#120 - The Great Awokening, Buffet Backed Nubank, and Bored Apes Are The New Amex Black
In this week's episode of Reformed Millennials, Broc and Joel tackle Tanay’s piece on Nubank and the emerging market banking system, Web3’s impact on government, and what the great awakening means for millennials. If you want some interesting takes on startup valuation and market sentiment, we highly recommend you tune in for this week’s show.
Listen on Apple, Spotify, or Google Podcasts.
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👉 For specific investment questions or advice contact Joel @ Gold Investment Management.
Today’s Chart of the Day was shared by Steve Strazza (@sstrazza). It’s a chart of the Industrial sector ETF, $XLI, year-to-date. The largest weighted stocks in $XLI include $HON, $UPS, $UNP, $BA, and $RTX. Several key sectors and indexes are retesting their recent breakouts this week. The Industrials sector is one of the more important ones to watch here as it has historically been one of the most correlated sectors to the S&P 500. In a comment to the Chart Report, Steve said “Industrials are my cheat sheet to the overall market direction right now. So far, this is just a classic retest, which is completely normal. If we’re above that ~$105 level, things are probably fine. But, if $XLI fails to hold that level, it would be time to start looking around for other warning signs.”
From JP MORGAN:
“Easing US-China tariffs are a potential non-consensus equity tailwind .. The benefit to US stocks’ EPS would be material, with improving margins and easing supply chain issues. The sectors most impacted by the trade war now stand to gain the most.
A reversal of existing tariffs could represent a direct EPS benefit of $5 for the S&P .. Trade tariffs have cost consumers and corporates a total of ~$128B cumulatively and $44B alone so far this year .. a partial unwind would be a source of margin and earnings upside.
Nubank is the world’s largest neobank with over 48M customers in Brazil, Mexico and Colombia, including 1.1M SMEs.
While the end goal for many fintech companies is to be a bank, very few start off like that. Most start with a single product typically targeted at their core customer segment which serves as a wedge and then layering on other products as they make their move towards becoming a bank.
Nubank started off with a credit card product, which was their initial wedge to acquire customers. Since then, they have expanded their product suite over time, with the pace of expansion continuing to accelerate, as in the chart below.
Balaji vs. Ferris - The great Awokening
💸Reformed Millennials - Post of The Week
The Restoration Hardware Business Model: $RH
The rise of modern brick and mortar. Furniture's version of Apple.
If you have 15 mins, watch the 3 videos attached at the bottom of this.
Retail -->Imaging your "new" life
In the last 10 years, RH’s real estate footprint went through a transformation. Their showrooms can be broadly aggregated into two segments: legacy galleries, and design galleries. Design galleries typically consist of multiple floors and ~30-50k sqft big, almost 3-5x in size of a typical legacy gallery. The idea of the design galleries is to elevate the luxury status and blur the utility nature of the products RH is selling. These new format galleries include restaurants, bars, gardens etc. which create a sense of luxury house rather than a retail store. I have checked out the restaurant menu; the food price seems reasonable. The inclusion of restaurants/bars within the store is more of a strategy to increase foot traffic and maintain a lively environment. The increased foot traffic is an important barometer to get good deals for its real estate which I will discuss later. As per this article, Chicago RH was the 7th most Instagrammed café in the US in 2017 and RH West Palm Beach location was trending 35% ahead of Chicago’s first-year numbers (interestingly, RH, the brand itself, has no IG presence).
See attached video
The first design gallery was launched in 2011 in Los Angeles and Houston. In its S-1, RH mentioned that “in the Los Angeles market, we have increased store demand by 85% and direct demand by 30% and in the Houston market, we have increased store demand by over 60% and direct demand by over 50%, in each case from the date of opening our new full line Design Gallery in that market to May 19, 2012.”
Why did Friedman shift their strategy from legacy galleries to design galleries in 2011?
I am not sure what prompted this change, but after the initial success of the first two full-format design galleries, RH decided to lean into this new format and radically change its store footprint by gradually closing legacy galleries and launching these new, very posh looking design galleries. In its S-1, RH identified 50 metropolitan markets where they would open design galleries and predicted in 2012 that their selling square footage in North America would double over the next 7-10 years. As you can see below, that prediction turned out to be a bit too optimistic, but even then I think we wouldn’t find too many physical retailers in North America in the last 10 years at RH’s scale which increased their sqft footprint by almost 50% when Amazon was wreaking havoc on the entire retail industry. This shift in strategy is evident in the store footprint numbers; in 2012, design galleries were only ~18% of total selling sqft which increased to ~72% in 2020 whereas legacy galleries share went down from ~80% to ~25% during the same time. Despite opening these ~3-5x sized galleries compared to legacy ones, sales per sqft increased by ~10% (not CAGR) over the last 8 years. But the business enjoyed impressive operating leverage as it increased gross margin from 36.6% in 2012 to 46.5% in 2020, decreased SG&A as % of revenue from 42.4% in 2012 to 24.1% in 2020, and hence significantly improved operating margin from -5.8% in 2012 to 21.8% in 2020.
