Yet Another Value Podcast - Shehryar Khursheed from Return on Capital on $RH's bull case

Episode Date: February 2, 2021

Shehryar Khursheed, the founder of Return on Capital, discusses the battleground stock RH (FKA Restoration Hardware), what Berkshire Hathaway saw in the company, what short sellers missed on the company, and his vision for the company over the next few years.Return on Capital website: https://returnoncap.com/Return on Capital Twitter: https://twitter.com/CapitalTalk2Note that we had brief technical issues around the 22:40 mark of the video; we've done our best to edit those out but there is still a brief gap / jump. For those watching on YouTube, my video freezes for ~5 mins at the 17 min mark.Chapters0:00 Intro2:35 RH Overview6:45 What is RH's moat and how do they build their brand?10:15 How building restaurants reinforces RH's brand14:55 Endgame for RH's brand18:00 Can RH's CEO hit his RSU target of $800/share?19:45 Is RH's 60 gallery target reasonable?24:40 What do margins look like in the long run?27:15 RH's international opportunity31:05 Exploring the bear case further38:55 What's the RH endgame?42:20 RH's membership program45:35 Last hits on RH

All right. Hello, and welcome to yet another value podcast. I'm your host, Andrew Walker. And with me today, I'm happy to have Sherryar, the founder of Return on Capital.com. How's it going? Good, good. And you? Doing good. Well, hey, let me start this podcast the same way I do every podcast, and that's by pitching you, my guest. You know, I really got to know you from your subscription service, return on capital.com. I mentioned in my December monthly links and things. It's one of my favorite services. It reminds me so much of Scuttle Blurb, which is one of my favorite services. So this is absolutely high praise.

You know, every time you posted on something, I felt like it was becoming an expert on a sector or a specific company. I loved it. Over the weekend, you sent out an email that said you're moving on to bigger and better things. So I'm happy for you, but I'm sad for me because I'm sad that the service is going to be going on. But really happy to get you on to talk about something before you kind of shut it down for real. So anything we want to say about return on capital or anything else? Yeah, I mean, you know, the blog was great. Yeah, unfortunately, I wasn't able to keep it going.

But yeah, I enjoyed it. I would consider, I mean, I don't know if I would say expert, but I consider myself a curious amateur on these industries. And I'm glad people liked it. The whole goal wasn't necessarily to pit stocks or anything. The goal is really just, I was already doing this research on the side, and I figured why not make it public so other people can benefit as well. So, you know, I got some decent traction over the year.

obviously did not expect the popularity that it got. So I was really happy with the feedback there. And yeah, I met a lot of great people. So I enjoyed keeping it, but unfortunately, it had to go. Yeah. One of the things about running subscription service I found, I don't know if you found, but I always found it's like a backdoor way to a lot of, if you write the right stuff and price it right,

like a lot of smart people kind of subscribe to it. And in a way, they become invested in you. And it's like, they actually are hitting you up like, hey here's holes in your thesis or here's a really interesting company I think would be for you and it's like I have all these people almost who are paying me and they're giving the ideas or like increasing my knowledge and stuff I just love that experience I don't know if you feel the same way or different or anything yeah I mean we're going to talk about RH I got a lot of feedback on RH just because it's such a controversial stock but yeah it was it was great especially you know I'd post something

and you have like someone who's been covering this same industry for years just reach out to you and just have a conversation. So it was great. Definitely benefits on both sides. Perfect. And that's a great transition to the company we want to talk about today is Restoration Hardware, RH. You wrote it up in June.

This has been a popular battleground stock over the years. Right now we're taping this at the end of January. Short squeezes with GameStop and everything are all the rage. But a couple of years ago, Restoration Hardware had a really interesting short squeeze where they bought up a ton of the stock and the stock just ripped but it's continued to do well since then i think the battleground's been decided in the bull's favor stock's up 15x over the past few years berkshire halfway bought in in late 2019 uh so why don't you tell me why don't you tell me the listeners you know restoration hardware background bull case what got you interested everything yeah i mean

the first thing is that um Friedman would skin you alive if he heard you call it restoration hardware okay sorry sorry that's my fault it's my fault but uh But, yeah, I mean, I think just that's a great segue. I mean, the company started as Restration Hardware. It sold antique furniture and things like that. And it was kind of, you know, sitting on the remnants of society until, you know, Friedman came along. And back in 2015, had the idea of what he calls elevating the brand and making it something that could stand on the shoulders of LVMH her knees and Apple even mentions. And that's kind of, you know, the whole strategy.

