MillerKnoll Inc (MLKN) 2016 Q3 法說會逐字稿

Good morning, everyone, and welcome to this Herman Miller, Incorporated third-quarter FY16 earnings results conference call. This call is being recorded.

This presentation will include forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. These risks and uncertainties include those risk factors discussed in the Company's reports on Form 10-K and 10-Q, and other reports filed with the Securities and Exchange Commission.

Today's presentation will be hosted by Mr. Brian Walker, President and CEO; Mr. Jeff Stutz, Executive Vice President and CFO; Mr. John McPhee, Executive Vice President Consumer and President Design within Reach; 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 would like to begin the presentation by turning the call over to Mr. Walker. Please go ahead.

Good morning, everyone, and thank you for joining us.

I'll begin the call today by sharing my thoughts on our performance and the overall direction of the Business, and then I'll turn it over to Jeff and Kevin to cover third-quarter financials in more detail. We also have John McPhee, the President of Design Within Reach, joining us for the Q&A portion of the call to offer his perspective on the Consumer segment, and the opportunities we see for growth and improvement in that business.

As we announced yesterday, despite headwinds in the global economy and recent volatility in the stock market, we delivered strong financial results this quarter, highlighted by organic sales growth of nearly 6%, and adjusted earnings per share up 24% from the same quarter a year ago. We are especially encouraged by the performance of our North American business segment, where our focused effort investment over the past year continues to drive improved top-line growth and operating leverage. This represents a significant turnaround from where our Business in North America was running just a year ago. And as encouraging as the numbers are, I'm even more proud of what it says about the character and culture of our people.

We do a lot of things well at Herman Miller, but like any business, we face issues and challenges. I believe the best companies are the ones that stand up and own their problems, and then rally around a solution. We did exactly that a year ago, and it's what you should expect from us now and in the future.

To be sure, today we face some clear challenges ranging from macroeconomic pressures to unique issues within our Business. With that said, our results this quarter prove that, on the whole, we are executing well on our strategy of delivering inspiring designs through a global portfolio of leading brands, and an unrivalled multi-channel distribution network.

From a macroeconomic perspective, the backdrop to our Business is mixed. Despite stock market volatility, pressures in the energy sector, and the effects of political uncertainty on the economy, the key metrics we follow closely in the US, such as corporate profitability, surface sector employment, and non-residential construction activity, remain generally supportive for the North American contract market.

The most recent industry forecast for BIFMA suggests a low- to mid-single-digit growth environment for calendar 2016 and 2017 combined. In the US consumer market, despite a recent dip in consumer confidence, overall fundamentals in the industry remain positive, with strong employment levels, rising household incomes, and a housing market buoyed by low interest rates.

Internationally, the strong dollar headwind continues to impact our reported results. We are also closely monitoring other pockets of economic uncertainty, including commodity-driven economies that we expect to experience slower growth, and the potential impact of a United Kingdom exit from the European Union.

Our diversified business outside of North America mitigates the risk of individual countries or regions. Overall, we continue to see long-term opportunities for global growth, with particularly supportive demographic trends in regions such as China and India.

Moving on to our segment results, we delivered another strong quarter in our North American segment, with core office, contract, and healthcare businesses driving a year-over-year increase in sales and orders of 6%. The trajectory of our positive results we're experiencing reflects very purposeful efforts to reposition from a product focus to solution-based selling approach that delivers our customers designs to solve real problems.

This key shift, which began in 2013 through the Living Office framework, builds on a legacy of modern workplace design, with a growing body of research, products and services designed to help our customers realize higher-performing environments. In fact, we've reached an important milestone on our Living Office journey, to research partnerships with a number of our customers to quantify the results of applying these concepts to their spaces. We are seeing measurable improvements in workplace effectiveness and user experience.

Our Specialty segment contributed broad-based sales growth of 8% across our businesses. Notably, we're seeing consistently strong growth from our Herman Miller collection, where classic modern designs are successfully capitalizing on the convergence of how people work and live. The Specialty brands of Geiger, Maharam, and the Herman Miller collection represent a powerful combination of inspiring brands that connect us to architect and design specifiers, expand our market opportunity, and serve as an increasingly important part of our economic engine.

Persistent currency headwinds and growing economic uncertainty in Europe and the Middle East combined to limit new order growth outside North America this quarter. On an organic basis, which excludes the negative currency impact, our ELA business segment posted a slight decrease in orders, where our net sales were up approximately 7%.

