Steelcase Inc (SCS) 2018 Q2 法說會逐字稿

Good day, everyone and welcome to the Steelcase's Second Quarter Fiscal Year 2018 Conference Call.

As a reminder, today's call is being recorded.

For opening remarks and introductions, I'd like to turn the conference over to Mr. Mike O'Meara, Director of Investor Relations and Financial Planning and Analysis.

Thank you, Nicole.

Good morning, everyone.

Thank you for joining us for the recap of our second quarter fiscal 2018 financial results.

Here with me today are Jim Keane, our President and Chief Executive Officer; Dave Sylvester, our Senior Vice President and Chief Financial Officer; and Mark Mossing, Corporate Controller and Chief Accounting Officer.

Our second quarter earnings release which crossed the wires yesterday is accessible on our website.

This conference call is being webcast, and this webcast is a copyrighted production of Steelcase Inc.

A replay of this webcast will be posted to ir.steelcase.com later today.

Our discussion today may include references to non-GAAP financial measures and forward-looking statements.

Reconciliations to the most comparable GAAP measures and details regarding the risks associated with the use of forward-looking statements are included in our earnings release, and we are incorporating by reference into this conference call the text of our safe harbor statement included in the release.

Following our prepared remarks, we will respond to questions from investors and analysts.

I will now turn the call over to our President and Chief Executive Officer, Jim Keane.

Thanks, Mike, and good morning, everyone.

We're reporting today on a solid second quarter with better revenue growth and stronger profitability than we expected 90 days ago.

Some unusual items helped our bottom line, but even without those effects, our results were better than we were expecting primarily because of stronger performance from the Americas segment and a successful effort to improve operating expense efficiency.

Our Asia Pacific segment had another strong quarter and EMEA delivered a better-than-expected loss in Q2, and we expect to break even in the second half of the year.

I'm going to use my time this morning to elaborate further on questions you've asked in previous calls or in investor meetings.

These relate to Steelcase and our strategies but also how we see things changing in our industry and the opportunities we see for growth.

Last time, we told you that large customers seem to be delaying or reducing spending, and at that point, we were seeing fewer large projects on the horizon.

90 days later, we're seeing some signs of improvement as the Americas pipeline of project activity has strengthened modestly over the last few months and global account orders in the Americas were up slightly in Q2 after 2 quarters of significant year-over-year declines.

As a result, Americas order rates and revenues were essentially flat against the prior year, which is an improvement versus the 3% order decline we saw in the first quarter.

We also spoke last time about the shift in customer demand away from legacy furniture and seating products supporting traditional applications like private offices, panel-based cubicles and even developed recent solutions like fixed-height benches.

Demand remains strong for height-adjustable solutions, applications that support mobile work and across a broader range of price points.

Over the last 18 months, we've increased our product development pipeline to respond to these trends.

The products we launched and enhanced over the last 3 years are doing very well against our expectations and have helped us improve our project win rate.

Revenues from these products now represent nearly 1/3 of our total revenues, and we believe we are approaching the point where the growth of new products will offset the decline in revenue associated with legacy products and applications.

In each of the next several quarters, we expect to launch innovative new products that respond to the breadth of demand we are seeing from customers.

Increasing our spending on new product development was not an easy decision, but a few quarters later, as we see these results, I know it was the right decision.

Some of you have asked us if we feel some customers are shifting to lower price points, and certainly, there is examples of that.

But overall, I believe it's more accurate to say that more customers are buying across a wider range of price points than they have in the past.

There's still plenty of demand for high-performance task chairs, and Gesture is doing well.

But there is also demand for lower priced chairs like Series 1 because it supports a different kind of work without compromising safety or quality.

So you can expect to see Steelcase offer more new products at lower price points but also expect to see new high-performance products.

We are doing both.

Together, a broader range of products helps us increase our addressable market.

We responded before to questions about whether we could efficiently increase our product development capacity, "Will there be growing pains?" It's a fair question.

Here at the midway point of the year in which we expect to launch more new products than in recent memory, nearly all our projects are on time, are hitting their innovation goals, are hitting their gross margin targets and the related spending is at or under their project budget.

We're spending more in product development in total including investments in our manufacturing capabilities and agility, but our productivity and efficiency is very good.

I mentioned earlier that we took some steps to reduce operating expenses in Q2, but we didn't pull back on product development.

We reduced spending elsewhere, so we can continue on our momentum.

Nearly every quarter, there's a question about pricing in our industry.

Our industry has always been competitive, but as we discussed last time, we believe we are seeing more instances of certain of our traditional competitors discounting major projects to new levels.

And now we're seeing that in every region.

One has even broadly announced their explicit intent to use deeper discounts to win business, and of course, word travels fast.

All the majors are feeling market share pressure because of the demand shifts I talked about earlier.

And some are feeling it more than others, which likely fuels more aggressiveness on pricing.

We are also committed to competing aggressively in our core business, but for us, that means investing more in product development, building stronger and deeper relationships with customers through investments like our new Learning + Innovation Centre in Munich; and continuing to drive better speed, quality and cost in every aspect of our business.

We don't try to win on price, but when we feel we've earned the right to serve a client through insights, innovation and relationships, we do what we must to defend our position.

And despite the higher pressure on pricing, we've held or improved our share versus the peer group of major competitors, and our win rates have also improved recently.

