Earnings Call Transcript - MLKN Q3 2022

Operator, Operator

Good evening and welcome to MillerKnoll's Third Quarter Earnings Conference Call. As a reminder, this call is being recorded. I would now like to introduce your host for today's conference, Kevin Veltman, Senior Vice President and Integration Lead for MillerKnoll.

Kevin Veltman, Senior Vice President and Integration Lead

Good evening. Joining me today on our third quarter earnings call are Andy Owen, Chief Executive Officer; Jeff Stutz, Chief Financial Officer; and John Michael, President of Americas contract. We have posted the press release on our Investor Relations website at millerknoll.com. Wherever any figures are presented on a non-GAAP basis, we have reconciled the GAAP and the non-GAAP amounts within the press release. Before I turn it over to Andy for a brief overview of the quarter, I would like to remind everyone that this call will include forward-looking statements. For information on factors that could cause actual results to differ materially from these forward-looking statements, please refer to the earnings release as well as our annual and quarterly SEC filings. Any forward-looking statements that we make today are based on assumptions as of this date and we undertake no obligation to update these statements as a result of new information or future events. At the conclusion of our prepared remarks, we will have a Q&A session. Today's call is scheduled for 60 minutes. With that, I'll turn the call over to Andy.

Andrea Owen, CEO

Thanks, Kevin and good evening, everyone. Thanks for joining us tonight. For nearly a year now, you've heard us say that MillerKnoll's competitive advantage is our unique combination of a strong global contract business and a well-positioned retail business. We leveraged that to drive sales and growth in all segments this quarter and our momentum is continuing to build as we move through our integration journey. Every day, it becomes more evident that we have created something special, a business built for long-term growth with the ability to have a tremendous impact on the world around us. Jeff will take you through the details of our third quarter performance. But before I hand it off to him, I'd like to share a few remarks about our business and the progress we're making relative to the integration. During the quarter, many parts of the world began shifting their focus to emerging from the pandemic and contract clients began activating their return to office plans. Employers are not pulling back. They're investing in new office experiences that their employees will love. There's a push for premium experiences. And thanks to our extensive product portfolio across many brands, MillerKnoll is ready to meet that demand. We benefit from our ability to meet the needs of a global customer base through our portfolio of premium product solutions. Our global footprint allows us to serve local clients and global accounts around the world. We take great pride in our thought leadership in the future of work. We have the insights our customers need to create their workplace strategies. Most of our customers are telling us that they're headed towards hybrid work arrangements and we know from our research that they will likely continue to evolve their approach over time. This creates amazing opportunity for MillerKnoll. We can support the work the way it happens today and in the future. The most compelling reason for creating MillerKnoll is the power of our combined portfolio and our distribution network. One of our top priorities since the deal closed has been activating our MillerKnoll dealer network and we're making great progress in nearing our North America market launch which is planned for early June. We brought our Americas sales team together in early March and it was an amazing and inspiring experience to be together for the very first time as MillerKnoll. The week was full of shared learning and, more importantly, the growing recognition that more really is more and together, we're going to do incredible things. That momentum has continued with our dealers. In the past few weeks, we've held several dealer activation meetings to help prepare for our cross-sell launch. We're building a highly capable and cohesive MillerKnoll dealer network. As I've met with dealers and our sales teams, I've seen the energy and enthusiasm they have for what's to come. They're invested in our future and eager to bring the comprehensive MillerKnoll portfolio to our customers. Our early pilots and dealer consolidations in North America provided the opportunity to build a strong foundation and we are feeling extremely optimistic as we approach our June go-live date. Our international team has also launched our first MillerKnoll dealer pilot in Europe which consists mainly of legacy Herman Miller dealers who are expanding to sell Knoll products. There's great opportunity to extend the reach of our collective brands around the world and we're pleased with the progress we're making during the early expansion phase. Moving on to retail, this business has nearly doubled in size in just two years. Retail played a pivotal role in helping us navigate the early challenges of the pandemic. And today, it's a meaningful contributor to MillerKnoll's overall performance, with year-to-date sales of $635 million. Retail is a high-performing, resilient business with distinct competitive advantages, including significant upside benefits now as a combined MillerKnoll organization. We began expanding our assortment of Knoll and Muuto products across our brick-and-mortar and e-commerce outlets, driving incremental growth and margin. We have the channels, geographic reach, and product portfolios to meet the needs of residential customers around the world. As we've grown our retail business, we've been making investments to modernize our operations and enable us to compete as a best-in-class retailer. Many of these critical initiatives will launch in the first half of fiscal 2023 and we're looking forward to the opportunities that they'll create. Alongside our global growth strategies, we have clear priorities relative to giving back and creating a better world. We continue to receive recognition for our commitment to sustainability, diversity, design, and inclusivity. For the 15th year in a row, we achieved a perfect score on the Human Rights Campaign Foundation's Corporate Equality Index. We were also awarded the platinum medal in recognition of our commitment to sustainability and corporate social responsibility by EcoVadis. This places our company among the top 1% of all companies assessed worldwide for the second year in a row. Before I hand it over to Jeff, I'd like to comment briefly on the tragedy that has unfolded in Ukraine over the last month. Our foundation made an immediate donation in support of humanitarian relief efforts and is matching donations from employees, dealers, and our suppliers. It's been inspiring to see our MillerKnoll community come together in response. And while this region makes up a small part of our international contract segment, it will remain a top priority in terms of both business risk mitigation and humanitarian support. So, with that, I'll turn it over to Jeff, who will cover a bit more about our results before we open it up for questions.