The ELA business represents a key element of our strategy, leveraging our brand and capability to enhance profitable growth around the world. With the addition of the POSH brand and distribution, along with expanded regional manufacturing and R&D capability, our international business is well positioned for long-term growth in key markets around the world. In the near term, our ELA team is in the process of launching a number of new products across a range of categories under both our Herman Miller and POSH brands.

As we expected, the Consumer business continued to feel the effects of the issues we outlined last quarter. The sequential improvement in order rates for the quarter gives us confidence the actions we have and are taking are headed in the right direction.

We are particularly pleased to report, as we promised, the ERP implementation issues are now behind us. Of course, it takes some time for these improvements to translate fully into top- and bottom-line progress.

In addition to the ERP improvement this quarter, we began the process of improving the effectiveness of our direct-to-consumer marketing investments. Like ERP, we believe it will take two or three quarters to fully realize benefits from these investments. Ultimately, the success of this segment will be driven by executing the vision we outlined two years ago, including: implementing our plan to transform and expand the Studio network, increasing the breadth of the product portfolio into new solutions, and increasing our depth of price points we consider, and improving the last mile delivery experience of the consumer.

Having said that, we continue to see real opportunity to make progress to serve both the trade audience of residential designers with DWR. This past quarter, we launched the first DWR trade source book in new terms to make it easier for these folks to specify DWR products for their customers.

In addition, the Herman Miller dealer network is responding very favorably to adding the DWR proprietary products to their portfolio of solutions. This reflects a very real trend of offices increasingly combining residential and contract sensibilities.

Overall, I'd like to underscore our confidence in the long-term direction of the Consumer business. Our key value drivers remain intact to drive double-digit revenue growth and operating margin expansion, as we continue to execute our product development and real estate transformation strategy.

Let me close by emphasizing that, at its core, Herman Miller has always been driven by a higher purpose: a unifying desire to make people's lives better. We have a century-old track record of seizing the leading edge of innovation, as people and environments reinvent themselves. Today is no different.

For the past five years, we've been among the most aggressive in our history for new product launches, and we continue to invest aggressively in this area. Our developed pipeline is exciting as it's ever been. We're also uniquely positioned with an unparalleled multi-channel infrastructure to access more markets and audiences than any other company in our space. Looking forward, we have a deep bench of talented people working with purpose to address the near-term challenges we face, and I'm confident as ever in our ability to drive long-term shareholder value.

With that, I'll turn the call over to Jeff, who will provide more detail on the financials.

Thank you, Brian. Good morning, everyone.

Consolidated sales in the third quarter of $537 million were 4% higher than the same quarter last year. Orders in the period of $509 million were 2% above the prior-year level. On an organic basis, excluding the impact of foreign currency translation, sales and orders increased approximately 6% and 3%, respectively, from the prior year.

With respect to this year-over-year order comparison, 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 approximately $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 of this year, and accordingly, saw no comparable shift in the timing of order entry.

Net, this had the impact of limiting our reported order growth this quarter. Now, to be clear, given the level of estimation required to quantify this, we've not adjusted for it in our calculation of organic order growth in the period. Still, we believe it's a factor worth considering as you evaluate our results.

Sequentially, net sales in the third quarter decreased approximately 7% from the second-quarter level, while orders declined 15%. These changes are consistent with average historical seasonal patterns for the Business.

Within our North America segment, sales were $313 million in the third quarter, representing an increase of nearly 6% from the same quarter a year ago. Adjusting for the impact of foreign currency translation, segment sales were up almost 7% on a year-over-year basis.

New orders in this segment totaled $296 million in the third quarter. This reflects an increase of 5% from last year on a reported basis, and an organic increase of 6%.

From a project perspective, after adjusting for the large energy project that ran through our numbers last year, order growth was fairly broad-based across all project sizes. Growth by industry sector was fairly broad-based as well, with notable exception being energy, which continues to reflect that sector's challenging economic backdrop.

Our ELA segment reported sales of $99 million in the quarter, reflecting an increase of 2% compared to last year. New orders totaled $94 million, an amount 6% lower than the same quarter last year. Excluding the negative impact of currency translation, segment sales increased over 7%, while orders were slightly below the prior year. Softer order demand in the UK and Middle East, tied to the timing of project activity and economic uncertainty in these regions, was partially offset by growth in Australia, and in India, which was aided by the recent manufacturing capability we have put in place.