Friedman shared bit of a funny story at 2017 Goldman conference how they decided not to pay for ads on Google:
“We had a marketing meeting in the company several years ago. And the online marketing team was pitching to double their budget, right? And at the time, saying, “Look, nobody in the company is doubling their budget, but tell me why you believe that’s the right thing to do.” And they said, “Well, look, our customer acquisition costs and our ad cost is the lowest in the company.” And I said, “Well, tell me about the data. Show me how.” And they said, “Well, people who click through the words that we buy on Google, the ad cost was the lowest.” And I said, “How do you know that they’re clicking on the word and going to the website because of the word you bought, versus they saw a store or they received a Source Book?” They said, “Oh, we know.” I said, “Well, how many words did you buy?” And they said, “3,200.” 3,200 words. I said, “Well, what are the top words? How are they ranked?” Yes, they ranked into the words that, “Oh, we don’t have that,” right?
And I was getting the look at like oh, Gary’s kind of one of these old brick-and-mortar guys. He just doesn’t get it. I said, “Well, what are the top 10 words?” And they didn’t have the information. I said, “Why don’t we cancel the meeting and come back next week when you have the data? I’m sure the Google sales representatives who are taking you to the expensive lunches and selling you the 3,200 words have that data. So why don’t we get the data and then let’s review the data.”
And they came back the next week and we sat in a meeting, and all of a sudden, I can tell there’s a little change in the faces. The heads were kind of down, everybody kind of came in. I said, “So what did we find out?” And they said, “Well, we found out that 98% of our business was coming from 22 words.” I said, “Wait, we’re buying 3,200 words and 98% of the business is coming from 22 words? What are the 22 words?” And they said, “Well, it’s the word Restoration Hardware, and the 21 ways to spell it wrong.” Okay? Immediately, the next day — okay, immediately the next day, we canceled all the words, including our own name. By the way, we were paying for the little shaded box above our words, and they said, “Well, no, we have to hang on to that because Pottery Barn might squat on top of us.” And I said, “Excuse me?” I said, “If someone goes to a mall or a shopping center, and they’re going to Restoration Hardware and there’s a Pottery Barn there, they’re already squatting, okay? It doesn’t mean they’re going to go into their store.” If somebody wants — Tiffany’s was just here. If somebody wanted to buy a diamond from Tiffany, and just because Zales is sitting on top of them in a shaded box doesn’t mean they’re going to go to Zales and buy a diamond.”
Given the shift to a larger size store format, one might wonder about the capital intensity of this new format. RH leveraged its ability to drive foot traffic and since it has effectively become one of the anchor tenants, it modified its real estate strategy over the years to ensure ROIC remains attractive. In the past, a typical RH store had contracts with landlords that included minimum rent, and then escalating rent based on % of sales after minimum thresholds are reached. As RH moved to design gallery format, they had opportunistically pursued either of the following three strategies (more details can be found in 2018 Investor Day):
a) Capital light leasing deals: While in the past landlords contributed 35-50% of the capital, RH mentioned landlords now contribute anywhere between 65-100% of capital. With their rooftop hospitality/restaurant experience attached to each showroom, RH managed to become a key driver of foot traffic which gave them leverage to get sweetheart deals in recent years for the design galleries.
b) real estate development model: In this model, RH develops the showroom and enters into a sale-leaseback with the landlord. Friedman explained the rationale in 2018 Investor Day:
“So the key benefits, it gives us the opportunity to buy and develop unique retail locations, the ability to structure the sale-leasebacks with significantly lower rents. The key is we’re cutting out the middleman. We don’t need the capital of the developer. And frankly, they don’t add a lot of value when we’re a key driver of great customer — high-income customer traffic, and we have this beautifully integrated experience like this. Going to having a developer in the middle of it really adds no value. Their capital is more expensive than ours is. They’re generating their own profits, and we’re able to cut that out. We can eliminate percentage rent we — and expensive triple nets and pass-throughs, and we’re also minimizing depreciation and amortization. Of course, if we have money left in a development, we have to depreciate and amortize that, so that’s an earnings drag.”
