Motley Fool Hidden Gems Investing - A CEO's Dire Forecast

Episode Date: March 30, 2022

Having led Restoration Hardware since 2014, Gary Friedman is an experienced CEO. But on his company's latest earnings call Friedman says he's never been more uncertain about the future. (00:20) Bill Mann discusses: - The record year RH just closed - Friedman invoking the 2008 collapse of Bear Stearns - Why RH is doing a 3-for-1 stock split Bill also answers a listener's question about small-cap stock 22nd Century Group. Post a review on Apple and include a question about a stock or industry! (14:00) Tim Beyers and Andy Cross talk with Jay Chaudhry, CEO of Zscaler, about what other cybersecurity companies are missing and the biggest misconception that Wall Street has about his company. Stocks: RH, WSM, XXII, ZS, CRM, TSLA Host: Chris Hill Guests: Bill Mann, Tim Beyers, Andy Cross, Jay Chaudhry Producer: Ricky Mulvey Engineer: Rick Engdahl, Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

Chris Hill. Today we're going to talk with the CEO of a cybersecurity company, analyze the comments of a retail CEO, and explore a small cap stock that just popped up on our radar. Motley Fool Money starts now. I'm Chris Hill, joined by Motley Fool Senior Analyst, Bill Mann. Thanks for being here. Bill Mann. Hey, Chris, how are you? I'm doing well. I'm not a restoration hardware shareholder, but I'm fascinated with what is happening both with this stock and this company. Let's start with the fact that they closed out a record year. You wouldn't know it from the fact that the stock is down 12% today.

Before we get to the comments from the CEO, which a lot of people are focusing on. Which are amazing. Which are amazing and it is appropriate, we should be focusing on these comments. But before we get to that, what did you think of the quarter? I mean, like I said, they closed on a record year. Yeah, they did. Earnings were up. I mean, they made $5.66 a share. If you take out some non-cash items, non-recurring costs, I'm not quite sure anymore what companies consider to be non-recurring. On a gap basis of $4.91 a share. Their margins are fantastic. Yeah, it was a great quarter by them, but revenues were a little bit light, but then they ended by making the most recent

quarter the least relevant part of what we're supposed to be talking about when it comes to this company. Right. Before we get to the comments from the CEO, I'll just add, this is yet another one of those companies with pricing power. Restoration Hardware makes high-end furniture, high-end products for your home. People have been more than willing to buy what Restoration Hardware is making. Absolutely. Their margins are up 2,000 basis points over the last decade. They are a tremendously profitable company, both from overall profitability and for the margins of the core products that they sell. Gary

Friedman has, and we have given him tons of credit in the past because Restoration Hardware for a bunch of years felt like the second coming of Bombay Company, a quirky home goods store that really didn't have that much going on for it, maybe it caught lightning in a bottle in some way, and he came in and he has reformed the company and he's really turned it into an incredibly credible competitor in that market and in the field. Friedman has been the CEO of Restoration Hardware since 2014. He was with the company prior to that. Before that, he was an executive at Williams-Sonoma. This is someone who has made his career in the high-end retail space. The comments on the conference call, there are really

two. The first is, and I'm quoting here, Friedman talked about how the business experienced softening demand in the first quarter, so this is the quarter they're in right now, softening demand in the first quarter that coincided with Russia's invasion of Ukraine. He talked about how it's prudent for them to remain conservative in terms of their guidance. I agree with that, but this is the first CEO who has talked about Russia's invasion of Ukraine, not in terms of supply chain, but in terms of softening demand. How are you interpreting this? Because, Again, nobody else is talking about this, not everyone, but a lot of other companies have come out and talked about the effect on supply chain.

Right. Well, he's absolutely right. Keep in mind where Restoration Hardware is maybe in the entire framework of consumer confidence. They are high-ticket, low-velocity items. Like, you're not, well, I got a couch last week. I think I need another couch this week. So for him to come out and say that these high-ticket, low-velocity items immediately dropped off at the point of the invasion, the Russia's invasion of Ukraine,

and it's important to point out, he's not saying that the two things have a link. He's just saying that the timing was there. So it could be that interest rates have taken off at the same exact time and that's the driver. But what he is saying is that consumer confidence fell off a cliff very suddenly at that moment in time. And perhaps it has to do with the fact that we are now feeling in inflation. Perhaps it has to do with the fact that it now costs some people $150 to gas up their car. Who knows what it is? He is not assigning any sort of causality to what he pointed out was happening at the same time. He is really very much wondering, though, if people in Washington really are paying attention. Later on the call, he got asked a pretty

vague question, sort of an open-ended question. It's like, hey, how are you doing? One of those questions that enables the respondent, a lot of directions they can go in, and holy cow, did Gary Friedman go in a lot of different directions. He talked about inflation, input costs for the company, the price of housing, and to top it all off, he invoked the collapse of Bear Stearns in 2008, leading a number of people, including me, wondering, wait a minute, is he trying to rationalize what is happening with his business at this point in time? Or is this someone who can see the future? Because if he is predicting the future and he's right, it means we're all in for a lot more economic pain. Right. He was saying things including,

well, our shipping rates used to be $2,400 and now they're $4,800. Are people paying attention to this? Now, you and I as optimistic cynics have seen thousands of times CEOs get on their quarterly calls and blame the weather, blame whatever it is, whatever it is, the exogenous pressure of the day for things that did not work out well at their company. The thing is, for the most part, they had a pretty good quarter. So, I mean, either he is attempting to blame these exogenous factors on some real problems at Restoration Hardware, or he's truly the canary in the coal mine. I mean, he's truly saying things are bad. And I don't know if people are paying attention. But if we are any indication, then the consumers are pulling back as quickly as