Sales in the third quarter within our Specialty segment were $55 million, an increase of over 8% from the same quarter a year ago, and reflecting sales growth across all three of our specialty businesses. New orders in the quarter of $54 million were roughly 1% higher than last year.

As Brian outlined at the start, while work remains, our Consumer segment showed meaningful improvement from last quarter. In total, the Consumer business reported sales of $70 million in the third quarter, a decrease of 3% from last year. New orders were slightly lower than last year, which compares favorably to the relative order levels we reported last quarter following the challenging ERP system implementation at DWR.

It's important to note that after the closure of two smaller studios this quarter, we have reached the expected low point in our total studio count. Moving forward, we will continue to expand our studio square footage through a combination of market repositioning and incremental new locations, including the addition of a new studio in Manhasset, New York, which is slated to open in June.

At the consolidated level, the impact of strengthening US dollar, while still significant, has lessened compared to the first two quarters of the fiscal year. We estimate this drove a negative year-over-year translation impact on net sales of $8 million in the quarter.

Our consolidated gross margin in the third quarter was 38.7%, a 180-basis-point improvement over gross margin of 36.9% in the same quarter last year. Favorable commodity costs, product mix, and ongoing operational improvements all combined to more than offset pressure from foreign exchange translation.

I'll now cover operating expenses and earnings for the period. In total, operating expenses in the quarter were $164 million, compared to $151 million in the same quarter last year. The majority of this year-over-year increase relates to spending on new product launch and marketing initiatives, higher incentive accruals, and variability from sales growth.

Operating income for the quarter was $44 million or 8.3% of sales, compared to $37 million or 7.2% of sales last year. Excluding certain restructuring costs, adjusted operating income in Q3 of last year totaled $39 million or 7.6% of sales. Against this pro forma comparison, we delivered operating income growth of approximately 13%. The effective tax rate in the quarter was 29.8%, and that compares to an effective rate of 33.6% reported in the same quarter last year.

Finally, net earnings in the third quarter totaled $28 million or $0.46 per share on a diluted basis. This compares to adjusted earnings of 37% (sic - see press release, "$0.37") per share in the third quarter of last year, and reflects a 24% increase in earnings per share. I would also add that foreign currency translation had an unfavorable impact on EPS of approximately $0.02 in the quarter, relative to the third quarter of last year.

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

Thanks, Jeff.

We ended the quarter with total cash and cash equivalents of $55 million, which is consistent with where we ended last quarter. Cash flows from operations in the period were $53 million, an increase of $24 million or 80% from the third quarter of last year.

Changes in working capital resulted in a net cash inflow of $5 million this quarter, compared to a net use of cash of $12 million in the same quarter last year. The primary contributor to the change in working capital for the current quarter was lower accounts receivable levels, offset by reductions to accounts payable, and other accruals.

Capital expenditures were $20 million in the quarter, and $55 million year to date. We continue to anticipate capital expenditures of $70 million to $80 million for the full fiscal year.

We have now fully repaid the debt incurred in the acquisition of DWR, with the repayment of $17 million in borrowings during the quarter. Cash dividends paid in the quarter were $9 million. We also continued a share repurchase program, at a level aimed at offsetting dilution from share-based compensation programs. In total, we made repurchases of $5 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 facility stands at $201 million. Given our current cash balance, ongoing cash flows from operations, and total borrowing capacity, we are well positioned to meet the financing needs of the Business moving forward.

With that, I'll now turn the call back over to Jeff to cover sales and earnings guidance for the fourth quarter of FY16.

Thank you, Kevin.

We anticipate sales in the fourth quarter to range between $560 million and $580 million. We estimate the year-over-year negative impact of foreign exchange on sales for the quarter to be approximately $6 million. So, on an organic basis, adjusted for foreign currency exchange translation, this forecast implies revenue growth of approximately 5% at the mid-point of the range.

Consolidated gross margin in the fourth quarter is expected to range between 38% and 39%. While we historically experience a sequential increase in gross margin in the fourth quarter from production leverage on higher sales volumes, we expect that relative product mix, continued strengthening of the US dollar, and a recent uptick in commodity costs, including steel, will result in gross margin at or near the third-quarter level.