c) Joint venture projects: Let me again quote Friedman from the 2018 Investor Day to explain this model:
“This is a situation where we’re able to value — to really leverage the value of RH lease to create a joint venture or profits opportunity with minimal capital investment by RH…this is typically where we can’t buy it. Someone owns it, they want to do a lease with us. We come to them and say, we’re not going to do a lease, but if you want to participate in some of the upside and we participate as well, we’ll structure a joint venture. This is one where we contribute the value of our lease in exchange for the joint venture profits interest in the project, and our profits interest is paid upon a sale or refinancing of a project within 5 years or less, typically.”
Apart from real estate deals, RH also made significant changes in its supply chain.
In its 2015 10-K, RH mentioned they had 6 distribution/fulfillment centers spanning 6.2 mn sqft. RH streamlined its fulfillment centers and reported only 3 fulfillment centers spanning 3.9 mn sqft in 2020 (planned to open another one in 2021 whose size is 1 mn sqft; also had one fulfillment center for Waterworks which was acquired in 2016). They also had 6 home delivery center locations and they even used 3 DCs for some home delivery. Instead of 6 smaller-sized home delivery centers, RH now has just one large home delivery center. If you want to return furniture, it goes to one of the 38 RH outlets where RH sells these products at a significant (up to ~70%) discount. While design galleries and outlets are different concepts, the mere existence of these outlets can potentially put a dent in RH’s ambition as Rishi explained:
“true luxury almost never sells at a discount. They will burn inventory but almost never sell at a discount. It may not qualify for true luxury (Ferrari, Hermes, LVMH) just based on this. Maybe better to call it a brand”
Because of the expanded store size of design galleries and the fact that it operates as showrooms and hence no huge inventory, it can accommodate ~30% of SKUs per gallery vs only ~10% SKUs in legacy galleries. Once a customer order either online, in-store, or by phone, the delivery can take weeks depending on product or availability. For larger merchandise and furniture categories, RH delivers the products by its own delivery professionals, but they also use third parties such as UPS to deliver some products. The delivery fee is dependent upon how far the nearest gallery is from your location (see delivery schedule below). These supply chain and logistics changes are important part of the RH’s transformation in the last 5 years. Days of inventory on-hand decreased from ~146 days in 2017 to ~118 days in 2020.
As alluded earlier, you can also order online, in fact, almost half of the sales come from online/sourcebook/trade contracts (B2B sales). If I had to guess, it would probably rank in this order:
While e-commerce has been a secular force, RH understood the inherent difficulty of building a luxury brand online. Friedman explained how the economics online can potentially be far more ruthless than in the physical world and if only a brand has a significant cognitive recall can it have a chance of profitably scaling online:
“The other thing we believe is that the web is the most democratic channel. It is the most democratic channel. It is the most difficult to differentiate. Holly’s Home Store looks as big as Restoration Hardware online, right? So we all have the same size storefront online. And in many ways, it’s an invisible storefront. You don’t walk by it. You don’t see it. But a consumer would have to click on our website 10,000 times to understand the real difference. So we believe it’s the most democratic channel."
The other thing we believe is the web is not the most profitable channel, and I think we’ve been saying that for 10 years and what’s funny as I’ve read so many reports and had so many people talk about their growth in online sales, and the fact is most retailers that have increased their online sales have decreased their operating margins. And I would challenge anybody to name an online-only retail brand that has reached $1 billion profitably. And when I ask that question I usually say, “Anybody? Anybody?” Because there hasn’t been one, right? There hasn’t been one. And I think it’s been one of the fallacies and one of the kind of simplifying assumptions that people have made that if you don’t have brick-and-mortar, you don’t have a cost structure that you don’t need, and therefore, online will be more profitable. And they overlook the fact that an online store is an invisible store. You don’t see it. The cost to acquire a customer for an online business is significantly higher than a retail business.
For brands not selling commodities and it will be the most capital efficient way to scale in a physical world, we still live in a physical world. A lot of people talk about the age of Amazon, and the death of the department stores, and we believe that Amazon falsely accused. The fact is department stores have been dying of old age and a lack of innovation for years. This is nothing new. It’s not just because of Amazon. If I asked everybody here to raise their hand of who likes to go into a department store today? I wouldn’t get a lot of hands, right? You kind of have to go there. It’s not like you want to go there. But I think that, that point has confused people and has gotten people to kind of believe that physical stores are liabilities.”
