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SCS Steelcase

Participants
Mike O’Meara Investor Relations
Jim Keane President and Chief Executive Officer
Dave Sylvester Senior Vice President and Chief Financial Officer
Mark Mossing Corporate Controller and Chief Accounting Officer
Budd Bugatch Raymond James
Reuben Garner Seaport Global Securities
Steven Ramsey Thompson Research Group
Greg Burns Sidoti
Bill Dezellem Tieton Capital
Call transcript
Operator

Good day, everyone and welcome to Steelcase’s Fourth Quarter and Fiscal Year 2018 Conference Call.

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

For opening remarks and introductions, I would like to turn the conference call over to Mr. Mike O’Meara, Director of Investor Relations, Financial Planning and Analysis and Assistant Treasurer. Please go ahead.

Mike O’Meara

Thank you, Candice. Good morning, everyone. Thank you for joining us for the recap of our fourth quarter and fiscal 2018 financial results.

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

Our fourth quarter earnings release, which crossed the wires yesterday, is accessible on our website. This conference call is being webcast and this webcast is a copyrighted production of Steelcase Inc. A replay of this webcast will be posted to ir.steelcase.com later today.

Our discussion today may include references to non-GAAP financial measures and forward-looking statements. Reconciliations to the most comparable GAAP measures and details regarding the risks associated with the use of forward-looking statements are included in our earnings release. And we are incorporating, by reference into this conference call, the text of our Safe Harbor statement included in the release.

Following our prepared remarks, we will respond to questions from investors and analysts. I will now turn the call over to President and Chief Executive Officer, Jim Keane.

Jim Keane

Thanks, Mike and good morning everyone.

We are reporting today on our fourth quarter that finished better than we were expecting as reflected in both our original guidance and in our February update. It is a complicated quarter because of non-cash charges related to tax reform and some other non-operating items. Dave will talk you through that in a few minutes and I think you will see what we see signs that our performance is starting to improve and reasons to be optimistic as we enter the coming year. Americas revenue was down in Q4 and while we are certainly not happy about that, it was actually a little better than we expected. Orders grew 2% after being down 6% in Q3.

Our win rates are gradually improving in part because of our expanded product portfolio. It’s good timing, because we are seeing an increase in project opportunities for later this year.

While we don’t have direct evidence, the customers are considering more new projects because of tax reform it is an important factor driving CEO confidence, which has historically been correlated with demand for our products.

As we entered fiscal ‘19 remember that for the Americas last year’s first quarter includes $20 million from a single project. Once we get past that comparison, we expect Americas revenue to begin growing as the declines in our legacy panel portfolio should be less than the growth from the rest of our portfolio. The legacy panel portfolio is about 20% of our sales and has been declining about 10% to 15% per year. The rest of our portfolio should drive higher absolute dollar growth as revenue from our significant product launches becomes more meaningful.

Some of those significant launches occurred in the fourth quarter.

For example, we launched products that broadened the range of our answer panel platform to respond to lighter scale applications already in high demand in the marketplace. This product line extension is a big deal as it allows our installed base clients to reuse some of their existing furniture as they migrate to new applications.

We continue to see increased customer interest in informal social spaces in the workplace with furniture inspired by hospitality for residential influences.

We have been developing our own branded products and partnering with others to extend the range we can offer our customers.

We have several examples around the world of customers who chose Steelcase for their overall project, because we are now able to respond to the so-called ancillary needs. We see great opportunities to grow in this segment and we will continue to pursue new partnerships and acquisitions and develop business models optimized to deliver these solutions.

We have made a deliberate effort in recent years to develop new products on global platforms so they can be launched in all regions at roughly the same time. In January, we unveiled our newest seating innovation, the SILQ chair and the reaction to this chair with a fresh approach to materiality has been even stronger than we anticipated. We plan to bring this chair to market in Q2 in the Americas and Asia-Pacific and in Q3 in EMEA.

We have taken our first orders for our new smart and connected offerings which generate data and insights about space utilization that help our customers improve the performance of their workspace.

We expect these offerings will generate meaningful revenue on their own over time, but in the short run, dealers are finding the smart and connected portfolio is enabling broader conversations with clients about space utilization that could drive shorter term growth across our portfolio.

As previously announced, our acquisition of AMQ closed during the fourth quarter.

We are very pleased with the execution of our integration plan and are already seeing strong signs of dealer engagement.

For example, we are looking at metrics by project registration which is exceeding our expectations. EMEA also performed better than we expected and delivered a small profit in the quarter. Operating performance continued to improve, our gross margin initiatives are making progress and we saw growth on the revenue line.

In addition, orders grew 15% in Q4 as a combination of our new products, great performance by our sales organization and the strengthening of the major economies are lining up at the same time.

We have a lot behind us, but we still have a lot of work to do and we are committed to returning our cost of capital in this business.

For this coming year, we need to reduce the losses in our first two quarters which are always seasonally weaker and then we need to deliver stronger profitability in the second half of the year. There is still plenty of risk, but we remain committed to the strategy since we can see clear evidence of improvement.

Next, I will talk about the impact of U.S. tariffs on imported steel and aluminum. We buy more than $100 million of these raw materials annually for our Americas based furniture factories, but it’s nearly all from U.S. and our Canadian sources, so we won’t pay tariffs directly on those purchases.

However, even before the tariffs were finalized, the price of steel began to rise significantly in the U.S. The prices have increased more significantly in the last two weeks and the CRU monitor is projecting those increases to remain for a couple of more quarters before moderating.

We expect this inflation will begin to affect our cost of goods sold more significantly in the second quarter. We estimate the incremental inflationary impact could exceed $10 million this fiscal year based on the CRU forecast. In the past, significant inflation has been a catalyst for us to take additional pricing actions to offset some of the impact, but there was always a delay of a couple of quarters before those actions took effect. It is unfortunate that this tariff intended to protect jobs in one important sector has the effect of reducing the competitiveness of those of us with the strong commitment to U.S. manufacturing who are potentially improving the competitive advantage of low cost importers.

