TIVP081 (Video): Restoration Hardware (RH): Building a Luxury Empire From Scratch w/ Shawn O'Malley and Daniel Mahncke

19:14Daniel Mahncke:No, it's fair. It's fair. People who know the company well, though, will concede that RH's entire aesthetic is really just Gary Friedman's personal taste made into a public company for better or worse, but mostly for the better historically. And so he rebrands restoration hardware to our age, pushes away from knickknacks and towards serious furniture and high-end home goods and design. And when people criticize the prices or the luxury ambitions that he brings to the brand, his answer is the following. really cool. He says, great brands don't chase customers. Customers chase great brands.

19:57Shawn O’Malley:That's actually pretty true. I mean, that's basically the luxury playbook, right? That I was also referring to earlier. And I think it's also a quote that could definitely come from Steve Jobs. So I have nothing to say here that would go against him.

20:09Daniel Mahncke:No, I think so too. And it explains why when this guy says he's going to destroy his current product line to create the next one. And I do take that seriously because he's the same guy who took a nearly bankrupt cabinet knob retailer and willed it into being something of a luxury house. And, you know, they've undergone a nearly unrivaled degree of creative destruction, emphasis there on creative. And the way he's executing it this time ties back to a retail concept called the thirds. And so the idea is, if you look at any mature retail assortment, whether you're selling dining tables, area rugs, or lighting, you can break the performance of every item down into a top third, a middle third, and a bottom third.

20:57Daniel Mahncke:And so if you introduce any new products and it performs in the middle third of your existing assortment, well, your business is going to stay flat. You're just substituting one okay seller for another. If it performs in the bottom third, sales could actually drop because you've now cannibalized something better for a dud. So the only way to meaningfully grow a mature retail business is to consistently introduce newness that performs in the top third of the assessment. So really the idea behind that framework is you have to swing for the fences when you're a mature business like RH. There is no middle path.

21:38Daniel Mahncke:And nobody can accuse RH of not having swung for the fences. And to find those top performers, you can't just design a few nice chairs and pray. You have to cast a massive net, which is why they revamped their source books in 2024 with new areas of focus, these massive, beautifully photographed catalogs. Those are the source books. And the new focuses were RH Outdoor, RH Modern, RH Interior, and RH Contemporary, which are these just different types of designs and design sourcebooks that you can use based on the style of the space that you're working with. And so the combined sourcebook circulation, which is such an important part of their brand and sales strategy, and actually their number of customer contacts, that essentially doubled from 2023 into 2024, which has allowed them to aggressively push physical inspiration into more homes than ever before.

22:37Daniel Mahncke:If you want to get a little profound about the mission of RH.

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23:56Shawn O’Malley:Well, he certainly has a vision. And also, you got to say, I mean, he did all of that in the middle of a housing freeze. So, you know, that's a massive marketing cost, of course. But you know, if it works out, it definitely shows that he has a vision. And at least you're not buying a mature company, right? You're buying a furniture market, which generally is not the most exciting business. But he has a vision that I believe if you want a growth company, and also a company that has proven that it can get there, even if times are tough, it does seem like a pretty good setup. Generally, I have to say though, once again, he is betting pretty heavily at the moment, which we talked about earlier.

24:29Shawn O’Malley:And he's doing that in not the best market, generally, pretty cyclical, and we're in a downturn. And also, the company's highly levered right now. So there's not a ton of room for error here.

24:39Daniel Mahncke:So we'll get to the leverage. And you're right, that overhead costs as a percentage of sales, it's definitely up a bit over the last few years. And if you view their CapEx, these acquisitions of planes and yachts as partially a form of marketing expense, that's also elevated too. But the source books are not entirely marketing. They do double as sort of this giant data collection exercise because RH uses them along with its website to basically test what actually resonates with the consumer before they make the manufacturing commitments to produce different inventory at scale. And so one example Friedman has been giving is finding what they call the cloud sofa of wood furniture.

25:26Daniel Mahncke:So the cloud sofa is RH's iconic, massively popular premium sofa. And you can imagine it's white and it does sort of look like a cloud. And rather than guess at what the wood furniture sales equivalent of a cloud sofa could be, they put a bunch of candidate designs into the source books, wait six to 12 weeks to read the data and customer reactions, and only then do they commit operationally to producing what's popular. And when they find one of these hit products, they don't just order more of it. They really do dimensionalize it. And we can get into exactly what that means in a minute because it's actually one of the more elegant parts of the strategy.

26:07Daniel Mahncke:And it's where the line between RH as a furniture retailer and RH as an actual taste curator really starts to blur.