I have ever seen. And I don't know how to predict what's coming next. God, I can't wait for 90 days from now when they report again. No kidding. And you know, and here's the thing. Gary Friedman is a great CEO. He really did take restoration hardware and transform it from an also-ran, who'd have ever noticed if they went bankrupt, to a really reasonable proxy for what's going on in that segment of the market. This is not an excuse-making CEO by any stretch of the imagination. It's also not a CEO who is prone to saying things just to get in the headlines. No, no. Last thing on restoration hardware before we move on, also overshadowed in all of this, they announced a three-for-one stock split,

the exact date is to be determined, but they talked about, similar to Amazon, they talked about, we're doing this so we can enhance our ability to recruit and retain talent. And sure, why not? I have no problem with this. I mean, I guess. I mean, what is definitely true is that high share prices make it hard for them to be precise with these types of grants. I think that there's so much myth-making about stock splits adding any value to companies, And I just, you know, I would encourage people to think about the pizza analogy, like how much pizza, if you cut the same pizza into four or eight slices, it's the same exact piece of, you know, pizza pie. But in this case, you know, I think that they really are trying to be more precise with how they can award their employees. And, you know, great.

It's news. I don't think that they're doing it right. Like, everybody else seems to get their stock prices to go up a ton when they announce stock splits. So, I think Gary Freeman, I'm joking, of course, but there's some improvement there that I think he could work on for next time. I want to give a shout-out to one of our listeners, Steven, who posted a review of the show on Apple, and he included this question. He wrote, I want to get your thoughts on 22nd Century Group, the ticker symbol is XXII. They are the first company to get approval from the FDA to sell low-nicotine menthol and

conventional cigarettes, and they are doing a test pilot at Circle K's in Illinois. This company could potentially be the king of tobacco. What are your thoughts? Thank you, Stephen, for the review and for the question. I'd never heard of this company before. Market cap is around $400 million. dollars. I am not necessarily someone interested in tobacco companies, but certainly you look at a business like Altria, shareholders have been handsomely rewarded for owning that stock for decades. That's very true. It is a low nicotine product. The product is called VLN and then VLN menthol king. I am not a smoker, though I am from North Carolina, so I can speak very appreciably, authoritatively about smoking. I always thought that the nicotine was at least partially the

point of smoking, that that was the draw. So I don't necessarily know what the attraction for low nicotine smoking is if it's the actual enjoyment of the process that said nicotine is the addictive uh compound within with within tobacco so there are you know so if it is something that would allow people to smoke because they enjoy it but smoke less and not worry about the long tail problems from too much nicotine consumption. I think it's great. This is the kind of company that has got a lot of promise out there. There is plenty of time for you to own this company. I would absolutely positively wait and see until you see a little bit of traction in low nicotine tobacco. But if it works and if people are attracted to it, I think that

you may have something there, but there's plenty of time. I was going to say, it does seem, particularly with the pilot test they're doing in Illinois, it does seem like the kind of business that if you're following it, and there probably aren't a lot of people who are following, this is not Apple. There are probably no analysts on Wall Street who are covering this business. but you probably can figure out how the pilot test is going, particularly if, you know, you have to assume that the company, if there's any sort of success and they expand the pilot to other states, they're going to make that known. Yeah. And you could absolutely positively do what Philip Fisher called scuttlebutt. Once these cigarettes are in the stores,

wander into your local Circle K and ask the guy behind the counter how they're selling. I mean, if they're sitting there backed up, you know you have a little bit of information on what the answer is. You know, again, I don't know. I tend to consider, you know, obviously Altria has been a spectacular investment for people over the last, I don't know, call it 40 years, which is at this point statistically relevant. I'm not sure what the market would be for this, but I do, I understand the theoretical attraction of a lower nicotine cigarette. It's hard to say for health reasons, but that's what it comes down to, isn't it? Absolutely. Thank you again, Stephen, for the question and for posting the review.

Again, you can pitch us a stock, hit us with a question or a topic idea when you post reviews on Apple and Spotify. Bill Mann, thanks so much for being here. Hey, thanks, Chris. What does cybersecurity mean when you're working from home and doing business in the Cloud? Jay Chaudhry is the CEO of Zscaler, a cybersecurity company built on the idea of zero trust. Recently, he talked with Andy Cross and Tim Byers about what other cybersecurity companies are missing and the biggest misconception that Wall Street has about his firm. But Tim kick things off with a very straightforward question.