We are hopeful a more thoughtful response will evolve as we take actions necessary to adapt the higher commodity costs.

You may remember our PolyVision subsidiary buy special steel that is not available domestically and therefore is subject to the tariff.

However, the Commerce Department guidelines suggest that we should be granted an exclusion as we were previously when the antidumping duty was established last year.

We are working actively on appliance of this exclusion, but it is not clear whether we will incur some additional tariffs related costs while we are waiting for approval. We intentionally increased our product development efforts over the last 2 years and it’s paying off now, because that meant hiring people and investing in our product development capabilities which caused operating expenses to rise. We reached our target level of product development and launch spending and we don’t expect to increase it further. The AMQ acquisition added some additional OpEx that will be more evident in Q1, but we also took steps to reduce spending in other areas, which is why we incurred some severance costs during the fourth quarter.

As we enter New Year, we expect to continue to increase investments when we see growth opportunities and to improve our fitness to reduce costs and improve competitiveness. Over time, we intend for our operating expenses to be lower as a percent of sales. Thanks for your interest in our company. I will turn it over to Dave for a deeper look at our quarter and our year.

Dave Sylvester

Thank you, Jim. I will cover our fourth quarter financial results first noting where results differed from our expectations and highlighting year-over-year and sequential quarter comparisons and then I will talk about our balance sheet and cash flow before getting into our order patterns and outlook for fiscal 2019. We were pleased to report adjusted earnings of $0.24 per share in the quarter which included approximately $0.05 related to the non-operating games we highlighted in the release.

As Jim said we finished the quarter on a strong note and we feel our momentum is building as we enter fiscal 2019.

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

First, order patterns in the Americas improved in the fourth quarter growing by 2% over the prior year compared to a 6% decline in the third quarter. Orders in the quarter did benefit from the pull forward effect of our February price adjustment, but we also had significant orders in the prior year related to the very large project we have mentioned on previous calls. Orders from our largest customers also showed improvement in the quarter growing modestly compared to a significant decline in the third quarter. I will give some additional color around our order patterns in a few minutes, but wanted to highlight upfront that we saw significant improvement in the Americas fourth quarter order patterns.

Second, EMEA was profitable in the fourth quarter, which represented a $7.5 million improvement compared to the $6 million operating loss in the prior year. The results were driven by 3% organic revenue growth, a 250 basis point improvement in gross margin and lower operating expenses in constant currency.

In addition, order growth was very strong in the quarter and resulted in a year end backlog that was 22% higher compared to last year.

Third, Asia-Pacific capped off a record year with a solid fourth quarter, which drove the 7% organic revenue growth in the other category for the quarter. Operating income was lower compared to the prior year due to continued investments in the region to sustain our growth in China and India as well as other markets. Fourth, we completed the acquisition of AMQ Solutions and we continue to evaluate similar opportunities to expand our capabilities and accelerate our growth strategies through acquisitions and additional partnerships. And lastly, the Board of Directors increased the dividend by 6% to $0.135 this quarter.

As it relates to our fourth quarter results relative to our expectations, the breakeven earnings were significantly better than the projected loss of between $0.05 to $0.07 per share we communicated on February 5. The actual impact of U.S. and French tax perform was about a $0.01 per share less than we estimated in February.

We also recorded a few other favorable items at year end, which accounted for another $0.01 of the variance, a few other favorable tax items at year end, which accounted for another $0.01 of the variance. The remaining favorability was primarily driven by revenue, which benefited from a stronger than expected mix of day-to-day business in the Americas and EMEA and better-than-expected project completions near the end of the quarter globally. The timing of our project completions often depend on the status of building renovation or construction, which are outside of our control. At the end of the fourth quarter, we had a number of projects in the Americas, EMEA and Asia-Pacific that were completed a few weeks earlier than we had estimated. And the effect of these completions all happening in the fourth quarter had a modest unfavorable impact on our first quarter revenue estimate. Switching to year-over-year comparisons, operating income decreased by $17 million in the fourth quarter due to declines in the Americas, the other category and corporate offset in part by a $7.5 million dollar improvement in EMEA.

As I mentioned previously, the improvement in EMEA was driven by top line growth, solid improvement in gross margin and lower operating expenses in constant currency. And we like the momentum we are seeing in the business reflecting the investments made in EMEA over the past few years. The Americas decline in operating income was driven by a 5% revenue decline and the unfavorable shifts in product mix related to reductions in legacy furniture applications as well as higher operating expenses, which included a total of $5.3 million related to severance costs and an impairment charge plus increased investments in product development and marketing.

For the other category, the reduced profitability was driven by the continued investment in Asia-Pacific plus our gross margin was negatively impacted by foreign currency fluctuations. And the higher corporate costs in the quarter were driven by lower poly income compared to prior year. Sequentially, fourth quarter operating income was $5 million lower compared to the third quarter and the comparison included reductions in the Americas and corporate offset in part by an improvement in EMEA. In the Americas, the sequential decline was driven by seasonally lower revenue, the severance costs and the impairment charge offset in part by improved operational performance and lower rebates. And for corporate, the sequential reduction was driven by lower early income. In EMEA the sequential improvement was driven by the same factors that drove the year-over-year improvement plus the non-recurring nature of some of the unfavorable items in the third quarter.

Moving to the balance sheet and cash flow, cash generated from operating activities totaled $132 million in the fourth quarter, which was approximately 2x higher than the prior year. Income taxes were a large contributor as we received a $19 million refund of U.S. taxes in connection with tax planning strategy related to foreign tax credit carry-forwards plus our estimated tax payments were much lower this quarter given the effective date of U.S. tax reform. Lower working capital also played a big role driven by both lower revenue and notable improvements in DSO in many markets around the world. Capital expenditures totaled $30 million in the fourth quarter and $88 million for the full year. We returned $15 million to shareholders in the fourth quarter through payment of the quarterly dividend of $0.1275 per share and yesterday the Board of Directors approved a 6% increase to $0.135 per share. We did not repurchase any shares during the quarter under a 10b51 program that expires tomorrow.