We anticipate a seasonal ramp-up in operating expenses this quarter, driven by higher sales volume and preparations for the NeoCon industry trade show in June. In total, operating expenses in the fourth quarter are expected to range between $165 million and $169 million. It's important to note that this estimated range reflects a net credit of approximately $4 million associated with an expected gain on the sale of a former UK manufacturing facility.

We expect earnings per share to be between $0.57 and $0.61 for the period, and this includes $0.06 per share related to the gain on sale of the UK facility. This also assumes an effective tax rate of 28% to 30%. If the impact of the UK sale transaction is excluded, the effective tax rate would be expected to range between 31% and 33%.

With that, I'll now turn the call back over to the operator, and we'll take your questions.

(Operator Instructions)

Our first question is from Matt McCall with BB&T Capital.

So let's start with the top down, I guess. The cyclical outlook, you are doing pretty well, I guess the comps remain about the same, as we move out into next quarter. But when you just think about the industry, the projections, I think from fiscal came down a little bit, but when you're talking about growth for this calendar year, what are you budgeting for, for core BIFMA?

Matt, when we look at our next fiscal year, so FY17 which splits to BIFMA years, when we look at the data overall, I'd say it still stays in the range of we have been saying longer term we expect to be in that 2% to 4%, call it 3% range, feels like it's in the right spot for us.

And Brian, is there still room for, I want to call it share recapture, or are we back to normalized levels, relative to your peers?

You mean us recapturing share? Is that what you're saying, Matt?

Yes, I think you've been doing a little bit better, and a lot of it's the moves you talked about from the issues a year ago, are we back to where we've seen the full benefits of those moves you've made, and you'll grow with the industry, or is there something else we should think about relative to that 2% to 4%?

Well, like I say, I think we've always believed, last year, I think we were under the industry for a couple of quarters. I think we've been doing as well or better than the industry for probably the last three quarters. I think the game still is the same that we've outlined probably within the last four or five years, Matt.

It will be, it's not necessarily as much head-to-head taking share from major to major, in my mind is, we do think there's room for us still to expand the share of a customer's wallet, and of dealer's wallet, especially as floor plate continues to change what customers are buying. As I mentioned to you in my opening comments, we see opportunities for even the Design Within Reach portfolio proprietary products inside of dealers, as we continue to see offices be much more of a mix between residential and contract sensibility.

We think there is room to continue to innovate in areas like around how people are doing collaboration, particularly as -- we knew when we rolled out the Living Office that we would be defining new types of settings that we did not have the full solutions for. One of the things we've been focusing our R&D efforts and our acquisition efforts at is making sure we had the products to fulfill those solutions across the full floor plate. So I think there's room for us to continue to use both innovation, acquisitions, and to be frank, rolling out capabilities we've already gained to gain additional, to additional share.

I also think there is ability inside of healthcare and education, where we see some real abilities for us to grow in those spaces as well, and in fact, if there's been an area of surprise over the last year, we've seen really good strength on the healthcare side over the last couple of quarters. This quarter was a little lighter on the order front in that area. We think that was a bit of a pause more than a change, but we have seen some real good activity on the healthcare business, capturing a bigger share of some of our larger healthcare targets.

Okay and you mentioned DWR, last quarter you talked about accelerating some marketing spend there, I think you quantified it at about $2 million. Did that get fully spent, do you have more ahead of you, and then any initial indications of success from that spending?

Matt, it's John McPhee. Most of that $2 million spend came at the end of the quarter, so we recognized the expense. Probably one of the best things we did was we mailed what we call a source book for the first time to our trade residential interior designers, and that was a 200-page book, which has been incredibly well-received by that important component of our business.

But you wouldn't have seen any real revenue benefit.

It was mailed right at the end of the quarter.

Okay, that's helpful. A quick one on deflation. I think its been a benefit. Are you starting to see the point where deflation, and the associated benefit, is resulting in customers talking about, or pushing back on price more, or are we still in a good place there pricing, relative to demand levels, relative to deflation levels?

Matt, I think we've seen at least what I hear across the industry, I don't have any hard data on this. I'll just tell you what I'm picking up from our product marketing folks, in particular.

We've seen more competitors announcing price increases. I don't know to what scale, but I've heard last week when we were at a conference that a number of folks have talked about price increase. I only know of one competitor in particular I've seen the announcement out, but I've heard others talking about it.

We in particular are not planning a price increase. We did some moving around of things by detailed component. I would call that more of a rationalization really by SKU, more than it was overall. The net was virtual zero but we did moving around between SKUs, just to get some things aligned where we thought they needed to be, at a product line level.