Our Americas gross margins are down but that's more because of recent material inflation and product mix shifts than higher discounting.

On the last call, I discussed another industry trend around the shift to noncorporate-looking designs that draw from hospitality and residential influences.

We believe the aesthetics of this trend will continue to evolve but the underlying forces are related to offering more choices to users and more control to users over how they work.

Another underlying force is how these spaces allow clients to express unique notions around the direction of their brand and culture.

These are spot on our own insights, things we've talked about for years.

Those of you who have been to our spaces in Grand Rapids see how we've done this ourselves by using our own product offering.

At its root, this trend is really good news, a complete rejection of the idea that office furniture is just a commodity and that workplaces should be cost reduced or outsourced.

But in the short run, customers are seeking even more choice than we, or any other major manufacturer, have offered, and that has led to reduced share of wallet.

While that has happened, we see a significant opportunity for us to respond to this trend, and we are doing so in multiple ways.

We are launching new products by Umami, of course, which will be shipping soon.

We are globalizing relevant products we currently offer in only 1 region, so we can meet customer needs in other regions.

We are forming partnerships like Blu Dot, which we announced last fall, and now 3 new relationships announced just in the last few days.

Mitchell Gold + Bob Williams offers a very broad and relevant line of high-quality furniture products.

FLOS is a very well respected provider of a lighting including architectural lighting; and Bolia is a European-based manufacturer of design-forward residential furniture, which is very relevant to today's demand from commercial customers.

We see an opportunity to leverage our scale and integrate these products with our existing products to increase the range of our offering and provide more choices to our customers.

We will also leverage our 2 market capabilities and our operational capabilities to make it easier for customers to access this broader set of choices.

Again, you can expect to see more activity in this space, both in terms of new relationships and new business models.

Over time, we hope to more fully embrace the trend towards choice and control to the point where it becomes an important growth engine for our company.

These actions are intended to enlarge our addressable market as we expand our product offerings through our own product development, through relationships and, potentially, through acquisitions.

And remember, those new segments we're addressing are growing faster than the core, so we see opportunities for sustained growth.

Finally, we're excited to be launching this month our first wave of products related to our smart and connected strategy.

As workplaces have become more dynamic, customers need a new way of assessing what's working and what's not.

There's growing demand by customers for data, and some have already experimented with sensors already available in the marketplace to gather that data.

We did similar experiments using existing sensors but felt that customers would really need a better end-to-end solution that gathers data, analyzes data and makes sense of the data to drive change.

We also felt customers wanted solutions that were robust and secure.

We knew individual users wanted comfort that personal information about where and how they work would be treated responsibly.

Our teams have been working with teams at Microsoft to develop a scalable solution using Microsoft's Azure platform.

Over the summer, we've learned from alpha and beta sites and are ready to now offer it to our customers in a broader way.

This is just the first of a series of products and services from Steelcase aimed at augmenting work, worker and workplace.

Though it will take some time before it materially affects our results, we believe the potential for future growth is significant.

I'm hoping that this approach of updating our answers to your previous questions help you see where we are in our journey as we position Steelcase for a new era of competitiveness and growth.

Now I'll turn it over to Dave to talk about our performance in Q2.

Thank you, Jim.

I will cover our second quarter financial results first, noting where results differed from our expectations and highlighting year-over-year and sequential quarter comparisons, and then I will talk about our balance sheet and cash flow before getting into our order patterns and outlook for the third quarter.

We were pleased to report second quarter revenue near the top end of our guidance and earnings which were better than the estimates we've provided last quarter.

The $0.31 of earnings were better than our estimated range, both with and without the $0.05 attributable to the property gain and discrete tax credit recorded in the quarter.

Before I get into the details of our results, I want to first share a couple of highlights, some of which Jim just mentioned.

First, we are seeing a few positive signals in our order patterns and pipeline that suggest the level of demand from our largest corporate customers may be poised for improvement following the significant decline we experienced in the first quarter and through much of the second quarter.

Based on our review of publicly available information, we are still seeing reductions in total capital investment across this group of customers, but total orders from these customers declined at a lower year-over-year rate compared to the decline we experienced in the first quarter.

In addition, large project activity from some of these customers included notable increases late in the quarter.

Second, the level of demand for our new products in the Americas has remained strong, continuing to grow by a strong double-digit percentage compared to the prior year.

In addition, revenue from products, which have been significantly enhanced during the last 3 years, also grew and the rate of growth was solid.

Over the balance of the fiscal year, we have approximately 50 additional new products and enhancements expected to launch.

And that's beyond more than 300 products, which will be available through our new partnerships which Jim just mentioned.

Third, we were pleased that EMEA returned to posting year-over-year improvements in their operating results, which included a 280 basis point improvement in cost of sales as a percentage of revenue and was driven by continued benefits from cost reduction and other gross margin improvement initiatives.

Looking forward, these initiatives and modest sales growth are expected to drive breakeven operating results in EMEA in the second half of fiscal 2018.

Fourth, Asia Pacific posted strong revenue growth and solid operating income again this quarter, accounting for much of the year-over-year improvement in the other category.

Although order growth in the region slowed in the second quarter, our level of customer order backlog and estimated pipeline of project activity remains strong.

As it relates to revenue in the second quarter, the organic growth of approximately 2% was at the high end of our expected range and included exceptional strength in Asia Pacific, which drove 19% organic growth in the other category this quarter.

