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Edited Transcript of MLHR earnings conference call or presentation 21-Sep-17 1:30pm GMT

Thomson Reuters StreetEvents

Q1 2018 Herman Miller Inc Earnings Call

ZEELAND Sep 26, 2017 (Thomson StreetEvents) -- Edited Transcript of Herman Miller Inc earnings conference call or presentation Thursday, September 21, 2017 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brian C. Walker

Herman Miller, Inc. - President, CEO & Director

* Jeffrey M. Stutz

Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer

* Kevin J. Veltman

Herman Miller, Inc. - VP of IR & Treasurer

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Conference Call Participants

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* Gregory John Burns

Sidoti & Company, LLC - Senior Equity Research Analyst

* Kathryn Ingram Thompson

Thompson Research Group, LLC - Founding Partner, CEO, and Director of Research

* Matthew Schon McCall

Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst

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Presentation

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Operator [1]

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Good morning, everyone, and welcome to the Herman Miller, Inc. First Quarter Fiscal Year 2018 Earning Results Conference Call. This call is being recorded.

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

Today's presentation will be hosted by Mr. Brian Walker, President and CEO; Mr. Jeff Stutz; Executive Vice President and CFO; and Mr. Kevin Veltman, Vice President, Investor Relations and Treasurer. Mr. Walker will open the call with brief remarks, followed by a more detailed presentation of the financials by Mr. Stutz and Mr. Veltman. We will then open the call to your questions. (Operator Instructions)

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

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [2]

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Good morning, everyone, and thanks for joining us today. I'd like to start with a brief overview of our quarterly results, followed by highlights of the progress we made during the quarter against our key strategic priorities. I'll close with a view of the current economic backdrop before turning it over to Jeff and Kevin for more information on the financial results, including the change we announced early this week to our segment reporting structure.

In short, the quarter reflected better-than-expected demand patterns as organic order growth of 8% over the prior year was a clear highlight. And we finished the quarter with organic backlog up 8% over last year. Adjusted earnings per share of $0.57 met our expectations for the quarter. Our North America, ELA and Consumer segments all delivered strong order growth for the quarter.

In addition to the ongoing work to transform our real estate footprint in the Consumer business by increasing selling square footage, our Consumer business also delivered its fifth straight quarter of comparable brand growth as our efforts to accelerate revenue growth across our Consumer sales channels gained traction.

Gross margin was near the low end of our expectation for the quarter. This was driven in large part by a strong demand for some of our more capacity-constrained product categories, namely height-adjustable tables and laminate storage. As we work to keep pace with demand, we incurred additional overtime and outsourcing costs.

Our operations team has done a terrific job responding to the challenge. And while some of these pressures are likely to continue in the near term, we are moving quickly to add capacity in key areas of our operations. We also incurred higher-than-normal warranty expenses this quarter. These expenses impacted the profitability of each of our segments but had a disproportionately large effect on our Specialty and Consumer segments given their relative size.

Despite this, I'm very pleased with the way in which our teams across the organization have managed overall operating expenses, which helped offset the gross margin and warranty pressures we experienced in the period. Our cost-savings initiative is one of the key areas of strategic focus, and we're making good progress towards our ultimate savings goal.

Now with that overview of the quarter, I'd like to update our progress on our 5 key priorities. These priorities are aimed at positioning us for the trends we see in our customer base, distribution channels, technology and the changing nature of work as we focus on driving sustainable, profitable growth for the long term.

As a reminder, the 5 strategic priorities that we are focused on across Herman Miller are: first, scaling our Consumer business; second, realizing the next generation of our Living Office proposition; third, leveraging our dealer ecosystem; fourth, delivering on our cost and improvement goals; and last, the continued commitment to product and service innovation. I'd like to focus on specific highlights of progress during the quarter on these priorities.

As we mentioned last quarter, we have brought in fresh outside perspectives to challenge our thinking about ways to drive profitable growth as we scale our Consumer business. As a result of the first phase of this work, we have growing confidence that we can meet our goals for profitable growth in this business and are targeting specific work in areas of pricing strategy, sourcing, logistics and e-commerce.

There's more work to do as we create detailed implementation plans, and this effort will result in short-term costs as we develop these next steps. That said, the path forward is coming into view, and we have growing confidence that this work will contribute meaningfully to achieving our stated profit-improvement objectives, namely, driving Consumer operating margins toward a 10% level. We'll have more to share in upcoming quarters as we make further progress.

Our ongoing real estate transformation to expand the footprint of Design Within Reach retail studio is progressing well. In total, we expect to add an incremental 60,000 square foot of selling space by the end of May. As sales at the new and expanded studios ramp up over the first 12 to 18 months of operating, their profitability will increase as they mature and help drive operating margin expansion.

Despite our growing confidence in the long-term profit potential of our Consumer business, the operating results this past quarter did not meet our expectations. This was due in part to the product warranty costs I mentioned as well as expenses arising from the bankruptcy of one of our past suppliers.

