Steelcase Inc (SCS) 2019 Q3 法說會逐字稿

Good day, everyone, and welcome to Steelcase's Third Quarter Fiscal 2019 Conference Call.

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

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

Thank you, Candace.

Good morning, everyone.

Thank you for joining us for the recap of our third quarter financial results.

Here with me today are Jim Keane, our President and Chief Executive officer; and Dave Sylvester, our Senior Vice President and Chief Financial Officer.

Our third 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 pleased with our third quarter results and we expect a good fourth quarter as well.

Let's start with the results of the third quarter.

We grew sales 17% globally on reported basis and 13% organically.

Americas sales were up 12% organically, which again, appears to be faster than the industry.

And by the way, the U.S. industry is doing pretty well with BIFMA reporting about 5% year-over-year shipment growth for the 3 months ending in October.

Our EMEA and APAC regions also reported strong revenue growth.

We grew global orders by 10% in Q3, which is supporting our 9% to 12% organic revenue growth estimate for the fourth quarter.

Orders remained strong in the first few weeks of Q4, and we expect December shipments to be the highest we've seen in many years.

Our reported earnings per share grew more than 40% over the prior year.

Earnings per share growth was more than 60% after adjusting for a pension charge, I'll cover in a moment.

We expected a good quarter, but earnings were a little better than we expected because of some favorable tax adjustments and also because Americas gross margins came in higher than we estimated.

Our gross margins are below prior year, primarily because of inflation, particularly in steel, labor and freight.

We are now approaching a point where our price increases earlier this year are offsetting the rate of inflation.

So we don't expect to see additional erosion.

As time goes by, we intend to recapture our lost margin through normal price increases and improved productivity.

Our EMEA business had another strong quarter of year-over-year profit improvement, driven by 12% organic revenue growth.

Our new products and partnerships and good performance by our sales organization in developing deeper client relationships have helped us sustain higher win rates.

As you can imagine, our factories are really busy and that led to higher overtime and overhead costs and some challenges to our overall operational efficiency.

Gross margins were somewhat lower because of these costs, and of course, our operations teams are on it, working to make sure we're ready to support additional growth.

EMEA's operating loss reflects the initial effects of purchase accounting related to the Orangebox acquisition.

Dave will cover that in his remarks, but for now, just know that if we exclude Orangebox completely, EMEA would have been profitable in the quarter.

I want to call out one more thing in our results.

We recorded an unexpected charge of $11 million related to a multiemployer-defined benefit pension plan that has long covered our active and retired unionized truck drivers and mechanics in the U.S. We make our required payments to the plan every month as agreed with the union.

We have previously disclosed in our 10-Ks, the possibility that we could be required to make additional payments to the plan because it is severely underfunded.

And in fact, we received a letter from the plan this quarter, notifying us that their trustees will review whether to terminate our participation in the plan because we employ far fewer covered drivers today than we have in the past.

Termination by the trustees would require us to pay our withdrawal liability.

This is typically done through a series of fixed monthly payments over 20 years.

We're still in discussion.

So we believe it is probable, we will accept their decision.

Our $11 million charge this quarter is a net present value of these payments.

Adjusted for the related bonus and tax effects, the net effect of the charge on net income amounts to $5.5 million or $0.05 of earnings per share.

Now let's talk about business conditions in each market.

Despite the obvious stock market volatility, we see a supportive economic environment in the U.S. CEO confidence has taken a hit because of trades concerns, but it's still very strong versus historical benchmarks because of lower tax rates.

Corporate profits, job growth, nonresidential fixed investment, all remain encouraging.

And companies are investing in their workplace.

In a recent PwC survey, 86% of CEOs agreed that modernizing their work environment is one of their strategies to attract or develop digital talent.

It's actually the strategy mentioned most often in the study.

At the same time, there is plenty to be concerned about.

Brexit could affect our U.K. business, and we saw significant softening in U.K. order patterns during our third quarter that we thought could be related, but in recent weeks, orders have improved again.

We're watching closely and preparing for various scenarios.

The disruptions in Paris had some minor impact on our logistics and again, we saw some weakness in our orders in France that might be related, but more recently, we've had a series of wins that could help to offset the weakness.

Trade tensions between the U.S. and China are likely to affect business confidence on both sides.

This could reduce investment by multinationals in the region as well as local and global expansion plans by Chinese headquartered companies we serve.

While that's all true, our APAC business has been strengthening throughout the year.

So yes, there's disruption, but it feels like our business is expanding because our clients need to compete for talent and reinvest in their workplace and that still has a lot of energy behind it.

The investments we made in new products and acquisitions are paying off, and we saw a 4% growth in our refreshed legacy portfolio this quarter as well.

One last point, and here I'm stepping back from just what happened this quarter or what we expect next quarter.

