but really given you had a pretty significant increase in seating sales of 30% versus from several years ago, are you seeing increase discounting in that category or are there other categories, which you’ve seen a disproportionate amount of discounting?

Brian Walker

It’s really hard to look at discounting necessarily by category because often in many cases you’re bundling a whole project together and you’ll move around your discounting depending on what area you think you guys strengthen at that time. So I’d just broken it down to that level of detail can become — it becomes a little hard especially when you are looking at over short periods of time.

I’d say overall I don’t believe there is a giant difference in the pattern. Certainly some categories have lower margins and in fact are more competitive on a day-to-day basis than others. But I don’t know that I’d say we see any significantly different pattern from one to the other.

Kathryn Thompson

Okay. It’s helpful. And then in terms of the pattern that you outlined of July not being great, August better and early September better, for what if were — what is worth has very much mirrored the similar type feedback we’ve had from other basic building materials and building product categories that we track regularly?

So when you look at other periods of time when you’ve had — periods of uncertainty, this year we got start off with a bang and the summer with Brexit, and then we have presidential elections coming up. Can you look today versus other major downturns that you’ve experienced?

Are there any similar red flags or any spread flags that are different about prior downturns versus what you are seeing in the market because what Wall Street is concerned about is it saw a big drop in July overall and you’re seeing some improvement in August and early September, but it this a head fake? So what gives you confidence that this is a head fake versus just the normal choppiness that we’ve seen in this recovery?

Jeff Stutz

It’s a really good question, Kathryn. I guess my answer to you is the two significant declines over the last 15-20 years that we saw, I’d say there was much more consistent bad news in an overall feeling of uncertainty that I don’t think really exist today.

I think even if you listen to the general economic news, you don’t hear calls that we’re in the midst of beginning of recession or something uglier than that or a crisis like in the financial sector. You hear much more of a discussion about I’d call it malaise, hey are we going to move up? We are going to move down.

So I don’t think there was anything out there today. The only thing that I can read that would say that the general tenure is that bad. Of course when Brexit happened a lot of people were trying to figure out and read the tea leaves what is the impact? It doesn’t appear to had a massive impact on the U.K. or the global economy when it happened immediately, right?

So I think the good news is that the data trailing behind Brexit was not followed by a consistent pattern of bad news about the U.K. or Europe. Certainly, there’s people worried about it, but to me, that’s kind of gone out of the headlines a little bit as of late, but still out there lingering.

And so I think the question is going to be, do we see a pattern of a number of those kind of bad news events? Certainly, the global terrorism stuff that we continue to see doesn’t help because all of those things erode confidence at one level right? So you can’t help but be — you can’t help but be concerned about what all of these events eventually put could add up to.

On the other hand, as Geoff said, I think you’ve got to look at multiple points to kind of get your mind around what you’re seeing in the business. If I look at Architectural Billings, those look pretty good. Those guys tend to be a little bit ahead of the industry in terms of what they’re feeling.

That’s hung in there pretty strong. If you look at generally corporate profitability while it’s not increasing at the rate anybody would like, it’s still actually pretty darn good, in capital structures are in great shape with very low interest rates, right?

So people can borrow money at very low rates to go do the things that they need. I also think there is a general backdrop for our business of a need for a transformation of the workplace to enable companies, not just the big tech guys, even though I think that some of them are asking similar questions.

But of the companies that are trying to cross the chasm of the impact of the digitization of the world, whether that’s automotive guys, whether it’s retailers, whether it’s restaurant companies, all of them are trying to figure out how am I going to play in this new world and to do that, they have to be able to go get the talent that they need to make that happen.

And they realize that their workplaces can’t look like they did in 1985 if they’re going to make that cross. That seems to leave a backdrop of not just facilities people, but business leaders asking the questions, what do I have to do and one of the ingredients seems to be what do I do around my facilities?

Now we’re not foolish enough to think that if we hit a really sustained downward trend in GDP and business activity, that we could play through that. I think the days when that happen are probably gone and corporate America in particular is darn good at adjusting cost structures and capital spending. So we’re not fools enough to see that.

On the other hand, I think when we look at the inputs to the industry we look at the proclivities of Chief Executive Officers. We look at contract activations, the number of customers that are coming here, not only to visit us about projects, but to talk about big ideas of things they need to do.

Our gut is that while we don’t see runaway growth, we see reasonable prospects that the kind of forecast we’re looking at today still feel reasonable to us overall.

Now that also combines by the way, when you look at our growth rate, believe that we’re going to continue to get traction that we started a bit in the fourth quarter started better in this quarter around the consumer business.

Certainly we had a lot of issues in the second and third quarter of last year the consumer business, that if we keep our act together and do the things that we’ve put in place and they continue to have impact, we should be able to see some growth in that area too that’s probably outside of the issues related to the contract business.

Kathryn Thompson

That’s helpful. Final question, this really gets more from some of our various checks that we do. Speaking to a large healthcare architect design firm focus, they had noticed a change in their healthcare demand, shifting from new builds to a greater wave of remodel taking over. And it’s just really, I’m curious, are you seeing a similar trend, or are you able to track that trend? Thank you.

Jeffrey Stutz

That’s a good question. I don’t know if I know that level of detail of whether it’s remodel or not. I would tell you part of the question, this is a little — you almost have to know what the architect was referring to because I think the way we are defining healthcare and I think this is increasingly way healthcare is being delivered and managed is a healthcare organization today is both a hospital, an outpatient clinic, a outpatient surgery center, a rehab center, an insurance company and on and on and on, right?

So you almost have to ask which organizations? What we see is a lot of these larger healthcare organizations are trying to deal with a two-pronged approach to I have to deal with cost pressure. At the same time I have to increase patient satisfaction if I’m going to get paid.

So I can’t just cut cost and not have people happy and by the way, have an increasing pressure to get talent and keep them healthy. So I think those combinations of things are what’s driving the whole healthcare space.

To me, the biggest question about healthcare going forward is what happens with the pressure that’s now on the exchanges and whether the exchanges continue because certainly a lot of healthcare organizations are building towards what they believe in a bigger and bigger customer base. That’s going to be the question, how does that play out the way everyone expects given the news out of Aetna and others.

Kathryn Thompson

Perfect. Thanks very much.

Operator

That concludes today’s question-and-answer session. I’d like to turn the call back to Mr. Walker for closing remarks.

Brian Walker

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

Operator

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

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