26:17Shawn O’Malley:Before we go there, though, the thing I want to understand a bit better is the pricing power underneath all of this. I mean, the thirds only work if your top third products actually carry premium margins. So a discount furniture chain doubling its catalog could just as well be doubling its losses. And we're talking about this company as true luxury. So I would also expect them to have quite high margins here.

26:40Daniel Mahncke:That's true, yeah. Yeah. And going back to the story, if you fast forward from their near-death experience in 2001 when Gary Friedman came in, by 2007, RH had gone private in a$267 million deal with a private equity company led by Catterton. And then it became public again in 2012, right as the country was really beginning to climb out of the great financial crisis. And at that time, it listed on the New York Stock Exchange at an initial price of$24 a share. And so by late 2015, shares would quadruple and actually rip to over$105. And then in 2016, Friedman does something that looks at the time like a catastrophe.

27:24Daniel Mahncke:He rolls out a membership program where for$100 a year, you could get 25 % off merchandise, more off-sale items, concierge services, and early access to clearance events that they would do. So the thinking was clearly to clone Costco or Amazon Prime, but do it for luxury furniture. And he simultaneously started stripping discounts out of the business for everybody else, meaning you could only get a discount if you were a member.

27:55Shawn O’Malley:whenever we talk about these subscriptions for example amazon we always think about them as being these no-brainers right like spending five bucks a month for amazon prime is an absolute no-brainer and to me it seems that a hundred dollars a year for a membership like this also is a no-brainer i would take a guess though and say that the actual customers of our age probably hated it right i see why membership programs with savings are great for high turnover businesses but discounting is sort of anti-ethical to the idea of luxury, right? Part of the sales prop is that true luxury products don't go on sale.

28:31Daniel Mahncke:Yeah, you're right. And I wouldn't say RH is close to being true luxury in the way that Hermes is true luxury, right? But it was definitely premium, for sure. And your instinct, I think, is sort of half right and half wrong. Customers and investors were definitely confused at first, and the stock tanked in response. through 2016 into early 2017. But memberships are actually still an important part of the business today. And so it works well because there's this psychological effect where you've already spent your$200 a year and you don't want that money to go to waste. So you feel like you have to justify that.

29:09Daniel Mahncke:And even if it doesn't make complete logical sense, you're still going to go and say, well, let me go spend more money so I can justify the$200 that I've already spent. And it's actually a very effective strategy. And so it's very good at driving customer loyalty. And the vast majority of sales today, about 98 % of their merchandise sales come from members. So even though memberships have gained traction, the market thought the idea looked like a huge self-inflicted wound at first. But what's really interesting to me is that given that the stock is puking on itself, despite Friedman's conviction in the membership idea.

29:49Daniel Mahncke:He started aggressively buying back RH stock at very depressed prices.

29:55Shawn O’Malley:But if it's not true luxury, then why exactly do you spend money on huge yards and private jets to charter for hundreds of thousands a week? I mean, if your customers care about discounts, I also have to believe that they're not the type of customers that would actually keep buying furniture in a recession or in a bad housing market. So I think I'm a bit confused of who exactly is the customer of our age. I got to say, apart from that, I still have some open questions and we'll probably get to all of them. But just regarding the buybacks that you just mentioned, we saw that again in 2022 and also in 2023, where you get these very lumpy buybacks.

30:31Shawn O’Malley:So the stock during that time was down by half of two thirds of its COVID peak, and they dumped$2.2 billion into share buybacks. And just for perspective, the company currently has a market cap of about$2.8 billion. So that does look like pragmatic capital allocation, but at the same time, the stock is now down to new lows and they don't really appear to be buying back shares at all right now. And between these huge buybacks and the investments in growing the number of galleries and sourcebooks, I do see how the company has gotten into this position where they seem to have financially overextended themselves with debt and long-term leases.

31:08Shawn O’Malley:Even if I think you said earlier, they believe they can be debt-free within three to four years.

31:13Daniel Mahncke:So we still have a lot to get to on the debt side of things. But the point I wanted to make is that when the market panics about a transition, Friedman's mindset has been to turn the company into a share cannibal. And in hindsight, 2016 was not a self-inflicted wound at all. In a way, it was the moment that RH stopped being a promotional retailer and truly became a brand in its own right and killing other forms of discounts in favor of a consistent membership program helped enable them to pour more money into experiences like the barista bars and rooftop restaurants and aspirational galleries and the yachts.

31:53Daniel Mahncke:These things that make people want to hang out more around RH's fixtures. And now that defines what the brand is about. So that elevation is what generated some of the pricing power that we'd seen flow straight into to their gross margins and growth profit growth, right? Gross profits are up by more than nine percentage points, 900 basis points from 2016. And that's actually on a low comp, right? This year, gross margins are down a bit from past years. So anyways, the point being, they have gained significant pricing power

32:28Shawn O’Malley:in the last decade. And that pricing power is the foundation behind the whole third side, right?