Jeffrey Stutz, CFO

Thank you, Andy. Good evening, everyone. It's great to be with you. To be sure, the tragedy in Ukraine is top of mind for all of us these days. And Andy, as a follow-up to your comments, FY '21 annualized revenue from the region was approximately $10 million. We don't have manufacturing facilities or offices in the region. And in terms of our independent dealer network, we have a relatively small presence with two dealers in Ukraine, two in Russia, and two in Belarus. We're not fulfilling existing orders or accepting new orders in the region at this time. Now turning to our third quarter results. We drove growth across every segment and every region of the business. Even with continued macroeconomic challenges pressuring margins in the near term, it was a strong quarter for demand generation. We're confident about our future, including our ability to further mitigate inflationary pressures and deliver on the cost synergies associated with the Knoll acquisition. Consolidated net sales of $1 billion were up 74% on a reported basis and 20% organically over the prior year. Sales growth was again constrained by our ability to produce and ship orders due to global supply chain and labor supply challenges. We estimate these disruptions adversely impacted net sales by approximately $34 million in the quarter. Orders in the period of $1.1 billion were 94% higher than the prior year on a reported basis and increased 32% organically. The International Contract segment delivered strong performance again this quarter with sales and orders up in all regions and across all brands. On an organic basis, sales were up 30%, and organic orders of $162 million were up an impressive 74% over last year, achieving an all-time record for this business. Strong demand from local customers, especially in China and Europe, helped accelerate growth. Global account activity was also very strong, especially in Europe and Asia and within the tech industry. Customers around the world are prioritizing workplace investments as they seek to differentiate themselves and create a premium, amenity-rich employee experience to attract and retain critical talent. We also saw a strong performance from Knoll in this quarter, with sales up 20% and orders up 37% from last year on a pro forma basis. Growth was broad-based across all regions, both for contract clients and through retail channels. Additionally, Holly Hunt saw record order levels in the quarter with growth in every product category. Spinning backfield sales also set a record for orders in the quarter. The performance of our Americas contract segment was also quite strong this quarter with sales up 26% and orders up 37% on an organic basis. Overall demand continues to be solid in all regions. At the same time, easing supply chain and labor pressures along with tremendous efforts from our teams around the world helped us improve reliability and lead times. This resulted in the highest sales volumes this fiscal year. Our Retail segment also delivered continued growth in the quarter. On an organic basis, orders were up 4% and sales were up 7% over Q3 last year. Gross margin in the quarter was impacted by channel and category shifts as well as production costs and freight charges. Now we've taken a number of steps to mitigate further impact from current inflationary pressures, including targeted price increases and new freight charge programs. Reinforcing Andy's earlier point, sales in our retail business have nearly doubled in the past two years, moving it from essentially breakeven operating margins to consistent double digits and we see tremendous opportunity ahead for further growth. Adjusted gross margin was 32.9% compared to 39.1% in the prior year at the consolidated level, largely due to the impact of rising commodity costs and other inflationary pressures like labor and transportation expenses. Recent price increases have helped offset some of these inflationary pressures and we expect to see the impact of these increases gain further traction in future quarters. We continue to carefully manage operating expenses and focus on what we can control across the business as we work to mitigate the impact of these macroeconomic pressures. And of course, we'll monitor cost trends and take further pricing actions as necessary going forward. Adjusted operating margin was 3.8% compared to 9.4% in the prior year and we reported earnings per share of $0.16 for the quarter. Adjusted earnings per share were $0.28 in the period compared to $0.65 last year. Looking ahead to the fourth quarter, we expect sales to range between $1.075 billion and $1.115 billion and adjusted earnings per share to be between $0.46 and $0.52. This guidance continues to consider the near-term inflationary and supply chain environment that we're navigating as well as the actions we're taking to help mitigate these pressures. And so to sum up, we're entering the final quarter of the fiscal year in a position of strength, given the continued strong demand environment and expect to continue building momentum through our integration efforts and strategic initiatives. So with those prepared comments, we'll now turn the call over to the operator and we'll take your questions.