EMEA and Designtex also grew revenue in the quarter while revenue in the Americas was flat with last year.

I will make a few additional comments about our business mix and other factors in the Americas, EMEA and Asia Pacific.

For the Americas, the flat revenue growth in the second quarter was somewhat better than expected and included mid-single-digit percentage growth in business generated from our continuing agreements, offset by a similar percentage decline in project business.

We are pleased to see the growth in continuing business, but it's worth noting that the prior year comparison was relatively easy as it reflected a double-digit percentage decline.

Revenue from our marketing programs was relatively flat following several quarters of declines, suggesting that our efforts to regain share of wallet in day-to-day business may be starting to pay off.

For EMEA, the 4% organic revenue growth was driven by growth in several markets including the U.K., Iberia, Eastern and Southern Europe and the Middle East and Africa, while Germany and the Central European markets declined.

With the improvement of economic and political sentiment in France and Germany, we are continuing to see improvement in our pipeline of project activity compared to the prior year, and we believe our new Learning + Innovation Centre in Munich will contribute to an improvement in our win rate as we compete for larger projects across the region.

In Asia Pacific, India drove the exceptional revenue growth this quarter, but we also posted strong double-digit growth rates in China, Southeast Asia and Australia.

And our optimism in this region continues given the current level of customer order backlog, our estimated pipeline of project activity and growing demand for our new products.

From an earnings perspective, the $0.31 per share in the quarter was much better than expected and included $0.05 related to the $4 million gain from the sale of a property in the EMEA segment and a $3.9 million favorable tax adjustment after consideration of related variable compensation expense.

Operating income exceeded the level contemplated in our earnings estimate due to favorable operating expenses and higher revenue, partially offset by higher cost of sales as a percentage of revenue.

Beyond the property gain, which was not included in our earnings estimate for the quarter, we reported a $2 million reduction in deferred compensation expense driven by the decline of our stock price in the quarter.

In addition, spending was significantly lower than our estimates due to a shift of activity from the summer to the fall, plus our efforts to pull back on nonessential spending in areas outside of sales and product development.

The higher-than-expected cost of sales was driven by some of the same factors that impacted the year-over-year comparison, which we detailed in the release, and I will summarize again in a moment.

Other income net was unfavorable to the typical $1 million to $2 million estimate we have communicated in the past, largely due to foreign exchange losses driven by the weakening U.S. dollar, plus various smaller charges.

Regarding our effective tax rate, excluding the $3.9 million tax adjustment we recorded in the quarter, the effective rate approximated 35%, which was largely in line with the 36% estimate we communicated in recent quarters.

Switching to year-over-year comparisons.

Operating income decreased by $8 million primarily due to a 140 basis point increase in cost of sales as a percentage of revenue.

Volume leverage associated with the 2% revenue growth was offset by higher operating expenses, net to the property gain I mentioned earlier.

Regarding the increase in cost of sales, it is important to first note that the prior year represented the lowest cost of sales as a percentage of revenue that we have seen at the consolidated level or within the Americas segment in more than a decade.

EMEA and the other category both posted year-over-year decreases in cost of sales, while the Americas posted a 250 basis point increase.

The increase in the Americas was due to increased discounting and incentives, higher commodity cost, investments in support of product development and manufacturing agility and unfavorable shifts in business mix, each of which contributed similarly to the increase.

Sequentially, second quarter operating income was higher compared to the first quarter primarily due to seasonally higher revenue, favorable business mix and lower operating expenses, which included the favorable items in the quarter I mentioned previously, plus the unfavorable impact of annuitizing the defined benefit plans in the first quarter.

Moving to the balance sheet and cash flow.

Cash generated from operating activities in the first 6 months of the year was consistent with the prior year with pluses and minuses being largely attributable to timing.

Capital expenditures totaled $20 million in the second quarter and $37 million year-to-date.

We continue to expect capital expenditures for fiscal 2018 to fall within a range of $80 million to $90 million, driven by our intention to sustain a high level of product development, strengthen our manufacturing agility, enhance our information and technology systems and continue to invest in our customer-facing facilities.

We returned approximately $42 million to shareholders in the second quarter through repurchasing 2 million shares at an average price of $13.65 per share and funding a quarterly dividend of $0.1275 per share.

And yesterday, the Board of Directors approved the same level of dividend to be paid in October.

We currently have $99 million remaining under the company's share repurchase authorization, and we will continue to evaluate opportunities to return excess liquidity to shareholders through opportunistic repurchases.

Turning to order patterns.

I will start with the Americas segment, where our orders in the second quarter declined less than 1% compared to the prior year.

After posting mid-single-digit percentage declines in April and May, we posted modest order declines in June and July, followed by 5% growth in August.

Customer order backlog at the end of the quarter was 4% lower compared to the prior year and order patterns early in the third quarter reflect a mid-single-digit percentage decline compared to the prior year.

Across quote types, order patterns related to projects, continuing business and our marketing programs were relatively flat compared to the prior year and order patterns included declines in larger orders, offset by growth in smaller orders.

Turning to vertical markets in the Americas.

Order patterns remained mixed and somewhat volatile quarter-to-quarter, reflecting year-over-year growth this quarter from the information technology, financial services, government and energy sectors, while the most notable decline came from the manufacturing and technical professional sectors.