Aside from these transitory issues, it's also important to point out that we currently have 7 new studios, plus a new West Coast outlet, that are in early maturing phase. While this will remain a drag on earnings in the near term, the Consumer segment has a double-digit revenue growth opportunity that we believe can increase operating margins for this segment from 2% last year to at or near 10% over the next 3 years.

In addition to the profitability improvement initiative and real estate transformation, continuing to increase the mix of higher-margin, exclusive product designs and driving growth through our catalog, contract and digital channels will also support this growth opportunity.

As we work to realize the next generation of the Living Office framework, we've been focused on adding new product and technology solutions in addition to new research, highlighting the benefits of applying these concepts. As a part of this effort, bringing Herman Miller quality innovation to a broader range of price points will create new volume opportunities for our business. The recently launched Verus task chair and a number of new desking products in the pipeline reflect product categories that we see particular opportunity in to drive sales growth.

While still in the early days, our Live OS technology platform makes furniture smart by providing robust space utilization data as well as wellness benefits and enhanced user experiences. The new program has strong initial momentum with 2 beta installations since June and several more customer sites scheduled to install in the coming months.

The platform has an active sales pipeline, particularly with large corporate customers that seek to better understand how their spaces are being used. The Live OS platform will grow over time with a smart version of the remastered Aeron chair and meeting room sensors being developed for launch in the second half of the year. These will provide further data insight for real estate professionals along with enhanced comfort and personalized experiences for people during their workday.

Moving to our cost initiative. We are making solid progress on our target of gross annual savings of $25 million to $35 million by fiscal 2020. During the quarter, we implemented additional actions, and we estimate our gross annualized savings run rate today is approximately $15 million. Looking ahead, this effort will not only help offset the potential for wage and material inflation and fund a number of key growth initiatives, but ultimately, this initiative plays a key role in our goal of increasing consolidated operating margins above 10% over the next 3 years.

Finally, we are advancing toward our goal of fully leveraging our dealer ecosystem to, simply put, increase our share of wallet. Over the last few months, we've enhanced our order fulfillment capabilities enabling our dealers to more easily order and specify products across the entire Herman Miller group of brands, including key contract-focused products from Design Within Reach. The progress we have made in this area sets the stage for additional work planned in the months ahead aimed at further improving our digital specification tools for dealers.

With that update on our strategic priorities, let me provide some specific points about the current macroeconomic picture for our business. While order levels for the North American contract industry remain choppy from month-to-month, we saw a clear improvement this quarter in both the pace and consistency of order patterns across much of our business. This is encouraging and appears consistent with what remains a fairly positive economic picture overall, supported by positive data around confidence measures, service sector employment, architectural billings and nonresidential construction activity.

While uncertainty persists around the U.S. administration's timetable and approach, tax reform has the potential to be a tailwind for our business through higher employment levels and increased investment spending. The devastation from the recent hurricanes and earthquakes in North America has a potential for near-term disruption in the impacted regions as they focus on recovery.

That said, these events have little to no impact on us for the first quarter. None of our dealers in those regions sustained significant damage to their physical spaces. Their people are safe. And relative to the recent hurricanes, the dealers have resumed operations.

On a Consumer front, Design Within Reach has studios in Houston, Miami and West Palm Beach that were impacted by the hurricanes. Here as well, our people are all safe, and none of the studios sustained significant damage and have already reopened. The concern is, of course, impact of businesses disruption as the surrounding areas undergo the cleanup and rehabilitation phase.

Like many in the retail space, there may be a boost in demand that comes out of this as customers receive insurance settlements and begin the rebuilding process. Both for our dealers and retail operations, there is potential that we could see some near-term demand impact as businesses and consumers begin the rebuilding process. Given the level of uncertainty tied to this issue, we have provided a broader range for Q2 revenue and EPS guidance than we typically provide.

Relative to the macroeconomic picture for North America consumer space, improved consumer spending, low unemployment, strong equity markets, historically low interest rates and limited unsold home inventory combine to provide a positive consumer environment. While the picture is fairly stable globally, the ELA segment will have to deal with pockets of disruption in some areas, including navigating Brexit; softness in various oil-producing regions, including the Middle East; and continued uncertainty of the geopolitical climate surrounding North Korea.

Encouraged by the strong consolidated demand level this quarter, we will continue to focus on executing our strategic agenda for Herman Miller. We see the profitability improvement potential in our Consumer business and have identified the areas that will release that potential. Our 5 key corporate priorities will guide our efforts as our multichannel business continues to deliver leading designs and innovations to new audiences virtually everywhere in the world.

With that overview, I'll turn the call over to Jeff to provide more detail on the financial results for the quarter.

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [3]

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All right. Thanks, Brian. Good morning, everyone. So before I begin, I want to cover some changes to the way we report our business results across each of our business segments.

Effective in the first quarter, we moved our Nemschoff subsidiary out of the North American segment and into the Specialty segment under the leadership of Steve Gane. This change was made to better leverage the unique skill sets and capabilities of our Specialty business teams, particularly in the areas of craft wood and upholstery manufacturing. It also provides a strong fit for this segment's focus on the architect and design community.