We're having a good year because the strategies we developed more than a year ago and because of the number of long-term investments we made over the last several years.

We invested in our Munich LINC and it's helping us improve our win rates.

We increased our investment in product development and it's helping us improve our win rates.

We made a few targeted acquisitions to expand our addressable market and we're very pleased with our early progress.

As we look to next year, we expect to see more impact from those investments and more traction from the partnerships we developed, including West Elm workplace, which began taking orders for new products just this week.

So the point is our strategy is working.

We have to stay agile.

We have to respond quickly as business conditions change.

We've done that several times this year, but the strategy itself is working.

We started fiscal year '19 expecting it to be one of the best years we've had in over a decade, and with a quarter to go, we believe we're on track to achieve that goal.

And we're optimistic about the outlook for fiscal year '20.

So thank you for your interest in our company.

I'll turn it over to Dave for a deeper look at our results.

Thank you, Jim, and good morning, everyone.

I will cover our third 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 fourth quarter.

As Jim said, we reported another quarter of strong double-digit growth in revenue and earnings.

The $901 million of revenue in the quarter was in line with the estimates we've provided in September and represented the highest quarterly revenue we've reported in the last 10 years.

The $0.36 of adjusted earnings exceeded the top end of our guidance for the quarter and represented a 64% increase over the prior year.

Before I get into the detailed results, I want to share a few additional highlights, some of which Jim just referenced.

First, we posted strong organic order growth again this quarter, driven by double-digit growth in the Americas, Asia Pacific and Designtex.

And while EMEA and PolyVision orders declined moderately in the quarter, we saw improvement in their order patterns during November and into early December.

I will share more details about our order patterns in a few moments, but I wanted to start with referencing this continued strength as it helped drive the strong revenue growth in the quarter as well as the relatively high levels of order backlog at the end of the quarter, which contributed to the strength of our outlook for the fourth quarter.

Second, the $0.36 of adjusted earnings included a $3.6 million favorable tax adjustment related to foreign tax credits, which had the effect of increasing earnings by approximately $0.02, after consideration of variable compensation effects.

Even without the tax benefit, the growth of adjusted earnings was still very strong again this quarter, exceeding 50% compared to prior year.

Third, the Americas operating margin of 8.1% was reduced by 130 basis points due to the net impact of pension charge, which Jim just covered, plus another 20 basis points related to the variable compensation associated with the favorable tax adjustment.

Adjusted for these items, the segment achieved a strong 9.7% operating margin, despite pricing benefits being largely offset by increased commodity, freight and labor costs, which dampened the Americas operating margin by approximately 60 basis points.

In the fourth quarter, we expect benefits from our April and June pricing actions to begin exceeding the significant inflation we have been experiencing since the start of our fiscal year.

Lastly, the $2.6 million improvement in EMEA operating results compared to the prior year included a $4.2 million improvement in our recurring operations and a $1.6 million operating loss associated with the acquisition of Orangebox, which was driven by the initial effects of purchase accounting related to acquired inventory and backlog.

And the improvement in EMEA was achieved despite some unfavorable shifts in business mix and some operational challenges associated with the revenue growth, which I will cover in more detail in a moment.

As it relates to our third quarter results relative to our expectations, revenue in total was largely in line with our estimates, but has included some pluses and minuses worth mentioning.

In the Americas, revenue benefited from stronger-than-expected order growth, plus some favorable adjustments to our incentive accruals, but these benefits were reduced by the impact of project delays.

Our customers often request extended delivery dates and/or make adjustments to installation schedules as projects near completion.

But the length of extensions and the amount of adjustments were more significant than a typical quarter in the Americas, and we experienced similar impacts in EMEA and the Other category.

From an earnings perspective, the $0.36 of adjusted earnings were higher than our estimated range of $0.28 to $0.33 per share.

Beyond the $0.02 from the tax adjustment, I mentioned a moment ago, we experienced better-than-expected performance in the Americas, offset in part by shortfalls in EMEA and the Other category as well as higher corporate costs.

Within the Americas, the favorable adjustments to incentive accruals contributed $3.1 million and were driven by contractual changes with a few of our largest customers.

Plus, our business mix between quote types and across our product offering was better than expected in the third quarter, albeit still unfavorable when compared to the second quarter or the prior year.

Elsewhere, the project delays were the largest driver of the shortfalls, plus we experienced some unfavorable shifts in business mix and some operational inefficiencies in EMEA and at PolyVision.

PolyVision also experienced softness in revenue from premium whiteboards in the European market.

And corporate costs were higher than expected due to COLI losses, driven by a decline in the equity markets, offset in part by a reduction in deferred compensation costs linked to participant investment elections.

Otherwise, spending across the corporate functions remains tightly controlled.

Switching to year-over-year comparisons.

