Perimeter Solutions (Ticker: PRM)

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Perimeter Solutions (NYSE: PRM — $598mm)

      ·  Perimeter is the only company in California that provides aerial fire retardants, a key but small part of the cost of fighting wildfires, and unpredictably recurring in nature. While there is a clear, secular tailwind in the extent and number of wildfires, caused by the progression of climate change, the past two immensely devastating fire seasons (2022/2023) have showcased just how significant year-over-year variability can be.

      ·       I am an investor, not a gambler. An investment is, essentially, a big gamble on the next fire season being substantial. It is statistically likely, but nonetheless, NOBODY can predict it with certainty.

      ·       The company has a net debt of $725 million and is paying a 5% fixed interest. This arrangement works against a business that is highly unpredictable and cyclical. I believe the management would have no other option than to significantly dilute its shareholders in the event of a low-fire season.

Introduction to the case.

Perimeter Solutions (PRM) went public via SPAC, backed by a team of savvy investors: Nick Howley of Transdigm (who achieved a 3900% return since IPO’ing in 2006), Warren Buffett’s mentee, Tracy Britt Cool; author William Thorndike, known for ‘The Outsiders’; and Sean Henessey, CFO at the house paint giant, Sherwin Williams, from 2001-2016. He was part of turning a company in the world’s slowest industry into a beast compounder that delivered a 17% IRR during his tenure.

But from all of those, let‘s zoom in on Howley, the driving force & initiator behind Perimeter Solutions. In 1992, he launched his holding company TransDigm with an initial equity investment of $10 million, he started building a collection of aerospace monopolies that had outsized pricing power. He noticed a lucrative pattern: many aircraft parts have just one or two makers, some doing it for over 70 years. By acquiring those companies that have a monopoly-like hold on niche aerospace parts and consistently raising prices, Howley built an extremely profitable portfolio of 50 such parts. Take airplane belt buckles, for instance – they bring in a 40% margin, and he owns 95% of that market. By focusing on high-margin products, his company’s operating profit margin averaged over 50%; the dwarfing the aerospace parts industry’s 15%.

Fast forward over 25 years, and Howley’s TransDigm grew to an enterprise value of $70bln, that was thousands of times larger and had rung up a total return of 29% annually for its investors since going public in 2006.

“When a TransDigm investor, in an effort to knock Howley off balance, forcefully asked him why he should believe in the company following Howley’s recent sale of millions of dollars of stock. Howley was said to have stunned the room when he sat up in his chair, put his elbows on the boardroom table, looked the guy in the eye, and said: “This may come as a surprise to you, but I’m in this for the money. I haven’t had many chances to sell stock under private equity ownership, and now I do. My wife wants a beach house. So we’re gonna get a beach house. You can believe what you want, but I’m not going anywhere. I’ve got more money to make, and if you choose to, you can make it with me.”

(Source from Book: Lessons from the Titans)

 

Tailwinds at a glance (Will Thorndike, on the first earnings call as a public company)

  1. Broadly speaking, the US is experiencing longer fire seasons because of climate change.
  2. Retardant revenue is extremely sticky. Customers rarely leave and often use more of Perimeter’s retardant over time.
  3. A growing number of homes are built close to wildlands, which means the ‘let it burn’ strategy is less of an option for firefighters.
  4. Increasing airtanker capacity. The larger the airtanker, the more retardant said airtanker can drop, and the more effectively wildfires can be put out. As fire severity increases, so should usage of the largest airtankers.
 

There are three main reasons the stock trades where it does today.

       1)     Devastating Fire Seasons

Investors in my opinion fail to appreciate just how devastating the past two years of fire seasons were. Management may also have come to learn who significant this year over year variability can be. The 2023 fire season was 54% below the 10-year average, and 71% below what it was in 2020. The 2022 season was also mild, with US acres burned ex-Alaska down 36% YoY (there was a large number of acres burned in Alaska but fire retardants are normally used in locations where the fire is a threat to humans or infrastructure). The business has been expanding internationally, but that was little help in 2022 when Australia experienced such an ‘unusually wet’ early season that the country literally didn’t buy any retardant in Q4. Perimeter has managed this season variability well, with Fire Safety revenue down 1% in 2022 and 8% YoY as of Q32023, but it’s much harder to get excited about a business that’s so heavily and unpredictably cyclical. In oil and gas investing one can at least come up with some approximation of whether there’s a supply shortage/glut; the same approximation can’t be made for how severe the wildfire season will be going forward. While there is clear tailwind of more frequent and close-to-urban area wildfires, it still is a highly cyclical industry. Fire seasons are just not perfectly linear.


 

      2)     Competition entering the monopolistic market

Second, there’s a shift in the market perception of Perimeter Solutions as a monopoly in aerial firefighting. This perception is being challenged by the approval of a new competing company, Fortress. I view the risk of them taking substantial market share as unlikely. Perimeter is currently the only supplier with USDA approval on all of the West Coast. While it is likely that, beyond their current test phase, Fortress will be widely approved, Perimeter’s infrastructure and integration into the supply chain provides a lasting competitive advantage to help maintain market share. This, combined with the fact that Perimeter’s product represents only approximately 3% of customers’ suppression spend, makes it challenging and unlikely for Federal and State agencies to switch providers. The fire-retardant business is characterized by its high cost-of-failure, the development and testing of products, and the approval and licensing of such products, is typically a complex and lengthy process, as a result there are only very few providers like Perimeter.

Context on that by my friends conducting research at East Coast Asset Management: 

Aerial firefighting started in the 1940s with planes dropping water, which is ineffective for fighting fires because the water would evaporate before it hits the ground. Original retardants were not great for the environment. The early 1960s saw the introduction of ammonium phosphates (Pos-Check started being used in 1963). Today’s retardants are much more environmentally friendly and effective. Delivery systems (airplanes) use much better technology today for retardant delivery. They have the same active ingredients as 40 years ago but at much lower volumes (50% of the active ingredients as 40 years ago). Retardants today are safe for animals, people, aquatic life, etc. Color is used so pilots can see where the retardant is on the ground. The color disappears after a few weeks’ exposure to the sun. Perimeter has been using phosphate-based retardant for many years and a recent lawsuit against PRM’s product amounted to nothing. A Montana district court ruled in PRM’s favor as a safe and environmentally friendly product.

Fortress’s FR-100 retardant is a Magnesium Chloride-based chemical, corrosive to metals. Fortress obviously says the fear is overblown and that their product does not corrode, but there is a lot of friction in the industry to get over that hump. PRM is not going to let the Fortress product flow through their on-base equipment, so Compass (Fortress’ owner-company) will have to make that investment of building bases across the country, which is amazingly capital-intensive. Matching Perimeter’s 150 tanker bases in North America is still a long way.