Turning to order patterns, I will start with the Americas segment where our orders in the fourth quarter increased 2% compared to the prior year. The prior year included approximately $16 million of initial orders from a very large project we have mentioned on previous calls. And in the current quarter we had an acceleration of orders in advance of our February price adjustment which we believe contributed up to $20 million of orders in the quarter.

In addition, prior year orders related to a recent divestiture were offset by current quarter orders related to the acquisition of AMQ. Customer order backlog at the end of the quarter was flat compared to the prior year. Across quote types, orders from continuing business and our marketing programs grew compared to the prior year, in part due to the estimated pull forward effects of the price adjustment. Orders related to project business declined by a low double-digit percentage compared to the prior year largely due to the very large project in the prior year.

Turning to vertical markets in the Americas, we saw order growth in seven out of the ten vertical markets we track and for each of the sectors that declined in the quarter, it’s worth noting that they face strong prior year comparisons each having grown by a double digit percentage in the fourth quarter of fiscal 2017. Overall, we feel pretty good about the fourth quarter order patterns in the Americas as well as our improved win rates especially since some of the largest opportunities have been won with some of our newest products.

In addition, based on a growing list of additional large project opportunities as well as improved sentiment from our dealers and sales organization, overall demand seems poised for improvement.

For EMEA, we experienced strong broad based order growth of 15% in the fourth quarter with the only notable decline coming from one market which faced a relatively strong prior year comparison linked to a few large projects. Orders in Western Europe have now grown for eighth consecutive months and in the rest of EMEA as a group we posted order growth in the quarter despite the relatively strong prior year comparison.

As I said earlier, customer order backlog in EMEA ended the quarter up 22% compared to the prior year. EMEA also had a price increase in February which we believe contributed to the growth in orders and backlog for the quarter.

For the other category, orders in total declined by 9% compared to the prior year and included growth from PolyVision which was more than offset by a decline in Asia-Pacific.

While Asia-Pacific posted a decline compared to the record level of quarterly orders in the prior year, it’s worth noting that the level of orders booked in Asia-Pacific during the current quarter were still more than 20% higher than the fourth quarter of fiscal 2016.

As we enter fiscal 2019, our current level of customer order backlog is solid and the pipeline of project opportunities remain strong thus we remain confident about our prospects to continue growth in this region.

Turning to the first quarter of fiscal 2019, we expect to report revenue in the range of $740 million to $765 million which includes approximately $20 million of estimated favorable currency translation effects and the impacts of divestitures and the acquisition of AMQ. The projected revenue range translates to an expected range on an organic basis of down 3% to up 1% compared to the prior year, which included $20 million of revenue from the very large project in the Americas mentioned previously.

For AMQ, we expect minimal contribution to operating income in the first quarter as the remaining purchase accounting effects related to acquired inventory and backlog will flow through our first quarter results.

Thereafter, we expect to begin realizing a small quarterly contribution to our operating income from this acquisition growing over time as we more fully implement our value creation plan.

We will continue to record intangible asset amortization, but the amount will be less than $1 million per quarter.

As we said in the release, we expect to report diluted earnings per share of between $0.12 to $0.16 for the first quarter of fiscal 2019. This estimate includes an expectation that our consolidated gross margins will be lower in the first quarter compared to both the first and fourth quarters of fiscal 2018 due to increasing commodity costs and continuation of some of the same drivers which negatively impacted gross margin in the fourth quarter.

In addition, we expect operating expenses in the first quarter to be similar to the fourth quarter with the sequential comparison including a full quarter of AMQ’s operating expenses and unfavorable currency translation effects reduced by the nonrecurring nature of the severance costs and impairment charge recorded in the fourth quarter.

Before I turn it over for questions, I will make a few comments about the full fiscal year of 2019. From a revenue perspective, we expect low to mid single-digit growth rates in the North American and European office furniture industries. And we are targeting revenue growth rates above these estimates.

As I said earlier, our current outlook for project activity has been improving and overall sentiment regarding next year is largely positive across our dealers and sales teams.

In addition, we are optimistic that tax reform and improved CEO sentiment will help bolster project activity and demand in our day-to-day business.

However, it’s possible we could continue to experience volatility in our annuity business until legacy standards become increasingly replaced with current office design constructs and the installed base of our newer designs gets large enough to generate meaningful follow-on day-to-day business.

Lastly, we are expecting to leverage our momentum in Asia-Pacific as well as new products at Designtex and PolyVision to help drive mid to single-digit growth rates across the other category during fiscal 2019.

Turning to our consolidated gross margin, we are targeting an improvement in fiscal 2019 due to the benefits of fixed cost absorption related to the expected revenue growth as well as continued improvement in our EMEA gross margins. How much we are able to improve our gross margins will be a function of many variables, including volume, the pace and extent of inflation and our ability to offset it with pricing actions, the mix of business and the success of our gross margin improvement initiatives in EMEA.

As it relates to operating expenses, we have talked over the last two quarters about the run-rate of our spending beginning to level off. The sequential increase in the fourth quarter was due to the addition of AMQ’s operating expenses, unfavorable currency translation effects and isolated things like the severance cost and impairment charge. And our estimates for the first quarter contemplate relatively flat operating expenses on a sequential basis with similar explanations of the net pluses and minuses.

Some of our cost structure is variable, so operating expenses will vary quarter-to-quarter based on the top line and bottom line and we expect to continue investments in a few areas of our business like Asia-Pacific and AMQ for example, but we expect the run-rate of the remaining spending in constant currency to level off at recent run-rates. This could help us achieve a relatively strong contribution margin on incremental revenue growth. And therefore, we are targeting to grow adjusted earnings per share at a rate that is more than 2x the rate of revenue growth for fiscal 2019.