He re-branded the company as RH and went on a strategy that's kind of looked down upon by Wall Street, right? In a world where everyone's kind of focused on, e-commerce taking a bigger and bigger share of revenues of total retail revenues. He decided why not just do a massive cap-ex expenditure and massive store rollout across the nation. and it just didn't jive well with people in the beginning, right? I mean, these stores took a long time to ramp up. If you look back, I think 2015, 2016, this company was operating at one to two percent margins. When you look at companies like Herman Miller, H&I, Kimball, they're all operating, I guess, you can call it mid to high single digits.

And so the strategy wasn't necessarily, it was lavish, but it wasn't working. And so a lot of people bet against the company. And then he levered himself up, what, three or four times and bought back 40% of the stock. And it's done well sense. I mean, here's how, you know, you characterize the both thesis, is that it's not really about e-commerce or brick and mortar. It's about how you execute on each of these two strategies. And I would say that R.H. has done very well on that front. I mean, fast forward three, four years, and the company has gone from two to three percent margins to about, most recently, I think they hit 21 percent.

I mean, I'll be it in a pandemic, but they were still able to hit in 2019 mid-teen margins. And again, that's double what you see in firms like Erman Miller who were here since, you know, the 1800s. And they kind of just shattered the industry ceiling. And so from there, the rest is history. Once Friedman proved that, and not just that, you know, if you read this company's earnings calls, he's very, very good at playing the market and driving up his multiple. And he has a huge personal stake in the enterprise. And so all those factors come together, you know, brought the company to where it is today.

I think, you know, it's a controversial stock. It's a controversial company. And it's a controversial CEO. But he's so far been able. will prove the naysayers wrong and we'll see what happens but um i think you have potentially you have a situation where you have you know a company with no real peers combined with an operator that that seems to know what he's doing and the shrewd person who knows how to take advantage of opportunities as they present themselves you marry those two and you have a company that can

potentially count down for a while and and yeah that's a story but then the math also works and night. We can go into that as well. Let's go into math in a second, but I do want to dive deeper into it because, look, I might not be the target audience for this. You know, my wife will, she'll hang, I'll walk in and I'll say, oh, that's a nice thing. And she'll say, oh, it's been there. I hung it four months ago. Like, you know, I just don't know this stuff. But when I, right, right, this is high in furniture. They're selling at 20% margins. And when I think, like I basically just think in my head, oh, that's a furniture, they're selling furniture, right? There's no moat there. That should be pretty low margin,

pretty capital intensive. And obviously, all these numbers that you've talked about or alluded to you so far are blowing that away, right? They're building out a luxury brand, 20% margins. These stores, I think they take a little bit of time to ramp up, but once they remember great returns on capital. So, like, what is the moat? How are they building? One more thing before I let you answer. With brand, one of the toughest things is to build a brand in something that people don't do a lot, right? And when I think, hey, going shopping for furniture, I think you move into a house, and maybe you do it, I don't know, how often do people do it once every five years, once every 10 years where they do a house, home remodel? Like, how do you build a brand when somebody's doing something that infrequently?

So I guess some questions who you are, what is the moat? And I think part of the mode is the brand. And how are they really building a brand in something that seems really undifferentiated? Yeah, and I think you hit the nail on the head, right? I mean, it's furniture. It's not something. You don't buy furniture for the brand, first of all. And I think he realized that really early on, which is why these galleries aren't furniture stores, right?

They're not a room to go that you've seen in the past. These are galleries with restaurants with wine tasting and things like that that are really meant to be social circles. I mean, I'm not the target audience either. The target audience are the really, really affluent. And, but even, you know, my friends and acquaintances, you know, they'll tell me that, hey, we just went to our, uh, our age just to hang out. We didn't buy anything. We just went to hang out. Um, and so what you really created here was a customer acquisition pool. You have people coming into your galleries. You have people winding and dining there. Um, and then you can sell on furniture on the side. Uh, and so if you look, if you go to Chicago, and you look at Sunday brunch and you see that the R.H., which has a brunt spot there, is basically full. And on top of that, you can start adding other services, not just furniture, you have interior designers. You have a market for freelance architecture to commute with the people.

So it's like you created a brand around the game. gallery and around the experience, not necessarily around the furniture. And the margin isn't necessarily on pricing. A lot of it also comes from just the distribution model, the fact that the stores aren't necessarily, they don't necessarily store inventory. And they really, and they really service the entire country with simply two distribution centers. So that's done a lot to help margin. But yeah, there's a little bit of pricing there. And what was your other question? I think it was just on building the brand. And I actually think you hit that well, but let me dive a little bit deeper in there. So like, you know, I think, all right, so I live in

New York City and I know one of the things they're doing is they, they, I think it just built out. They built out a store like in the meatpacking district. I think it's a store, hotel, restaurant, all these things that you talk about, you know? And you mentioned the Chicago, did you say Chicago, the brunch spot? That's like, well, every. And I get all that and that's built in the brand, right? But at the same time, Like, there are plenty of popular restaurants in New York City that sell up for brunch every Sunday. And they're, you know, it just, it seems weird to attach popular brunch spot or popular destination to go get wine to this is a $10 billion high-end furniture company.