In addition to this move, we've refreshed our methodology for allocating functional SG&A expenses to the business segments. Our business has changed significantly over the past few years, and this change better reflects the utilization of these services across the Herman Miller group of businesses.

We've also identified a pool of corporate support costs that will no longer be allocated to the reportable business segments. Rather, these costs will be tracked and reported as corporate unallocated expenses. This change more closely aligns to industry practice and provides a better reflection of how we will measure and manage our business going forward.

And finally, we've expanded our supplemental disclosure information to include gross margin results for each segment to help investors better understand the financial profile across our business segments. Given these changes, we filed an 8-K earlier this week that provided a restatement of our segment results by quarter for fiscal years 2016 and '17 in order to be comparable with this new approach.

With that bit of housekeeping out of the way, I'll now cover the results for the first quarter. Consolidated net sales in the quarter of $580 million were 3% below the same quarter last year. As a reminder, the first quarter of fiscal 2017 included an extra week of operations.

In addition, during the quarter, we made a change to our standard customer shipping terms at DWR. This change impacts the point at which revenue is recognized on product sales, in general moving it to the point of shipment rather than delivery. The effect of this is purely one of timing. But the change this quarter resulted in approximately $5 million of revenue being recognized that would've otherwise been deferred into Q2 under the previous terms.

On an organic basis, which excludes the impact of this change in terms as well as last year's extra week, foreign currency movement and dealer divestitures, consolidated net sales were 4% higher than last year's level. Orders in the period of $595 million were flat compared to the same quarter a year ago. And on an organic basis, orders were 8% higher than the first quarter of last year.

Our backlog included -- of last year, included approximately $12 million in orders related to dealers that have subsequently been divested. Excluding the impact from the dealer divestitures, the ending backlog for the quarter was 8% higher than last year's level, which as Brian highlighted, gives us a nice tailwind as we enter Q2.

Within our North American segment, sales were $329 million in the first quarter, representing a decrease of 5% from a year ago. New orders were $335 million, reflecting a slight increase from last year. However, on an organic basis we posted year-over-year revenue growth of 3%, while orders were 9% higher than the same quarter last year.

Higher order levels during the quarter were led by medium- and large-sized projects, noting in particular that we saw a marked increase in large projects from what we had been seeing in recent quarters. Sector results showed fairly broad-based growth, led by communications, wholesale and manufacturing, partially offset by lower demand in business services, pharmaceuticals and computer equipment.

Our ELA segment had a relatively slow start to the fiscal year with revenue -- from a revenue perspective, reporting sales of $93 million in the first quarter, a decrease of 4% compared to last year on a GAAP basis. But organically, sales were up 3% in the quarter. New orders totaled $109 million, which is down 1% from last year on a reported basis but up 7% organically. The year-over-year order growth on an organic basis was driven by strong activity in Latin America, Australia and Europe, partially offset by lower demand patterns in the U.K., Middle East and China.

As mentioned earlier, our Specialty segment now includes the results of our Nemschoff subsidiary. Sales in the first quarter within our Specialty segment were $75 million, a decrease of 5% from the same quarter last year. New orders in the quarter of $75 million were 7% lower than the year-ago period.

On an organic basis, net sales were 1% higher compared to last year, while orders decreased approximately 2%. The decrease in orders was primarily due to year-over-year declines at Geiger in the face of a large project reflected in last year's order patterns and partially offset by year-over-year growth in orders for Nemschoff, Maharam and the Herman Miller Collection.

Profitability within this segment was lower than last year, tied to a number of transitory factors in the quarter. This segment bore a relatively large share of the warranty costs that Brian referred to earlier. Nemschoff also experienced a supplier quality issue during the quarter that negatively impacted their sales and operational productivity in the period.

The Consumer business reported sales in the quarter of $83 million, an increase of 10% compared to last year, driven by strong growth across our studio, catalog, e-commerce and contract channels. New orders for the quarter of $76 million were 7% ahead of last year.

On an organic basis, which excludes the impact of the change in shipping terms on net sales and the extra week last year, sales were 11% higher than Q1 of last year, while orders improved 13%. On a comparable brand basis, DWR revenues for the quarter were up 12%.

Related to Consumer operating earnings for the quarter, we estimate the additional revenue resulting from the change in shipping terms increased operating earnings by approximately $1 million in the quarter. While operating earnings for this segment continue to be limited by the rollout of new studio locations and other investments that we believe are necessary to support our longer-term growth potential, as Brian mentioned, we see a path toward operating margins near double digits for this business over the long term.

During the quarter, we estimate the unfavorable impact to operating earnings related to this drag from new studios that have not yet reached full maturity was approximately $2 million. Additionally, warranty costs and the write-off of a claim against a supplier negatively impacted segment profitability in the quarter by approximately $1.5 million.