There was a gumming up issue when tanks switched from PRM to Fortress, and they needed to be heavily cleaned in between, which was costly when a fire was raging. Furthermore, aerial tankers need to be convinced to use the product in their planes. Most are hesitant to expose their most important assets to corrosive material or need to be heavily cleaned when switching between the two products. In the 1950s, the USFS studied a total of 12 types of retardants: Ammonium phosphate, magnesium chloride, boric acid, etc. Ammonium phosphate was found to be the best, and magnesium chloride was the worst, even at twice the concentration. Because of that study, ammonium phosphate has been the primary retardant since the 1950s. Recently, the USFS relaxed requirements, and magnesium chloride has come back. Many studies on magnesium chloride suggested toxicity, handling, corrosion, and storage issues. 

 

      3)     Record weakness in Specialty Products segment

To compound misfortune, Perimeter was unsuccessful at predicting demand for its Specialty Products segment. On its first earnings call as a public company in late ’21, the outlook for Specialty Products was that revenue would be about flat. Instead, 2022 sales were up 32%, but with a significant slowdown in Q42022 due to inventory destocking. Management expected this destocking to ease in Q1, but it’s instead persisted through the most recent quarter, with Specialty Products sales down 35% YTD.  Perimeter’s CEO, Haitham Khouri, said the following on the company’s last earnings call: “We were surprised by the duration and magnitude of the destock…. we’ve frankly been wrong on magnitude and duration so far, and therefore, I’m hesitant to make a future projection on when it will end.”

 

      4)     Egregious Compensation System?

The fourth factor concerns Perimeter’s compensation structure. My view is that if a compensation plan is clearly defined and you can model it out, you can account for it going forward. If management runs the business well and shareholders are rewarded with above average returns, management should be compensated. At Transdigm employees should think, act, and be compensated like owners — Howley is doing something similar here. The compensation structure in the EverArc Founders’ agreement (EverArc Entity = the directors that took PRM public as a SPAC) involves both a fixed and a variable component

1.      Fixed Annual Advisory Amount. Fixed payout of 1.5% of market cap through 2027, max 50% in cash, which they generally use to pay taxes.

2.      Variable Annual Advisory Amount: Variable is similar to any fund management fee. The directors earn 18% of stock price appreciation with a high water mark (currently the HWM of 13.69) based off end of year price in 2021. . At this point Perimeter shares need to increase by 250% for them to receive a „variable compensation amount“ again.

The advisory setup should encourage the team to not rush into privatizing the business at today’s price. The egregious pay structure makes me wonder if the directors are focused more on having this as their self-enrichment structure. According to people close to the board and my relationship with one of the directors, I believe them to be honorable people, that have accumulated enough wealth throughout their career already, for this not to turn the needle for them.

 

      5)     Highly levered business

With capital allocation and capital structure in mind, Howley realized that TransDigm, a business built with a high degree of recurring revenue from spare parts, pricing power, low volatility in input costs, and limited capital requirements, could shoulder a higher debt load than an average business. TransDigm has a 6.1x Total Debt/EBITDA.

Does the same apply to Perimeter? With a 5.4x Total Debt/EBITDA ratio, it certainly indicates that a similar playbook is in force. However, I am very worried when I look at this. Perimeter’s quality of revenue is far from that of Transdigm. While it ticks the box of being recurring, it relies on a very hard-to-predict, cyclical revenue stream. All their debt is fixed 5% through October 30, 2029. Debt service is roughly $40m/year on this debt vs $125m EBITDA in 2022 and ~$110m in 2023. Management has shown a fantastic ability to take price (fire sales down much less than acres burned) as well as protect margins with sales down. Stress testing their business, even if fire sales were down another 25% each year and margins falling, they still make their interest payments. The data shows cyclicality in the acres burned with an upward sloping trend in rolling average. When forest fires do not occur, all that is left is fuel for the next fire, typically making years after “bad fire seasons” major acres burned.

The fixed cost component to pay the cost of debt does restrict their ability to do meaningful share repurchases or M&A that provide catalysts for the stock price. There is a risk of the company being stolen from us at depressed valuations.

 

Going Forward. Sizing the Opportunity. Perimeter is a business in an industry with significant tailwind, that with it exceptional leadership, should grow free cashflow per share by over 10% per year for the next decade. Volume growth will continue to be fueled by continued increases in acres burned, larger fires, and further stretched-out fire seasons. Outside of the North American Fire business, additional growth should come from underpenetrated international markets and the Specialty Products segment. International is currently around 20% of revenues and is gaining traction. The second leg of Perimeter, which gets less focus and represents one-third of revenues, is Specialty Products which, as of the third quarter, has grown year-over-year revenues by 40% and has more than doubled EBITDA. While this is a business entirely correlated to unpredictable wildfires, it is mostly uncorrelated to economic cycles, and I believe there is limited downside to normalized earnings. I see a path to nearly $0.75 per share of free cashflow by 2025. Revenue should be able to compound around 10% from a combination of increased volumes and mid-single-digit price increases (like the price increase play book at TransDigm).

Sonos (Ticker: SONO)

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  • Recommendation: I recommend against buying SONOS at its current share price of $20. While SONOS is a wonderful brand, it is not really a wonderful business. Hardware businesses rarely create lasting moats and exceptional business models (unless they involve a subscription, which is not and will not be the case for Sonos)
  • Moat: Sonos will be able successfully expand into new product categories such as headphones and video conferencing, likely ensuring mid to high single-digit revenue growth in the coming years. However, zooming out even further on the 20-30 year time horizon, I can’t say with certainty that Sonos will maintain the necessary pace of innovation. In the long run, it’s extremely difficult to stay relevant in a market that sees at least two or three major technology upgrades every year. Another drag are also some key patents that will run out by 2026. Sonos‘ moat doesn’t seem sustainable for decades to come, but instead has an expiry date attached to it.
  • Business: currently ~14 million households own a Sonos speaker, mostly in the US and Europe. Sonos makes its money by selling speakers that can be easily integrated into a complete home audio system. A major line of business for Sonos is home theater systems, where multiple speakers installed in the living room provide a unique spatial sound experience. According to Masimo (the acquirer of a direct Sonos competitor, „SoundUnited“), the market for high-end speakers is about $6.5 billion, implying a 27% MS.
  • Top-Line: The market is already fairly saturated and growth rates are unlikely to exceed 6%. Drivers for sales growth are (1) existing households buying additional speakers, (2) geographic expansion, and 3) expansion into adjacent product categories.
  • Margins: The economics of manufacturing speakers are far from exceptional: the 50% gross margins, deceptive. Based on the company’s own projections and an analysis of competitors (SoundUnited and Bose), the long-term EBITDA margin is unlikely to exceed 15%. This will compress to an FCF margin of 5-6%. However, the markets seem to value Sonos more as a software company that generates FCF margins in the mid-20s.
  • Management: CEO Patrick Spence took the reins in 2017. He runs the company in a very pragmatic and “brand preserving” way, focusing heavily on the bottom line. He holds a 0.7% stake in the company valued at about $19 million. The other members of the management team have been with the company an average of 3.8 years but do not own significant stakes. In Spence’s case, ownership has accumulated over the past few years through severance payments.
  • Valuation: By 2027, Sonos will generate FCF (incl. SBC expenses) of about $121 million, topline growth will have slowed to about 6.5% y/y, while a 5% FCF margin will leave little room for bottomline improvement. For reference, competitor SoundUnited (revenue: $910 million) was recently acquired by Masimo for 8x EBITDA/15x FCF in a Private Equity deal. In FY21, SoundUnited still grew at 10% and had an FCF margin of 8%. Applying this valuation multiple to Sonos, I’d arrive at a fair valuation of $1.82bln by the end of 2027. Roughly 27% below current levels.
 