For EMEA, order patterns also remained mixed with growth in some markets being offset by declines in others.

But across the months, weakness early in the quarter was offset by broad-based strength in August, and order patterns early in the third quarter have remained strong.

Customer order backlog in EMEA ended the quarter down 7% compared to the prior year.

Within the other category, orders in total grew 3% compared to the prior year and included growth from Designtex and PolyVision.

Order patterns in Asia moderated in the second quarter following 3 consecutive quarters of exceptional growth.

Tax changes in India, which took effect on July 1, likely contributed to the moderation, and some of the geopolitical tensions in the news over the past several months may have also stressed business confidence.

Nevertheless, our customer order backlog is strong, order activity during August and early in the third quarter have been solid and our estimated pipeline of project activity remains robust.

Turning to the third quarter of fiscal 2018.

We expect to report revenue in the range of $785 million to $810 million, which includes approximately $11 million of estimated favorable currency translation effects compared to the prior year and reflects a range of an organic decline of 1% to organic growth of 2% compared to the prior year.

As we said in the release, we expect to report diluted earnings per share between $0.21 to $0.25 for the third quarter of fiscal 2018.

This estimate includes an expected sequential increase in operating expenses of approximately $10 million compared to the second quarter adjusted for the gain on property sale, as well as an expected sequential increase in cost of sales as a percentage of revenue due to seasonal shifts in business mix.

Related to EMEA, recall that the third quarter of the prior year included approximately $2 million of favorable adjustments to accrued liabilities, which were nonrecurring in nature and primarily impacted gross margins.

For the third quarter of fiscal 2018, we expect our gross margin improvement initiatives to provide year-over-year benefits that will largely offset the prior year nonrecurring items.

We also expect operating expenses in the third quarter to increase compared to the prior year and, sequentially, compared to the second quarter adjusted for the property gain due to unfavorable currency translation effects, higher levels of product development, investments in the sales and dealer conference and the full unveiling of Munich during the quarter.

In the Americas, we expect to report lower gross margin in the third quarter compared to the prior year due to many of the reasons I cited in the explanation of second quarter gross margins.

And we also expect a sequential decrease in our gross margin due to unfavorable shifts in business mix, including higher levels of government business and higher logistics and commodity costs due to the recent hurricanes.

For operating expenses, we expect to report a sequential increase in operating expenses compared to the second quarter as well as a year-over-year increase compared to the third quarter of the prior year.

Beyond the third quarter, we are optimistic about the potential for improved growth in the Americas as we estimate the growth in revenue from new products and partnerships could begin to exceed the declines in legacy applications within the next few quarters.

At that point, we could also begin to moderate the level of incremental investments in operating expenses across our industrial model, which would have a positive impact on our operating leverage related to the projected growth.

In addition, we expect to continue monitoring commodity cost inflation and take pricing actions when appropriate as we have regularly done in the past.

However, it is important to note that the competitive environment remains highly dynamic as the industry is competing for a reduced number of large projects and aiming a higher percentage of resources towards small to medium-sized opportunities.

From there, we will turn it over for questions.

(Operator Instructions) Our first question comes from the line of Budd Bugatch of Raymond James.

Jim, in your prepared remarks, you talked about some changes that you've seen in the landscape versus what you were talking about last quarter amongst some big large corporate customers, can you maybe give us a little bit more color on some of the underlying factors that might be behind that?

And what you've learned in the conversations with them?

And does that continue?

I see that, from what David said, that orders grew in the third month of the quarter, but then in the first couple of weeks of the new quarter, it have moderated back negatively?

Is that correct?

Am I right on that as well?

Yes.

So maybe I'll step back and even go back to previous comments in previous calls.

So we had been seeing a decline in orders from, what I'll call, global accounts as they're related to the orders in the Americas, and that's what I was really referring to.

And in previous calls, we've discussed theories about why that might be happening.

Could it be related to uncertainty around tax reform?

Could it be related to other political factors?

And I don't know that we've ever been able to completely identify it, because it could be a combination of those things.

And it seemed that as we got into this quarter, that is, as we got to July and then August, we saw a strengthening in our orders overall.

And as we analyze the quarter, we see that it is these global accounts that have gone from significant, like in some cases, double-digit year-over-year order declines in previous quarters to moderate or slight growth, and so we see that as a positive thing.

Now why is that happening?

It's hard to say, but maybe people are beginning to look past their expectations for immediate tax reform and are settling in and thinking about the underlying economy.

I would only be speculating, so I will stop since I'm not an expert at that.

As we look at these first few weeks of September, it's too early for us to really do a good analysis of what's growing and what's not growing, but we know overall that the orders are a little softer here in early September.

Could the hurricanes be a factor?

Too early to tell.

So we're going to continue to watch that, but we wanted to give you an update on where we were.

Okay.

And the other question goes to how does the future look compared to what the BIFMA forecast?

It came out a couple of days ago.

Talks about it looks -- the BIFMA forecast is a lot better.

They actually upped their forecast for '17 and '18.

How does that comport with what you are seeing?

And what's your confidence that, that forecast might prove to be accurate?

Well, I think the BIFMA forecast is an industry-wide forecast, and it includes -- and as you know, they've changed the methodology for that.