Operator, Operator

Our first question will come from Steven Ramsey from Thompson Research.

Steven Ramsey, Analyst

I wanted to start on the retail segment maybe with sales kind of a bigger context. Quarterly sales from Q3 '21 and to Q3 '22, were all between $202 million and $222 million each per quarter. Does the Q4 guide imply stepping up off of that level in Q4? And does that imply a step-up in sales per quarter going into FY '23? And then lastly, what factors go into driving that step-up in growth?

Jeffrey Stutz, CFO

Steven, this is Jeff. Let me start and Andy, you can certainly pile on. So yes, I would say, in general, it does imply we had good order entry for the retail business, good demand levels overall. And so yes, we would expect to see a ramp-up in revenue as we move into the fourth quarter. I'm not going to comment on FY '23 at this point. Although I will tell you that overall, we feel quite good. I mean, across most product categories, we're seeing good traction. Bear in mind, we are up against a fairly tough prior year comparisons in the workplace category, just given the strong e-commerce demand we saw in workplace furnishings. But we're feeling good that overall as we move forward, we'll be able to comp those certainly in total over the next 12 months.

Andrea Owen, CEO

Yes. Additionally, as you consider our retail business, it's still in the early stages. We have significant opportunities for new product growth, and Debbie and the team have been working hard on this. There are categories we need to develop further. We also have new channels to explore, and our global wholesale business remains very strong. We continue to experience growth in the retail sector of our business.

Steven Ramsey, Analyst

Okay, great. That's helpful. I wanted to get more details on the decline in delayed sales, both in dollar amounts and as a percentage of quarterly sales. What does this improvement indicate? Do you believe this trend will continue, or is there some existing delay in sales reflected in the Q4 guidance? Also, you mentioned that North America contract lead times are improving. Is that contributing to this situation?

Jeffrey Stutz, CFO

Yes, it's a good question. I would summarize that the trend in the business is positive despite some constraints we've faced throughout the year. I don’t want to give the impression that we’re fully clear of these issues, but we’re heading in the right direction. Specifically, we’ve made significant improvements in overall production staffing levels compared to last quarter. Although we haven’t reached our target levels yet, we’ve made progress from where we were. This improvement is contributing to a positive trend line, even as we still experience some limitations. Overall, lead times are improving. However, there are still challenges in certain areas. For instance, in the contract business, both case goods and upholstered products are experiencing longer lead times, though there has been improvement. In retail, lead times are, on average, about four weeks longer than last year. The contract business is better than that and is moving toward normal. I want to emphasize that we don’t believe we’re fully out of the woods yet, and we can expect some continued constraints on shipments, but we feel optimistic about our current position.

Andrea Owen, CEO

I would just add to that, Steven, what we've done to attract and hire labor right now has paid off. We are starting to see a lot less open roles. However, you'll notice in the margin we're paying more for it. So what we've had to do to attract labor in this market has been tougher but as we've gotten more people in the roles, we're starting to see reliability and production increase across the board.