32:35Daniel Mahncke:Yeah, so you alluded to it earlier, but the focus on the top third makes the most sense only when your top third is genuinely premium. And the funny thing is, if you're looking for some non-financial validation of this strategy, let's just look at who showed up on the shareholder register. In 2019, Berkshire Hathaway took a 6.5 % stake, becoming RH's fifth largest shareholder. And as you know, Buffett doesn't just buy any furniture retailers. He buys brands with moats in pricing power.

33:07Shawn O’Malley:Well, one of Buffett's best known investments actually has been into the Nebraska furniture mod, right? It's true.

33:13Daniel Mahncke:It's true. It's a special exception though. You know, for the sake of journalistic integrity, I should clarify that Buffett would go on to sell out by 2023, which I think had more to do probably with the outlook for housing generally than anything, right? Interest rates are rising post-COVID. And so anyways, Berkshire no longer owns the business. And with the stock trading at a fraction of its 2023 price, you could either say Buffett was right to have exited, or you might argue that the opportunity has only gotten more attractive as they've continued to invest heavily in grabbing market share while the stock has only gotten dramatically cheaper.

33:53Shawn O’Malley:I guess it kind of depends on how you frame it. I actually got to say that if I would see Buffett or let's say Berkshire by now getting back into a business like this, it would probably help me getting more comfortable with this CEO. Although obviously you should always, you know, have your own opinion on people and not just follow some super investors. But at least the fact that he invested in it gives me some pause and thinking, well, maybe I do misjudge the people or the management team of this company. And so going back to the restaurants that you mentioned, I would love to hear more color about how these factor into the strategy, because I think you told me they're more important than I actually would have thought.

34:29Daniel Mahncke:they're sort of absurd in a good way right the restaurants are seamlessly integrated into the galleries which is you know another word for stores that's rh's parlance and on average the operating income that these restaurants throw off covers about 65 percent of the entire galleries rent and so in some of these standout locations the math is even crazier at rh newport beach The restaurant alone is a$20 million plus operation, and it's expected to generate enough cash flow in its second full year to potentially cover the rent for the entire 90 ,000 square foot gallery that they sell furniture from.

35:10Shawn O’Malley:That's actually insane stats. You know, I think if you would have told me a couple of years ago about a business model and you said that they would now put restaurants or bars into those places, I wouldn't have thought that would work out. What would actually be interesting to know is the data of how much more money people spend on average if they go to those restaurants regularly, let's say, you know, once a month. So that would be pretty interesting. But I also can imagine that this is data that the company is most likely not going to give you. But, you know, for the unit economics, and especially the unit economics of those galleries, that's a pretty, pretty remarkable thing to see.

35:44Daniel Mahncke:yeah that's right and you know the galleries with their ornate beauty drive way more foot traffic than old school furniture stores and the ones with restaurants on top drive dramatically more than that and the margins do follow and you know notice the through line all the way back to steven gordon and his staging rooms in 1980 right the entire model is still about walking into a fully furnished scene, falling in love with the whole room and buying the whole room. It's evolved a lot along the way, right? They've just wrapped it all in marble and rooftop restaurants and started charging luxury prices for it.

36:21Daniel Mahncke:But that same idea remains. And for anyone who already forgot, Stephen Gordon is the founder of RH. And I think it's easy to forget that because the story has been so much about Gary Friedman.

36:33Shawn O’Malley:And that kind of brings us back to today's question, which is about the yachts, the jets, the guest houses, the residences. Do you think, or would you consider that to be sort of the same instinct of Stevens taking to its logical extreme? Or would you say that's mostly Friedman having his own idea of what the branch look and also feel like?

36:54Daniel Mahncke:I think it's a billion dollar question. And to be fair to the skeptics, the ambitions here aren't actually new, right? They have been telegraphed for a few years. You know, going back to 2020 and 2021, Freeman was already saying out loud that he thought two-thirds to three-quarters of RH's business could eventually be outside of the United States, putting it in the same conversation as an LVMH and an Hermes. He's also openly said his real model isn't just the European luxury houses, it's Apple. What he admires about Apple is the ecosystem. You get someone inside your world with products and services, and then the loyalty compounds, right?

37:35Daniel Mahncke:I know I'm trapped very deep in the Apple ecosystem as I use my Mac and my iPhone and my Apple watch. And so, you know, he said pretty flat out that he wants that kind of brand loyalty for RH products in people's homes.