Backdrop

Sonos has long been a founder-led company. Founder John McFarlane, who started in 2004, led the company as CEO until 2016. He was a very strong personality with a very clear idea of how a company should be run: he focused very much on the customer experience and the brand, he called it “Sonos‘ race, not the race of everyone else”.

Sonos was the first company to sell wireless speakers to the world. Thanks to lucky timing with the launch of Spotify in 2008, Sonos struck a chord with young consumers looking for ways to „fill their homes with music“. The company knew it couldn’t limit itself to simple speakers, but needed to get into the “home cinema” market, which meant veiling the living room in sound by using multiple speakers in different locations. It turned out to be the right bet, catapulting the company into a state of great growth and admirable margins.

Impressive brand advertising followed, really spreading the word about what Sonos was all about and taking the speakers beyond the small market of tech-savvy and affluent households. The brand was now truly ubiquitous and enjoyed extremely high customer affinity, often described as a cult-like following.

After a few product launch missteps and a dramatic slowdown in product innovation however,  John McFarlan decided to withdraw. In 2017, he handed the reins over to Patrick Spence, who ushered in a new era for Sonos as its new CEO. It was a major shift in the company’s culture and dynamics. Since then, the company has been run much more pragmatically and profit-focused than before.

There was a clear recognition that they will have to keep a certain pace of product launches to drive growth: It could be a replacement or it could be a new product. The pace of innovation at Sonos had slowed dramatically, and Patrick realized that he needed to pick up the pace of launching new products. And so it’s no coincidence that he publicly stated that Sonos would launch two new products per year. At least one of these product launches per year had to be significantly different from previous products in order for sales to continue to grow in the double digits.

 

A Wide Moated Business

Sonos is one of those unique David and Goliath stories. Even as Amazon, Google and, Apple began to encroach on its space, Sonos kept its dominant position, and arguably even continued on growing it. That’s certainly a testament to the company being #1 in terms of consumer preferences, but what I find even more interesting is the dynamics of switching costs that play a role in the speaker market.

If you look at competitor Bose, one of the legacy players in the market, you’ll quickly see that while the brand has lost significant ground over the past years, it’s in a fairly slow decline. While it will be difficult for a brand like Bose to attract new households, it is unlikely that those who have already installed Bose speakers will switch to a new brand. In general, I would call this a very slow market, since we are talking about speakers that last at least a decade.

But just because the market is slow doesn’t mean it’s not tough. I would like to bucket Sonos’ competitive landscape into three different categories:

  • There’s the smart speakers, the voice-controlled speakers, which I think are highly competitive. A tough market. So if Sonos was just making higher-end versions of Amazon or Google products, that would be a difficult market for them.
  • Portable speakers are also very competitive, but resonates well with the installed base. So if a household is already familiar with Sonos, they will buy a Sonos branded speaker that is compatible with what they have at home. But this is also a highly competitive space with players like JBL.
  • However, the area I find most interesting is the home theater. There they have managed to create a wide moat for themselves. From a design, technology, and “works with everything” perspective, it’s a unique product in the market. And in fact, the home theater products are also one of the biggest drivers of new home acquisitions for Sonos.

The wonderful thing about the home theater market is not only that it is much less competitive, but also that customers place multiple high-value orders to get the full home cinema experience. About 45% of Sonos’ revenue already comes from the home theater market.

Selling smart speakers like Amazon and Google do, is a very costly thing and rarely a profitable business. Sonos is truly unique in that regard, and can keep a very impressive pricing power on their products. However even a seemingly undefeatble position like Sonos‘ is not assured indefinetly and the possibility of it adapting too slowly is real.

Many companies have failed to replicate what Sonos has achieved. And indeed, it’s hard to match the company’s dominant and growing position in the high-end market. Some startups (like Syng) have taken a fresh angle but ultimately failed because they didn’t achieve the necessary scale, and even Apple, which entered the market five years ago, never quite managed to gain the traction it had hoped for. While Sonos has shown promise in the past that it is capable of defeating such challengers, I think it would be naive to believe that this success is a forever kind of thing.

While Sonos is currently quite well protected thanks to hundreds of patents, eventually those patents will expire and many companies will challenge Sonos’ position. In order to „kill“ Sonos, all it takes is a company that is able to get the right music to the right place in less than 2 seconds. Because the future of home theater is just that: if you listen to music in your living room and go to the kitchen, the music will instantly move there  with you. If you go out the house for a walk with your earbuds, or if you get into the car… the music will be able to always follow you around. If Sonos can’t do that, sooner or later another company will, which could be fatal. Sonos’ success will always be very directly tied to exceptional innovation – you can’t afford to be late to new technological advances.

Bose had good high-end speakers, but couldn’t make the software work. Sonos came in and built the system from the ground up as a software product, they had some pretty brilliant minds behind the industrial design that really made it an appealing speaker, but Bose couldn’t match Sonos’ software capabilities and so lost the race.

Bose has been a wonderful and consistent company for about 50 years, and so will Sonos, but at some point a moat in this industry has an expiration date, and then a new company comes along that takes a fresh angle and turns everything that once was on its head. I’m confident that Sonos can last another couple of decades. Most likely it will be adapt quickly and be successful in participating in the major technological innovations that industry will be going through, however, I don’t see the Sonos surviving „forever“ in a market that is constantly going through technological upgrades of all sorts. At some point they will inevitably do something wrong, underestimate potentials or make fatal mistakes that will lead to them being replaced by another company.

 

Opportunities for top-line expansion

The market in which Sonos operates is already pretty saturated. Considering the 14 million households that already own at least one Sonos speaker, there’s not much room for growth. Household growth probably peaked during the pandemic. People had too much cash thanks to the stimulus checks and decided to spend that check on «nice-to-have» things at home. So let me explore how top-line expansion will look like for Sonos:

  1. Expansion across different regions

The market in the U.S. and Europe is already pretty saturated. Looking at Sonos’ sales by geography, the U.S. accounts for the largest share (55%), followed by Europe (33%). Sonos has not really been successful in other regions to date. A few years ago, a considerable amount of money and effort was invested in entering the Chinese market, but it quickly came to a hald due to major cultural differences.