Like, how did he marry the two and how does drawing people in for brunch every Sunday or wine tasting or whatever? How does that sell the furniture and build this brand that's way bigger? You know, I think in his letter I tweeted out, he said when I, 20 years ago or so, we were a 20 million. company and we were putting a laundry detergent on the front of our cover. Like, how did he go from that to this $10 billion furniture selling company? Yeah, and I think he was inspired by what he saw at Apple. And if you look at his, if you go back to 2018 and you look at some of his talks then

and some earnings calls from that period and also their investor presentation that they had at the time. He really says that Apple created what he says, a brand like no other. And I think he was really referring to the ecosystem there, right? The ability of Apple to sell you an iPhone and an iPad, an IMac and whatnot. He's trying to do the same thing here, right? Where there necessarily isn't any integrated service, right? Let's say you're an affluent couple.

We're going to move into a new house in Beverly Hills. You need to enlist an interior designer. That interior designer is going to contract with a company like H&I, like Herman Miller. to actually design the place. And you contract with someone else to actually build the place. So it's a very fragmented process. And no one really thought of marrying the three aspects together. And RH isn't there yet.

RH is trying to get there. But I think that's his big vision. And when you look at some of the recent investments they're making in development and things like RH guest houses, that's what he's trying to do. He's trying to create an environment in which you come in and you get all the services given to you on a silver platter. And given that, I think he was able to create that customer lock-in that other companies simply haven't seen. And on top of all of that, he builds a direct-to-consumer relationship that other companies that sell through department stores or through contract sellers or general distributors simply haven't been able to

build, which is why you don't see people going specifically for the Herman Miller sofa or specifically for the Kimball desk. So whereas in R.H, you're actually going to the art store. And I think that is pretty valuable. We have yet to see whether he will eventually marry the three, architecture, design, and furniture. But I think we're in the early endings of that. And it's certainly doing a lot to help the company's multiple things.

today. So R.H. Guest House is correcting you can wrong. They're literally rolling out R.H. Hey, here is a, it's a hotel. It's our brand hotel and it's got all of their furniture, their design and everything. So it's almost a double thing, right? Like they put it in the big one that they just announced it. It's a $105 million dollar investment they're making into a resort and ask them that's going to have a bunch of RH stuff. And actually they'll also, in this, it's an equity investment, so they'll invest in other stuff. But you know, it's a high end resort with RH guest houses, hotels, they'll hopefully make money from the hotel and everything. And then also people will go in and they'll experience the RH lifestyle at the hotel and maybe

buy their furniture or have their house designed. Am I thinking about that correctly? Yeah, yeah. He calls it the RH ecosystem. And it's funny because, you know, when I was originally looking at the company back in February, he never used that term. But I figured that's kind of what he wanted to go to. Just look at the influence he got from a company like Apple. And so, yeah, it calls it the Rage ecosystem, basically a one-stop shop where you really go for the social experience and they cross-sell you the real business, which is the furniture. Yeah. Go ahead. No, that was that was it.

And so is the ending for this, and I'm just imagining this is just talking to me, you know, like one of the things I was really interested in recently is Peloton and partly because I got the bike, partly because I'm interested in the company and stock and everything. But Peloton, I think when you look at it, right now it's the bike. But over time, increasingly they're going to have the Peloton lifestyle things, right? Like I'm sure at some point they're going to be selling a ton of just gear, shirts, shirts, shoes, all that type of stuff. Is RH over time as the ecosystems expands is going to be, hey, anytime you travel to an affluent city, you know, Tokyo, New York City, Aspen, they're going to be trying to lure people into the RH guesthouse. And then are they going to be selling clothes at some point? just a whole R.H. lifestyle. Is that the end game? Yeah, I think it's limited to Friedman's imagination. And that's certainly honest. I don't know

about clothes or anything like that. But yeah, I certainly definitely trying to get into the development business, right, actually develop these houses for you. You have a concept that you want to move somewhere. He wants to take you from there to actual move in, everything in between. So that's certainly something he wants to do. But here's the thing, right? People, I guess nowadays the popular word is optionality, right? Those are all options on future developments, right? And what attracted me about this company wasn't necessarily all those options, which for some of these other valuations, you actually need a belief in order for the investments to work out. But just doing the math on the current strategy, the investment kind of works out. And you can choose to be a

believer in his vision or not. And so that's what attracted me when I first got involved in R.H. When I first looked at it back in, what is it, a year and a half ago, where if they just continue their gallery strikes, so right now they have, what, about 24 galleries. And I think they're trying to get to, they say 60 to 70 in the U.S., if you just assume 60, just employ a Peter Lynn-style way of thinking about it. and you can kind of back out what the so-called TAM in the U.S. would be.