Operating income increased by $8.9 million in the third quarter or $16.4 million adjusted for the impact of the pension charge.

The increase was driven by improvements in the Americas, EMEA and the Other category, offset in part by higher corporate costs, which were driven by the same factors I just mentioned.

In the Americas, operating income increased by $15.1 million excluding the pension impact, and was driven by organic revenue growth, which totaled $68 million or 12% in quarter.

The strong operating leverage was achieved in the quarter even though revenue from our recent pricing actions was largely offset by higher commodity labor and freight costs, which totaled -- which approximated a $13 million increase compared to the prior year.

There is still a relatively significant effect on our gross margin, but we feel good about our pricing actions and the pace at which our sales teams are driving customer agreements to more current list prices.

We also experienced some unfavorable shifts in business mix which negatively impacted our gross margin in the third quarter, but we held our operating expenses, excluding acquisitions and variable compensation, relatively flat at the same time so the contribution margin associated with the volume growth was still quite strong.

In EMEA, we reported an operating loss of $700,000, which included a $1.6 million loss at Orangebox, driven by the initial effects of purchase accounting and a $0.6 million reduction in variable compensation expense associated with the pension charge recorded in the Americas.

Adjusted for these items, the slightly better than breakeven results represented a $3.6 million improvement compared to the $3.3 million operating loss in the prior year.

This improvement was driven by $19 million of organic revenue growth in the quarter while holding our operating expenses relatively flat.

In connection with the higher volume, we incurred increased outsourcing costs and higher overhead spending, plus we experienced higher logistics cost in France and unfavorable currency impacts associated with some of our cross-border sourcing.

Some of our global operations leadership is in Europe this week and plan to return after the first of the year to help address some of these issues and strengthen our momentum around continuous cost reduction.

We also experienced some unfavorable shifts in business mix across EMEA.

In the Other category, the operating leverage associated with the organic revenue growth was impacted by a higher mix of large projects that were more heavily discounted and increased operating expenses to support our longer-term growth strategies in Asia Pacific.

Sequentially, the comparison of third quarter operating income to the second quarter was impacted by a number of factors, including the favorable nonrecurring items recorded in the second quarter, which included the property gain and lower warranty product liability and workers' compensation costs, the pension charge, partially offset by the favorable adjustments to incentive accruals recorded in the third quarter, the seasonal strength of Smith System in the second quarter and other unfavorable shifts in business mix in the third quarter and higher sequential operating expenses related to product development, the National Sales Conference in the Americas and other initiatives.

Moving to the balance sheet and cash flow.

We used $79 million of borrowings under our global credit facility to fund the acquisition of Orangebox in September, but we were able to pay down our borrowings to $27.5 million by the end of the quarter from the generation of strong cash flow in the quarter, which totaled $84 million.

In addition, we received approximately $12 million of proceeds in connection with the sale of a corporate aircraft.

Working capital growth in the quarter was driven by a $14 million increase in inventories, excluding acquisition impacts.

The increase was linked to the project delays I mentioned previously as well as the overall growth in our business.

Capital expenditures totaled $15 million in the third quarter, and we continue to expect fiscal 2019 to fall within a range of $80 million to $90 million, driven by our growth strategies and related investments to broaden our industrial capabilities, enhance our information technology systems and strengthen our customer-facing facilities.

We returned approximately $16 million to shareholders in the third quarter through the payment of a cash dividend of $0.135 per share.

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

We did not repurchase any shares during the quarter, except for those used to settle income tax obligations related to the vesting of equity awards.

Turning to order patterns.

I will start with the Americas segment, where our orders in the third quarter increased 14% compared to the prior year.

Across the months, we posted double-digit order growth in September and October followed by mid-single-digit growth in November.

Customer order backlog at the end of the quarter was approximately 16% higher compared to the prior year.

And through the first 3 weeks of the fourth quarter, order growth has been tracking at a strong double-digit percentage.

Orders from our largest customers showed improvement again in the quarter, growing by a strong double-digit percentage compared to the prior year.

Across quote types, orders for project business grew at a double-digit percentage and orders associated with continuing agreements in our marketing programs grew by a mid-single-digit percentage.

Turning to vertical markets.

We saw order growth in 5 of the 10 vertical markets we track, including strength in the insurance services, energy, financial services and healthcare sectors.

In addition, the group of untracked vertical markets grew at a strong rate again this quarter.

Areas of weakness included information technology, technical, professional and manufacturing.

Overall, we feel very good about the third quarter order patterns in the Americas as they outpaced our expectations from the beginning of the quarter and have remained strong through the first 3 weeks of the fourth quarter.

In addition, based on the most recent information from BIFMA, our order growth over the trailing 6 months ended in October has outpaced the industry.