37:51Shawn O’Malley:Now, I'm honestly questioning myself here and why I'm so skeptical today. I'm kind of sorry for it, but I kind of feel like he wants everything, but you can't always have everything. So on the one hand, he wants to be true luxury. On the other hand, he also wants to be Apple and that everybody sees his brand basically as Apple. I would also say, you know, there's obviously a difference in the products Apple just has because the products that it sells a significantly better chance to become this brand where people go to every single time. And I think that's just different for furniture in general.

38:19Shawn O’Malley:But I got to say that I do really like the idea of having an ecosystem around the brand. And after seeing the success with the cafes and bars and restaurants that they do have, it seems that that is working quite well. And maybe the hospitality angle could be something like that too. So is that a new idea? Is it an old idea? And how is it playing out?

38:38Daniel Mahncke:RH's very first hospitality experience goes back to RH Chicago years ago when they put a restaurant inside a gallery. And then it changed the trajectory of the whole brand, honestly. By 2021, they were building a guest house, which again is just a fancy RH term for hotels in New York City. and then they would put$105 million into a real estate project in Aspen alongside a gallery, a guest house, a spa, restaurants, and these homes all under one roof. And so today's RH residences and RH guest houses are not a wild pivot, even if they have fancy names. They're basically this Aspen blueprint, but just scaled up.

39:20Shawn O’Malley:I guess there are two questions that jump out to me here. So the first one would be is whether a brand that's known for furniture generally becomes credible as an architecture or interior design or landscape firm and even our hotelier and also a real estate developer. I mean, one thing, for example, that we do see with these two luxury brands is not only history, but most of them focus on one specific thing, then get incredibly good at it. Then over time, they expand into other things. We see that with almost all of the luxury brands that come out of Europe. And technically, you could say this is the beginning of such a story.

39:55Shawn O’Malley:You could also say that he tries very hard to be exactly that, and he's not really getting there. I mean, those are all completely different businesses, and each of them need enormous attention and capital. And I don't know, Friedman is a man not necessarily defined by a circle of competence, I would say.

40:13Daniel Mahncke:That's a really good way to put it in. I mean, for as painstakingly as they've worked to redefine their brand, people have wondered for years whether a furniture company can pull off being taken seriously as a broader design authority, not just a design retailer. And now one of the things arguing for their growing clout in the design world is that when they pivoted to memberships in 2016, one perk that they've successfully offered is a free RH designer who helps you set up the home. And so it very much seems to make the customer relationship stickier, gets them coming back, and then it turns a single couch purchase into a whole home project as you work with your RH designer.

40:56Shawn O’Malley:And there's a second risk that is almost the opposite problem, which would be that RH becomes almost a victim of its own success. So when you put up blockbuster numbers, those numbers sort of become the benchmark for your business, and you're almost measured against them forever. So the bar just keeps rising. So you said that they made almost$700 million in net income in 2022. And if you compare the 125 million in the last year to that, it looks obviously far less impressive. We talked about this a couple of weeks ago when we talked about AutoOne. And I basically talked about AutoOne and its competitor, Mobila, which is a way higher margin business and way more asset light.

41:36Shawn O’Malley:And we kind of talked about, well, will they be able to get into their business? And the difficult thing is if you have a great business and the benchmark is set quite high. Investors don't want to see you spend a lot of money and bring margins down. And here you kind of have the opposite where in the past, your results have been fantastic. And now they're going down because you invest. People just generally don't like to see that.

41:57Daniel Mahncke:That's right. And you can see the tension in the financials, which is where I want to take us next. Because under all this beautiful brand storytelling does sit what is genuinely a very aggressive balance sheet. And so there's a substantial debt load that we've alluded to and something of a maturity wall and also a deleveraging plan that depends on a lot of things going right. And so looking at the company's debt picture, they have$2.5 billion of term loans due late in 2028. And again, remember, that's about what the entire company is worth. And then they also have a$600 million asset-backed credit line where they're borrowing against their real estate assets.

42:41Daniel Mahncke:And that expires in 2030. And so the good thing is that both of RH's term loans require very small fixed quarterly principal payments of just a few million dollars relative to the total size of the debt. But that's how you get to what's called a maturity wall. When the bulk of this debt comes due and most likely needs to be rolled over, which just means refinance, meaning you need to get a new loan to pay off the old loan. And you're just kind of pushing the can down the road. And should there be some sort of liquidity crisis in 2028, some sort of financial crisis, banking scare? If RH doesn't roll that debt over sooner or be able to pay it off entirely, which would be very challenging, they could be in some trouble because they certainly don't have the cash on hand at the moment, nor the cash flow to tackle that debt.