Consolidated gross margin in the first quarter was 37.4%, which was 100 basis points lower than the first quarter last year and near the low end of our expected range coming into the period. As we outlined in the earnings release, we faced some capacity challenges in the quarter given strong demand for certain product categories.

This resulted in additional labor and outsourcing expenses necessary to meet our quarterly -- our customer delivery commitments, a factor that we estimate reduced our Q1 gross margin by approximately 20 basis points. In addition, we continue to feel the impact of higher steel prices and experienced lower production leverage in the ELA and Specialty segments.

Operating expenses in the first quarter were $166 million compared to $174 million in the same quarter last year. The prior year included approximately $2 million in expenses related to dealers divested since that time. After adjusting for those items, operating expenses were $6 million below last year due to a variety of factors. The primary factor was the prior year reflected an extra week of operations.

As Brian noted, we also made good progress in our cost-savings initiatives this quarter, which contributed to lower operating expenses. We also benefited from favorable claims experienced for health care benefits and had lower incentive compensation levels compared to last year. This favorability was partially offset by higher warranty costs, increased occupancy and staffing costs related to new DWR studios and investments in growth initiatives.

Net, our teams have been very focused on managing operating expenses across the organization, and it is making a difference. To be sure, the walk toward our ultimate goals for profitability will not be an even one, as required investments for growth are not necessarily linear with our cost-reduction plans. However, we feel very good about the progress our teams are making, and we feel we are on track with the cost reduction plans we've previously outlined.

Restructuring actions involving certain workforce reductions that were announced in the first quarter resulted in the recognition of severance and outplacement expenses in the quarter. We also recognized other charges related to the consulting fees associated with our profitability improvement initiative for our Consumer business. On a combined basis, these amounts totaled $2 million in the first quarter.

On a GAAP basis, we reported operating earnings of $49 million in the quarter. Excluding restructuring and other charges, adjusted operating earnings this quarter were $51 million or 8.8% of sales. By comparison, we reported operating income of $56 million or 9.4% of sales in the first quarter last year. The effective tax rate in the quarter was 30.5% and this compares to an effective rate of 32% in Q1 of last year.

Finally, net earnings in the first quarter totaled $33 million or $0.55 per share on a diluted basis. Excluding the impact of restructuring expenses and other charges, adjusted diluted earnings per share in the quarter were $0.57 compared to $0.60 per share in the first quarter last year. And as a reminder, the first quarter of last year included the extra week of operations, and we estimate that extra week contributed approximately $0.05 of earnings per share to the first quarter in that period.

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

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Kevin J. Veltman, Herman Miller, Inc. - VP of IR & Treasurer [4]

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Good morning, everyone. We ended the quarter with total cash and cash equivalents of $80 million, which reflected a decrease of $16 million from last year. Cash flows from operations in the period were $19 million compared to $30 million in the same quarter of last year, primarily due to a onetime contribution during the first quarter of $12 million to increase the funded status of our U.K. pension plan.

Capital expenditures were $25 million in the quarter. Cash dividends paid in the quarter were $10 million. As a reminder, last quarter, we announced a 6% increase in our quarterly dividend rate that will be paid beginning in October. This increase brings our expected annual payout level to approximately $43 million. We also repurchased approximately $11 million worth of shares during the quarter.

We remain in compliance with all debt covenants. And as of quarter end, our gross debt-to-EBITDA ratio was approximately 0.8:1. The available capacity on our bank credit facility stood at $388 million at the end of the quarter, which includes $150 million set aside to repay the private placement notes that are due in January of 2018.

Given our current cash balance, ongoing cash flows from operations and our total borrowing capacity, we believe we continue to be well positioned to meet the financing needs of the business moving forward.

With that, I'll now turn the call back over to Jeff to cover our sales and earnings guidance for the second quarter of fiscal 2018.

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [5]

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All right. Thanks, Kevin. We anticipate sales in the second quarter to range between $590 million and $620 million. While the midpoint of this range reflects our best estimate for the period, we are providing a wider-than-normal range for sales and earnings this quarter to reflect increased uncertainty resulting from the recent storms in Texas and the Southeast.

We estimate the year-over-year favorable impact of foreign currency on sales for the quarter to be approximately $4 million. On an organic basis, adjusted for dealer divestitures and the impact of foreign exchange translation, this forecast implies a revenue increase of 6% compared to last year at the midpoint of the range.

We expect consolidated gross margin in the second quarter to be between 37.5% and 38%. Operating expenses in the quarter are expected to range between $172 million and $176 million. And finally, we anticipate earnings per share to be between $0.55 and $0.61 for the period. And this assumes an effective tax rate of 30.5% to 31.5%.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Kathryn Thompson with Thompson Research.

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Kathryn Ingram Thompson, Thompson Research Group, LLC - Founding Partner, CEO, and Director of Research [2]

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Just following up on Specialty. I wanted to get a little bit more clarity on the order decline. And was the higher warranty cost the primary driver for the margin decline in that segment?