For EMEA, we are targeting significant improvement in our operating results in fiscal 2019 compared to the $14 million operating loss in 2018, which you will recall was comprised of the $2 million loss in the second half of the year and a $12 million loss in the first half of the year which included a $4 million property gain. Taking into consideration, our objective is to grow the top line and further improve our gross margins as well as the seasonality of our business and the recently strengthened euro, we expect to report an operating loss for the first half of the year and operating income in the second half of the year. Those results will depend on our ability to sustain organic revenue growth and drive additional improvements in our gross margin as we are continuing to target relatively flat operating expenses in constant currency and adjusted for the property gain in the prior year.

However, I will share that we are currently projecting an operating loss in the first half of fiscal 2019 between $10 million and $15 million using a euro to U.S. dollar exchange rate of 1.23 which would represent an improvement compared to the $17 million to $18 million operating loss we posted in the same period in fiscal 2018 adjusted for the property gain and stated in constant currency. In summary, we expect to report organic revenue growth and improved gross margins in fiscal 2019 by leveraging the investments we have made in our business over the past 2 years, while leveling off the run rate of our operating expenses which we expect will improve our operating income margins in both the Americas and EMEA.

Moving each region towards their respective longer term targets of a low double-digit percentage in the Americas and a mid single-digit percentage in EMEA. And for the other category we continue to target a mid single-digit operating income margin, largely due to our intention to continue our investments in Asia Pacific.

Lastly, a couple of other data points for your fiscal 2019 modeling.

We are at sometimes asked about non-operating costs, so I will share that we do not currently anticipate any significant changes in interest expense or investment income and we estimate other income net will approximate $2 million of income per quarter assuming no significant foreign currency gains or losses.

Regarding the effective tax rate, we are currently modeling 27% based on our understanding of U.S. tax reform and our estimated mix of foreign source income. And related to uses of cash; first, we expect capital expenditures to fall within a range of $85 million to $95 million or similar to the level we incurred in fiscal 2018. And these investments will be driven by our intention to sustain a high level of product development, strengthen our industrial capabilities, enhance our information technology systems and continue to invest in our customer facing facilities.

Second, as we continue to expand our portfolio of offerings beyond product development and marketing partnerships, it’s possible we could choose to expand internal capabilities or otherwise accelerate some of our growth strategies through additional acquisitions or joint ventures.

Lastly, the quarterly dividend remains our priority for returning cash to shareholders as evidenced by the 6% increase in the cash dividend approved by the Board of Directors yesterday. And to the extent we project having excess liquidity, we expect to remain opportunistic as it relates to share repurchases, taking advantage of any potential stock price volatility to at a minimum offset dilution from equity awards. From there, we will turn it over for questions.

Operator

Thank you. [Operator Instructions] And our first question comes from Budd Bugatch of Raymond James.

Your line is now open.

Budd Bugatch

Thank you and thank you, Jim and thank you, Dave for much of the color on the table on some of the expectations for the year. I realized there are a lot of moving parts, let’s just cut right through the chase on inflation if we could, I think you said the second quarter will be, you fear, the biggest impact, did I get that right? And how do you think that will phase in over the year and I realized that maybe little hard it took pricing actions, but maybe you can give us a little flavor of how you look at that?

Dave Sylvester

Yes, Budd, it’s Dave. I will take you back to where we kind of snapped the line in our decision to take a price adjustment in February to start there and then maybe move through what we are seeing more recently. Back in the fall, we took a decision based on inflation we have seen through that date to initiate a pricing action in February. And since then, we have seen inflation up through the February price adjustment and after the February price adjustment up through just a week or two ago we have seen even additional inflation, which was either in advance of or linked to or shortly following the tariffs. And what Jim was referencing is that last piece of inflation is what we are going to start to feel more significantly in the second quarter.

We are feeling inflation today that was part of the reason we took – link to the reason that we took a price adjustment in February.

We are also feeling some additional inflation since that decision point in the fall, but the significant rise in commodity cost will start to feel more significantly in the second quarter. And it’s tough to estimate, because we are using projections of like the CRU monitor and other sources and it’s also kind of difficult to estimate the magnitude of steel and aluminum in our cost structure, because it’s embedded in so many different purchase parts, but we tried to give you a sense that it’s a relatively big deal at more than $10 million of incremental inflation from just what we have seen in the last several weeks. And from there, all I can really say about pricing actions is refer you back to what we have done in the past when we have seen inflation. We know with our customers that the best time to talk about the price adjustment is when you have inflation and we have inflation right now. And in the past, we have taken surcharges for steel, we have taken surcharges for commodity cost spikes in general and we have periodically when necessary took pricing adjustments more than once a year. And we know that we can’t absorb this level of inflation, so we are obviously paying close attention to it.

Budd Bugatch

So, I just want to be clear that $10 million incremental is really since the November timeframe when you felt the need to initiate the pricing action and that doesn’t include the Japanese steel issue, which is a couple of million dollars, is that right?

Dave Sylvester

Yes, that’s right. That will be separate.

Budd Bugatch

And so it���s somewhere pick the number $12 million, $13 million is kind of the range we should kind of try to feather into a model for the remainder of the year and then maybe offset that with pricing however long we take that type back.

You had said…

Dave Sylvester

I think directionally you are right, but I do want to say focus you back to what Jim said which was more than $10 million. I mean, we feel like it’s minimally going to be that kind of number that you are estimating.

We will of course update you as we see it play out, but that’s what we are roughly estimating at this point.

Budd Bugatch

So, I got a little confused. We look at gross margin down versus the fourth quarter and the first quarter in terms of our overall consolidated impact and then I think you said gross margin for the year you think you will actually have a positive comparison year-on-year, so when do we see that second or third and fourth quarter or is it notable mostly in the fourth quarter, how does that factor?