Looking forward, our win rates have remained strong and we're continuing to see solid year-over-year growth in our pipeline of project opportunities projected to ship in the fourth quarter and fiscal 2020, which is consistent with the general level of optimism we are feeling from our dealers about their near and mid-term outlooks.

For EMEA, the 6% order decline in the quarter was driven by weakness in the U.K. and France, which may have been driven by some of the recent political and economic unrest in these countries.

Elsewhere, Germany and Iberia posted order growth again this quarter and the rest of the EMEA as a group continued to post declines.

Across the months, order declines in total moderated from a 9% decline in September to a 1% decline in November.

And through the first 3 weeks of the fourth quarter, order patterns reflect double-digit growth across most markets, including the U.K. and France.

Customer order backlog in EMEA ended the quarter up approximately 11% compared to the prior year.

For the Other category, orders in total grew by 12%, driven by strength in Asia Pacific which posted order growth of 16%.

Orders at Designtex also grew by a double-digit percentage, while PolyVision declined by a low single-digit percentage compared to a strong prior year.

Turning to the fourth quarter of fiscal 2019, we expect to report revenue in the range of $860 million to $885 million, which includes revenue from the acquisitions of AMQ, Smith System and Orangebox, net of the few small divestitures and approximately $14 million of estimated unfavorable currency translation effects.

The projected revenue range translates to expected organic growth of 9% to 12% compared to the prior year.

Taking into consideration the projected revenue growth, we expect to report diluted earnings per share between $0.24 to $0.28 for the fourth quarter of fiscal 2019.

This estimate projects the yield from our recent pricing actions will begin to exceed commodity, labor and freight costs and unfavorable business mix will continue in the fourth quarter.

In addition, the estimate includes a modest sequential decrease in operating expenses compared to the third quarter and a 27% effective tax rate.

As it relates to the acquisitions of Smith System and Orangebox, we anticipate modest earnings dilution in the fourth quarter in part due to the seasonality of Smith System, which generates approximately 2/3 of its revenue in the summer months of June, July and August.

In addition, the operating results from these acquisitions will include $3 million of ongoing amortization expense in the fourth quarter.

As it relates to our acquisition of AMQ, which we completed a year ago, we are very pleased with how this acquisition has been contributing to our organic revenue growth and earnings expansion.

And we expect similar positive contributions from Smith System and Orangebox in fiscal 2020 as we more fully implement the related value-creation plans.

Taking into consideration the outlook for the fourth quarter, our fiscal 2019 results are on track to represent one of our strongest years in more than a decade.

And we are targeting to grow revenue and earnings again in fiscal 2020, consistent with the midterm targets we shared at our Investor Day in October.

From there, we will turn it over for questions.

(Operator Instructions) And our first question comes from Bobby Griffin of Raymond James.

First question, I was hoping to get a little bit more color on the West Elm partnership.

How's that progressing?

And maybe when we could start to expect seeing some of those orders start to ship and flow into revenue?

Yes.

So this is Jim.

I'll respond to that.

So over the last several weeks and months, we've been preparing for it by getting our operations ready.

There's some work we're doing on some of the products.

Of course, we want to make sure we've got all the distribution ready to go and so on.

And that's all moving exactly as we would like.

We're also readying our dealers and our customers to make sure that they know about the products.

We'll begin building a pipeline as we begin to open up order entry.

So order entry really just opened this week and it's happening almost exactly as we expected it, in fact, just a little bit earlier than we expected.

So we're happy about that as well.

So the orders should start flowing here over these next few weeks, of course, with the holidays, we'll expect mostly that to begin flowing next year -- next calendar year.

And then the shipments will be a couple of months after that.

So we're -- everything is turned on and we're ready to go.

And each month and quarter -- so when I say we've turned them on, I should also clarify that it's for the products we've developed and activated so far.

We'll continue to add to that portfolio as time goes by.

So we'll have more order entry opening moments for other products as next year continues.

Jim, can you give any color on the level of SKU count in the first kind of order entry opening period that you guys are going to have with them?

I don't have a SKU count in the room here.

I know it's significant enough that -- it is significant enough that we're excited about it and our dealers and customers are excited about it.

And we're getting a really good reaction from customers, from the design community and others.

Okay.

Fair.

And then my second question is on the -- just kind of in the U.S. average project size, when you look at the project business today, anything different in the size of projects versus this time last year or 2 years ago?

We'll look that up.

A few seconds.

Dave is right going through his papers over here.

Nothing that we're talking about internally.

I will start with that.

I -- we don't really look at it that way.

We look at orders and sales in lots of different ways.

But I'd say we have -- I can think of examples of some very large opportunities that we're working on, and I can also assure you there's an ongoing stream of smaller projects.

So nothing that's notable to me.

We'll see if Dave has any data.

Just a little bit of a bend towards the larger bucket of order size, where most of the growth -- or I'd say the growth was driven by the greater than $3 million size this quarter.