Steven Ramsey, Analyst

Very good. And last quick one for me on the range on gross margins. Maybe go into is that segment dependent? Or is there a certain component of cost of goods that's driving that? Or is it sales dependent and operating leverage?

Jeffrey Stutz, CFO

Well, Steven, Jeff again, certainly, in this business, if we can push more out in the form of shipments, we'll get leverage on that. So volume plays a role here without a doubt. I think overall channel mix matters as well. As you know, the retail business has structurally higher gross margins than our contract business does. So if we can if we overperform our current internal forecast in retail or vice versa, if we underperform, that will be a factor just from a mix perspective. And then lastly, it's a dynamic environment. While we feel quite good about our performance this quarter and we feel like we've got good momentum, we're also well aware that there's a lot of change in the air with energy prices and interest rates and all of those things can flow through as a factor. But as a general rule, I'd say, mix and overall volume levels are probably the biggest factors.

Operator, Operator

Next question will come from the line of Greg Burns from Sidoti & Company.

Greg Burns, Analyst

I want to follow up on the previous question regarding gross margin. Can you quantify the price-cost gap for this quarter or year-to-date? How significant has it been as a headwind? When can we expect to see the price increases you have implemented start to close that gap, or potentially turn into a tailwind for margins? Do you anticipate that happening in the next couple of quarters?

Andrea Owen, CEO

Yes, we do. As you all know, you’re very familiar with this business. Price lag is a significant issue for the contract side of our operations. We have been proactive with price increases and will continue to address as much of the inflationary pressures as possible through our pricing strategy. However, due to our backlog and the volume of orders we are handling, it will take us several quarters to fully realize this. We expect to see improvements in the next quarter and continue to see them over the following two to three quarters. We strongly believe that our pricing adjustments have been appropriate thus far, but the results are coming more slowly than we would prefer, though the situation is improving. What would you like to add, Jeff, in terms of quantifying these aspects?

Jeffrey Stutz, CFO

And Greg, just to kind of get to the numbers, I'll give you a bit of a sense for year-over-year Q3 kind of the walk between last year to this year from a price/cost perspective. First of all, on the negative side, commodities were a drag on gross margins to the tune of about 220 basis points. Then you add to that about $210 million related to freight and transportation costs, so another 210 basis points. a bit of impact from labor, as Andy mentioned, we've had to raise wage rates a bit and you've got some drag on productivity. That's 40 basis points. So those are the kind of the negatives. The price increases that we've announced have been quite substantial, as you know, and are slower than we would like to see layer in. And the early impact on this quarter was about 110 positive basis points from pricing. And as Andy said, we expect that to ramp up as we move forward.

Andrea Owen, CEO

Yes. And the one thing I'll add too, Greg, because the contract business is known for the price lag but I would say in retail, normally, we would expect to see a much faster turnaround in pricing because it's much more dynamic and agile. However, if you look at the lead times in some of our third-party suppliers and some new categories that we still have on boats waiting to come in, haven't captured the full kind of 10% increase that we've actually put on the books for retail. So there's a little bit of a lag in the retail business as well due to the same constraints that we're seeing in the contract, not as much but it's still there.

Greg Burns, Analyst

Okay, great. And then when we look at some of the retail initiatives you mentioned some of the growth investments you're making. How should we think about that business over the next couple of quarters? Are we spending on to rise and margins take a step back and then we kind of hopefully realize some growth on those investments? How should we think about the model for that business over the next couple of quarters?

Andrea Owen, CEO

Yes. We expect in this quarter, we'll still continue to see a little bit of pressure. The big challenge in retail is really about product mix. So, if you recall, in the beginning of the pandemic, we were selling a lot of task shares which are incredibly high-margin products for us. And we've entered into new categories but we've actually seen a decline in our task share business which we're expecting. But we expect that, that will continue to push down our margins a little bit along with inbound and outbound freight. But some of the investments we've made, specifically the customer data platform, some of the planning and allocation systems that we have in are really focused on improving the customer experience as well as our efficiency driving up the long term with the lifetime value of our customers and also driving down customer acquisitions. So over time, we also expect to see a gradual step up in our retail margins throughout 2023 and Q4. Would you add to that?