On the other hand, you can also just look at major metropolitan areas. And in my post, I actually talk about both methods. And you basically get a figure of this company essentially being able to produce anywhere from, you know, 600 to 800 million in operating earnings by 2025, 2026, depending on how quickly you think the rollout will happen. And from there, the valuation makes sense. Now, if you believe in the other optionality, then you believe his 10-year vision

where he's going to become the next Hermes, but that's another question entirely. Hey, my computer froze up for a second there. Can you hear me? Yeah, I can hear you. Okay, hopefully there was nothing. No, that all made sense. I guess one thing, so we were starting to get into

So I guess I'll go start from the end, and we can work a way back. So, you know, I think you and I were texting you before this. In October, they filed a new pay package for the CEO, and I think this is about the third one they've done. But the high end of the pay package calls for share by May 2025. That's how he gets paid, the highest end, full amount of payment. That would be 14% annualized from today's price. So it sounds to you like you think that pay package, you know, pretty likely that he's going to hit the high end of this by May 2025.

Am I kind of thinking about that right? Yeah, yeah. I can go through the math if you want, like back of the envelope. Yeah, let's go through the back of the envelope math, please. Yeah. So it's just by my head. You can check my post to see the exact numbers. But, you know, each gallery is doing what, about 18 million in sales.

And you have to kind of divide them, like the New York gallery is doing about 30, 35 million and some of the other gallery. Their low galleries are doing about 10 million, which already tells you something about the business because, like, I always compare it to Herman Miller because they're also trying to roll out their direct-to-consumer strategy. And their AUV is nowhere close to 10 million. But anyways, you can back out about 15, 18 million per new gallery. And so right now they have about 24, so if you get to about 60 galleries in the United States, that gets you to about $4 billion, $4.5 billion, which aligns up nicely to their estimates. Now, they also think they can get Europe, but let's put that aside for now. The biggest question, can I pause you for one second? You've mentioned 60 galleries a couple times, right?

Where is the 60? I can't remember if the company gave 60 or not specifically, but where is 60 coming from? because 60 is a strange number, right? Like there's, you know, I've heard people say we want to hit the major sports in these cities. They call it the NFL or NBA cities or something. And I think there's 30 to 40 cities like that. 60 is a little bit above that. Normally you would hear something like below 50 or in the hundreds of 120 range.

Is there any number behind 60 or do you think it could be plus or minus maybe plus 20 or 25 or something? Yeah, so 60 is what they say. They say 60 to 70. Now, alternatively, like you allude to, you can also take the major markets. So there's 30 to 40, you know, really large metropolitan cities in the U.S., and they also take into account that some cities have multiple galleries, right? Yep. So in California, it's interesting, he's so colorful on his conversation.

You can actually back out some geographic figures. But in California, two quarters ago, he was saying that it was doing about 450 million in sales. he thinks he can get that to 700. Last quarter, he said it was 500 million in sales. And I believe they opened another gallery there over the past year. And so there's some opportunity to do, call it on average, 1.5 per large metropolitan city, just taking to account some of the really large cities. And so that gives me a little bit of confidence in kind of the 60 number.

Can it be higher? Yeah. but I think this is a pretty reasonable bet and it's kind of on the lower end of what they say. And I think we can also talk about kind of Gary's strategy of under-promising and undershooting people's expectations just so he can outperform when he reports numbers. If I'm going to go to an RH and get a home design by them,

how much am I going to pay to get a home design? Well, right now they do it for free. That's a thing. These are options, right? I guess how much am I going to pay? They designed it and then I get all the R.S. Furniture and stuff. How much is it going to kind of be on average, do you think?

So what was that? Sorry? So if I go get the design, but then I'm filling a house with the RH furniture and stuff. Like, how much is the average trip transaction or whatever going to be? I don't think they break that out. Yeah. Okay. Because I'm just wondering, like, I think it would be pretty high.