 

Sonos entered China with marketing that focused heavily on sound quality and volume, which was completely irrelevant to the typical Chinese consumer, as they rarely have large homes, but rather want something discreet for a small apartment. In this case, a cheap Bluetooth speaker does the job just as well. Sonos may never reach China, and while there is room for expansion into other regions such as the Middle East and South Africa, these are only minor market and it is clear that most of the growth will have to occur in the existing regions and homes where Sonos already operates in.

  1. Lowering Pricepoints

Lowering prices would be one of the most obvious ways to reach additional households. It’s an interesting consideration to perhaps offer $100 products and then try to trade up those customers to more expensive products. Sonos also explored lower-end sales opportunities in a partnership with Ikea. The idea behind this partnership was to incorporate Sonos’ audio system into traditional furniture pieces such as lamps or cabinets.  As a result, it became clear that it was a real challenge to move these customers from buying a very inexpensive Ikea Sonos speaker to more expensive follow-up purchases.

Looking at the pure cost structure of a Sonos speaker, there is a minimum cost required for the chipset that supports for example the WiFi network. So it was clear that they needed to reengineer these core elements of technology if they wanted to reach lower prices. But wherever you subtract cost to the manufacturer a speaker, there’s also the concern that the quality you embody as a brand will suffer.

  1. Tying the speakers to a subscription

In an effort to generate higher margins and lucrative revenue from existing households, a music streaming service, Sonos Radio, was launched. However, the service did not achieve the hoped-for market penetration. It was also very difficult to run a profitable music service, so they had to limit the available catalog in some ways to have any chance of making money. And that fundamentally limited the choice for customers, so most people didn’t take up the Sonos Radio offer.

Another option that was discussed was to put certain features behind a paywall. With small test groups attempts were made to put several features behind a $9/month subscription, but it was quickly concluded that there were no features that people would actually be willing to pay for without taking away the key benefits of owning a Sonos speaker. So it turns out that it’s probably going to be pretty difficult to make money from Sonos users through a subscription.

  1. Expanding the Product Line

In evaluating all the opportunities for revenue growth, it’s clear that the company needs to maintain a very fast pace of product launches so that existing households feel compelled to either replace their old Sonos speaker or add a new one.

When Sonos went public in 2018, Patrick Spence publicly announced that Sonos would launch two new products per year. Something that requires a high level of efficiency in expanding product offerings. The pace of innovation at Sonos has slowed dramatically in recent years, but to continue to grow sales, the company needs to launch at least one substantially different product each year. If it can deliver on Patrick’s pledge, Sonos should be able to grow revenue at a 10% rate. If it fails to do so, the company will likely only achieve 2-3% above economic growth.

When it comes to product innovation Sonos is looking to enter adjacent categories. One obvious one is headphones. Assuming that 5% of the existing 14 million households buy a single pair of headphones each year at a price of $400, this would immediately add $280 million in revenue. People would replace their headphones much more frequently than their speakers at home. So the economic opportunity for headphones is really enticing.

A lot of work, money, and resources have been put into headphones, and while there have been very strong rumors of this product launching as early as 2019, it has never seen the light of day until today. The reason for this lies in Sonos’ culture, which strictly refuses to compromise on quality.

If you have a pair of Sonos headphones you want them to interfunction as part of your Sonos system at home. It’s both a user experience issue because it’s difficult to seamlessly transfer music between your home audio system and headphones when you’re away from home, and then also a licensing issue because you now have a music stream coming from Spotify but being sent to two places (your home and your headphones). Sonos probably faces too many challenges for it to feel comfortable to deliver quality yet.

Apart from headphones, there will probably be a combination of audio and video: Video conferencing. Imagine joining a conference call and the conversation following you as you walk freely around the house.

Finally, there’s the auto industry, which could potentially equip millions of cars with its speakers. There were even talks with BMW, but they walked away from them because they didn’t want to stretch the brand too much. Personally I believe they will need to leverage the brand much more and really get into as many adjacent product categories as possible.

If you take Sonos’ core strength: Combining hardware and software to create a unique experience for consumers, then I think Sonos will find a lot of other areas that could be really desirable.

It’s going to take a little more risk-taking, a little more „stretching the brand“, to keep the company growing in the high single digits. 

On a final note: Growth companies that stop growing are a tough investment case. Going from 10x revenue to 10x earnings messes up company and team dynamics. 

Thank you,

Richard

 

Arlo Technologies (Ticker: ARLO)

Please Read through the updated version of this research, published on March 15th 2023: Updated Arlo – Investment Case

I am optimistic that the highly cash generative subscription business is going to drive significant growth in the short term. 

In the long run however I believe that the DIY smart security market doesn‘t allow for wide-moated business models, and therefore is not an attractive market to be in and falls out of my scope.

As a friend of mine correctly evaluated, Arlo‘s management team also does not appear capable of succeeding in a dynamic, ecosystem-based, services-oriented market.

Best,

Richard

Initial Research

(Published on January 11, 2023)

Download printable PDF (initial research)

➢Recommendation: I recommend buying ARLO at its current price of $3,75. Arlo will be succesful in upselling their customers to a $13 monthly subscription. The share of the subscription business in the revenue mix will increase massively and eventually make up two thirds. This revenue stream is a >75% gross margin business that could propell Arlo to become a highly cash generative business.

➢ Business: Arlo currently has ~7mn registered accounts on their platform, that bought their DYI camera systems. It makes money mainly by: (1) Selling subscription plans that allow the customer to store/analyse recorded footage on the cloud; (2) Selling best in class surveillance cameras. I estimate that its TAM is ~$6bn, which would imply market share of only ~8%.

➢ Top-line: The market for DYI surveillance systems is growing at a 18% CAGR and is expected to reach $20bln by 2028. Drivers for revenue growth are (1) Growth of total number of paid accounts, (2) Increased marketing efforts to drive brand awareness – marketing spend has been close to 0 in the past four years. Arlo benefits from several trends: (I) Consumers not wanting Big-Tech like (Amazon or Google) in their homes, (II) Consumers going with much cheaper DYI systems, instead of pricey legacy broadband cameras.

➢ Margins: As the subscription business is growing in share, gross margins are likely to double to the 50-60% range in the next 5 years, while consequent cost optimisation will lead to a LT 20% FCF Margin (Adj. For SBC)

➢ Competition: In my view Arlo is operating in a market that allows for many dominant players to co-exist. Arlo will carve out the segment of the less price sensitive customers

➢ Management: Matt McRae has been CEO ever since the company went public in early 2018. He has a 2% stake in the company, worth around $6mn. The remaining members of the management team have average tenure of 4,6 years (ever since Arlo went public), but lack significant ownership. Arlo has a strong Product-DNA that made them lose significant market share to Ring in the past years.