Jeffrey Stutz, CFO

Yes. In the very near term, we are focused on opening new retail stores, including the seating store, and we are very pleased with their performance. This is one of the key strategies our team has adopted to adapt to the changes in product mix as e-commerce order volumes return to more normal levels, and it is working for us. We plan to continue opening more stores. However, setting up these locations requires time for leasing and staffing, which may lead to a temporary decline in overall margin flow in the next quarter. Despite this, we are confident that this will be beneficial for the business moving forward. Additionally, we are monitoring transportation costs, which have increased significantly in the past few months. The team is actively implementing changes such as increasing delivery charges and adjusting proximity thresholds to manage these costs. We believe that these investments in stores and digital technology will enhance data analytics in our business. We are confident that these are the right steps to take, and as mentioned, we expect margins to improve in the medium to long term, although there may be a brief dip in the near term.

Operator, Operator

Our next question will come from the line of Reuben Garner from Benchmark.

Reuben Garner, Analyst

Thank you, everybody. So orders growth in the Americas and with Knoll even very strong, I think, 36% across the board. Can you talk about what you're seeing in those orders? What kind of product mix? Any signs that this is more than just a catch up from offices being closed down for a period of time and maybe folks looking at companies looking at how they're going to set up their offices into the future of hybrid work?

Andrea Owen, CEO

Reuben, this is Andy and I want to hand it over to John Michael. There is certainly pent-up demand globally, but the more significant news for us is that there is a complete reevaluation of how people are working and how they view their office spaces—shared, remote, and hybrid. This shift is really affecting what we are observing in the A&D and design communities regarding office space. It's more than just being out of the office during the pandemic; most people are reassessing their spaces to find ways to work more efficiently, which is driving the demand. John, what would you like to add?

John Michael, President of Americas Contract

Thanks, Andy. Reuben, I'd say we're seeing a few different things. The first is, I think C-level executives understand that their space has to work harder now than ever before. In terms of attracting people back into the office and being a destination where people want to come to work for culture and connectivity and collaboration. In terms of product mix, a lot more amenity spaces which lends itself more to sort of lifestyle or ancillary products as opposed to maybe the core workstation type products that were popular sort of pre-pandemic but I do think companies aren't hesitating any longer as they were previously. I think once we got through the Omicron surge in late January, customers became much more definitive about when they were going to be back to work, whether that was April 1, June 1, or September 1. And as opposed to sort of easing into that work, it began in earnest and at a lot faster pace. So we think the continued change to more of a hybrid environment will continue and that spaces are going to have to do different things now than they have in the past. And I think that bodes well given the portfolio that we have as the collective of MillerKnoll.

Reuben Garner, Analyst

Perfect, very helpful. While I have you, regarding the integration, when I see 36% order numbers, I think that's at the very least growing with the market, if not more.

Andrea Owen, CEO

Outpacing the…

Reuben Garner, Analyst

That's what it looks like to me. How sustainable is that? I mean, I imagine that parts of your business may have easy comparisons, especially with Knoll, but other parts don't. So, what is it that is allowing you to do that? Are you seeing any kind of negative impacts from revenue dissynergies related to the merger with Knoll, or is there still more to come? Or is this kind of outperforming your internal expectations?

John Michael, President of Americas Contract

I don't know that it's outperforming our expectations. I think there's a couple of factors that are favorable. The first is demand is strong with people returning to the office and the increased focus on that. I would tell you in terms of the unified MillerKnoll sales organization as well as the work we're doing to unify the MillerKnoll dealer network. That work is really just taking off and just getting started. I think we're just beginning to feel the impact of those powerful combinations. Andy made reference to our sales conference that we had about a month ago in the energy level and the positivity there was incredible. We are in the second week into three weeks of a dealer activation experience, where we've got more than 500 dealer sellers and designers with us in Chicago, getting oriented to the brands, the products, that's going to be followed up by eight weeks of virtual training to reinforce the product specifics, ordering processes, installation, et cetera. So momentum is building from a MillerKnoll perspective and we expect to see that continue for the next several months.

Reuben Garner, Analyst

Okay. And my last question for you, Jeff, I appreciate the insights on the price-cost dynamics from the third quarter. I'm trying to consider how this will unfold over the next year. It seems to me that you are approximately 350 basis points behind on the price-cost front. I assume that you aim not just to recover this gap but also to address the shortfall from previous quarters. How quickly do you expect to see this improvement? Should we anticipate a 100 basis point improvement each quarter over the next five quarters to return to previous margin levels? Or will there be a significant change? How should we approach modeling for 2023? I know it's early, but I'm interested in your conceptual thoughts on this.