And, you know, I am kind of wondering, let's say Houston and Dallas, right? If they've got one in Houston and then they're going to go open one in Dallas, obviously they're going to increase their sales. But I almost wonder with something that is this expensive and happens this infrequently, if there's almost a little cannibalization when you open a store for out. Hopefully I'll be able to edit this together. But I was basically asking about cannibalization when they open store. So I'll let you take it away from there. Yeah, I mean, there's definitely going to be some cannibalization. I think, I mean, the biggest aspect of cannibalization is in fact that they're closing all their legacy galleries.

right? And so each of these legacy galleries you're doing about half of the A.A.U.B. And they're replacing them with some of these newer galleries. That being said, there's basically going to be on net a revenue uplift. If you just consider the replacement of the legacy galleries into the new galleries. And you can see it if you look at market by market. So look at Chicago, look at Atlanta, look at Dallas, I believe, and then look at New York. And specifically focus on the markets. And what I did was, first of all, you can map these all on Google Maps and kind of see time when things closed and when things open. But essentially what you'll see is that there's about a two to three times revenue uplift when you basically so-called replace a market with a new gallery. And so based on that, another way you can kind of back this out is take revenues when pre-2015. and give it that uplift, so assume a full transition. So anyways, any way you cut it, you know, you're getting about 15 to 18 million per gallery, and then you're getting about 60 galleries.

And so whatever that gives you, I believe I backed it out to be about $4 billion in sales. And you can, you know, argue when that's going to happen. But they're saying they're opening three to four, or now they're saying five to seven, but previously it was three to four a year. And so that gives you that. And, you know, the big question, I think, and if you look at what sell side is saying, the biggest question isn't necessarily what the revenue is going to look like. The biggest question are what margins are going to look like.

They basically proven the revenue model over the past three to four years. And this was what I had trouble with, too, as well. I mean, if you read my original RH post, I was forecasting about 15% margins. Yep. And I thought that was overly aggressive. I mean, I looked at every other comp, and they have eight, nine percent margins. I didn't really appreciate the distribution model, how efficient that was. It's basically a Warby Parker for furniture, and Warby Parker is massively profitable.

You have the direct-to-concern relationship, so you don't have the lower margin distributor sales or wholesale sales. Anyway, so I said, you know, 15% margin, that turned out to be grossly incorrect because when they reported Q4 numbers, they were already operating an 18, 19% margin. And like I said, most recently they hit, this past quarter, they hit 26%. This year, so far, they've hit about 21%. And so the margin I've seen it was grossly understated. But even then, back when it was trading about 200, I basically got a mid-teens IRR on that price.

And just on a free cash flow basis, it was trading at low teens. And so this is a company, for any, if you just think about a company with a low teens multiple, you don't need to assume much will go right. So everyone is focusing on things like interior design, on things like architecture, that didn't really need to be figured out for the thesis to work out. You really just need to assume that they continued a strategy that has been working for the past two or three years. And you assume they'd do it for another two or three years.

And the investment would have worked out fabulously. At 500 or what is it? Yeah, about 460, I think right now. At 460, you need to assume a little bit more. You need to assume they actually get full penetration in the United States. But again, the margin estimate has changed as well. And so when I revisited the stock again, you know, my mid-year review and then my final year review, I found myself upping those estimates on margins because the company was just proving me wrong every single time.

Later at 18% and later I had 20% margins. And so right now I have about 20% margins. You mentioned we talked about six, we got interrupted, but we talked about 60 stores domestically. You mentioned U.S. When I think of luxury brains, you know, I think most of them get the majority of their revenue internationally, actually, right? Like Louis Vuitton bought Tiffany's, and I think Tiffany's got like 75% of their revenue internationally if I'm remembering that I'm kind of doing that off the top of my head.

But most people get most of their revenue internationally. And like Tiffany's, even the revenue they do in New York at their flagship store, a lot of it was international tourists coming in and buying goods at Tiffany. So, you know, obviously furniture distribution. right, it mentions a little bit they're in the UK and they think they might even be able to distribute from the US to cover UK and something. How do you think about the international opportunity there? Is there a lot of upside? Have you baked anything into your numbers? Do you think this doesn't play out in the national? Yeah, I mean, you've read my post for the year. You

know that I always lean towards being extremely conservative, almost to a fault. And so you could probably answer that second question yourself. But realistically speaking, right, not with numbers I underwrote to make an investment, but realistically speaking, Gary says that the European market is basically almost double the size of the California market. He always uses that as an comparison. Europe market is about $1 billion. He says the other advantage of the New York market is that the AUV is going to be far higher, just the population density and the fact that you don't need to open as many galleries per square mile versus a place like California, just make the economics much better. And then like you allude to, he also says that you can just ship

everything from the East Coast distribution facility to Europe. So the economics look good. And he says one billion there. The company puts out a report. I think they say 20 billion is the international opportunity, which aligns up well when you look at LVMH. and some of these other luxury brands. But here's the thing, right? Gary has instilled in everyone's head that we should be compared to LVMH and Hermes. That's not true. At the end of the day, it's a furniture company.

Like the way their whole investor relations strategy is kind of change the comps, right? We don't want to be comp with Hermie. I mean, we don't want to be comp with Herman Miller, H&I. We want to be conflict with Hermes and LVMAs. I don't think that's true yet. So I do think a good amount is them tooting their own horn. And like you said, the stock grant that Gary has is pretty lucrative. You can get the stock to 750.