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [3]

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Kathryn, this is Brian. I'll start with the revenue discussion, and then I'll let Jeff talk a little bit more about the warranty impact.

There was -- we had a big quarter last year in the first quarter for both Nemschoff and for Geiger that was, I would say, largely project related on the Geiger side. Nemschoff, same thing, largely big projects last quarter. Those businesses tend to bounce around a little bit by that. Nemschoff was also impacted a bit this quarter on the revenue line by some of the supply chain challenges we had, particularly with a foam supplier, that caused them to be a little bit late with some shipments. So when you add those 2 things together, that was the majority.

I would say the textile side was down a little bit too year-over-year. So overall, there was just some softness across that business. The Collection side of it did really well. We feel really good on the order front, and particularly at Geiger, that had a really good quarter on orders, and see really good activity as we look at the second quarter. That's also true in the Collection.

Nemschoff, I would say, we're going to have to see what happens as we get some of these challenges behind us on the supply side. And Maharam, we have a number of really great ideas in progress to expand the breadth of the textile price points we cover, a number of new products which are getting good reviews. The leather business is just ramping in that business, and we're doing pretty well on the rug side.

So we feel good about the balance of the year at Maharam, although with a little bit of a light start to the year, to be frank. And then, like I say, really good momentum at both Geiger and the Collection. So a little bit -- we got work to do at Nemschoff, to be frank. We made a number of leadership changes in that business in the first quarter that were needed. We've done some retooling of sales leadership there. We think those things, combined with getting their product pipeline ramped up will be important for that business. But we've got work to do in that one.

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [4]

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And then Kathryn, this is Jeff. To your question on segment profitability for the Specialty group. They are really 2 fundamental issues, I alluded to them in my prepared remarks. But if you quantify the 2, there was warranty, which we talked about. But then, there was a fairly significant supplier issue that we think we got our arms around at this point, but it definitely impacted our Nemschoff subsidiary in the quarter.

The supplier issue was actually the larger of the 2. The combination of those, however, was about $1.7 million on the period. So if you normalize for that, you kind of get more to a 4.4% operating income. Now that's still lower than last year, but as Brian pointed out, we had particularly tough comps in a couple of those businesses and much higher volume as a result that drove -- and within that, I think we had a little less favorable channel mix across our businesses this quarter than a year ago. That moves around period to period. So that would be the big driver.

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Kathryn Ingram Thompson, Thompson Research Group, LLC - Founding Partner, CEO, and Director of Research [5]

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Okay, great. And then on pricing, seems to be a theme within the industry, discounting and just overall pressures. You see a greater preponderance of ancillary-type products becoming more competitive. Are you seeing pricing pressures in other regions outside the U.S.? Or maybe just focus a little bit more on what you're seeing in pricing in general company-wide.

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [6]

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Yes. I would say, Kathryn, this is always a very competitive industry on pricing, especially on the contract side, because you're often bidding project-to-project. I don't think -- by the way, I would say it's more acute in ancillary areas. In fact, I'd argue some of those newer areas are less driven by price overall because you don't tend to play in as much bulk often.

So it's maybe more than it used to be. But I wouldn't say that is where you see -- the significant price pressure typically is on the workstation side. I don't think pricing this period got significantly different than what it's been in the past. In fact, I would call it fairly stable in our view. It is competitive, but it's not more competitive than what it's been.

I do think you see a lot of folks, including us, trying to figure -- trying to make additions to their product portfolios, be that through acquisitions, be that through internal development, or alliances or whatever, to broaden the breadth of their offer to cover more of the new types of settings that are out there. And/or to broaden the price points in which they cover as we all continue to figure out how are we going to continue to get the share of wallet from customers across their floorplate or of dealers.

I think at one level, I think we are a bit ahead of that curve when we made the moves we made with the Collection a number of years ago, the addition we made with naughtone, the acquisition of DWR and to be frank, the addition of Nemschoff a number of years ago. So we've been playing towards those themes for 4 or 5 years. That work isn't done, and it won't be done, that we have to continue to rotate into those new areas.

But I think I'd say those are things that we saw coming as we rolled out the Living Office. That's actually one of the reasons we began to try to even talk to our own folks about thinking about the office as having a wider variety of settings and types of places that people go, and then aiming both our development engine and our M&A engine at making sure we could fulfill those needs.

And we feel pretty good about where we're at there. There's always more work to do. And certainly, making sure that we've got kind of a full bell-shaped curve of price points that we can play at in almost all of the areas that we play is going to be important going forward.

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Kathryn Ingram Thompson, Thompson Research Group, LLC - Founding Partner, CEO, and Director of Research [7]

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Okay. Great. And then could you give a little bit more color on the strong growth in Consumer and any color on areas, either be it geographic or product? Or is it just really reaping the benefits of changes that you'd been ongoing with DWR?

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [8]

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Yes, I think the growth in the Consumer business, which was quite strong. I think the team's done a really good job on getting the revenue line moving again since the hiccups we had, I guess, now 2 fiscal years ago when it hit us, really starting right about this time 2 years ago. The drive, if you look underneath the volume, first of all, we've launched -- I think the number, Jeff, is around 100 new products on that business...