Jim Keane

Well, so let’s start with the first quarter, so remember we have sequentially lower revenue in constant currency or therefore lower volume in Q1 versus Q4.

So that’s part of the equation.

In addition, we have the early signs of inflation.

Now, what we expect for the balance of the year is of course we are targeting improvement in gross margins largely driven by the fixed cost absorption benefits from targeted revenue growth. But I also said that how much we are able to achieve will depend on the pace of inflation and our ability to offset it with potential pricing actions.

So, it’s hard to say we are sharing with you what we are targeting and I have to kind of stop short of specifically telling at quarter-to-quarter because there are so many moving variables, how much will we grow in the second quarter as an example is a question mark, how much will inflation continue to rise and therefore impact more broadly our commodity costs in the second quarter, what pricing actions might we take and when and how successful might they be are other factors along with our gross margin improvement initiatives in EMEA.

So we are targeting improvement for the full year, so we believe it will be mostly driven by fixed cost absorption and we are hopeful that inflation will be controllable and offsetable, but you have to form your view on that as well.

Budd Bugatch

So just as my follow-up, just making sure you also opened the door and talked about contribution margins in your talk, look it sounded like a step function improvement in contribution margin at least maybe for the near-term is can you kind of give us where you think contribution margins are to the extent that imply that for you segment by segment I would love that is played that as well?

Dave Sylvester

I don’t know that I can give them segment by segment and I will remind you that historically we have talked about our contribution margin on incremental revenue growth when operating expenses in total are relatively flat and came in the mid 20% range. But I also said we are growing operating expenses in some areas because of investments in AMQ and Asia Pacific for example.

So from there I think the contribution will be somewhere let’s say between 15% and 25%, but it’s going to be larger and more dependent on volume than it is on the relevant – on the level of operating expense investments, because contribution margin is a function of both how much revenue we are generating and how little we are increasing operating expenses.

Jim Keane

I would add as you looking into your models make sure you remember that part of our growth next year will be a full year of revenue from AMQ. And that’s – for that you have to think about in terms of average operating income not contribution margin, because it’s not truly – it’s not organic growth, so just one thing to keep in mind as you are doing your modeling.

Budd Bugatch

And what do you think that is this year, what’s the – if you look at it today acquisition, divestiture, what is that net revenue impact?

Dave Sylvester

Well, we are certainly targeting for to be a positive.

We have very high expectations of AMQ. And as Jim mentioned we like how it’s coming out of the gate with things like project registrations and the like.

So we are optimistic that that will be positive, it will certainly grow over the level of revenue that they had last year would be our expectation and should – if it does that it should more than offset the impact of divestitures.

Budd Bugatch

Well, when I look at that – when I look at what your organic growth was for the first quarter, it look to me like you are going to have not only the AMQ acquisition factored in, but then also some divestiture factored in to get to a comparable sales base, a lot of that that organic revenue of down 3 to plus 1 to get to your revenues to $20 million factor for currency?

Dave Sylvester

You got all the pluses and minuses. And in the release we have a table that shows how we get to the projection of down 3 to up 1 which takes into consideration the revenue from AMQ, the revenue that AMQ had in the prior year as well as the revenue related to divestitures that we had. What the down 3% to up 1% include – also reflects is the $20 million in revenue from the very large project. And it also takes into consideration a little bit of the effect of how project completions all seem to fall in our favor for Q4 at year end versus be more balanced across the year end line as we typically see in a quarter.

Jim Keane

It’s mean to pull Q1 down – some of those projects we had the revenue in Q4 and so Q1 so it has a…

Budd Bugatch

Are you taking the large project out of the base as well for that…?

Dave Sylvester

Not in our projected down 3% up 1%, so that’s part of the reason why it’s down 3% up 1% is because we don’t have another single project of that magnitude in the current year.

Budd Bugatch

Okay, we can continue that offline. Thank you very much.

Jim Keane

Thanks, Budd.

Operator

Thank you. And our next question comes from Matt McCall of Seaport Global Securities.

Your line is now open.

Reuben Garner

Thank you. Good morning guys. It’s actually Reuben on for Matt.

So, a couple of quick clarifications about the guidance, I just want to make sure I understand that the low to mid single-digit market growth for North America and Europe and you guys are hoping to grow faster than that? Are those organic growth rates that you are talking about when you are saying growing faster and so you are layering FX and I guess start there?

Dave Sylvester

That’s right, Rueben. That’s a good question. Those would be organic references.

Reuben Garner

Okay. And then I didn’t catch what you said about the EPS growth, so I wanted to get that as well? Did you say more than 2x revenue growth?

Dave Sylvester

That’s what we are targeting.

Reuben Garner

Okay. And then I want to follow-up on Budd’s question about so maybe it would help if you guys give a lot of detail on the steel impact and about how you are expecting some of your investments to kind of level off. Can you help us with maybe a bridge from Q1 of last year to Q1 of this year? It looks like the guidance implies EBIT margin down about 150 basis points year-over-year flattish to slightly down top line. Can you help us with those three big buckets that you have referenced the mix pressures, the steel impact and the one….

Dave Sylvester

Operating expenses will be higher.

Reuben Garner

Yes. Can you help us with those buckets in Q1 and then maybe how they transition through the year, I am just trying to see how you flip from being under so much pressure in Q1 to kind of turning it around, maybe if you can just help us with those three?

Dave Sylvester

Well, let’s start with revenue right.

So, we have – what we have said for the last couple of quarters is we were projecting that we believed that the success of our new products would begin to offset some of the decline associated with legacy applications as we got into this year, but we have this large project comparison as a challenge in the first quarter.

So, Jim specifically referenced that in the Americas we feel like the line should cross in Q2 and we should start to see some growth.

So, that’s revenue. I will go from there to operating expenses.