What is Zscaler and what is so important about what Zscaler is doing, especially right now? I think there's a lot of people that are interested in what you're doing right now. We all know that technology is changing over time. It's changing the way we live, the way we work, where we work from. There are incremental changes that happen, and there are disruptive changes that happen every 20 to 30 years. For the last 30 years, the world has been doing networking and security in an old way. We call it castle and moat security. The new way is zero trust, which says trust no one. There's no castle to hide inside.

Your applications are everywhere, in the cloud, SaaS, or wherever. Your users have left the castle. They are working from everywhere. So in this world, a new paradigm was needed. Just like we're seeing disruptive changes in other parts of technology, For example, DVD players used to be wonderful to play music. The Netflix streaming came. It was a totally different way of listening to music.

In another example, think about traditional cars. That internal combustion engine car was built about 100 years ago. It has slowly been refined and gotten better and better. But when Tesla came with electric vehicle, EV engine, life was very different. In the same way, Zscaler came and said, old way of doing security no longer works. We need to do a new way, the zero-trust security, where we securely connect the right user to right application, not the network. That's the most disruptive part of it. And that's really what's needed to secure our customers, their data, and their applications.

That's why 40% of the fortunes, sorry, it's just under 40% of the fortune 500 companies are Zscaler customers. And just under 30% of global 2,000 companies are Zscaler customers because they need this new type of security. And that's what I started in 2008 to build from a clean slate. Jay, building on that, I've always been impressed by the fact that you've recognized this opportunity and taken it, but also wondered, why isn't everyone else thinking zero trust? or maybe that they are now, but why is it hard to innovate and adapt in the security environment such that you were able to step in with your team and your innovation and your foresight to really, essentially, you didn't create or invent the terms of your trust,

but you really have brought it to the forefront? Yeah, Andy, the answer is actually pretty simple. They said the technologies that make you successful, in a given paradigm hold you back from being successful in the new paradigm? Think of many examples. You think mainframe companies could ever build a new kind of computers? Not really. Think of software world.

We all know Siebel Software used to dominate in the Salesforce area. Till Salesforce, a tiny company, came from nothing. But with a clean slate, they build a cloud-native multi-tenant architecture. PeopleSoft used to dominate the HR system space. Workday came from a clean slate. They built it. In the same way, we have so many legacy network security companies building firewalls, VPNs, and all that type of stuff. And they keep on adding features after features.

But it's a wrong architecture. So the reason we became successful is because we had no legacy security to worry about. I could dream with a clean slate of paper and said, if applications are in the cloud, users are everywhere, where are you going to keep on putting your firewalls? There's no place to build a moat. So let's build a switchboard, the opposite of moat. You come to the switchboard, you say, I want to talk to someone. We stop, you say, who are you? Show me your credential. Where are you going? Are you allowed to go there? If all those conditions

met, we connect you. If they don't, we don't let you connect. So there's no such thing as you're inside my network, you're outside our network, you're always untrusted, and you're trusted to connect to one thing at a time, and then that trust is gone. The new architecture, new mindset. Now, the question is, if things are hot, why aren't some of these big network security and firewall companies jumping in? Well, building new architecture is not easy. Let's use the auto example. How long ago did Elon Musk start Tesla? About 10, 12 years ago. All these car companies were watching? Do you think they wanted to build these cars? Well, for a long time, they're hoping that this thing goes away, this won't work. In the same way, network security vendors were hoping

that what ZSkill is doing would never happen. Our boxes will always be needed. And then later on, they said, ah, if I need to get there, let me bolt on a few things on top of my firewall, spin them in the cloud and call it cloud security. Because building a new architecture takes a long time. Architecture like the foundation of the building. If you build a building for a two-story building, architecture and foundation is different. If you need to build a 20 or 30-story, it's a very different foundation. And you can't keep on building on top. You need to start from a clean slate, that's what we've done. That's our barrier to entry and others can't easily come and catch up. If we could wrap up on this one, let's do a quick thing here because

it's inevitable that every company, all companies have a story. What is it that folks who are following you, the street or otherwise, don't really yet understand about Zscaler that you wish they understood? I think the street and investors sometimes think that the old technologies can be bolted on to become new architecture. The street doesn't understand that architectures need to be started from a clean slate. You can't bolt on an electric engine on top of a traditional car and say, I got the best electric car. In the same way, you can't build zero trust on firewalls and VPNs. That's why these customers are looking, are buying us, deploying us, and they are speaking about how well Zscaler helped them to realize these business goals. And it helps the businesses

and it helps the professional career of these IT leaders. Awesome. Jay, thank you so much for for joining us today. Uh, we really appreciate it. We are going to be watching Zscaler with, with keen interest, and obviously we hope you come back. We'd like to keep having these conversations if you wouldn't mind. Of course, Andy and Ben, thank you for the opportunity. That's all for today, but coming up tomorrow, we'll answer a straightforward question of our own. why does the stock market go up? As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks

for listening. We'll see you tomorrow.