But if I look back over the last 4 quarters, Bobby, there isn't really an obvious trend.

If anything, we have had more consistent strength in, let's say, $1 million to $3 million size bucket, and this -- but this particular quarter was a little stronger in the greater than $3 million.

Okay.

And then -- and I guess lastly, just on the raw material front, are you starting to see any type of relief in steel or transportation or any of the other cost buckets or it is still kind of a steady grind higher?

No.

If you double click and you go into the individual commodities, you'd see some things that were spiking and peaking before like steel starting to show some signs of coming off of those peaks.

On the other hand, we have others like transportation that are a steady grind upward.

And typically, when it's transportation, you think it's related to fuel, but here, it's really related to shortages of drivers and trucks and just a lack of capacity in that segment of the economy.

It's causing, first of all, some risk of disruption to our outbound supply, although we've been able to manage that pretty well but the costs are rising.

There is one example.

And also we see a general upward pressure in labor cost.

So as we look across all the factors of production, we see some things coming down and other things going up.

And our next question comes from Matt McCall, Seaport Global Securities.

So maybe start with the price-cost comments, Dave.

Can you talk about the impact that you felt in Q3?

Remind us of the impact kind of year-to-date in the fiscal year.

It sounds like it's going to be positive.

Did I hear that right, price is going to exceed cost?

It will be a benefit and that's assumed in your guidance?

Yes.

So I'll speak in terms of dollars first and then I'll go to gross margin percentage.

But in dollars, as you know, through the first half of the year, year-over-year inflation was exceeding the benefits we were getting from the 2 pricing actions we took.

This quarter in Q3, the pricing actions approximated the level of year-over-year inflation that we're seeing from our commodity, freight and labor cost.

And next quarter, we think that our pricing actions should begin to exceed the year-over-year inflation.

From a gross margin percentage perspective, we're, obviously, have been feeling pressure on our gross margins because we're getting a lot of pricing revenue with no margins.

So this quarter, somewhere in the $12 million, $13 million range of revenue and offset by $12 million, $13 million of inflation.

So we get revenue with no gross margin dollars, which has an obviously negative effect on our gross margin percentage.

So I think that pressure on the margin percentage will ease next quarter as well as the dollars of pricing benefits should begin to offset the higher year-over-year inflation, assuming we don't see anything dramatically different in the commodity pricing.

So Dave, the dollars there were $12 million, $13 million, both revenue and inflation.

What about the first half?

What were those numbers in the first half?

I don't have them off the top of my head, Matt.

But, I mean, you could say -- so they were significant.

I think the inflation's shot up quickly.

So maybe inflation in the first quarter was not quite $10 million, maybe in Q2, it was a little more than $10 million.

And the pricing has built its way up to the $12 million or $13 million that I just referenced.

But if those numbers are important, we could follow up with the call and try to go back to the transcripts.

Okay.

I can do that.

I just -- I was just trying to put it all in one place.

So I guess the same question around mix.

We've talked about this for a while.

And, I guess, the first part of the question, Jim, have you seen a period like this?

I've got some theories on what's driving it, but I'd love to hear what you think is driving this outperformance on the project side.

And then Dave, what has the impact been, same kind of question, year-to-date in Q3 and what's the outlook look like?

Well, on the project part, I think it goes back to what I talked about in the script that we see more and more customers who are not simply coming to us because they want to expand or refresh the products they have, but they're doing more significant reinvestments in their work environments.

And they're doing it because they want to attract a new kind of workforce.

They want to retain people they have.

They're trying to drive productivity.

So we're seeing this shift from simple refresh to a more complete reinvestment.

And we're seeing that here, but we're seeing it in other places around the world as well.

I think this is one of these things that's universally true these days.

So I think it's part of it.

We also saw a lot of strong end-of-year business and that can help us with certain product mix.

So I think those are the 2 things, one is just the continue gaining emphasis by our customers on reinvesting in the workplace.

And secondly, some really strong year -- end-of-year business.

But those are the 2 favorable mix shifts we saw.

Okay.

So, I guess -- well, I'm going to sneak in 2 shorter ones.

The new products you talked about, Series 1, I thought it was an interesting story at the Analyst Day, just given the initial strength that you've seen there.

Can you give an update on the volume activity from Series 1 in some of those lower-priced products?

And the success you're having with maybe customers -- an update on the success you're having with customers that historically, maybe weren't Steelcase customers?

Yes.

So I think, first of all, we have seen -- our intent with the products of Series 1 was to be able to address the part of the market that we haven't been able to address before, and we believe we've been successful in doing that.

So a lot of that is qualitative.

We can go customer by customer internally and we can see evidence that there -- they're shifting their buys from people that are outside of majors in many cases towards Steelcase, so we're happy about that.

Our total sales of Series 1 are in -- far in excess of our expectations.