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [9]

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Right.

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [10]

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Which we're seeing really good take-up of new products. We, of course, have really been hitting the mark in terms of getting new studios opened last year. We opened a number of new studios this year. That's certainly helping.

Probably the biggest standout, if you look at where we were 2 years ago and where we are today, if you set aside the disruption that happened with ERP system, is actually the greater productivity that we're getting out of our catalog and how that is also feeding into the web. Because we're seeing significant growth online. In fact, at one level, the online segment of the business is growing faster now if you look at, especially at a unit level, than what's coming through the studios.

Now we're -- because we really are an omnichannel model, it's hard to tell, do they come into the studio and then order? But I would say online is growing quickly, and we think there's room to continue to accelerate that.

The last thing that I would point to is the addition and focus of DWR on the contract channel has also been a help, and we've seen significant growth on the contract side, some of that being through Herman Miller dealers. I would say, we're in the early innings of that. That's also DWR's own contract focus, whether that's hospitality and those kind of places that they also play.

So it's really a combination of 4 or 5 things that have worked quite well on the top line. And like I said, we think the work we've done around e-commerce, we think there's more work to be done inside of DWR. We also will this next quarter be implementing the new DWR e-commerce platform for hermanmiller.com, which we've seen significant benefits from that new platform because it's mobile, works much better and our ability to target consumers and connect -- and make sure that we eliminate the amount of dropped carts and those kind of things. It's just a much better platform.

So we're really excited that we're going to have that platform up and running. I think it's about 30 days from now, we'll cut over certainly in time for the Herman Miller online sale. So really good work by the team. And I think the work that we're doing with the outside firm is giving us a lot of confidence of additional levers that we can pull, both levers in terms of expanding the price points we cover. One of the things we talk about is a segment we call HENRY, those are our high earners, not rich yet, and how do we get to them.

But additional things we think we can do around the price positioning of the total assortment, working harder in the supply base. And we think those things can actually drive additional revenue and better profitability. So we're not done yet. I wouldn't call it -- we wouldn't declare victory. But certainly, from where we were 12 months ago, our confidence level's increasing that we got the right folks, we're working on the right things, and we can see the next set of steps.

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Operator [11]

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Our next question comes from Greg Burns with Sidoti.

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Gregory John Burns, Sidoti & Company, LLC - Senior Equity Research Analyst [12]

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Just in terms of the order growth, could you give us a sense of -- particularly North America, is it coming from a handful of large projects? Is it more broad-based? Just where is that demand coming from?

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [13]

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I would say it's generally broad-based. I know that we certainly saw -- we didn't have any -- in fact, there was an area that was down. I would call it the super-large projects, was an area that we didn't see nearly as much of as we saw a year ago or even 2 years ago.

So I would call -- it's more in the mid-sized to small projects is where we've seen it. I think, Kevin, if I remember from the data, project activity actually -- a percentage of project business was actually up this quarter compared to last year. Is that correct?

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Kevin J. Veltman, Herman Miller, Inc. - VP of IR & Treasurer [14]

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Yes.

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [15]

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So projects were up, but I would say, they did not range into that kind of very large, which we typically talk about as projects above $5 million. I think that category overall was actually down a bit, if I remember the data right. Is that correct, Kevin?

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Kevin J. Veltman, Herman Miller, Inc. - VP of IR & Treasurer [16]

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Yes, I think that's right. The one with the $5 million was strong, yes.

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Gregory John Burns, Sidoti & Company, LLC - Senior Equity Research Analyst [17]

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Okay. And looking at the guidance for OpEx for next quarter, sounds like it's going to be up sequentially. Is that seasonal factors? Or is it just increased investments on your part?

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [18]

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Greg, this is Jeff. I'd say really it's 2 things: Number one, you've got, obviously, our guide calls for quite a bit higher top line. And with that, we've got volume-related increases. I'd say in total, the volume-related increases -- and I'd point to variable selling and incentive costs, account for about $4.5 million of the increase.

And the remaining volume related is really investment at the Consumer level to -- that are somewhat seasonal. It's a seasonally high period for that business, that increments for about $2 million of the total increase.

And then above and beyond that, we've got some -- net of our cost-savings initiatives, we've got some growth investments. Some of that is initiatives that have been planned for this time of the year. Some of it, candidly, is timing spillover from Q1 into Q2. But I would -- so that, you might call that another $1.5 million. I think that accounts for the bulk of that increase.

Now I will tell you, and I'd be remiss if I didn't say, we give a range on operating expenses for a reason. And clearly, we've done a nice job the past 3 quarters, really doing I think a good job managing costs toward the low end of the range we've been giving. That's our goal, and we're not going to stop with that focus. But those are the categories that account for that increase.