We do continue to see input cost at a favorable spot. I don't think we have any expectation that we'll see the improvements or decreases in inputs that we saw this past year. In fact, we've seen some areas like steel appears to have bottomed, and maybe seeing a little bit of an uptick, although I wouldn't call it a -- certainly not a runaway train at this point, and if we saw that stuff moving, we would obviously reconsider and ask ourselves when would we think about the price lever. But right now, we feel really comfortable with the work we've done, that we don't need to go through the energy that it takes to do a full list price increase.

Okay, all right, and one more. Balance sheet at less than 1 times debt to EBITDA, just any thoughts there, Brian, on how to maybe better utilize that or plans for cash, just some broad balance sheet cash flow thoughts?

Well, Matt, first of all, we're very pleased that we've been able to get the balance sheet to a spot that I think is incredibly strong. Coming out of the financial crisis, we had a real emphasis on saying, we thought we needed to do some things to improve the flexibility and strength of the balance sheet. We're really pleased we've been able to get those things done and what we've done with the pension plan, paying down debt.

We've also said consistently, we think we will continue to use targeted bolt-on, tuck-under, whatever term you like to use, acquisitions to add to our -- complement what we do on the R&D side. The great news, as Kevin said, we now have the debt that we took on for Design Within Reach fully cash flowed.

Certainly at this point, we have been increasing over time our cash return to shareholders. We've done consistent dividend increases, as well as you see, we're now back into doing some share repurchases, at least at the level of dilution.

Every year, at our April Board meeting, we take a hard look at capital structure. It certainly is one of those things will be top of mind for them again, to say, how do we want to position the Company from a return to shareholders perspective, and the balance sheet. I don't think you will see us do anything significant in terms of debt load.

One of the things we are paying attention to is knowing that as we build out the DWR portfolio, we are taking on some fixed cost, if you will, with an expanded lease portfolio. So we are making sure we think about those things in their totality, but we're very comfortable where the balance sheet is today, and believe if we continue to grow and see the profitability numbers we have today, certainly, that should portend well for our ability to continue to increase the cash we return to shareholders, while at the same time, we have great flexibility in what we need to do around acquisitions, investing in new studios, and building internally through R&D.

Okay, perfect, thank you, Brian.

Thank you, our next question is from Budd Bugatch with Raymond James.

Can you give us maybe some color on the quarterly progression of revenues in North American furniture solutions? How did it unfold during the quarter? Any notable call outs on that?

Budd, one of the funny things about this time of the year, is it's always hard to look at progressions in the third quarter, to be honest with you. December is always a very large month, particularly on the revenue side. We also tend to see a pretty heavy order pacing in the early part of December, as people are finishing up their work before they go on the holiday break, and then you have this period that my team would say every year, I get neurotic when you're through the holidays and early.

I would say, since then, its been pretty much back to the pace we saw in the second quarter and running fairly steady. I wouldn't say a major shift one direction or the other. If the one area we've been watching, which we have talked about, is the international side, particularly in Europe, where if there's any place we've seen some moving around in patterns, it's probably been there as much as anywhere. If you look at the business in total though, and you don't look at it by segment, I would say the pattern has been pretty consistent barring you draw a line through the holidays. Is that fair, Jeff?

This is Jeff. Brian is exactly right. I think maybe a little more color, if you look at the North American segment, the core traditional, if you will, the core office side of the business, fairly consistent, albeit the typical seasonal pattern in the month of January, where you tend to see a dip, and then it starts to come back.

On the order front, one thing I'd add to Brian's comments is the healthcare business did see a little bit of a slowing in order entry in the quarter, specifically related to Fed Gov. The government customer, VA, Department of Defense, as an example. I know the team, they are not viewing that as anything more than a bit of a pause in some of that activity, as we get purchase orders and some contracts put in place. So I don't think -- they view that as more of a timing issue than anything else, but that did affect order entry in quarter, and it's one of those factors that informs the fourth quarter guide, obviously.

Budd, as you often use the term that the industry is lumpy, the healthcare business has historically been more lumpy than I would say the core contract furniture business, as well. It tends to be bigger projects, particularly because in healthcare, as you know, we plan the infrastructure side of healthcare, back of house on the supply side, and that tends to be pretty lumpy. So you'll get a bouncing around in that business, more than what you do in the core.