And they're -- as they changed the methodology, there seems to be a disconnect between the growth of the legacy traditional large competitors, Steelcase and others like us, and what the overall industry is doing.

And that disconnect can be explained by lots of things.

It seems that imports might be one of those factors.

So I'm not -- I don't have an analysis because it's really not possible at this point to try to reconcile the difference between what the total BIFMA industry is and what we're seeing.

We look at the data, of course, but I do feel that there's a little bit more of a disconnect now than there was in the days when BIFMA's forecast were an extrapolation of the numbers of this month.

So we are really just looking at what we're seeing and that is looking into our backlog, looking into our order patterns, understanding what's in the pipeline, seeing a growth in opportunity creation, in some cases, in some markets.

And all these are more positive signs than what we were seeing just a quarter ago.

Okay.

And my last question, Jim, is Munich now opened entirely?

And is it -- what can you see about the early read on that?

Yes, so we have -- all our employees are in Munich now.

So it's open and operating as an innovation center and a learning center.

We have 3 parts of that facility, and the third part will be opening in about 60 days.

No, in 3 or 4 days so.

Okay.

Well, and we're going to have our official -- a series of events that continue to open it and that will be a dealer and sales conference, in particular, that will happen out in November, and that'll be really the opening for a lot of our market-facing folks to come in and experience the facility and to immerse in all the new products we've been launching and so on.

Now over the course of the summer, we've been bringing customers to the space and doing it -- doing the best we could to create a good customer experience even though we don't have the resources of the whole facility open, and we've gotten really good feedback.

And in fact, we won some business.

So we had at least one order we've seen recently, which is a direct result of a visit to that facility.

So I'd say we're at the early stages, but I'm really pleased with the feedback we're getting and the progress we're making and we're on time to open.

And our next question comes from the line of Matt McCall of Seaport Global.

Maybe -- first, Jim, thank you for the details in the beginning.

I like what you've prepared.

That was very helpful.

The guidance, can you give us a little more detail on the guidance by segment, the revenue growth that's assumed, kind of the progression through the quarter that you have baked in into the guidance?

And maybe what's driving that?

And then anything from a segment margin perspective that you'd like to call out?

Well, Matt, I did give a lot of color in my remarks, and so I don't want to reiterate everything I just said.

I'll just point you to that when you go back to the transcript, what you will notice is that we do expect modest revenue growth in EMEA, and we are silent to what we expect in the other category and in the Americas.

And the overall range is down 1% to up 2% organically with the midpoint being relatively flat.

So I think you're going to have to make some assumptions from there.

Okay.

Think about this, though.

I mean, I remarked that we have backlog in both Americas and EMEA are down compared to last year going into the quarter.

In the Americas, order patterns in the first few weeks are down mid-single digit versus last year.

And then in EMEA, we said orders were strong in August and continued into early September into the third quarter.

So we -- in order to hit our guidance, we need order patterns to improve in the Americas and stay steady in EMEA.

Okay.

So to hit the guidance, you need the order patterns in Americas to improve a little bit.

Is there something in the pipeline of activity that caused you to assume that, that improves?

Is it more of what Jim's talking about?

More of what Jim is talking about is the improvement that we saw in August, the sentiment from some of our largest customers, it all is pointing toward a reasonably good improvement relative to recent order patterns, so we're banking on it.

And the third quarter is typically one of our better quarters from a revenue perspective going into the fourth quarter.

December is always a huge month for us as companies approach calendar year-end, and then January and February fall off.

But we're feeling a little bit of an improvement, and we've seen growth in continuing business.

We've seen our marketing programs, the declines, moderate to flat.

We've been pushing on various actions that we talked about last quarter and Jim made reference to again this quarter, and we're hopeful that, that will play out and support our guidance for the third quarter.

Okay.

And then Jim, this might be for you or Dave, either one.

For the Americas business, as we think about it today, and the right gross margin, the right SG&A and the things I'm thinking about that have changed that -- you've talked about the competitive dynamic has changed a little bit, both legacy and new competitors, the additional partnerships you're adding, I'm trying to think about the impact on margin -- on the margin structure there and in the need for new investments and new products and then the mix shifts, so there are a lot of puts and takes, I guess, going on.

I'm trying to figure out structurally, what has changed in the Americas from a gross margin or SG&A perspective as we look forward?

And how will this all settle out?

Yes, that's a good question.

I don't see it as being a significant shift in gross margin percentages as a result of the factors that you mentioned.

I think the need to make these investments is real, but it actually makes our business stronger.

And we've seen before that when we make investments like that, it helps us continue to reduce our costs, improve our efficiency, and we're still quite committed to fitness.

We continue to drive cost reductions every year in our operations, whether it's in the Americas or EMEA or APAC.

So those investments are good investments, and we hold them to pay back targets and return investment targets.

The broadening of our offering will be done, both through product development of our own, which should hit the normal kinds of gross margins, as well as partnerships.

And partnerships aren't bad in terms of gross margins.

We bring a lot of value to those partnerships and those relationships in the way we provide to market access and the way we provide operational fitness and efficiency and the liability.

Now if that was the only thing we were doing, that would have a downward pressure because it's not the same as when you're designing, engineering, making your own products.

But it helps us cover a wider share of wallet, and it has a positive contribution effect.

So it's -- I think those are really good moves taken as part of the total strategy.