I was out on our lines last week where we build that product and we're continuing to expand our capacity and are at volume levels that we weren't expecting to see for quite some time.

So it's been very, very successful.

Now when you launch a product like that, you get some cannibalization.

You do and we expected to see some cannibalization, but overall, we're happy with the results of that.

And I think Series 1 is also something that's responding to changes in the ways people work.

As you see more people working in more mobile ways with more unassigned desks as they move from space to space, the length of time they sit in any particular chair could fall and that's some of what's driving customer's adoption of that.

It's just the recognition that the people are working differently and they're shifting their dollars around their mix of things they buy for their facilities.

Does that answer your question?

It does, it does.

I'm sorry, I'm going to sneak one more in.

The -- some line item help, Dave.

I know you gave some insight into SG&A, but you could tell where I was going with price cost in the mix.

I'm trying to get an idea on what the kind of the gross margin trajectory from here is as price cost gets better, as you anniversary some of these mix impacts.

And what is the -- what's baked into the Q4 guidance and how do we start to think about the gross margin trajectory next year?

Well, I'll start with Q4.

And remind you that we did give color on what we expect operating expenses to be sequentially in the fourth quarter and we gave revenue guidance.

So that ought to be able to allow you to back into a range of what we're expecting for gross margins.

And certainly implied next year in our target, our midterm target to grow earnings at twice the rate of organic revenue growth, would be implied in that would be improvement of -- in our gross margins, which would come from volume benefits, our continued focus on cost reduction to help offset, if not more than offset, some of the necessary investments in our manufacturing as well as the gross margin improvement initiatives in EMEA, all contributing to implied improvement in gross margins for next year.

And our next question comes from Kathryn Thompson of Thompson Research Group.

I wanted to -- really appreciated the color you had on month-to-month in terms of orders and the magnitude of order growth.

I wanted to pull the string a little bit more on the Americas business in terms of thinking about of that large versus small customers or smaller orders.

And were you -- are you seeing any change or deviance or certain patterning in terms of the mix of large versus small orders.

And when you look at prior, there's lots of questions about if there's going to be a recession.

But it would be helpful if you could also put into perspective the mix of large and small orders in past downturns, maybe to help us understand where we are.

Because we tend to think that we may be more at a pause versus an outright recession.

But wanted to really gather from your experience an understanding how orders can be reflective of thinking about the product cycle.

Okay.

So Kathryn, I'm looking in front of me at the last 5 quarters worth of order growth rates or decline across how we bucket our order size, which is I'll call them very small, small, medium and large.

I talked about the large being greater than $3 million and the medium being kind of $1 million to $3 million in size.

And as -- really, as I look across the trailing 5 quarters and look at the ups and downs of those buckets, there really is not an obvious pattern, except for across the $1 million to $3 million bucket.

We've had more consistent growth in that group of orders, in that grouping or bucket of orders than we have in the other areas.

More recently, in the small and very small buckets, we've actually seen growth in 3 of the last 4 quarters.

And even recently in the current quarter, they -- in total, those buckets grew.

One was up, one was down.

But I don't think we're seeing anything in the Americas and all this is relative to the Americas.

But I don't think we're seeing anything yet that might be concerning.

To your question around is -- are we -- is -- are the dark clouds in the horizon starting to show up at all in our order patterns either across our small customers or our larger customers.

Yes.

And get -- go ahead.

Well, I was going to continue with your question about what have we seen in other recessions.

And what are some -- I think what you are saying is what are some of the things we want to be watching for to see early sign.

So if you go -- and I will try to stop short of a history lesson, but I'll do a little bit just to provide context.

So the 2 recessions that most of us remember is 2001 and then again, 2008.

2001 affected us in a dramatic way.

And that was really recession triggered by the drop in the NASDAQ.

And at the same time, a number of financial scandals, Enron and things like that, that caused kind of a sandwiching of big customers who were now concerned about what does that mean for valuations, what does it mean for the ways they're thinking about long-term investments?

What does it mean for attracting a new kind of workforce?

Remember that NASDAQ was really the dotcom crash.

And the scandals caused business confidence to just kind of plummet.

So that was a business first kind of recession.

And I'd say in that one, what we felt was big customers dropping their orders very quickly.

I remember us dropping significantly, 40% or something from peak quarter to trough quarter, back in that period.

But it was a large company cut back that was unmistakable.

And the second recession, the financial crisis, of course, that is driven more by the financial sector.

And you might remember people talking about how -- it really felt at first as if it was a Wall Street versus Main Street kind of recession.

Like will it ever hit Main Street?

Is this something that's only going to affect the financial sector, well, we know how that story ended.

But as a result, it was the financial sector where we saw the softness initially.

So both recessions were, I mean you could say, well, there were similarities in those large companies, but there were differences because of the nature of it.