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Gregory John Burns, Sidoti & Company, LLC - Senior Equity Research Analyst [19]

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Okay. Then lastly in terms of the margin potential on the -- in the Consumer segments. Where can that go, just based on getting the existing studio footprint up to maturity versus some of the incremental initiatives you have in place with the outside consulting firm and what do you plan to implement?

So I'm trying to understand, like what will just naturally accrue to the bottom line of that segment based on kind of the maturity of the studio footprint versus kind of what you can drive incrementally over time?

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [20]

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Yes, it's a little -- so, Greg, this is Jeff, again. I'd say it's a little difficult to answer it just from the standpoint of studios because obviously, we've got growing elements of that business across other channels, as Brian mentioned, contract and e-commerce.

What I would say is within our existing studio footprint, in combination with those other channels, I think you could see that growing 7% to 8% range op income over time.

Now we're making, obviously, incremental investments in additional studios, additional square footage that we think can help us leverage that higher. That's why we talk about our ultimate goal of being -- approaching that 10% level. But that's how I would view the business right now, given our current footprint.

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Operator [21]

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Our next question comes from Matt McCall with Seaport Global.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [22]

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So forgive me, I had a few technical difficulties. So wanted to first hit North American margins. I like the new detail and trying to compare and contrast across the industry and trying to understand some of the differences. But maybe start with operating margin.

You're -- I think you're 14%, 15% in North America. Brian, you talked about a number of initiatives you have ongoing. But what's the right level of operating expenses? What's the right level of gross margin for that business? Is there the potential to use that profitability to maybe drive top line? Or is the goal still to expand those margins further?

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [23]

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I don't think our margin expansion, if you're looking at operating margin line, is going to probably come from that business over time. We think we can continue to grow the top line, but it's probably not going to come from lots of expansion at the operating income line.

The place for operating income improvement for us is really going to be focused, I think, Matt, largely in the Consumer business as well as in the Specialty businesses. And those are the places we've got work to do.

Certainly, Greg will continue to work on efficiencies. He's got cost saving goals just like everybody. Part of that is, how do we continue to find ways to be more price competitive, at the same time, not give up margin. So that's -- a lot of Greg's objective is, how do we continue to find ways to be able to be more competitive across every place that he plays. Including, by the way, we know that there's going to be a lot of wage pressure.

So -- and we're trying to get in front of that, because you can see it every day on the -- especially the direct label labor side right now, where we're making a number of investments in that business over the next 3 years in new manufacturing equipment. Some of it, I would call maintenance. But a big chunk of it will also drive greater efficiency so that we can, to be frank, be able to run with fewer people.

That'll largely be, how do we not replace folks that are retiring and at the same time be able to grow volume? So I don't think it'll be margin expansion. I think it'll be growth in revenue in that business. And if you could look at the other 2 or 3 segments, if we can get each of them up in that kind of 10% range, that really helps us get to our goal, obviously.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [24]

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Okay. So just to clarify, the operating expense, the percent of sales, will that be -- Greg's going to drive some efficiencies in the factories. But is the operating expense, I think I just did the math, about 21%, 22% or so, in that 21% range? Is that the right percent number? Is that going to remain steady so you'll maybe spend more there, keep that percentage unchanged and maybe drive a little bit of efficiencies that will help offset it?

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [25]

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Matt, this is Jeff. Let me try to take that one. So one of the things we clearly benefited from this quarter, notwithstanding some of the noise around the warranty costs and so forth that we talked about. But in total, operating expenses, particularly for the North American business, were very well managed. We had some of that that was a timing element.

So overall, profitability in that segment is very strong this past quarter. We continue to expect that to be our leading profit segment for the business just because it's a big leverage play. But ongoing, particularly as it reflected in our Q2 guide, we -- you're going to see some of that timing turnaround in operating expenses.

So I would not view our Q1 operating expense, if you will, burn rate for that business as being normalized. I think if you look at overall operating profitability in the -- over the near term, i.e., the balance of the fiscal year, it's probably more in that 14% to 14.5% range is more of a reasonable expectation.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [26]

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Got it. Okay. Yes, I'm looking back the last couple years, it's been closer to 22.5%, 23% you got operating expenses. Okay, sorry (inaudible) quarter.

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [27]

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Now Matt, let me just point out -- obviously, we're working hard on the cost side, right? So our goal is to focus on that and drive some improvement. So don't take that comment as same as last year. But nonetheless, I just want to point out that you wouldn't expect our Q1 run rate to necessarily repeat over the balance of the year for that segment.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [28]

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Okay. And I know Kathryn asked about price cost. But did you quantify the inflationary pressure? Did you quantify the pricing pressure? Any discounting? I didn't hear the numbers if you did, I'm sorry.

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [29]

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We didn't, but I'm happy to. On the steel side in particular, year-on-year, we felt about a $3 million drag from commodity prices. I'd say that is mainly steel and other metal components.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [30]

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Okay. And then on the price net of discounting?