Jeffrey Stutz, CFO

Yes, that’s a valid question. To clarify, we do want to accelerate our progress. First, I want to emphasize that we are in a dynamic environment with many changes. We are pleased with the aggressive pricing strategies we've implemented, especially on the Knoll brand since mid-February. Despite the fluctuations in oil prices affecting transportation costs, we believe we have adjusted our pricing sufficiently to cover these expenses over time. Our goal is to exit fiscal year 2023 with margins exceeding pre-COVID levels on a combined basis. We are closely monitoring the situation in real time, and as mentioned in our prepared remarks, we are ready to take further action if necessary. Our expectation is for a gradual improvement in margin performance. While I’m hesitant to commit to a specific 100 basis points per quarter, that doesn’t sound unreasonable to me. Ultimately, we anticipate finishing fiscal year 2023 at levels better than our overall performance pre-COVID. I hope that provides some clarity.

Reuben Garner, Analyst

Jeff, just to clarify that last part, exit, say that last part again, exit what quarter at pre-COVID levels?

Jeffrey Stutz, CFO

Well, our belief is that because this is expected to ramp quarter after quarter over the next year. Our expectation would be that we would exit next fiscal year at a combined gross margin level that exceeds the pro forma combined margin for the two companies combined.

Operator, Operator

Our next question will come from Alex Fuhrman from Craig-Hallum Capital.

Alex Fuhrman, Analyst

I wanted to ask more about your retail channel. Growth has slowed compared to the significant changes during the work-from-home period in 2020, but it is still showing positive year-over-year growth. Can you explain where that growth is coming from? You mentioned that the Herman Miller seating stores are contributing to that growth. Is the product assortment similar to what you offer in your corporate business, focusing on seating, or does it include more home decor options? I'm interested in the overall perspective, not tied to any specific quarter. It looks like this segment could quickly approach $1 billion in revenue for you. How should we view this in the next three to five years? Could it represent 30% of your business? Is there the potential for having 100 or more Herman Miller branded stores? I'm curious if you've seen any indications of where this might lead or if you anticipate continuous growth.

Andrea Owen, CEO

Alex, thank you for mentioning the word billion-dollar; we appreciate that. These are excellent questions. The growth is coming from all areas. Almost all of our categories are performing better than last year, with task seating being a slight exception, which we expected. We're experiencing solid growth in DWR and Hay. Our HM stores have been exceptionally productive, achieving double-digit growth in those that have been open for over a year, even in small spaces. We're witnessing growth in upholstery, bedroom, dining room, and more. It's evident across the board. Any slowdown we've observed is largely due to the impact of Omicron in December and January, which affected our shipping capabilities because of labor shortages, similar to what others are facing. However, I believe the opportunities ahead for our business are significant. When we compare ourselves to competitors, there's plenty of room for expansion in the new categories we are exploring, and gaming is a major focus for us. Starting from nothing, we could see our gaming business grow to between $90 million and $100 million next year, which represents a significant opportunity for us. Putting all this together, we are very optimistic about the potential of the Herman Miller brand and what all our collective brands can achieve in the retail sector.

Alex Fuhrman, Analyst

Great, that's really helpful. And then just as you think about building out the retail channel more with more stores, I mean, are there any other brands that you think could be a really big source of investment for additional stores over the next few years?

Andrea Owen, CEO

Yes. I can't elaborate but of course, we have a great collective of brands. And of course, we look at all of them with that lens.

Operator, Operator

I’m not showing any further questions in the queue. I’ll turn the call over to Andy for any closing remarks.

Andrea Owen, CEO

Well, great. Well, thank you guys for joining us and MillerKnoll really has the momentum and unique competitive advantages that are fueling growth and creating exciting new opportunities for all of our stakeholders. So we appreciate your time with us today. We appreciate your continued interest and we look forward to updating you again next quarter. Take care, everyone.

Operator, Operator

This concludes today's conference call. Thank you for participating. You may now disconnect. Everyone, have a great day.