43:31Daniel Mahncke:And because of that, let's call it a challenge, the$2.2 billion of stock repurchases across 2022 and 2023, it does make their use of cash in the recent past even more aggressive. And so effectively, those buybacks in hindsight were debt financed. And when you're also sitting on$1.5 billion of leases, which are effectively a form of debt you've agreed to commit to because you're making set payments going into the future on a recurring basis, I would argue that's debt. It just only makes the picture messier. And so this added leverage plus three years of flat revenue and weaker operating margins and declining gross margins from tariffs and other things, that has all negatively impacted the company's credit profile as a borrower.

44:20Daniel Mahncke:And so we actually saw some very meaningful credit downgrades that happened in 2025 for RH, which is not a good sign for equity investors. And fortunately, that is now starting to stabilize. But again, that does them really no favors because with a lower credit rating, if they do go to roll over their debt wall, which I presume they'll need to, they'll have to do so at a higher rate than they otherwise would have, which just increases the cost of debt. So that's more interest payments that are going to reduce net income in the future.

44:50Shawn O’Malley:I feel like the debt question is probably the most important thing in today's thesis. So I would like to take the chance and actually talk about accounting here a bit, which I know isn't the sexiest topic, but I think understanding, especially lease accounting, can be important for this case and actually for all of the retail businesses that we ever looked at. And given RH's leveraged profile, I think it's especially important here. And when we are accounting for leases as a form of debt, as you have basically suggested a minute ago, how does that actually happen and why do we do that? And also, what is a change for us as potential investors in this case?

45:27Daniel Mahncke:Gosh, I'm getting flashbacks to studying for six months for the CFA exam. It turns out some of that stuff, like lease accounting, is sometimes useful. There are two types of lease classification. There's operating leases and finance leases. You might be thinking, look, a lease is a lease, but it is not actually as redundant as it sounds. There's some sort of logic to it. With operating leases, the idea is that you are renting an otherwise viable asset. Whereas with a finance lease, you're effectively getting someone to lease you a property for, to use accounting parlance, the majority of that asset's useful life.

46:09Daniel Mahncke:In which case, what you're doing is you're buying something. You're not leasing it, which is why some leases get classified as finance leases. So it would be sort of like, maybe to make a parallel, if you customized a car that has your name branded in big cursive letters on the side with bright pink seats, and then you leased it for a decade, given that no one else is going to want the car afterward, it has effectively no remaining useful life by the time you're done. There's no residual value or very little. So in the truest sense, did you really lease it or did you finance a car purchase without explicitly getting a loan?

46:49Daniel Mahncke:That's sort of the point of the logic here. And so, you know, on the other hand, if you lease store space in a popular shopping mall for five years, well, that space can be easily repurposed afterwards. And in that case, then you truly just rented it, right? You rented an apartment for the year and then afterwards, you know, it's passed on to the next person. And so that's an operating lease. It's not something that resembles debt quite in the same way. And so again, that's the logic of it. And so it's generally important to account for leases in a company's debt picture. And I think this just adds an extra wrinkle to how you think about it because of the way that accounting for operating leases and finance leases can actually have different effects on the income statement.

47:33Shawn O’Malley:I don't know about you, but if you give me a good price for a Porsche with pink seats and a company slogan on its doors. I still take it. I mean, put a nice little black wrap on it and it's as good as new. And I'm also rocking it with pink seats. So it's not a problem for me. But jokes aside, I mean, which one of those two types of leases is RH? And I would just take a guess and say they probably personalized or customized quite a lot of the spaces they are in. Does that affect to any extent how we should account for that? Yeah.

48:02Daniel Mahncke:So they have a decent split between operating and finance leases, but a bit more toward finance leases. And the reason this matters is because as we know, they lease a lot of physical assets like galleries and showrooms and restaurants. And many of the galleries they use, some of them can be classified as regular operating leases, but some of the more highly customized properties that they've constructed that really serve no other purpose outside of their role in RH's ecosystem, well, then there's more of a case that those are finance leases.

48:37Shawn O’Malley:Without getting lost in the weeds at a high level, why does the distinction between operating and finance leases actually matter for us? I mean, you mentioned there's an impact on the income statement, right?

48:49Daniel Mahncke:Yeah. So if we can do a 30 second deep dive here into some accounting. So in both cases, something known as a right of use asset is created on the balance sheet, reflecting the value that you get from making use of the leases. And then a matching lease liability is also created and amortized over time. That's just accounting 101. But on the income statement for an operating lease, RH records a straight line lease expense and its operating expenses. But for a finance lease, they break out that cost into two parts. And so the cost is separated into the depreciation of the right of use asset and an interest expense based on the imputed interest rate on the lease.