➢ Valuation: Dampening consumer demand in the US moves Arlo’s retail partners to increase promotions, which leads to lower hardware revenue which still makes up 60% of total revenue. Arlo is currently trading at 2,5 times 2028‘ Cash/Share (adj. For SBC & Shareholder Dilution)

➢ Risks: 1) Ring to establish a monopoly in the market by catching up with Arlo’s technological capabilities; 2) Arlo not being able to convince consumers to buy their pricey cameras that are twice as expensive as from its competitor, Ring; 3) Excessive promotional activity by its retail partners due to a potential recession could lead to a 30- 40% reduction in hardware sales.

 

Background

In 2014, Netgear acquired a brand that specialized in cameras. They quickly realized that this could be an amazing market where there were very few vendors at the time. Ring and Nest were not among them. So in 2016-2017, they created and conceptualized their “internal startup”, Arlo.

Netgear had its own pace and Arlo scaled quickly. So they spun it off. The two were completely different companies. Arlo had a different business mentality. It had a different agile mentality from a technical standpoint. The whole technical stack was different. The mentality was different. The culture was different.

One problem with Arlo, however, was that for a long time it focused too much on the design of the hardware and not so much on the really big opportunity: billing customers monthly with a subscription plan.

Of course, one could argue that this was also the basis for the company’s great success. Arlo was one of the few vendors that provided seven days of free cloud storage for its cameras. Ring, Nest and all the others charged a $10/month subscription.

That was Arlo’s biggest competitive advantage at the time. People were buying their cameras because they didn’t want to pay Ring’s recurring subscription-fees. The free cloud storage for seven days was originally a feature to gain critical mass, but quickly evolved into Arlo’s main selling point. People were willing to pay more for the camera so they didn’t have to pay for a subscription.

The original plan was to reach critical mass in this way within the first 12 months of Arlo’s launch, and then reduce it again. It was a very interesting proposition to consumers and it really had a big impact on initial product adoption. Arlo quickly became the market leader and owned 40% of the outdoor camera market in the US.

The free seven-day cloud storage offering attracted millions of customers, but really inhibited subscription revenue. At a certain point, it became very difficult for Arlo to cut the free cloud storage offer. It would cost Arlo massive penalty in their sales volumes, but on the other hand, could also make the business much more profitable. Their product was rich enough and could still be favorabely compared to other cameras like Ring, but management decided at the time that it wasn’t a worthwhile move for them to cut the free cloud storage, so they went beyond the 12 months initially planned and it became more and more part of Arlo’s identity.

Does it stand a chance against Ring?

Technologically I would say, Arlo was actually always ahead of the game. Obviously this is because a lot of Netgear’s infrastructure was copied and pasted into the organization. Resources were divided up and all kinds of system architects and experts were brought in to Arlo. So there was always kind of an expertise advantage in software and wireless that Ring couldn’t match. Ring’s advantage was Amazon’s massive distribution power.

Shortly after Amazon bought Ring, they hired Shaq as a spokesperson, who kicked advertising into high gear and really helped the company launch. They used the power of the media to cover up their product shortcomings. Yes, Arlo has a great product, but Ring had Shaq.

Everyone in the industry knew that Arlo had the best technology, the best product. Arlo had invented the wireless camera category and Ring had invented the doorbell camera. Back in 2016, the smart home market was not well enough defined and it really looked like the two were operating in separate markets. But slowly Ring, the doorbell company, picked battlegrounds where Arlo didn’t have a presence or where it had weaknesses. And after launching product after product, a Ring ecosystem emerged that would take over Arlo’s dominant role.

Fall from Grace

In late 2018, they launched the Arlo Ultra 4K, a four-camera kit for $1,000. It was a debacle. For one thing, it was a completely counterintuitive thing to do. At the time, the market was saying that the average selling price (ASP) for cameras was plummeting as low-cost Chinese vendors entered the market. The ASP for a single video doorbell was $120, but Arlo released a four-camera kit for $1,000? That’s more than double the price per device.

The Ultra came to market with tons of bad reviews. At one point, Arlo was even forced to pull it off the shelves and re-release it a few months later. 

At the time, Arlo was the only provider with free cloud storage for seven days. Everyone else, including competitors like Ring, charged $10 per month. And really, Arlo’s biggest selling point was that there was no subscription associated with it. The free seven days were really the main driver for Arlo’s early success. But now it was all about the “Arlo smart” subscription plan. Customers were very unhappy: they were spending $1,000 on this kit, and after the first year, Arlo was telling them they had to spend another $100 a year on services? So that was a big problem.

Another big factor in Arlo’s 2019 revenue decline was that they really blew it with their promotional strategy: Let’s say Arlo projected $100,000 in sales for calendar week 20, and let’s say at the end of the week they only sold cameras for $60,000. The guys in the marketing department will say, “Oh, crap, we missed by $40,000. We’ve got to make up for that now. So, Costco, Best Buy, you guys run a promotion and we’ll try to make up what we missed last week.”

What happens then is that this kind of promotional activity just becomes a vicious cycle, that you can never get out of. When you’re on and off promotion all the time, what happens is that the the consumer will not be an impulse buyer anymore, but instead you create a buyer that does researched purchases.

A customer who is researching an Arlo purchase carefully, is seeing price changes over time. One week on promo, two weeks off, one week on, two weeks off or a week- on, week-off, week- on, week-off, that price continues to fluctuate. So, Arlo now trained the customer to wait for that lower price. This obviously caused Arlo to sell for a lower ASP, revenue per device went down. As soon as Arlo was back at full retail, sales went to zero. They were going to go back on promo the next week and sales went through the roof. An certainly they didn’t make up everything they missed the week before. So, it’s really a vicious cycle that they got themselves into, where they‘ve got all these vultures out there that wait for that low-low price.

 

Arlo – the software company

After two difficult years, in 2020, Arlo’s management finally realized that remaining a hardware-first-business might not be worthwile. By the end of 2019, the age of the subscription business had arrived. The world was moving toward subscriptions. You pay a few dollars and subscribe to the Arlo service. That was the focus. The devices that would be sold from now on would no longer offer free seven-day cloud storage, and there would be a subscription fee of $10/month.

The shift to a service-based business model was a paradigm that caused some turbulence within the company. „Arlo is no longer a hardware company. Arlo is a company that sells hardware because of its very strong software and platforms“ was the new theme.