This time last year you were going through, as you have reminded us, a lot of challenges in the North American business and you added sales people, you took care of some product gaps. Where are you? You're seeing the success. Where are you in your checklist of things you wanted to get done? How much is left to be done, or I think we were about 10% sales people short, if I remember right, and where are we on that, and how about the product gaps?

Well first, I think Budd if you remember the outline of things we had, the first thing was we believed we had to get out and get all of the show rooms reset. That was done pretty much by the time we exited June or July of last year. Of course, that's one that you're constantly going back and resetting as you launch new products, but I think the basic set-up of the show rooms is behind us.

We are opening a new show room as we speak in New York City, the first time we've got all of our brands in one location, I think all of our brands with the exception of DWR. We will have, by the time we get to the Fall, we'll have a retail store branded Herman Miller on the ground, and then we'll have Herman Miller, Geiger, Maharam, and even our healthcare product all in one space for customers to interact with. So that's probably the biggest single thing going on the show room side. But I think globally, we virtually touched every show room last year early in the year, that was a big effort.

On the sales side, we're in good shape, in terms of number of sales folks. That was pretty much tuned up by the time we got to the end of the summer. Of course you're always adding and subtracting sales folks, but overall the total capacity, I think is in really good shape.

We have been going through a change in the sales force, that I would say we're probably 50% to 75% of the way through, and that is, we've added -- created a new component of the sales force that we're calling channel sales managers. Their job is to be 100% focused by geography on the dealer, to ensure that all of the Herman Miller brands, including in this case DWR, are well-positioned in front of the dealer, in terms of our total capabilities.

I think as we got into last year, one of the ah-ha's was that we had done a really nice job of positioning ourselves around each of the audiences we were focused on, and our sales teams were very much focused on the end client, but we weren't as well-positioned to make sure that we were capturing all of our potential through the dealer every day, and that the dealer knew as much as possible about our total offer. And so that has been in a process of becoming.

I think we've got most of the folks are identified now, at least in the first round. That will build over time. I think we've got 20 or 25 folks in that role now, that will probably expand over time.

It was a little bit of a reshuffle of those folks, I should say, from -- we had created a group to work on primarily small business accounts. They're still carrying that, but they were really focused around the dealers.

So we expanded their role, added some folks to it and put a person specifically in charge of that. One of our really good young sales execs who is doing a fantastic job for us. So that part I think on the sale side is in pretty good shape.

The other thing we've been doing with the sales force, wee started running this process we call the boot camp, where we created a space specifically in West Michigan that included all of our brands. We didn't have one space that you could go to, that you could see everything from Herman Miller to Geiger to Nemschoff, to Maharam, to DWR to our Thrive Portfolio in one location, and train the sales force.

And I think what we recognized is we had spent a fair amount of energy and money building a much more expanded portfolio, and as we went out and did what we were calling and are calling dealer blitzes, where Bylsma, myself, and Malisa Bryant are in the dealers every month talking about what are they winning on, what are they losing, how do we tune our offer. One of the ahas was that they didn't have as good of picture of our full offer as we needed them to have.

So we created a space and we created a process to bring back regional groups of folks, both dealers and Herman Miller folks, and do deep dive training across the whole portfolio. We have now two more to go in the fourth quarter before we will have been through everyone in the country, but we've been working those very consistently. The first one was -- first couple were so successful and oversubscribed, where the dealers were sending their people, that we've been running those every quarter, and I think that will be an ongoing process. So that has had a big impact of just making sure our folks are fully tuned up on details.

So all of those things, product side, Budd, I think we're in good shape there as well. We've launched a number of products. One of the big activities for myself, Ben Watson, our Creative Director, and Don Goeman, the Head of R&D, and Greg Bylsma over the last year, has been retuning, using a lot of the same principles of HMPS, or if you will, Lean, around our whole new product commercialization process.

We've completely reorganized all of the core R&D resources in Michigan, and created standing teams around each of the major product categories, as well as separated between long cycle development, short cycle development, and what we're calling our innovation kitchen. That has really increased the throughput, which has enabled us to not only respond to short-term stuff, but I think is giving us a lot more confidence in the long cycle innovation capability of the business, so that one, I would say, is not done. To me, we're probably 75% of the way through getting that where I think it ultimately will come, and I would say, we haven't seen the full benefits from it yet, but I'm really good that the catch up work we had to do, I think we got behind us. Now we're putting in place what we need for the long run.