49:37Daniel Mahncke:If you treat all the lease payments as a form of debt and calculate the present value, the implied interest rate on that debt, that is the imputed interest cost. And so anyway, this interest component then gets accounted for below operating income on the income statement, which means that operating income could be somewhat inflated in a way or look better than maybe reality would show, especially if RH or any company were more aggressive about how they categorize finance leases. And that's just something I think to keep in mind as you dig through the numbers. And that's not to say that they are being aggressive, but really just the whole classification process involves judgment.

50:21Daniel Mahncke:And so as a savvy stock investor, I think you should understand the assumptions that go into these accounting differences and recognize the way it impacts the cash flow statement, the balance sheet, and operating income versus net income. And so I honestly would recommend just treating all lease obligations as finance leases. I think that's way simpler. Accountants may disagree with me, but that's way more of an accounting tangent than I wanted to go down. So I apologize to the audience, but hopefully that is helpful for some people out there that really enjoy lease accounting.

50:57Shawn O’Malley:Certainly there are people listening to us who actually do enjoy that. So I think it was pretty helpful. I guess this, just to kind of get back to the topic, matters for RH in regards to their debt obligations and also their ability to pay them back, right? Yeah.

51:11Daniel Mahncke:So it's a prelude to discussing the reality that RH is expected to increasingly use sale leasebacks as a way to raise cash to pay off this term loan debt that we keep coming back to that's coming due in 2028. And so in other words, they will sell real estate that they've developed and own and And then lease back the same property from some sort of outside investor. So operationally, nothing is changing. They're still operating out of the same galleries. But they freed up a bunch of cash that they can use to pay off their term debt while effectively taking on more lease leverage. And much of this, I'm guessing, will be classified as finance leases.

51:54Daniel Mahncke:But that's entirely speculation.

51:56Shawn O’Malley:So when RH says they're going to repay all of their debt by 2029, what that really means is they're going to take on more lease liabilities, which aren't technically debt, but still very much show up as long term liabilities on the balance sheet.

52:13Daniel Mahncke:I think that's right. I think that's right. And so Friedman has also stated that the company is exiting the peak of its investment cycle. So that does help reduce the need for fresh financing going forward. But yeah, it is mainly going to come from selling off real estate, which they're expecting to do to the tune of$200 to $250 million per year. So that will help raise some cash on the balance sheet. And again, as part of its real estate transformation, RH is shifting away from a traditional retail leasing approach toward a development model where RH buys and develops real estate for its new design galleries, either directly or through joint ventures with third-party developers.

53:01Daniel Mahncke:And then once construction is complete, RH's ultimate objective is to execute a sale leaseback transaction, where, as we said, they sell the property to an investor and agree to lease it back from that investor for a set period of time. And to execute all of this, RH actually brought back David Stanchak as chief real estate and transformation officer recently. And David is, for context, the previous mastermind of RH's sale leaseback strategy. So they're getting the gang back together again to do some financial engineering here.

53:37Shawn O’Malley:I don't know if I like that. And maybe that's part of the reason why I'm so skeptical today, because we talked about this before. And to me, it just not seems like the best way to actually get rid of your debt. I think partly selling assets feels a bit different than actually generating enough quality cash flow. So you can truly say they aren't being debt free. And that's just me. I mean, if all of these investments, they are actually paying off and you can see how they at least believe it will all work out for them, then that will be a good investment. I mean, you could see sales rebound while the debt gets paid down with real estate sales.

54:11Shawn O’Malley:And realistically, I think they will still have some more debt to all over, but they may actually thread the needle of having done accretive debt finance buybacks, reinvested massively into taking market share, doing a slowdown for the industry, and then done some clever financial, let's call it maneuvering, that doesn't truly eliminate the debt, but certainly reduces the risk to shareholders and then clean things up. So I guess if I have to summarize anything, that's how I would summarize the bull case, right?

54:40Daniel Mahncke:Well, with your skepticism today, I appreciate you being able to make the arguments for the bull case. And yeah, I mean, management believes the company can hit$5.5 billion in revenue by 2030, which would be something like a two-thirds increase. And some of the estimates I've seen on Wall Street aren't as optimistic, but they still model a jump in sales to$5 billion or more. And if you're talking about a 10 % net income margin on$5 billion in sales, that would be$500 million in revenue. And I don't think we need to get deep into the valuation weeds here. But if you put a 10x multiple on$500 million in revenue, that is a$5 billion valuation, which would be a double from current prices.

55:26Shawn O’Malley:I think there's no doubt that at the current valuation, if they could get back to the amount of money they've made in the past, this could easily be a good investment. I think the question is, do you think this is a business that can achieve luxury industry margins, even if sales bounce? Because an 11 % operating margins is where we currently are. And for a self-described luxury brand, that's not actually a luxury number, if you ask me. And I look at the past, they've earned more money in the past, but I just don't see how you can just normalize earnings as with some of the other value plays that we have had on the show.