That transition was a really necessary step. Hardware sales had completely left the triple-digit growth path after the Arlo Ultra debacle and were down 25% from their all-time high in 2019. Gross margins turned negative on their hardware product as several technical issues had to be fixed, leaving not a dime for any meaningful marketing spend. In addition, most of the original Netgear employees who had built Arlo in its early day when it was a sort of “in-house startup”, were leaving the company in early 2019, and the company’s future really didn’t look bright.

Now it was time to really monetize the millions of households that had Arlo cameras installed. As mentioned earlier, this created a lot of headwinds and frustration.

Management’s fear that Arlo would lose its main selling point if it eliminated free seven-day cloud storage came true. The number of devices sold dropped by 30% when Arlo switched to the more subscription-based business model. And I also think Arlo will make it through this rough patch. These days, everyone is charging $10 a month. People will get used to it, and new customers won’t even know the old rates, so they won’t care.

Looking at the last few quarters, the number of devices sold seems to have stabilized, so it’s likely that consumers have gotten used to it and see subscriptions as normal. In a year or two, no one will talk about it anymore; it will be the new normal to pay a subscription on top of the pricey camera.

I buy because of the software – but it’s all about the hardware.

Now that customers are, in a sense, “forced” to buy a subscription, since the free cloud storage has been taken away from them, Arlo is poised to become a software-services company. When I used the word „forced“ I didn’t mean that it’s just a useless product if you don’t subscribe. You can still check live who’s at your door – but really not much more than that. Because the main thing you’re paying for with a subscription is storage, and that’s super valuable. As millions of new households convert to paid accounts, the revenue mix will be much more skewed towards the high-margin subscription business. The greater the subscription revenue share, the more cash generative will Arlo be.

With an annual churn rate of 5% and a conversion rate of 80%, it seems like Arlo has really made this service addictive to some degree. Once you get used to looking who was at your door, or what your kids did in the backyard, you don’t want them to be deleted after a day and you are willing to pay $13/month to get that insight.

It’s clear to everyone that Arlo is about to become a subscription business, but let’s not forget who makes it possible. The hardware.

Ultimately, it comes down to how well Arlo is able to sell its expensive hardware to the masses so that it can sell the high-margin subscription service that goes with it.

Losing Market Share to Low-Cost Players

The market for smart surveillance systems has really grown in recent years, and Arlo has not grown at all, or in some cases has even declined. The 25-30% market share that Arlo had in 2017 has diminished into single digits.

The security camera market is a very brutal market. It is highly fragmented and competition is fierce. Yes, Arlo’s product was kind of innovative, and the DYI approach was cheaper than what was on the market, but it would be a tough sell to get people to buy it over already established security camera systems.

Ring had a clever approach. The company came to market with this completely new idea of a doorbell with a video camera. And it didn’t stop there, as Ring used the doorbell only as an entry point into the home and then upsold entire camera systems to its customers. Clearly, spending advertising dollars on doorbells and then encouraging customers to buy cameras yielded a much higher ROI than Arlo, which began by marketing a security camera for which there were already a hundred established alternatives.

Ever since its initation Arlo had quite some financial stretches. It was a hardware business, gross margins barely ever exceeded 20%, and squeezing a positive bottom line from that would be very difficult. So while all of Arlo’s competitors spent a lot of money on advertising to get to market, Arlo spent virtually no money on marketing in recent years. There just wasn’t enough cash flow to spend on marketing.

Unable to promote their product in a meaningful way, Arlo was severely hurt by the influx of cheap cameras from China. An Arlo product is just super high-priced, and so of course there is still a niche market for people who are less price-sensitive, but the options for a decent camera at a lower price have increased tremendously in recent years.

The offering of these low-cost brands is simply unbeatable, and they seem to be grabbing a significant market share. At least at the topline they are doing well, but any camera company that sells at 50% below the industry ASP and offers seven days of free cloud storage on top of that, simply doesn’t have a sustainable business model.

Arlo is holding very strongly to its price tag, and it’s unlikely to lower prices. This will certainly allow Arlo to capture the high-end market, and perhaps the market of really privacy averse people who don’t want Amazon (Ring) or Google (Nest) in their homes.

That’s actually Arlo’s biggest selling point: while it integrates very well with smart home devices like Alexa/Apple Homepod, etc., it’s still an independent brand that doesn’t send your information to a centralized database of a big tech company.

I would say that Arlo can afford to remain a high-end product simply because it is “independent”, but also because it has probably the most advanced tech capabilities. I would argue that Arlo is perhaps the strongest innovator in the market, and even ahead of Ring. And that’s not just about the hardware, but also the service offering, which has many more features than Ring. It does a better job with object detection and facial recognition. And for consumers, the app’s functionality is just as important as the hardware itself. Going back to the low-cost brands, we could also argue that consumers still prefer to buy Ring, Nest, or Arlo over the cheaper products from China because the apps are much better.

Arlo’s software capabilities are truly one of the strongest. According to a former senior product manager at Arlo, more than half of the company’s 350 total employees are involved in some way in the development of the software portion of the business. The main component however that differentiates Arlo’s software from companies like Ring or Nest is the base station.

Although some consumers don’t like base stations and it’s a hassle to install and find a place to plug them into Ethernet, it’s an amazingly useful system. First, it bundles a lot of the electronics that would otherwise have to be built into each camera. This is obviously very cost effective for Arlo to manufacture. Secondly, it also brings clear benefits in terms of connectivity and data processing. Once the base station is connected to a households WiFi, all the cameras can connect to it wirelessly and send all the rolling footage in real time to the base station, where all kinds of intelligence can be applied.

Ring and Nest, which operate without a base station but solely through the cloud, often provide a poorer customer experience. There are many compromises that need to be made. The battery drains much faster and the device really needs to be used as little as possible. It has to constantly send tiny shots to the cloud, to which things like facial recognition and other intelligence can then be applied. With Arlo, a lot of the computing can be done in the base station, resulting in a much smoother experience.

How big is the opportunity?

One of the reasons Ring has worked so well as a business model is that the company has always been able to effectively use the cash flow from its subscription revenue 1) for advertising, their aggressive marketing strategy, and 2) lowering the price point hand in hand with the ASP of the industry over time, even offering a camera for as low as $59 now.

While I don’t think Arlo‘s management would ever consider cutting prices for their cameras, the additional cash flow generated by subscriptions will give Arlo more options to increase marketing spend. The product is great, and I’m convinced it just needs more awareness. The hardware part of the business will likely grow again once Arlo allocates some money to marketing.

The global market for DYI cameras is growing at about 15% every year, Arlo may be moving slower but will capture the market of people who are 1) less price sensitive or 2) really don’t want big tech companies, Amazon and Google, in their homes. And as long as Arlo manages to maintain its technological superiority over Ring, there is nothing to stop the hardware business from growing steadily at about 5% per year.