And the mix shifts we're talking about are real, but I don't think those are directionality negative as it relates to gross margin.

And the thing you didn't mention was the broadening of price points.

But as we shift towards broader price points and launch products like Series 1, as well as products like Gesture, taken together, again, we don't think there's a downward pressure on gross margin percentage as a result of those things.

So overall, I -- but all things considered, I'd say we have the same expectations for our gross margins as we have in the past.

So if we take that a step further, if you look at the Americas, 12% -- 11%, 12% operating margins, the -- over the last few years, is that still the bogey?

I mean you hit gross margin, it doesn't seem like there's much concern there.

But will SG&A be a source of pressure?

Or we would get to the same spot over time?

I think what's important to remember, Matt, is as we were hitting those 11%, 12% and even better operating income percentages in the Americas, we were doing it by pretty thin operating expense investments, and we paid for that a little bit with some product gaps that we've had to fill in with more aggressive investment in product development and capability.

So I -- we've always talked around here about mid-30s gross margin objectives and mid-20s operating expense objectives for double-digit or better operating income performance in the Americas segment.

We have hit the 35%, mid-30% objective a few quarters here and there, and we had consistently been delivering operating expenses in the lower 20s.

And with hindsight, we wish we would have done that a little differently and that's why you see operating expense investments increasing.

But like Jim, I don't see the mid-30s, mid-20s and double-digit objective being significantly different for us to go forward.

The other thing on operating expenses is even though we're increasing our total spend on product development, the shifts we've made over the last several years towards a global product portfolio helps us leverage those investments more completely.

So take Series 1, for example, so that -- those important product development initiatives over the last couple of years.

But as we launched that product, we launched it almost simultaneously, like within a few months of each other in Americas, EMEA and APAC.

And the ability to do that means that we can ramp up our global revenue faster for the same kind of investment that would've taken just to do that chair for one market.

And so we're going to continue to try to do things like that.

More products designed for global markets and launched more as global products than what we've done in the past, which should help us get leverage.

To a large degree today, our product development infrastructure is a global product development infrastructure.

The teams might be in America, they might be in Europe, they might be in Asia, but the products they are working on are really increasingly global products.

Our next question comes from the line of Kathryn Thompson of Thompson Research.

I wanted to circle up on the hurricane potential impact, not just this quarter but really, more realistically, as we look over the next couple of quarters.

How much of your business currently is in the kind of the greater Florida and Houston markets?

Or maybe put differently, what percentage of your larger dealers are concentrated in these markets?

Really, what we're trying to understand is potential relative impact from the inevitable disruptions that we're already seeing in other lines of business.

Thank you, Kathryn, and your question also gives me a moment just to comment on the tragedy of those hurricanes.

We all felt together the impact on our country and the impact on people of the devastation that came from those 2 events.

We have Steelcase employees that are based in Texas, of course.

We have Steelcase employees in Florida.

We have dealers who are affected by the hurricanes, and their people are affected by the hurricanes in Texas and in Florida, and our hearts go out to those folks.

We've also taken some steps as a company, and also Steelcase Foundation independently have taken steps to provide resources and support to people in those communities.

So I appreciate that question.

From a business impact perspective, the first thing we can feel are the -- are our own actions to delay shipments, to divert shipments, to store product that we would have normally have been shipping and billing.

And so there is an interruption in our revenue recognition simply because the product isn't being installed.

There's also higher costs, for us, of handling product that was already on its way to customers, bringing it back so there's freight cost associated with that and then there's storage costs.

So we don't have a full estimate of all that right now.

Our first priority has been to make sure that we've protected that product and we're working with customers to make sure that we weren't delivering things before they were ready to receive it, so that's one piece of it.

Of course, also, you'd expect to see, and I don't have numbers to confirm it, but an interruption in order flow from the markets that were affected most directly.

Down the line what we have typically seen, this is a little further out, is that there will be products that is already in place that customers that's damaged by events like this, and they need replacement product.

What we also -- and so that can have a potentially positive impact on revenues.

At the same time, the rebuilding process can take labor that would normally be available to our dealers for installations and so on and create a tighter labor market.

That can also slow down construction or renovation projects that our customers might be seeing.

And so I'm kind of painting a picture of the various courses that are out there.

It's hard for me or anyone right now to predict the fact on how those all will off sail.

I'd let Dave take a shot at quantifying some of that.

Yes.

So specifically on revenue, we did not take a significant hedge against our projected deliveries in either of those markets in the quarter under the belief that by the end of our third quarter in November, we believe matters would have settled down by then.

And we'd be allowed -- we'd be able to deliver the projected revenues that we have in those markets.

We did factor in incremental costs associated with all things Jim described.

And it's -- it was worth noting, and it's a driver of -- or one of the drivers of the sequential decline in gross margins that we're projecting but not the biggest driver.

The only thing that I would add to what Jim said is all of our estimates were based on what we saw from hurricane Harvey and Irma.

We have nothing included in our third quarter guidance for the potential impact of Maria, which moved to a category 5 late yesterday afternoon.

So we have to kind of wait and see how that might affect our results.

So just to clarify, you -- it includes Harvey.

Does it also include Irma?

Yes.

Okay, helpful.

Then shifting to cost of goods sold and raw materials.

Just a reminder of where raw materials is as a percentage of cost of goods sold.