And if we have another recession, it kind of depends on what the nature of that recession is.

If it's consumer-driven, it may affect us differently.

If it's a credit crunch affecting small companies, it could affect us differently.

If it's big companies, we know what that looks like.

But as Dave said, at this point, we're not really seeing any signs of that.

If anything, the fact that we've got really strong orders here in Q4, a time when we're normally seeing more of a seasonal lull, is really encouraging.

Even though we have all these things, we're watching, like I mentioned, Brexit and disruptions in Paris and U.S.-China trade.

All those things are disruptors, but it feels like underlying demand is remaining pretty strong right now.

Okay.

That is very helpful and I appreciate you taking the time to flesh that out fully.

My follow-up question really has to do with how you think about, speaking of tariffs and inflation.

2018, from a broad construction standpoint was -- has definitely been the year of inflation with a wide variety of costs going up.

But we -- one of the things that we're seeing as we look at in our world of construction value chain, is price increases into 2019 that maybe not as many and maybe not the magnitude of the size because companies have been able to catch up with that price-cost.

And also you have seen, as you noted in your prepared commentary, some abatement of certain cost.

Do you share a similar view and maybe could you broadly think about that price cost and internal pricing strategy as you go into calendar 2019.

Yes.

So we've been lucky enough to have to deal with much inflation for the last several years, but we all remember dealing with this before.

And this is one of the benefits of having experienced management team.

We've been at this for a while.

We've learned the lesson that if you don't respond quickly when you see inflation begin to spike that you never are able to make up those gaps in the long run.

So we try to be very aware of what's happening.

We have regular meetings, whether there's inflation or not, where we're just constantly looking at that and asking ourselves if we're doing right things.

We have pretty sophisticated models we use all over the world to look at the rises and falls of commodity prices and what that might mean for price increases.

We've also been able to reduce the time it takes us to go from the decision point to actually implementing it.

And so we've done a lot of things to become as good at this as we can be.

And normally, if you do all that and you look at forecast, you don't get too surprised.

But the impact of tariffs has been the big difference this last year.

So even though we don't pay very much in tariffs, when a tariff goes into place or it goes away, it can create a certain -- a sudden shock to the commodity prices you pay.

Even if you're not paying the tariff, it affects the prices anyway.

And so that's been a big difference this year, but I'm pleased with our team's ability to respond to it.

We are switched on.

We're constantly -- we were just in a meeting a week ago looking at this again and we will continue to monitor it, as we go forward.

So I think we will be able to continue to make those decisions.

We've been successful so far in showing our customers that these price increases are fair and warranted, and we continue -- we expect to be able to continue to do that.

Dave, do you want to add anything to that?

No.

And our next question comes from Greg Burns with Sidoti.

So just looking at EMEA, volumes were certainly up, but it didn't look like they were that far out of line with what was implied in guidance.

So I was just wondering if you could give us a little bit more color on what surprised you there.

Where the shortfalls came from, from an operational perspective?

What kind of investments or other actions you need to take to rectify that situation?

And what that means for margins in that segment going forward?

Yes, it's Dave.

I will start and then Jim can add some comments.

I would say, first, we're definitely pleased with the year-over-year improvement.

You have to adjust for Orangebox and the variable compensation effects of the tax item, et cetera.

But when you do that almost $4 million year-over-year improvement.

So we feel very good about that.

It was lower than we were expecting.

And it was in part lower because of revenue, which you could say was influenced by the order patterns being soft early in the quarter and/or influenced by the fact that we had more project delays towards the end of the quarter than we expected.

So that was certainly a contributor.

And the other contributor was the operational inefficiencies that I gave reference to, and you can tell we're on it immediately with some of our operations leaders in Europe here the week before the holidays and plans to get back in January and into February.

And it's not because so much that we have a bunch of problems, it's just that we're -- with the increased volume, that we're -- the factories are dealing with, we've had some inefficiencies that we want to get rectified.

And which allows us to keep more energy focused on our continuous cost reduction efforts and our other gross margin improvement initiatives.

So a good quarter.

It was not exactly what we expected, but we're pleased with being profitable, if you set aside Orangebox, and showing another significant year-over-year improvement in our results.

Yes.

And I don't have much to add, other than to point out the 12% organic revenue growth in EMEA is in the face of a bunch of headwinds.

If you think about, EMEA includes the Middle East, and the Middle East is always going to be affected by oil prices which are down right now.

And so it's 12% revenue growth despite that -- despite the disruption we've seeing in the U.K. and despite several other things.

So 12% revenue growth, net of all of those headwinds, we're really pleased with performance.

And when we dig into that, we're seeing examples of customers we have served for long time, increasing their purchases.

But also lots of examples of customers where we had small share of wallet and we're growing into a larger share of wallet, customers whose business we've lost in the past that we won back.