And that's one thing I guess you can say what I don't like about the investment, where a lot of it is promotional, which is why it's still controversial as a CEO. I think you're right, yep. But the funny thing is he's controversial, but he also delivers on his promises. He said 20% margins, he got 20% margins. And one thing he made very clear, which is why RH might also work or would have worked as a short-term trade, he literally said on earnings calls that we're underselling you our expectations.

Yeah, telling you 20%, we're going to hit 25%. Yet the sell side never updated their models, and then they were just proven wrong with stock rips every earning. Yeah, and look, you can, I did not follow the company closely enough to know, like, the short piece is super well, but you can see the short piece where they said, this is a furniture retailer that's trading at 25 times earnings, and the CEO's out here screaming, hey, don't compass other furniture retailers, compass to Louis Vuitton, and the short sales is like, what the heck is this guy? What is he talking about? What's he doing? Let's dive a little bit more into the bear case. So, you know, I think the bear case today, you can come out of it from a couple different angles. But I, I think probably the best would be, hey, 2020 was maybe the best environment for these guys in Hitchfield, right? Like everyone was upgrading their homes, people, major cities, people were fleeing, especially the fluent, were fleeing and doing anything to get out. I mean, it probably pulled a ton of demand for it. Maybe it created unsustainable demand pulling it for it, right?

Like the guy who lived at the penthouse at the top of Park Avenue, he went to some Aspen house and he wouldn't have done that otherwise. that's a demand that's never coming back, right? So I think they would say, hey, yeah, it's over 20% margin now, but all this demand was pulled forward unsustainably. By the way, if you ever got like a real recession that really hit especially their fluent, this would be a disaster for them. And you're, you know, you lit up in great detail how this can grow and all this stuff. But I think they would also say, hey, if you look at Trilling Numbers, this is still a physical

retailer, is trading it 20 times EBITDA. And EBDA, you know, the DNA is. real there. They're investing a lot of money into these stores. There's a lot of cash costs. It's expensive. So I think all of that would meld into the overall fair pieces. So kind of how would you respond to this? Yeah. Not just that. One of the important things is that all of their low margin businesses are not operating. The restaurants aren't operating. All of their experiential sort of human capital intensive businesses. within these galleries are not operating.

And so that actually pulls up your margin. And so the real margin is a lot lower. And we saw a glimpse of that, right? When the pandemic first hit, and they had to close down every single one of their galleries, and furlough whatever number was of employees, right? You saw the operating leverage in play. Not just that, but the stock also fell to 70 bucks.

So there's a lot of very, valid points there. But I think the correct way to view it is kind of in the middle ground, right, where, yes, they are a furniture retailer. They should not be combed with LVMH and Hermes. But they should also not be combed with Herman Miller because they've been very, very consistent in even 2019, which is a normal year, they generated 15% margins, which is double the furniture industry. And so that bare, people with a bare argument have to respond to that. Not just that, but when it comes to these Cappex buildouts, you have developers literally fronting all of the CAPEX requirements to build out these galleries just because they know that they're going to get

a huge demand uplift from when the gallery opens. And so that, you know, I think they mentioned that they have a vote of about 50% on some of these capitalized deals. So you have to respond to that as well. And so that's kind of the where I would respond to the bare arguments that you have to look at the middle ground and you have to also respond to the fact that this company has been successful, 24 different galleries that have been, I can't think of a single new gallery that has not generated a 20 plus risk higher on. And so the model is working.

I think in 2017, you had much better arguments. And I'm sure if I looked at this company in 2017, I would have passed. It would have been a hard pass. I may have not even read the full on your report. But I think looking at this company in 2019, 2020, it's doing much better. And the multiple reflects that. Someone recently responded to me on a Twitter post. They basically said, I don't know if it's going to work or not,

but I would not bet against Friedman. And I think that's a general strategy amongst the short sellers where they're thinking, you know, he might be right. It might work. So no one wants to bet against it. I think there's still, I'm also kind of skeptical of a long-term model working out. I wouldn't pay, if you really believe Europe's going to work out, if you really believe this interior designer is going to work out,

you should be willing to pay about over $1,000 for this stuff. I don't necessarily believe that. So I want to back up to the point before that, actually, we said, I wouldn't bet against Fear Friedman, the CEO. You know, I think there's two things I kind of think about here. He's controversial, but at this point, I think he's pretty much proven it, right? But there's two things here. One, how do you think about the key man risk, right?