Then perhaps a little bit more detail on the categories that are seeing greater inflation and what you're doing to offset that.

Well, as you know, steel is our biggest commodity, and steel prices are public.

And we've disclosed in the past that our pricing is tied to the market but lags the market by 90 days.

So we're feeling the steel inflation that you see from the CRU monitor, and the projections are for that to continue to increase at least in the near term.

We're also feeling some pressure on fuel and some of the other related commodities that are impacted by fuel prices.

It's -- as I said, the year-over-year erosion in gross margin was driven by 4 buckets, and one of them was material cost inflation, and it was in or about the same impact.

So you can do the math and get to somewhere around $3 million to $4 million effect of year-over-year commodity cost inflation.

And then I said at the end of my remarks that we're monitoring, and we will, of course, take action, pricing actions as necessary as we've regularly done in the past.

Our next question comes from the line of Greg Burns of Sidoti & Company.

When we look at the partnerships that you've been developing with Blu Dot and some of the others you've recently announced, do you have any targets for what kind of revenue contribution you see those partnerships bringing over the next 12 to 18 months?

And then also, are they fully integrated into your order system so that your dealers can easily order across these different partnerships?

Yes, so I'll do the second part first.

So the intent as we do -- as we enter into these relationships is to make it easy for our dealers and our customers to access those products using the same selection tools and ordering tools that they use today.

So being able to integrate those is really a key part of the value we're bringing as well as being able to leverage our logistics system, so that we can consolidate shipments and so on.

So as we enter into the relationships, there is still a time period between when we enter into the relationship and when we can actually implement against what I just said, but that work is underway.

In terms of trying to estimate the impact -- and yes, we have internal growth targets for these and expectations for these, but these are also new.

So it's a little bit too early for us to -- we have no way to really triangulate it because we've got -- new in our experience.

We believe we have a sense of the share of wallet that's available for us to capture within our distribution, but there's a lot of questions about how -- to what extent will dealers actually shift from the sources they're using today to the sources that we're building these relationships with.

We obviously believe that there's a lot of value we're bringing and there's a lot of reasons why dealers would want to make that shift, but it will take a little while before I have enough data to give you a good answer to that.

Okay.

And then in terms of EMEA, the sales reorganization that you are implementing over there, how far along are you in that process of changing the sales model over there?

And maybe have you seen any positive indicators that the changes are having a positive impact on your ability to win business there?

Yes.

So to reframe that, I'd say that there's been an ongoing evolution and improvement of our selling function in EMEA.

I would stop short of calling it a kind of reorganization because it wasn't quite as dramatic as that.

It is a matter of reemphasizing things that have always been important in sales.

Like it's really important for us to have the right relationships at the right levels and have them early in the process, and those are things that were true 20 years ago, and we're taking new steps to reinforce that and to help our salespeople develop those sorts of relationships.

And I do see progress there.

So I was in Europe in the last quarter, and we had some good discussions, we believe, in every one of our geographies there about sales opportunities and recent wins and recent losses and what causes the wins and what causes the losses.

And we can point to things that we're doing as it relates to some of those wins.

There's some extraordinary efforts that people do to win business and those are working.

And we could also learn a lot from losses.

So I don't think we're there yet.

I think there's still plenty of opportunity for us to get better.

The opening of the Learning + Innovation Centre in Munich is part of our sales process.

It's something we've done in the U.S. with success for a long time, and it will be nice to have that tool available to complete our approach to the market.

But I think we have a lot of opportunity ahead of us to continue to get better.

So I hope that answered your question.

It's a little less of a reorganization and more of a continuous improvement, but I am seeing signs of progress.

And our next question comes from the line of Budd Bugatch of Raymond James.

A couple of quick follow-ups, if I can.

You've given us some forecast on currency and divestitures and that $10 million sequential cost increase.

Can you maybe give us a little bit of flavor as to the segment breakout for those items, David?

Well, I gave certainly a lot of color about EMEA, right, with projecting modest revenue growth and essentially saying that gross margins could be relatively flat with current year benefits offsetting the prior year nonrecurring benefits that we had.

And then I commented that operating expenses are expected to increase, and we're still targeting breakeven.

So I think you can probably get to a pretty good estimate on EMEA.

We're -- and if you look in the Other category, we've increased our operating expenses a little bit year-over-year but not anything like we have in the Americas segment.

So I think if you take the sequential increase in operating expenses that we've highlighted in the release and I talked a little bit more about and you allocate a little bit to the Other category, a little bit more to EMEA and the balance to the Americas, I think you're going to get there.

And the currency, where's that mostly?

Is it mostly EMEA?

Or is it also in...

It's mostly EMEA, but the dollar versus the Canadian dollar has also strengthened.

So it's probably 11.

I would say, 9 is probably Europe, 8 or 9 is Europe, and 1 or 2 might be in the Americas with a little bit in the Other category as well.

Okay, and in imports.

Imports are growing.

It looks like a little bit faster than the industry.

Where is that coming from?

What are you seeing in imports?

Are you seeing anything in the major items?

Or is it in specific items?

So we're looking at each other because we've had this discussion and we can't figure it out, to be honest.

I mean, when I look at the data and I think imports are growing at that rate across the industry.

And when I figure, we have to be feeling that some place.

You would think that we'd be hearing from customers and dealers and salespeople that there's something significant happening in that sector.