For the last couple of quarters, we have talked about our level of product development and other investments in our business beginning to level off with the run-rates that we had in the back half of 2018. And as we said that we reminded everyone that the run-rate of our spending was increasing in ‘18 so as we get into ‘19 even though the run-rate is leveling off, we would have higher operating expenses in Q1 and Q2 versus 2018.

Reuben Garner

Right.

Dave Sylvester

Okay. And then on the margins we have inflation that’s affecting the numbers.

We have inflation in Q1 that originated back in the fall and we will have a little bit of it from the from the growing level of inflation that we saw since we snapped the line for our price adjustment, but we won’t really feel any significant impact from the significant inflation we have seen in the last 4 weeks, where we have seen steel prices as an example spike that we anticipate will start to work through our contracts and through our inventory and show up in cost of goods more in the second quarter.

Reuben Garner

Okay.

So, it sounds like you…

Dave Sylvester

You asked Q1 over Q1 our guidance has revenue of down 3 to up 1. I gave color in the release and in my scripted remarks that gross margins are likely to be down sequentially versus Q4 as well as last year for reasons of inflation and some of the other drivers that I referenced in the Q4 year-over-year comparison like, for example, legacy product mix shifts away from legacy towards new as an example. And I just walked you through operating expenses, so that should give your pretty good year-over-year bridge for Q1.

Reuben Garner

Yes, perfect. Thanks Dave. And then one more quick one, EMEA I think you referenced down are losses of about $10 million to $15 million in the first half, any color on today or what you are expecting or hoping from a profit perspective to come off…?

Dave Sylvester

Yes. I mean that we – the further out it gets the more difficult it gets to project and there is still some fair amount of uncertainty in the first half of the year projection. But I wanted to make sure that you guys understood that even though we have made money in the fourth quarter because of the seasonality of their business with revenue being so much lower in the first half versus the second half, I wanted to make sure that the you are all aware that it was more likely than that that we would see an operating loss in the $10 million to $15 million range.

So that’s why we were a little bit more explicit about the first half.

The second half because of the distance and the time as well as the number of variables that will affect it, we are just going to tell you that of course we are targeting profitability, how much will depend on too many variables for us to give you a specific marker.

Jim Keane

We feel a lot of – because of the order growth we saw more recently, because of the amount of activity we are seeing in our Munich Learning and Innovation Center, the level of customer engagement is significantly higher today than it was 1 year or 2 years ago. And the economy seem to be strengthening in the larger markets in EMEA, so there is a lot of hybrid things to point to and lots of reasons we believe it will continue to improve our performance.

Reuben Garner

Correct and thank you guys.

Operator

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

Your line is now open.

Steven Ramsey

Good morning. This is Steven on for Kathryn.

First question revolves around the other segment with orders down 9% after good, pretty solid sales growth in Q4 and kind of getting to the guidance of mid single-digit growth for the year for fiscal year ‘19, was there much pull forward effect impacting the other segment in Q4 and what are the drivers to go from low order growth leading to Q1 and mid single-digit growth for the year?

Dave Sylvester

Okay.

I think I got all of that, so let’s start with the order decline in the fourth quarter.

As I said in my remarks it was versus the record level of orders that we had in Q4 of last year. It’s still 20% higher than 2 years ago on a 2 years back basis and our backlog is pretty good and our pipeline of opportunities that we are working on feels pretty good.

So we have some relatively difficult comparisons, because of the growth we posted in any other category this year. But we have – we believe that we have nothing is moving in our favor that we can continue the growth in Asia plus we expect growth from Designtex and PolyVision.

So the fact that we have these difficult comparisons it is going to bring the growth rate down to the mid to high level single digits versus what they experienced this year which I think was stronger than a double digit, but we still think we can drive growth there.

Steven Ramsey

Got it. And then thinking about price increases driving customers to accelerate orders and therefore the sales being conducted at the lower price points, can volumes also – can volume growth from that offset the inflation pressures that you may see I guess on is there any concern going forward that customers accelerating orders on price increases makes it tougher to get the gross margin expansion that you want for fiscal year ‘19?

Dave Sylvester

Yes.

On the acceleration of orders the way you should think about that is because we are taking a price increase, those companies, those clients that were going to place orders over the next several weeks anyway chose to place them a few weeks earlier than they otherwise would have so that they were not subject to a higher price. Occasionally, as we – as our sales people go out and talk to clients about a price increase, it might stir up a little additional activity. But generally when we talk about the acceleration of orders, it’s really about just the timing of those orders following.

In fact, the shipment dates don’t generally change and we don’t allow clients to book orders as they want delivery of next fall, let’s say as an example, we don’t let them book that order in advance of a price adjustment now that would be too far outside of window of acceptability.

Jim Keane

I will answer that on your question about margins.

So, when customers accelerate, so say in the February price increase, we had some orders that were pulled forward, that means that we make those products a little bit earlier than we were expecting. But because of the seasonality of our business, those orders were pulled forward into a period of when our factories are naturally less busy and so it actually helps us a little bit with overhead absorption.

You would rather see that surge in orders during a period when the factories are little bit slower than a time when they are very busy, because our variable costs are higher in the peak quarters than they are in the low quarter.

So, net-net, you are trying a bad thing when we have a price increase we see that pull forward even though we give up the price increase, we makeup something on absorption.

Steven Ramsey

Right.

Okay, thanks so much.

Operator

Thank you. And our next question comes from Greg Burns of Sidoti.

Your line is now open.

Greg Burns

Hi, just a pull question on the pull forward you were talking about with the price increase, was there a price increase last year and was the timing of the price if there was, was the timing different this year in February?

Jim Keane

It was in October of 2016 was the last price adjustment that we took in the Americas.

Greg Burns

Okay, thanks. And when we look at the year, your opportunity in the ancillary market, can you give us a sense of kind of what percent of your dealer wallet share you have in the ancillary market, maybe your view on increasing that wallet share or maybe some of the initiatives you have in place to increase your wallet share with the dealers on the ancillary side of the business? Thanks.