Like a lot of this is the aesthetic, the brand. You know, Tim Cook did a nice job taking over for Steve Jobs, but I think for a lot of these really brand-heavy kind of designer or vision-heavy things, when the key man leaves, the company crumbles within two or three years, right? So I guess that's point one. And then I'll follow up with another point of the new response to that. Yeah, and I think that's an important part of the RHS thesis, where it's really, you know, I don't know if you've noticed in this conversation.

We keep saying he did this, he did this. We don't say the company did this, right? A lot of his freedmen is always doing this. So that's an important thing, very similar to how Warren Buffett built Berkshire Hathaway, very similar to how Steve Jow's build at all. So a lot of it depends on betting on Gary Friedman. And it's interesting. I think the way he's been described is basically like Steve Job.

I actually mean that in a bad way. Because Steve Jobs wasn't the most fun person to work with. He was very irascible. And we know him in his final years as this nice dude who was unveiling an iPhone every year. but in his 30s, he wasn't, he wasn't so nice. He got in a fight with Eisner back when he was chairman of Pixar. So it's a big bed on free me. And he's so far delivered, but I think he's also someone who believes in his strategy a lot

to the point where it could go wrong. And so they've had mishaps in the past. And I think their biggest mishap was probably RH modern, right? If you look at around 2017, it was basically a catalog that they essentially, it was not thought out. It was too ambitious for a company that small. And it just didn't get the traction that Preetman expected. Now, the interesting thing is that he recognized the error and immediately fixed it, which is speaks good about his personality

but I do think he's very promotional he's very flashy, he pays himself well so that's something you kind of have to live with that he's going to take some of your upside with you and can he leave if he leaves the whole basis is gone

that's a simple way to put it because I wouldn't I mean I haven't spoke to any former employees or anything but I would imagine based on just things I've read I spent a lot of time reading interviews of folks, him and, you know, other people that worked at at R.H. And without him, they have no direction. So it's, it's definitely like an Apple Steve Jobs type play, where if you don't believe in

Friedman, you don't believe in the company, you should not be invested. And that's quite the risk because, you know, he is, he's approaching 65, right? He's what, 63, 64, something like that. He's approaching 65. You know, obviously 65 is pretty young in today's society, but he's not going to run this forever. So, like, what do you think the end game is for our age? Like, if he's 65, I believe he said before, he has basically 100% of his network in the company. It's going to keep getting higher if he can hit 800.

Like, you know, is this whole food selling to Amazon? Is that the end game? One thing that pops in my head, company saw him to Louis Vuitton? Or does he find the next Friedman who's got the same design and vision and who's 35 right now and he passes it and they run this thing, they expand internationally, they grow this for the next 50 years. How do you think about that? He doesn't sell the company. I don't think he'd ever sell the company. And even if he did, I don't know if there would be a willing buyer. You can say her

a means or LVMH, but again, I would imagine that they're thinking that this is a very different business than themselves. That's probably what they think. They wouldn't buy it. So there's that. And in terms of the end game, I mean, your guess is just as good as mine. We'll see what happens. We'll see what he does. But rest assured that if he leaves a company or something happens where he's, I mean, we had a scare, right? Back when he, when it was made public that he was having a relationship with one of the RH employees, he had to resign from chairman, right?

So that was a small scare. and the stock moved in lockstep. And so it proved to be not that severe because he still wasn't in that relationship and he's still CEO. But I do think most of bulls would have to re-evaluate the whole thesis if he were to leave. I don't think there's a strong second in command

in the business. He's also, if you've noticed, he has a very, very strong grasp of the financials. If you read Ernie's calls, like he just throws out numbers at you as if he was a CFO as well. So I don't think he has a strong number two

and we'd have to seriously reevaluate the case if you were to leave. Then again, right, all this, my personal investment, different people might disagree, but my personal investment in the company basically says that you don't need a lot of it to work out in the next five years.

The company should produce a good iron. And I would say that this wouldn't be dead money either because he's shown to, I mean, mostly because like you said, all of his net worth is in this one company, he will produce value in any way he can. You saw it in 2017 when he bought back 40% of the stock. And in the recent earnings call, he said that in the depths of the pandemic, they were seriously considering issuing a billion in debt and buying back half of the company, which is insane for a brick-and-mortar retailer

with all its galleries closed with no prospect of revenues or at least the next few quarters. You know, A, that would have been epic, but B, at the depths of the pandemic, I don't think they would have been able to raise a billion dollars of debt. I think any lender would have looked at

and be like, no way, man, no way, the economy stuff. Just two more things. before we go, because I'm cognizant we're running out of time. You know, one thing, this is such a small piece in the story, but it really tickled me, right? RH has rolled out a, I think it's $100 per year membership. You buy it. I think if I'm looking at it, you get 20% off all their stuff, which could be a lot of money. You know, I'm sure as they expand the RH, kind of in-person experiences, you know, as when we talked about the year, I'm sure you'll be able to go with your membership and get this kind of drinks and stuff. But I just think that's interesting, right? Like, when I think