Being realistic, Arlo will never be what it once was, and the way I see it, they’re only going to grab the high-end of the market – Ring has won the game, and pushing it from the throne will be impossible. Simply because Amazon’s distribution power is so powerful.

The price of Arlo devices will likely remain at constant levels, while average devices per user may increase slightly as Arlo expands its line of “smart home” devices. But as I’ve pointed out several times in this article. The hardware part of the business is not the exciting part. It is a critical component and enabler, but the reason I really buy this company is the subscription division.

Arlo is already achieving spectacular conversion rates in the subscription business. While according to a former director of Ring Europe, Ring’s conversion rates are above 75%, Arlo is seeing spectacular conversion rates of sometimes even over 80% (although this figure is still quite inconsistent).

When comparing Ring to Arlo, it’s important to keep in mind that Arlo appeals to a different set of customers who are truly concerned about security and are willing to pay more for an independent brand. For these customers, a monthly fee is acceptable, and conversion rates for the subscription will likely be high.

Conversion rates are probably one of the most important factors to consider when evaluating where Arlo’s subscription business is going. I forecasted that by 2030 an additional 10 million households will join Arlo’s ecosystem. At an 80% conversion rate this would mean that 8 million households would start paying a $120 subscription fee. What an exciting business, if you’re earning a billion dollars in recurring revenue, and have a 80% gross margin on that! This would be literally printing cash.

Unfortunately, the $120 subscription fee does not translate into $120 in revenue, and there are a number of factors that complexify service revenue. Upon my request Arlo’s IR told me that while for the domestic retail business and the subscribers added through the Verisure partnership in Europe, it is reasonable to assume that their $10 per month plan (recently increased to $13) is fairly representative of their domestic retail ARPU, there are additional factors that lower revenue per subscriber.

Because of its relationship with Verisure, Verisure’s pricing is usage-based, which means its revenue per subscriber is lower. Still, the company maintains a healthy gross margin in this business.

In addition, there are non-recurring enginerring costs (NRE) for the work Arlo does for Verisure to develop a custom camera to their specifications. These costs significantly reduce the $120 revenue, bringing it down to currently $85. Since these NRE costs vary and tend to increase with additional partnerships, it is very hard to forecast where the „revenue per subscriber“ metric is going. For my forecast I made the assumption that it would bottom out somewhere in the $60s/per subscriber.

While this is kind of a complication in modeling the evolution of the Arlo subscription business, I think it’s pretty clear that an additional 10 million households subscribing to your “Arlo secure plan” is a massive opportunity.

You also have to remember that the existing 7 million households that have Arlo installed will need to replace their old camera after 4-5 years. For the Pro2 camera and older models, storage is still free, but starting with the Pro3 camera, which was launched in the fall of 2019, users will now have to pay a subscription. So in 2025, we will likely see the first households needing to purchase a new camera system that no longer has the free 7-day storage – it will be interesting to see whether those stick to Arlo or go for Ring.

As subscriptions grow as a percentage of Arlo’s total revenue mix, margins will improve massively. The inherent gross margin for services will likely be around 80%, a typical software margin. Combined with the hardware margin of 15-20%, the total gross margin could be close to 60% by 2030.

Five years from now, in 2028, you’ll get a company that has $1 billion in revenue, notes a 13% revenue growth, a 55% gross margin, and 15% FCF* margin (adjusted for SBC). Adjusting the FCF of $150 million for an assumed shareholder dilution of 6% per year through 2028, it would result in $1,05 FCF/share.

Applying a conservative 15x multiple to this free cash flow, we would arrive at a share price of USD 15.75. An upside potential of 320% from current levels, corresponding to a 5-year CAGR of 33.5% p.a.

For these returns to materialize, management must be able to keep administrative costs constant so that a most of the subscription revenue can be converted directly into free cash flow. In addition, Arlo’s hardware DNA must transform into marketing DNA. Ring has been very successful in selling o.k. cameras to the masses thanks to its brilliant marketing. I’m still on the fence about whether it’s a disadvantage that Arlo has over-optimized the product and is therefore still too high-priced. For the average consumer, the technological difference between an Arlo and a Ring camera is hard to see at first glance, but the price difference is there.

Top-Line

 
 
 

 

Bottomline

Exhibit, Earnings Call 3Q2022:
„While we were pleased with our execution against a challenging supply picture, near the end of Q3, we started to see a shift in consumer behavior, where broad-based inflationary pressures, coupled with the threat of recession are dampening consumer demand industry-wide.
With a weaker demand outlook, our retail partners are moving to increase promotions and lower inventory. In consideration of this, we took immediate action to adjust our strategy and match our operational footprint to this new outlook for Q4 and 2023.

First, we decided to pause, our branding campaign. As we discussed, the initial awareness spend was a test implemented to measure via paid account uplift over our baseline subscriber run rate.

However, despite creating nearly one billion impressions and a promising list in consideration in the first six weeks, the volatility of the baseline in this market makes it difficult to effectively measure and evaluate the efficacy and ROI of the spend. So this spend is paused indefinitely, until we see the market return to a more positive and stable trajectory.

Second, we initiated a review of expenditures across the company to identify areas of further optimization of our business. We have well-defined plans to lower run rate in various areas of OpEx to ensure we are structured to maintain our most important levers of top line growth and achieve our long-range plan in the most efficient and disciplined manner“

As Arlo optimizes operating costs, I believe positive FCF for the full year is no more than a year away. However, taking into account stock-based compensation, we won’t see positive FCF until 2025 or even 2026.
I expect Arlo’s awareness campaign to relaunch in early 2024. If we annualize the $8.5 million spent on the awareness campaign in the third quarter of last year, we can estimate that Arlo will spend about $30 million to $40 million on additional marketing efforts. It is likely that this number will however increase once a clearer picture of ROI is available.
I am optimistic that, thanks to the OpEx optimizations, administrative costs can be pushed to a much lower level than they are now, and eventually, even together with the increased marketing spend, will only represent about 25% of gross profit by 2028, instead of the current 80%. R&D spending will likely be increased in line with Arlo’s revenue growth. This is absolutely necessary, because all that differentiates Arlo from Ring at the moment is its technological advantage and perhaps design.