56:01Daniel Mahncke:No, it's not a luxury margin. LVMH would faint, I think, if they saw this. But the costs from scaling operations and from tariffs is definitely weighing down margins. And if tariffs roll off in 2028, while the business reaps the benefits of these investments, you could definitely see operating margins start to rise back maybe towards as high as 20%. And for context, they peaked at 24 % a few years ago. So again, this would mostly be the bull case. Debt reduction after massive buybacks previously while operating margins normalize and sales take a real step forward after being flat for a couple of years following the COVID era bonanza, where you then did have a huge jump in sales that I think pulled forward a lot of the business.

56:49Daniel Mahncke:And the question is, where does the company go from now? And I would probably say like a mid-teens operating profit margin is realistic. And then that's how I get to say, you know, approximately maybe you get like a 10 % net income margin on$5 billion in sales. And then that's how you get to this idea that the company could be worth$5 billion. And then it's just a question of the multiple you use, right? If you use a 20 times multiple, then it could be a four-bagger. But there is a question of whether this company deserves that kind of multiple. For context, it currently trades at about 23 times earnings.

57:23Daniel Mahncke:So the market is paying a meaningful premium for a business that is highly levered and would otherwise look like it could be in trouble.

57:32Shawn O’Malley:I think it's always difficult to look at multiples whenever you have these depressed times in earnings. I think that's similar to when we looked at Nike back a year ago, where it was basically still trading at a P of 30. But obviously, part of the thesis has been that the earnings will recover over time. There's one topic that actually also comes up with Nike all the time, but you also bring up today, which is tariffs. And it's kind of surprising to me because mostly when you talk about a luxury brand, they manufacture their things locally, which for this brand would obviously mean in the US. For many other luxury brands, it means in Europe.

58:04Shawn O’Malley:But it seems like they are quite exposed to tariffs. So why exactly is that and how exposed are they?

58:11Daniel Mahncke:More than you'd want to be, right? They did smartly move some of their sourcing out of China, but a lot of it went to Vietnam. And Vietnam got hit with tariffs too. So they definitely did not fully escape it. And they've talked about doing some stuff like trying to produce a majority of their upholstered furniture in the US and a chunk in Italy. But then also, it's probably more expensive to do so in those places. So I'm sure they'll continue to try and mitigate tariff costs or hope it just goes away with the next administration. but there's really been no way for them to completely escape the effects of it.

58:45Shawn O’Malley:Yeah, I mean, that's the case for many, many brands. So I wouldn't say that's specific to R &H. Although I would say that probably going from Vietnam for manufacturing to let's say the US or Italy doesn't necessarily help the margins, even if you don't necessarily have to pay the same amount in tariffs. I would just assume that manufacturing in those countries would be way more expensive than it is in China or Vietnam. But how about we bring it all together here? because I'm honestly still not sure where you're going to land with this one. I'm not sure where I land on this one. So do you mostly see it as a big opportunity with big risks or do you just see a big risk and you don't necessarily think that it's highly likely this will be a fallback at any time?

59:25Daniel Mahncke:I've gone back and forth on this one, but ultimately I do see it as a no-moat business. And yet I would also say even if a watered-down version of Friedman's vision for the next few years comes to fruition, then the stock is almost certainly undervalued. And so to me, it's just a matter of how much conviction you have in Friedman's plan. And that's where I start to trip up. And 18 months from now, if you told me that RH stock had more than doubled, I would absolutely not be surprised. And with our luck, it probably will. But we know from Buffett that the first role of investing is not to lose money.

1:00:07Daniel Mahncke:and I don't think we can confidently say that there's no risk of losing money here, that we have a substantial margin of safety. There's a lot of things outside of their control, right? If macro factors take a turn for the worse, we talked about like maybe a banking crisis, not to say there is about to be one, but we know that historically these happen every few years and in that case, they would be quite vulnerable to this debt wall that they have in 2028 and so I think I'm close here. I could almost get really excited about this one, but I'm just not totally sold that their bets are going to pay off.

1:00:42Daniel Mahncke:And for example, Friedman had really big ambitions for RH residences with the homes they built in Aspen. But the plans have pretty much been very dramatically dialed back in the last year or so around RH residences. So it's not like Friedman is infallible, even if he does embody a pretty impressive degree of boldness and belief in himself. But to me, that also raises another question of key man risk, right? Friedman is not exactly a young guy. And I think the stock at more than 20 times earnings could get a heck of a lot cheaper if the market has to price in Friedman's retirement in the coming years.