membership, I think Costco. I think something you go to once a week or once every other week and you're habitually using, like, I don't think furniture and design where you're, that's probably a, you know, once a year or once every three years purchase or something. I don't think that for membership. I'm really here. And I don't think they talk about it too much anymore, but like, how do you think about that membership? Is that the sign of like where this company is going? Is that a sign of the brand stream? So the sign, the reason we did the membership was because he never wanted the company to be, judged on price. Again, he wants it to be luxury. And so he doesn't want people to focus on price. And what these other furniture companies will do is they'll seasonal offers, right?

Yep. They'll send out a source book every, every X months with discounts. By the way, can you hear me? I can hear you. Yep. Okay, it just said my internet connection was unstable. All right. So essentially, yeah, these other companies would send out source books. every few months and offered discounts. He didn't want to offer discounts. He wanted the company to essentially be a luxury brand. And that's the real reason for the membership, right? I wouldn't say they're doing it for the revenue mall.

They're doing it so they don't have to issue discounts on a lot of their furniture. It helps financially because they have, I guess, more recurring revenues. And like you, I don't know how it would work. But it somehow did work. People signed up for the membership. And I would imagine that the reason that occurred was simply because your audience is very, very price and sensitive and they're very fine signing up for, you said it was a $100 membership, which is pennies in the bucket for some of these customers.

It's great for RH, it increases, it increases the exclusivity of the brand is one. Number two, it reduces the variability of revenues. And number three, it kind of changes the model, right, from discounts, when is it, in the third quarter, to a more stable revenue base where you don't really depend on the discount season to drive the majority of your profits for the year. Do you know how many members they have right now? I have not checked recently. I haven't checked either. I was just curious how big this one should we have. It's just interesting, right?

Like, I wouldn't have never thought furniture company, you get a membership program. But that's what's great about this brand and what's interesting, because you could see how a membership could be used as the background for so many different of the options that we've been talking about here. Look, we've covered a lot here. Anything else you want to talk about? Get off your mind on RH or anything we have to discuss yet? Yeah, I mean, we kind of talked about it, but I think we didn't talk about it enough where, clearly the economics work out right but but i think what makes it such a controversial bet is just the personality of the CEO um and so anyone really considering investing in our

age needs to you know understand that this is an eccentric dude um and and i would imagine that that one would need to do a lot of work on just understanding where this person's head is at because it seems like every other question that someone asks someone in earnest school, he looks to his compliance officer and asks, can I talk about this? And not just that, this is a person who's just going to let his pet projects run. If he has an idea, he's going to do it. No one can really tell him no within the firm. And he can make or break the company based on that. So on the other hand, I think it's interesting because if you had this same character, but the company did not do well, let's say, you know, these galleries did not work out to stop his trading at 50,

we would say he was a failure. He was a bad personality, bad CEO. And now, because the company's been successful, we're praising him as a visionary CEO who can deliver on his promises and know what he's talking about. He did an amazing bet buying 40% of the company. That one investment has probably produced better returns than any of his company's other capital. investments. Though it's produced better returns, but all of that is driven by him successfully executing on the operational side, right? So in a way, it was a bet on himself, his vision, and he obviously had to make his own numbers of stuff, but it was a bet on himself that paid off in spades. Yeah, exactly. But, you know, that same investment, and he hadn't executed,

we decried as the worst investment. Everybody makes fun of Eddie Lampert nowadays, right? He bought that, he was buying back Sears at $100 per share, and he said, hey, look, ratings agencies reward other retailers who go and open new stores at bad returns on investment and we buy back shares. And if you read his early letters, he was very early into like, he was painting the vision for what Amazon would become. And operationally, F. And because it was operational F, all of his vetting on themselves in his vision, F doesn't matter. Yeah, exactly.

So this is sort of coming as not for everyone. In my opinion, the meth works in five years. Whether the math will work in a 10 or 15 year period is up to quite a question. So that's kind of the last word on our age. I think it's going to continue being a controversial stock. It's going to have huge vacillations depending on what he says on an earnings call. And people should be ready for that. I mean, you should know what you're up against going in.

And it's not easy when the stock goes to 80 or 70, and he's on the verge of announcing a buyback when all the sorts are closed. Well, hey, look, I would recommend people go sign up for return on capital again it was one of my favorite subscription services but you're on to bigger and better things so we'll look forward to hopefully having you back on the pod where you can provide us on an update on something else but uh thank you so much for coming on the pod thanks for the return on capital and we wish you luck in the things to come all right great thanks and you really appreciate it have a good one bye