Restoration Hardware (Ticker: RH)

RH is a good example of a very well-executed turnaround and operational improvement driven by a strong owner operator. The company has been able to introduce a new omni-channel retail model in a traditional industry, with customers attracted to the company’s design galleries, a desirable place where they can have an immersive contact with the company’s products. However, at the current stage I am not convinced about the potential of the business for a number of reasons:

  •  RH’s business model is strongly related to the housing market and as such might face further difficulties: the furniture industry is strongly correlated with the housing market and current outlook is challenging due to potential deterioration in macroeconomic sentiment.
  • RH’s growth over the last 5 years was fueled also by a strong price increase: the company has aggressively increased its price points and significantly expanded its selling space. As such, future growth may be more difficult to achieve.
  • RH’s business model is closer to traditional furniture retailers than personal luxury goods companies: RH business while characterized by higher margins than its closer peers, is still very dependent on high inventory, low sales productivity ($/sqm) and limited gross margins. This translates into a lower operating leverage and lower resilience and flexibility to adjust to costs inflation.
  • RH’s current valuation does not seem particularly cheap compared to historical levels and other luxury players: the company is currently trading at ~8x EV/EBIDTA which is in line with the furniture sector long-term average. The company’s discount to personal luxury players is also in line with its historical levels 

Company overview and history:

RH (market cap $6.7bn) is a premium luxury furniture company operating in the US. The company was founded in 1979 by Stephen Gordon, it was listed in 1998 and in 2008, on the verge of bankruptcy, it was taken private by L Catterton and its current CEO, Gary Friedman (who today holds a 21% stake).

  •  After the take private, the company went through a transformation to reposition itself towards high-end furniture and started to replace its old-style stores with “design galleries” offering customers a more immersive and refined experience of RH products. The company went public for the second time in 2012 and has had some initial success, driven by its new positioning.
  • In 2016, RH started to restructure its operations and has since been very successful in streamlining and optimising the business.In In addition, the company continued to shift its positioning towards the luxury world with the aim of becoming a lifestyle brand. In recent years, RH has further expanded itself by opening restaurants on the terraces of some of its stores to drive traffic and announced other luxury initiatives such as a high-end guesthouse and a yacht.
  • 2020 represented the perfect time for the company: operations, particularly inventory management, and (by consequence) profitability were much improved, while sales soared as furniture companies were strongly supported by pandemic tailwinds. Share price surged to ~3 times the pre-covid levels.
  • 2022, back to reality: The broader market correction brought the stock back down to its pre-pandemic levels with the fear of a recession weighing on the company’s performance. Supply chain issues further deteriorated the situation.

POSITIONING IN THE MARKET

  • The global furniture market is a large (+€500bn) and very fragmented market with small local players competing in specific niches.
  • Premium and luxury segments represent a sizeable part of the market (~25%) with higher profitability levels and a brighter outlook compared to their mass market counterpart.
  • In particular, the luxury market (~€50bn) has shown strong resilience during COVID-19 and bounced back in 2021 to levels beyond those of 2019.
  • Unlike personal luxury which is more retail focused, luxury furniture still strongly relies on wholesale (~70% of sales).
  • RH has gained share in the fragmented $118 billion (U.S. Census) domestic furniture and home furnishing market in recent years, curating differentiated offerings from specialized global artisans. The firm has broadened its brand awareness by expanding into underserved categories including modern, teen, and hospitality, where few peers have scale, helping capture incremental market share from boutique competitors.
  • Brand equity should remain stable given the pace of tailored store buildouts, category expansions, and consistency of pricing, but the diverse end-market expansions RH is pursuing could make it difficult to capture a cost advantage.
  • Entry into $200 billion hotel industry and $1.7 trillion domestic
    housing market should help support high-single-digit top line growth.
  • RH’s e-commerce business helps enhance brand awareness. I believe RH’s focus will be to strategically expand its global presence over the next decade via a wider set of luxury product offerings (yacht, plane), alongside a multipronged gallery strategy set to suit local market demands.

 CURRENT SITUATION

  • Higher interest rates, slowing housing sales, and fears of a recession are all taking a toll on RH. However, those things are temporary, and this company has proven itself an extremely profitable leader in a space that will never go away. People aren’t going to stop furnishing their homes, and RH will be there to grab that revenue in the years to come.
  •  RH was one of the first retailers to report rapidly slowing consumer demand in March 2022. This hints at a unique risk factor for RH investors, the company’s luxury consumers are heavily dependent on asset prices. A prolonged bear market would likely take a heavy toll on demand for RH’s bold vision.
  • Over the next two quarters, based on my thesis of persisting macroeconomic challenges in the U.S., I expect the company to generate softer revenue growth, despite the launch of RH San Francisco, and the introduction of the Contemporary Collection.
  • However, I anticipate that margins will increase driven by solid sales associated with the Contemporary Collection, which is priced at a considerable premium to RH’s legacy furniture collections.
  • RH is well-positioned to expand the business, to include not only its current focus, high-end furnishings, and hospitality, but also real estate development, entailing the construction and marketing of fully furnished luxury homes, condominiums, and apartments, with integrated services. Ancillary business projects planned include, fee- based: architecture, interior design, and landscape design services; guest houses to accommodate travellers; and luxury yacht and private jet charter services.

GARY FRIEDMAN

  • Despite macro headwinds and ferocious competition in this fragmented market, I believe its much more important than in any
    other investment case to understand the visionary behind RHs reinvention.
  • He is credited with turning around RH, which was on the verge of bankruptcy when he joined in 2001.
  • Gary, a retail veteran, started at Gap as a stock clerk and eventually worked his way up to managing 63 stores in Southern California. He then spent 13 years at Williams-Sonoma Inc. where he led Pottery Barn from a $50 million tableware business to a furniture brand with sales of more than $1 billion.

VISION

Sell a vision, not a product: a crucial step in the company’s transition to more premium furniture was the switch in real estate strategy from traditional-looking retail stores to its “design galleries”.

  • These are much larger shops (>30k square feet vs 8k square feet for legacy retailers), creating an immersive shopping experience, located in historically significant buildings in top metropolitan cities.
  • Compared to legacy retailers where less than 10% of product range was displayed, in the new design galleries >30% of the company’s product is showcased. As a result, this creates a better customer experience, incorporating also hospitality elements such as rooftop restaurants and wine bars.
 

EXECUTING ON THAT VISION

The transition has allowed for better economics with the improved sales levels compensating for the extra cost.

  • The company’s operating model was successful with new design galleries driving strong sales growth and margin expansion.
  •  However, the business and supply chain complexity greatly increased and the company started to have inventory problems.
  • In fact, while the company was growing at a double-digit rate, return on inventory was not improving (as it should thanks to economies of scale) highlighting an operational issue. At the same time, RH was also burning a significant amount of cash.
  • After RH’s IPO, RH demonstrated double-digit same store growth from 2011 to 2015.
  • However, with same store- sales growth decreasing and eventually reversing in 2016, the inventory problems started to become evident.
  • Sales growth was the result of the company’s large range of products but that also led to poor inventory management.
  • When the market realised this issue, the company lost more than 70% of its value
 

CONCLUDING REMARK

RH’s CEO has historically shown his ability to go against market odds and deliver strong returns to shareholders. Should he be able to weather the current difficulties, RH could definitely constitute an attractive short-term financial investment. However, given the fundamental attributes of the business I believe that RH does not constitute a strong candidate for a long term investment.