1:01:20Daniel Mahncke:And this is a business that almost just doesn't make sense without Friedman. So then what's the terminal value of the company without Friedman involved? I don't know. People like to debate whether Berkshire makes sense without Warren Buffett, and there's something to be said for that. But still, the underlying businesses are all viable. If you have a company here that is really completely dependent on the aesthetic vision of one man, yeah, what is the company worth when he's gone. To me, that is a real concern. And I don't know if he leaves in a year from now, five years from now, 10 years from now or what, but we know he won't be around forever.

1:02:00Daniel Mahncke:So I'm getting enough yellow flags that tell me that this investment would be vulnerable to a number of very tangible risks.

1:02:11Shawn O’Malley:Well, he would probably say that every act of creation is first an act of destruction when he leaves.

1:02:19Daniel Mahncke:Yeah, destroying a shareholder's faith in the company, right? I mean, he hasn't been afraid to break things. He has ripped up margins and levered the balance sheet and made some exotic investments along the way. So it really is a very, very interesting story, but one that I'm happy to watch from the sidelines.

1:02:37Shawn O’Malley:Yeah, I mean, look, throughout the entire episode, I might have seemed a bit more skeptical than I've actually been. I mean, I could also compare this case to Wix, for example. I mean, Wix is a company where I feel like if it works out and it still exists in five years time. And Base44, which is a huge part of the thesis for everyone who didn't listen to the episode, is still existing and thriving. The company could easily be a three or four X, but you could also make the argument that it doesn't exist anymore. Nobody needs it in two or three years time. So we know that people will still need furniture in two or three years time, but we don't necessarily know if R &H is still existing if you look at the debt they have compared to the market cap right now.

1:03:12Shawn O’Malley:And that's why we don't know what to think of this one either. I mean, you have a CEO here who turned this little furniture store into a multi-billion dollar business. So, I mean, honestly, who am I to question his decisions? And at the same time, if I think about putting my money to work, I also have to trust the people at the wheel, right? And to be completely honest, from what you told me today, I don't really know what I would be buying. I mean, am I buying a top-tier luxury brand? Am I buying a restaurant chain or am I buying a founder's vision for what could be a global hotel brand? So, you know, I sometimes joke with you that we are value investors and we are value investors because we lack the vision or the risk appetite to act like someone like Friedman and completely destroy something to build something new.

1:03:59Shawn O’Malley:And I admire that, but I also wouldn't want to be invested in it. And it always sounds like a cop out to say, you know, I could see this double when things play out, but it's not for me. but like an insurance. It's sort of like an insurance so that when it's actually doubling, nobody can tell us that we were wrong. And when it goes bankrupt, we also seem smart because, well, we didn't invest into the company, right? But honestly, that is to some extent the game of investing. We deal with uncertainties and we have to figure out whether they fit our risk appetite and also what chances of success we actually believe this business or this company he has.

1:04:35Daniel Mahncke:I really wanted to hit a home run on this one so I could go out and buy that$10 ,000 couch, Daniel.

1:04:42Shawn O’Malley:Well, maybe that's, you know, I joke with you that whenever you buy something on Lululemon, it's like an extra 2 % on the next quarter's earnings report. So maybe you should start doing the same for R &H.

1:04:55Daniel Mahncke:Oh, for the audience, I took a picture of my most recent Lululemon haul, and Daniel sent me a message back, you know, plus 2 % for North American sales.

1:05:07Shawn O’Malley:Okay, I think that's a perfect place to leave it. And if you want to keep going deep on names like this, the Bull and the Bear Cases, for example, all of that you can do in our intrinsic value mastermind community where almost all the time we keep talking about the companies that we cover on the show with the members in the community. I actually also believe that today's pitch has been the recommendation of a member we talked to in Omaha. And of course, we will link to our community, the network, also the free newsletter that we have in the show notes. And Sean, as always, was a blast joining you and hearing this pitch, even though I might have been a bit skeptical from the beginning.

1:05:44Shawn O’Malley:That's not because of your pitch, I can assure you.

1:05:47Daniel Mahncke:I'm glad to hear it. Well, let me leave the audience with a quote. Bernard Arnault, the patriarch of luxury giant LVMH says, money is just a consequence. I always say to my team, don't worry too much about profitability. If you do your job well, the profitability will come. And yeah, Friedman has very much, for better or worse, been channeling his inner Bernard Arnault, it seems. And so with that, see you all again next time.

1:06:28Daniel Mahncke:and with every company we dig into, pulling 20 years worth of financials, digging into segment data, grabbing quotes from the latest earnings calls, and making use of real-time institutional grade data all in one place. And if you want to try it yourself, well, head to fiscal.ai slash T-I-V-P. That'll include two weeks of Fiscal Pro for free and 15 % off if you upgrade to a paid plan. That's fiscal.ai slash T-I-V-P. Thanks for listening. Thank you.

1:07:33Thank you.