One more for me, because I don't want to take too long. We have had a number of upsets around the consumer landscape, particularly in the upper end and areas like that, and you've got John there. Maybe he can give us his read, the competitive landscape is certainly vibrant there, and a lot of controversy at least in the investment community, and trying to understand how that's all playing together, between the new lifestyle retailers, the online retailers, and your effort to bring the consumer into the classic modern design.

Sure, hi Budd. Certainly, we all saw that the retail furniture industry became extremely promotional in the calendar fourth quarter, and we saw many of our competitors e-mailing every day with very aggressive discounts. We chose to hold the course.

When we have a sale at DWR, it's at 15% off. We believe that there's long term value in protecting our brands and protecting our standing with our clients, that we offer true value day-in and day-out, and certainly we know that furniture sells best when it's on promotion, but we didn't jump into the fray there. And I think we're seeing benefits of that, as we move forward.

We're really focused on internal things that we can do. How can we service our client better, how can we draw more traffic into the stores? One of the things that we're doing is opening new locations that are in much higher traffic locations, so that we have natural walk by.

So as an example, in Dallas, we're moving from a street presence, we'll open next week in NorthPark, which is arguably one of the best shopping centers I believe in the country. And NorthPark came after us, which is happening throughout the real estate development community, where the best landlords have seen what our studios look like. The volume that we're able to generate, and are reaching out to us, so where we had a bit of a problem filling a studio pipeline and getting stored opened in this year against our plan, we have a very robust opening schedule, and we'll run great stores.

How many next year, and how many at the end of this year?

So we'll end the year at 30 locations this year, and we should end next year, fiscal year, at 35, and there will also be a few, Dallas as an example, will be a new store, but it doesn't add to the store count, because we'll be closing one.

Budd, that doesn't include the outlets, which we have two locations for outlets.

And ending square footage this year versus next year?

I think this year we're projected to end around 250 [million], if I remember right, Budd, and I think next year, it won't be the average for the year, but I think if you get end-to-end, we're up about 40,000 square feet when we get to the end.

That's close.

In that range.

And last question on that is the rental, the annual rental stream for Herman Miller? At the end of this year and end of next? What do you think it will be?

Total Herman Miller, Budd, or just DWR?

Sure.

I don't know if I got that number off the top of my head. We can call you with it though.

That's fine, that's great. I appreciate that. You're right, and obviously with the new FAS rent, is going to wind up on the balance sheet at some point in time. Maybe in my lifetime.

And Budd, we have looked at that. We know the size of that, so I don't know if I know total rent across everybody. We've got a rough idea of what that does to the balance sheet, from a debt perspective. Give or take, if you look at all of it I think today, this is a Brian Walker rough estimate.

It's about $100 million give or take and net debt, assuming you've got not no leases, that it's full length. We haven't read the full FASB yet so that's just me using an old man's accounting method, but I would say we stay well within any of our current debt covenants, even if we had to capitalize it and nobody adjusted the covenants, so I'm very comfortable we don't have an issue.

I understand. Thank you very much. Good luck on the quarter and balance of the year.

Thank you. Our next question is from Kathryn Thompson with Thompson Research.

The first is on margins. Maybe you could give a little bit more clarity on lower operating expenses in the quarter, versus guide. Were there certain segments that drove this change, and any other color you can just give in terms of that operating expense? Thank you.

Kathryn, it's Jeff. Good to talk to you this morning. So with respect to the guide, we did obviously come in, I think we came in about $5 million lower than the guide at the midpoint.

I'd bucket it into three categories. We had lower than expected, or lower than guided revenue, so you're going to get some variability there. Call it $1 million to $1.5 million, in that range. I

would suggest that the balance of that delta came in two categories. Number one, we had a general, we did, I think, the teams did a good job managing costs. As we came through the January time frame with all of the skittishness in the stock market and the nervousness, we definitely pulled back where we could, and I think the teams did a good job managing program spend, and I think that the balance, so that would be maybe half the balance.

And then rest of it, Katherine, is candidly a push. We actually pushed some spend, that we just didn't get to, into our guide for the Fourth Quarter. This would be things like, there is a bit of facility spend related to the show rooms that we're putting in place, that Brian alluded to in New York, that was just a move out of Q3 into Q4.