Customers we never served before that we're serving for the first time.

So the underlying performance of EMEA from a win-rate perspective is really encouraging.

Okay.

And turning to Asia Pacific.

You mentioned some larger deals.

Are those from international companies operating in China or are those from domestic Chinese companies?

What is the complexion of the growth of that -- in that market?

And I don't know if you mentioned what the exact growth rate was, but if you could give that to us also, that will be helpful.

The -- so to characterize the business in Asia overall, is that, historically, by that I mean, if you go back 5 or 10 years, our business would have been primarily serving multinationals with operations in Asia.

And what's really changed over the last several years is that, although we continue to serve those customers, we are building relationships and successfully serving locally headquartered companies.

These are Asian-headquartered companies in China and India and other places in the region.

And that's really a big part of what's been fueling our growth.

So today, it's a mix.

We continue of course to serve multinationals.

We also serve these locally headquartered companies.

And as they've grown, they've expanded their operations outside of Asia.

So our relationships that we've established with them in Asia has helped us grow our business with them in other parts of the world.

And that shows up in the Americas and EMEA numbers, but it just gives you a sense of where we are.

So it's a much different business mix today than it would have been even 5 years ago.

And their revenue growth in the quarter was stronger than the 16% order growth that I referenced in my comments.

(Operator Instructions) And our next question comes from Bill Dezellem of Tieton Capital Management.

A couple of questions.

First of all, the EMEA operational efficiencies, is it fair to say that those are largely a function of business being stronger than you had anticipated there and -- or overwhelming the plants a bit?

Is that the long and short of it?

I think that's the key driver.

So yes, the business is stronger than we anticipated.

I wouldn't say we overwhelmed the plants.

But we are seeing higher levels of overtime, higher spending on overheads to support that surge in volume and also seeing some inefficiencies.

So it isn't though -- I don't want to leave you with the idea that whenever we see volume like this, we're going to face these sorts of challenges because that's what the team is working on right now to make sure that we are scaling up and we're able to support volume as we continue to grow.

We also felt unfavorable currency impact from our cross-border sourcing.

And also had unfavorable logistics cost in France, in part linked to some of the unrest in and around Paris.

That's helpful.

And then you had referenced that Smith System, in particularly, is our seasonally slow time of the year.

Would it be a fair guess that they lose money this time of year, but conversely, as they enter their seasonally stronger period next year that that will lead to an additional push-up in earnings?

And so we are seeing a little bit more volatility in your earnings than we historically would have, which would imply that your results are just that much better here in this seasonally slower period for them than maybe the overall numbers would indicate?

I wouldn't say that they'll lose money.

They won't make as much money as they used to as a stand-alone company because of the purchase accounting adjustments, all the amortization of intangible assets that we've had to put in place.

But they -- with 2/3 of their revenue coming in 3 months in the summer, you can imagine that's where they make the bulk of their profitability.

And then what they have historically targeted and what we continue to target is to not lose money in the off-season.

But certainly not generate a lot of -- or as much income as we do in the summer.

The second part is right that we have mild seasonality that our summer months are stronger and more profitable for Steelcase overall.

And they are like that to a greater degree.

So as we add their business to our business, we see a little bit more of that seasonality.

But it's a fair point, Bill, to say, "Hey, if you didn't have the acquisitions in the fourth quarter, it sounds like your earnings would be a tad higher" and that's accurate.

That's really helpful.

And let's just continue on with Smith, if we could.

And I suspect it's a little early for this question, but to what degree have you had success taking Smith and pushing their products into dealers that you never really had a good educational offering for and/or taking products of Steelcase and put them into what had historically been the Smith sales channel.

Where are you at with that process?

Yes.

So we're right in the middle of it.

It's going well.

So we've had good reactions from our dealers.

We have a number of dealers who have been introduced to Smith.

And this is where the seasonality is helping a bit because in a sense, this is the time of the year to do those kinds of introductions because the buying season starts in late winter, early spring for shipments that are done in the summer.

So the key here is for us to get all that activated right now so that we're ready for this next season when it comes.

I'd also say one other audience that we're addressing is the A&D community.

Some of whom are quite familiar with Smith but a lot of them aren't.

And we've been able to introduce some of the large players in this world of education to the Smith System portfolio, and we hope to see good things come from that as well.

And that concludes our question-and-answer session for today.

I'd like to turn the conference back over to Jim Keane for any closing remarks.

Thank you, and thank all -- I want to thank all of you for joining our call today.

I know it's a busy time of the year and we really do appreciate your interest in our company and the good questions you asked.

And from all of us here at Steelcase, I want to extend our best wishes to you for a wonderful holiday and a great start to the New Year.

Thank you.

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

This does conclude the program.

And you may all disconnect.

Everyone, have a great day.