And yes, there are some manufacturers that have imported product but if I quantify it, I can't come up with anything, like, this sort of numbers that we're seeing.

Maybe ancillary, residential, hospitality furniture, some of that is coming from overseas.

But again, a lot of the suppliers that we see out there are actually either United States-based suppliers or Americas-based suppliers so they're not -- maybe it's imports but it's not in the places where we would normally think about.

So I don't have a good answer for you on that one, but I -- David and I have had this conversation, and again, we would think we would be hearing a lot of squeaking sounds if we were losing business in that kind of furniture, but we're really not seeing it.

One other possibility is we do have some traditional manufacturers who are using imports more frequently than maybe they have in the past.

But again, I don't know that I can add it up and come up with those numbers.

Yes, I mean the numbers are coming from the HTS system, our monitoring system, and sometimes, that data is interesting, let's put it that way.

It's possible it may relate to other segments of our industry that -- where we just aren't participating.

The office furniture category can mean lots of things, and people buy furniture in lots of different ways, but it's likely not in our addressable market or among our various customers.

Or it could be probably low end.

(Operator Instructions) Our next question comes from the line of Julian Allen of Spitfire Capital.

Dave, you gave some good color on your, let's call it, target operating model for the North American business.

So sort of mid-30s gross margin, mid-20s SG&A spending so hopefully, back to double digits operating margin.

Could you walk us through what the similar analysis might look like for EMEA?

You mentioned in your prepared comments that this fiscal third quarter, you might hope to achieve breakeven.

Obviously, the third quarter is your strongest quarter from a revenue perspective.

But perhaps you could walk us through the path to breakeven on a more sustainable basis in EMEA?

Well, I think it's indicative -- in the back half of the year, it's indicative of what we need for the full year.

To get there for a full year, we're going to need some incremental revenue growth and continued improvement in our gross margin initiatives, while maintaining modest growth in operating expenses.

What we've said in the past is that we're targeting a mid-single-digit operating income margin in order to return our cost to capital, and that the way we get to that is we're targeting a mid-30% gross margin, which implies that operating expenses might be in the mid to high or higher 20% range to get to that mid-single-digit.

We've got a ways to go on all fronts.

We've got to improve our win rate on large projects and regain share and continue to grow on the top line.

And we have to continue to drive the many gross margin improvement initiatives that we've talked about on previous calls, and we've got to maintain control of our operating expenses.

And what I feel good about is we are entirely through the disruption from the manufacturing footprint changes that we implemented.

The model is even more stable than it was before we launched those changes.

The confidence that we have from our customers and dealers is back to or above levels than it was pre-restructuring.

And as Jim said, we're leveraging our global product development more and more, which allows for localization of global product versus unique product development in EMEA, which should help drive operating expense efficiency.

And with Munich and with our sales strategy now fully deployed, we are hopeful that, that will continue to drive gross margin improvement and growth on the top line.

So think of it as mid-30s on the gross margin objective and high 20s on the OpEx objective as we pursue getting to a mid-single-digit operating income.

And from a volume standpoint, it looks as if -- because you achieved breakeven in the fiscal third quarter last year.

Do you need something like the $575 million revenue level to get there?

Is that about right?

That's about right.

It depends on the currencies, right, but.

And that is all the time we have for questions today.

I'd like to hand the call back over to Mr. Jim Keane for any closing remarks.

Thank you.

So I'll just close by adding one more thought on the relationships we're entering into.

What this is not about is just trying to go out and create as many different product relationships as we possibly can, to access as many products as we possibly can.

That strategy is available, but that really isn't our strategy.

We took a lot of care in selecting the partnerships that -- and relationships we've entered into.

As we did it, we wanted to make sure that yes, that these manufacturers were on trend and had -- and were relevant to the trends we've seen in our industry.

Well, we also wanted to start by talking about quality and understanding how these relationships would supplement and reinforce the Steelcase brand because our dealers and our customers expect that the products we offer, whether it's directly or through these relationships, are carefully curated so that we're offering quality products.

I'm really happy with the quality we've seen from the manufacturers we've worked with through these relationships.

Also, we wanted to take organizations that weren't just on trend but were demonstrating leadership from a design perspective.

They're progressive in their own designs and were seen as leaders in their segment.

And we wanted to make sure that manufacturers and their products were at the right prices.

It's easy to find great products at superpremium prices, but that's not really where we see the market being.

We think leading organizations want these kinds of spaces, but they want to be responsible with their own spending as they create spaces like this.

And so we're very happy with the quality, very happy with the design leadership and very happy with the price points of the partnerships and relationships we've entered into.

So I encourage you all, if you have a few minutes, to go out and look at these websites of these manufacturers.

Look at Blu Dot's website, look at Mitchell Gold + Bob Williams.

It's really a terrific broad range of products that they're offering across, again, a broad range of aesthetics and market-centered price points, plus it's a wonderful provider of architectural lighting and other kinds of lighting.

And Bolia, a European manufacturer, again, very progressive design and very experiential in the way they think about their stores and their customer experiences.

So I'm very proud of how we started this, and I'd encourage you all to take a few minutes and go out and learn more.

Thank you for joining our call today, and thank you for your interest in Steelcase.

Ladies and gentlemen, thank you for participating in today's conference.

That does conclude today's program.

You may all disconnect.

Everyone, have a great day.