We had some IT-related costs that was just a timing. We knew it was on the bubble as we closed out the third quarter. Some of that moved out, and then just in general, some marketing dollars as well.

Okay, helpful. Thinking longer term on margin expansion, what is a reasonable bogey off the base this year, and how much of this is dependent upon market, or success of the DWR expansion or any other factors such as expansion of product?

So when you talk margin, let me answer that with an op margin reference point.

Yes.

Gross margins, it gets difficult, because we have to decide what's going to happen with commodity pricing, and currency. That's to you at all levels. Let me just give you a long-term --

Well and it also, SG&A is also different for DWR, versus office furniture, so yes.

Yes, so at a consolidated level, we have been pretty consistent in over time, to drive an increase in operating margins, at a rate between 2 and 2.5 times the growth in organic sales, okay? So that's how we look at it, and we've always said, look, our contribution margin performance in the business depends on a number of factors. This quarter is a great example, right, where we had some tail winds from commodities. So we got, I think we came in somewhere on the order of 25% contribution or leverage, right at the op income level. That's pretty good.

Now we had some help from commodities and so forth, so things went our way. Longer term, we think that 15% to 20% contribution margin lines up with that ratio of 2 to 2.5 times the rate of organic revenue growth, and if you back test that for our business, we've been able to deliver that over the past five years.

One thing you have to keep in mind, Katherine is that some people want to draw that as a straight line. You'll have periods below and above that.

It's very much, that's why we've tried to get folks to think about it as a ratio. If we're higher in the growth curve, we're higher up on that. If we're lower, it's going to be below that.

So our base assumption in that is we're going to see, you've got to believe the industry is going to grow a couple 2 to 3 points because you're getting something to grow off from. Certainly, for us to get that from where we are, some of that has to come from DWR getting to grow, because we always believe that as DWR grows, grew -- we had the ability to actually expand margins in that business, and that does remain a part of that formula, as we look at the future.

Okay great and that segues to just a little bit more of a return on investment question. So what is the return on investing in pushing DWR, and the retail change that you currently have been implementing, versus investing in North American furniture? And just maybe broadly speaking, could you discuss philosophically how you're thinking about returns and risk to investing between those two strategies?

Well, first, we believe and remain a belief that DWR in the long run, and I would set aside DWR and talk about the consumer business in total, because I think you have to think about those as a combined thing, that we believe that over time, we could run the operating margins of EBITDA margins of that business up to a level that it would be at or above our consolidated business. We still think from looking at it in the long run, that is doable. If we get to that, the return on capital of the investment we've made, will be quite good, and actually be above our overall average.

So that is what we set out to do. We've not taken our eyes off that ball at all. I would tell you, if you look at it as a store basis, actually the return on capital is quite strong when we open a store. The payback is something around two years or less for opening a store.

The thing that I think sometimes folks miss is the actual capital to open a store is not that significant. It's not like we do lots of construction. We don't do lots of fit out. Really, basically, we've built beautiful white boxes, and the star of the show is the furniture, not the building. So to me, that's actually how we've thought about that business from the beginning.

I think the return on capital there for investing in the core business is really a matter of, when we built our strategy five years ago, we said if all we're going to do is invest in North America contract furniture, it be a nice business, with great returns, but our ability to grow at the rate that we think is required to be a public Company was not going to be there, because the industry was going to grow on average 2% to 3%, maybe 4% in a good year. We thought we could beat that by a bit, but if we're really going to grow at the level people expect, we had to find a much bigger market opportunity. Consumer is but one part of that.

We also believe that investing in the consumer business was congruent with what we believe the trends were in the contract business as well, and I think that is being justified, if you talk to our dealers today, who I don't believe saw it in the beginning, who realized today that their customers are also asking for more residential-oriented products as part of their floor plate. So to me these are -- you can't look at these things as being separate. They are an integrated strategy where we see that products we're designing and developing in the consumer world will play.

In the contract world, likewise, we are selling high performance seating, high performance desking, and other things to our consumer customers as well, and we think longer term, that also gives us a platform with what we built from a channel construct, to reach out to small businesses as well. So to me, I think you can't put these, you can -- each of them have to stand on their own at one level, but I also think they are self-reinforcing on top of each other.

Perfect. Excellent, thank you very much.

Thank you. I'm showing no further questions at this time. I'd like to turn the call back over to Brian Walker for closing remarks.

Well, thank you all 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, and a great spring.

Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day.