Jim Keane

Yes.

So the good news on ancillary is that we think our dealers capture relatively the same share of their customers spend in ancillary as they do on the traditional office furniture and so that volume is going through our dealers. Historically, we know that we don’t capture the same share of dealer wallet even if I went back 3 or 4 years ago before the ancillary trend began. That’s always been an area where you always bring a lot of value, they can extend what we offered by offering the products from other manufacturers that have products where we don’t compete. But as ancillary has grown that has been a bigger part of our dealer’s business.

So we probably capture about the same share of wallet as we did before, but the size of that part of the business is growing and so we intend to increase our share of dealer spent. And it’s exactly as you said, so combination of multiple things, first of all, the products that we have in our portfolio of making sure we are merchandising them by brand, but also across our brands.

So, for example, in our tradeshows and a lot of our marketing materials, we are now showing how customers and dealers can take products across the portfolio and create the kinds of settings that our customers are looking for.

Secondly adding to the portfolio by developing more branded products, we have pre-announced and we have announced and launched a number of products over the last year and continued to launch new products in the ancillary segment. And then the partner products like Mitchell Gold and FLOS and Bolia and Blu Dot and more partner products to come in the future, we expect these continue extend our reach. And we have seen evidence as we have added those partners that in fact that’s helping us win projects, so examples in Americas but also in Europe, where dealers are beginning to access the Bolia portfolio and blend that portfolio with the Steelcase portfolio to help us win overall projects.

So, as we continue to do that, the expectation is we capture higher percentage of our dealers spend on the ancillary.

Greg Burns

With the partnerships that you have, they were just mentioning what’s the – can a dealer just what’s the benefit of going through you and your partnership with them. Can the dealer just like source directly from Bolia or some of these others like Mitchell Gold, why they need to have you as the middleman between you and those other partners?

Jim Keane

Yes, it’s a good question. Yes, they can access products from a whole variety of different manufacturers. The benefit that they get is first of all the ability to simplify the pricing process.

So, they begin to understand what the pricing is without having to negotiate on every deal, because we are able to offer them pre-negotiated pricing.

We are also able to integrate the products into the design tools the dealers use.

So, today when a dealer is laying out of space, it’s easier to do a design or is able to stay within the tool and not have to go to other products that maybe don’t have the same renderings available and things that can drop in their tools. And when they want to place an order, they can place an order for these products using exactly the same systems, they used to place the order for everything else that’s going into that accounts floor plan from Steelcase.

So, it simplifies the order process. It simplifies the process of paying those invoices. And then from a logistics perspective, we can consolidate those products and for the same shipments and sequence the deliveries to meet the customer’s installation needs.

So, kind of across the board that’s a big deal. And when we talk with our dealers and our dealers and lots of other dealers out there in the marketplace one of the challenges they face is as this ancillary segment has grown, their costs have risen faster than their profits have risen.

So, they are not able to recapture the cost of the complexity of trying to deal with lots and lots of different manufacturers.

So, they can do it themselves, but the economics aren’t great and if they can do it through us because of the simplification and the pre-negotiated prices that they have, it’s more attractive to them economically.

Steven Ramsey

Okay, thank you.

Operator

Thank you. [Operator Instructions] And our next question comes from Bill Dezellem of Tieton Capital.

Your line is now open.

Bill Dezellem

Thank you. Couple of questions.

First of all, is the customer deposit growth, is that another sign of the solid orders and that you are really on the cusp of things turning?

Jim Keane

I would attribute that more to timing than anything Bill or the nature of different projects the locations of them. We don’t give deposits on all of our projects and they tend to be more geography driven, so I would say timing and mix of geography of projects is probably what contributed mostly to that. Yes, I agree. I wouldn’t get too much into it.

Bill Dezellem

I am sorry, I cut you off, Jim, did you have more you wanted to add there?

Jim Keane

I would just agree in saying I wouldn’t read too much into the change in deposits.

Bill Dezellem

Thank you. And then you have talked around the win rate from multiple different directions, I am just going to ask the question head on and ask you to really detail why it is you think that your win rate is increasing and from what you see do you believe that win rate will continue to increase?

Jim Keane

Yes.

So as I have been trying to think about how to go at that question, I think first of all if I take it market by market, but I would say, overall, I think our sales organization has done a good job of executing across every element of the selling process from developing the right relationships with customers upfront to making sure we are executing our mockups which is a key part of selling process effectively and through the final price negotiations being very aware of what pricing is in the market, so that we are always competitive. And I think in every aspect of the sales process kind of end-to-end, we had opportunities to improve and our sale leaders and our sales organizations have done a nice job of doing that, so just across the board execution.

Secondly, I think the investments we have made in product development are paying off. These investments started really 2 or 3 years ago, we have been talking about it on these calls for 2 to 3 years and we have some really major introductions happening here in the fourth quarter that are only beginning to affect win rates, but I say cumulatively, the investments we made in product development are making a difference.

We have also done a lot of investments in our brand. The partnerships we have built with Microsoft, the investments we have made in our showrooms in the Americas, we won showroom of the year last year at Neocon, the investments in the Munich link. These are all physical environments where we host customers and can tell this complete story of the Steelcase brand.

As I said earlier, the ability for us to show the range of offering we have in ancillary costs entire portfolio, they kind have to take all these together, we work in a very competitive industry, you got to be good across the board in order to win against any of these very strong competitors we face everyday around the world.

So, I think it’s collectively those efforts have made a difference, so we are happy to see it happening.

Of course, competitors just getting better everyday too, so it’s not a matter of us just being better, we have to be better at an accelerating rate and we do everything we can everyday to do that.

So, thanks for that question. It’s actually where we spend all of our time.

We are with customers everyday, as soon as I am off this call, I am off to see another potential customer. And it is really where we work on day-in, day-out.

Bill Dezellem

Jim, I don’t want to keep you from talking with that customer.