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Kevin J. Veltman, Herman Miller, Inc. - VP of IR & Treasurer [31]

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Yes, that was a slight loss, about $500,000 year-over-year.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [32]

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Okay. So the -- I think you said that the backlog, I don't remember if it was you, Brian or Jeff, but backlog ex the dealer divestiture is up about 8%; the reported number, up 3.6%. The revenue outlook looks to be up about 5.5% at the midpoint. You had some good things to say about the order trends.

I just don't -- I don't know the timing off the top of my head of when the dealer divestitures anniversary. So is the 5.5% meant to be an acceleration from the backlog that was up 3.6%, or a deceleration from the backlog that was up 8%?

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [33]

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Matt, the one thing that you always have to be careful with, by the way, don't assume all backlog ships the next quarter, to start with. Because you do get projects (inaudible) out. So be careful that you don't draw too high of a correlation between those 2.

I also think, when you look at the range that we gave, you remember Jeff pointed out that we expanded the range out a bit with some concern, which by the way is almost unknowable at this point, of what is going to be the impact from some of the storms. So that pulled the midpoint down a little bit as we looked at taking -- making sure that we'd given enough room to account for what could be some disruption in the Southeast and in Texas that's ongoing in the quarter.

So that could have 2 effects: A, it could slow some order patterns down in those markets. It could also delay projects from being implemented as folks are trying to see is their building actually ready now to accept furniture, right?

So I don't think we're trying to signal acceleration or deceleration with any of that. The one thing you do see that happens in the second quarter, don't forget is, it is one of our heavier promotional periods in the Consumer business. So the second and fourth quarter tend to be the largest 2 quarters in that business because we have 3 sale periods in both of those, where we typically are running 2 a quarter in the other.

So I do think you get a little bit of difference in the year, that the second and fourth tend to be a little bit larger. And then of course, the third quarter you get impacted by the holiday season. So I'd just give you -- I don't think I'd read too much into the difference in between backlog and order rates.

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [34]

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Got it. Okay. Just making sure. And finally, I want to go back to the puts and takes on the cost line. Looking forward, what's the price cost expectation? And any other items, like warranty expense, that we should keep in mind as we progress through the year either that will occur this year or that occurred last year?

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [35]

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So Matt, in terms of commodity, one of the things we do have is our comps for steel pricing are easing a bit. Our guide implies between $0.5 million and $1 million worth of pressure year-on-year. So that's the -- on the commodity front.

In terms of price and discounting, we don't have enough of a crystal ball to have a read on that necessarily. So I think our assumption is something akin to what we experienced year-on-year in Q1. Make sure I get all your questions, Matt, what else were you asking?

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Matthew Schon McCall, Seaport Global Securities LLC, Research Division - MD and Furnishings & Senior Analyst [36]

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Well, I was just thinking, if the warranty expense was high, I don't think anybody else had that modeled. Anything else that we should think about that you know about today that is either in the guidance or would be expected in the rest of the year?

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Jeffrey M. Stutz, Herman Miller, Inc. - Executive VP, CFO & Principal Accounting Officer [37]

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So the only thing -- so no, clearly on the warranty and some of the supplier issues, there's nothing that we see. Of course, that's the trouble with these things, is that you can't ever predict them. But nothing I would really point to.

We do have some potential for impact from a change in shipping terms at the Consumer business in the near term here, that is potential. And Brian, in terms of -- I don't know that you're going to want me to quantify that, Matt, and I'm not sure I can give you a number.

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [38]

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Yes, Matt, what we're doing is, we did a deep dive for -- that was one of the things we did with this outside group, although we were looking at it ahead of time. We've got 2 things going on at once. We've done some -- we've changed our logistics model to further consolidate shipments. That helps us drive down cost of delivery.

At the same time, we're making some changes on the other side to how we bill out -- how we bill customers for shipping. As you know, there's a lot of pressure on that as folks have gone to a lot of free shipping. One of the things we've done is we had a model that was more driven as a percentage of the order plus an up charge to do white glove.

Our intention is to move more to a flat rate on white glove without the percentage. We think that'll drive more people towards white glove, it'll become more of a default. We believe in the long run, actually, there's 2 things that'll occur with that: A, it'll reduce the number of returns and problems we have in shipping; and it'll increase customer satisfaction.

There will be -- and the question will be how close can we match the consolidation gains to the flat rate. And how much of that flat rate can we hold on to. Because we know a number of shipments today, you'll often work with a customer and you'll allow the sales team, when they need to, to make changes on what they're really going to charge the customer.

So the question of how much will we recoup, that's one that I would say we could see a little bit of movement around in the margins, the gross margin on the Consumer side. We think by the time we implement all the other changes we have, that'll turn out to be not a big deal. But we could see some movement next quarter.

I don't know how to even really quantify it because there's so many moving parts in there. But I'd tell you if there's one that certainly we as a team are watching, it's that one.

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Operator [39]

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And I'm not showing any further questions at this time. I'd like to turn the call back over to Brian Walker.

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Brian C. Walker, Herman Miller, Inc. - President, CEO & Director [40]

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

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Operator [41]

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Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.