However, we would like to hear a little bit more about the Microsoft relationship and update there if you would, because I don’t think that has come up at all in your release or on conversation on this call?

Jim Keane

Yes, so there is multiple parts of the Microsoft relationship. One part I will start with is the launch of creative space.

So, this is a way for us to talk to our customers about how the spaces they use can respond to the ways work is changing.

So, these days customers are interested in growth. I imagine every company you guys follow, every company that is talking about the earnings this quarter is going to talk about how they are trying to shift their efforts towards growth. And as they do they are focused on the things that are disrupting their business that could potentially be engines for growth and these include digital technologies, so every company these days is talking about digital transformation and how to be more responsive as a software-based company. The culture shifts that customers are going through therefore are significant and you are trying to think about what kind of culture they need to support innovation, what kind of culture they need to support design thinking, how do they create a culture that encourages and nurtures creativity? So, the work we did with Microsoft are on creative spaces to take our research into the how the work of creative people, people who are actually creative on-demand everyday, how that work is actually different from process work and therefore what kind of the spaces they need that are different. And we have integrated Microsoft’s products like Surface Hub and Surface Studio and so on into those environments to show how technology integrates with the architecture and the furniture delivered that completes solution. This is quite different and just to make it clear that very different from the way furniture is typically purchased, where the customers will identify an application they will boil it down into each particular product categories, they will have markups for some of that, that have had pricing for some of that. This is fundamentally different, because we are leading the discussion around this application as a whole.

We have been investing in putting those applications in our showrooms around the world, including here in Grand Rapids, I get to see firsthand the reactions of customers who can see the difference between that kind of experience than something else.

So, the impact we have is not simply whether we sell creative spaces themselves. The impact is how it changes the conversation of a customer across the board and I am definitely feeling then the question about win rates, I think is part of it. Every time we make these investments that can broaden that conversation, it’s useful for us. A second part of the Microsoft relationship has to do with the way they are supporting our investments in our smart and connected solutions.

So, this includes products as well as services.

We are just now beginning to take orders for those offerings and behind the sensors, I mean, we started off with this, we looked at a lot of third-party sensors, which were fine, but what we found was those sensors were not based on scalable back-ends often and our customers who are Fortune 500 companies and the largest companies all around the world, they expect if technology is going to make its way into their environment that it’s scalable, it’s reliable and it’s secure and by partnering with Microsoft, we are able to build our sensor technology off the Azure backend.

As you know, those of you who follow Microsoft, you know that Azure has been very successful for them growing fast in this last quarter.

We are one of the first people to actually build these kinds of applications on the Azure platform and we are very happy with that partnership.

As time goes by, we expect to broaden the partnership.

So we will continue to do the things we have been doing, but add more and more elements of the partnership.

So I think it’s been very successful.

Bill Dezellem

Thank you. And I would like to ask quick one additional question please. Relative to tax reform, particularly the expensing of capital expenditures in year one, press release mentioned you really have not seen a benefit yet from tax reform.

However, I am curious just in conversations qualitatively are you hearing that that is something that that prospective clients and your clients are saying that is relevant to them or is this really a very quiet topic right now?

Jim Keane

So I was in Washington last week and at the business roundtable meeting and listening to CEOs talk about their general outlook for the future. And as the new tax reform is central to their building optimism, the data is clear if you look at the surveys of the business roundtable and others, we see CEO confidence rising and when you ask why everyone points to tax reform. It’s quite significant not just because of the accelerated depreciation but the just kind of at the lower rates to begin with the ability to repatriate cash in the sense that the business environment is in the Americas at least is allows for investment, allows for CEOs, begin to making potential investments they want to grow their business.

So that is all positive, there can be no doubt about it. And I would say compared to – I have been on these meetings for a long time, I have never felt that kind of optimism before. When you come to our projects, so we are often dealing with facility managers, we are dealing with real estate managers and so in the background, their capital expenditure budgets might be increasing because there is a meeting happening someplace where people are connecting it optimism and tax reform. But we also have to frankly say that those conversations don’t come up in our meetings, so people have been coming to our spaces and said we are doing project specifically because of tax reform, I believe it’s there. And I think there is no question that that optimism in the C suite is driving increase in investments around growth and increase in investments around when you quit environments that attract if I call it workers which is really tough do these days.

So I think there is – that optimism is definitely feeling it, but it’s probably also true that we haven’t felt the full impact because tax reform has just started, it will take a few months for that kind of flow to the same making. I will also temper that with the acknowledgment that people are concerned about trade, so while there is very – our tax reform there is concern that things like the tariffs and threats of other kinds of trade actions and the territorial efforts that could take place, could take some of the wind out of the sales. And I am not an expert at this, but I would just point out that these days is a little bit of both.

Bill Dezellem

Great. Thank you both for all the color.

Jim Keane

You bet.

Operator

Thank you. And that concludes our question-and-answer session for today. I would like to turn the conference back over to Jim Keane for any closing remarks.

Jim Keane

Thank you and thank you all for joining the call. We feel the energy of the positive demand momentum we are feeling right now in all three regions of our business.

We are also feeling the benefit as we enter fiscal year ‘19 of the investments we have been making over the last couple of years in product development. It took some faith and some trust and some courage to make those investments when we see that the revenue wasn’t growing, but I am glad we did because now we have got the product portfolio we need as we enter a New Year. And in EMEA, it’s been 3 years of effort to transform that business, again encouraged by the kind of momentum we are seeing and realizing that the investment we made in unit is really just beginning to have an impact on the conversations we can have with customers and maybe the beginning of an impact on orders.

So it’s gratifying to see that it’s gratifying to see EMEA have strong order growth in Q4. We know we are going to be fighting against seasonality in the first half, but good momentum as we go into fiscal year ‘19.

So thank you all for your interest in Steelcase and thank you for joining the call this morning.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program and you may all disconnect. Everyone have a great day.