One other sales channel is RH’s sourcebook which is ~2,500-page catalog of RH products that is sent to RH members. Even if you are not a member, you can order it to be delivered to your address or you can just browse the whole catalog online.
One of the important elements of RH’s transformation over the last few years is RH membership program.
What exactly is it? Friedman was inspired by Amazon Prime’s success. I have a lot of sympathy for the way Friedman views the fickle behavior of customers online. Very few retailers online actually own the customers; almost all of them own mere transactions as customers mostly start their journey on Google, Amazon, or via Facebook/Instagram ads. It is these companies that own most of the customers that shop online and the rest of the world is mostly competing against each other to mostly share lucrative economics with those big tech companies. I suspect even Bezos understood this fickle nature online and I wonder whether he too felt Amazon just owned millions of transactions and not nearly as many customers. Perhaps this prompted Bezos to launch Prime which certainly let Amazon “own” the customers. Friedman too understood how unfair the fight is if you have to compete for the same customer again and again till eternity. In 2016, RH launched this membership program that lets customers sign up for just $100 and enjoy 25% savings on all full-priced items and additional 20% savings on all sale items. Given that almost every single item that RH sells costs more than a thousand dollars, it is very tempting to sign up for the membership program since the discount you receive pays more than what it costs to be an annual member. What it does for RH though is create a significant cognitive recall from their members whenever they are in the market for new furniture. As per its latest 10-k, RH had 434,000 members and 97% of its sales come from its members. Recently, RH increased the membership fees to $150, implying some pricing power here as well. This is also lucrative from a profitability perspective as all the revenue from the membership program has a 100% gross margin. Unfortunately, there is not much disclosure around the membership program, and I don’t know the frequency of purchase and churn/retention of the members.
While RH today is primarily confined in the US (just four galleries in Canada), Friedman has his eyes on Europe. He also does not want to stop at luxury furniture as he appears to have much bigger ambitions with the “RH” brand with plans to launch RH Guesthouse and many other initiatives going forward.
Some really good further reading:
The Visa Opportunity or It’s Last Hurrah?
Visa's share price has fallen 6.7% since Amazon announced it will stop accepting U.K. Visa credit cards in 2022 - an over-reaction in our view.
While the ban is ostensibly about Visa's U.K. fee increases, Amazon is applying pressure on multiple fronts and the U.K. may be a pilot.
However, Amazon's U.K. volume is immaterial for Visa, and its global volume is likely just a low-single-digit percentage of Visa revenues.
We believe there will be a resolution, as with past disputes - the consumer is on Visa's side, and Amazon risks losing business.
Here is a quick framing for the $Visa valuation and why this could be an interesting entry.
Depending on the timeframe $V CAGR'd EPS @ 15-20% over the last ~5-10 years which is nothing new for long-term holders.
The economy coming off Covid lows and cross-border travel/business is not expected to be back to 2019 levels until roughly 2023/24.
On 23/24 forward year (ending Q3) $Visa is trading at ~24x and 20x, discount to trough valuation for any period in the last ~8-9 years.
Valuation matters - investors seem to have needed a reminder.
At 30x Next Twelve Months Price/Earnings would get to share price of ~$250 and ~$300. We don't think it's a stretch, as sentiment for these high-quality businesses tends to ebb and flow with narratives/price action. Uncertainty around next ~3years of recovery and xb.
Elevated savings rate globally = pent up demand for xb, the upshot being the estimates could be conservative, especially with new treatment such as $PFE pill. COVID will persist, seeing with 4th wave now & reminds investors of LT challenges, adding to de-rate with $AMZN headline. (see above link)
The world of faster innovation cycles brings higher regulatory barriers.
How defensive is the $V/ $MA business?
I think it’s safe to argue competitive pressures will take longer to affect growth, and both will grow EPS at similar rates post 2024 as pre-COVID.
The war on cash continues.
🌊Companies To Peruse🌊
PartyRound - An automated fundraising tool for founders - Raises $7m Seed
🔮Best Links of The Week🔮
Idea Legos - Ideas can build on each other like legos, just like software. Ideas are composable. from not boring
The Face of Inflation: An Energy…Mistake - Peter Zeihan
Near Record ARKK Underperformance - Bespoke
The Rising Tide of Semiconductor Cost - Fabricated Knowledge
Eric Golden - Bored Ape Yacht Club - Eric Golden is a former Portfolio Manager at Fidelity. We cover the Bored Ape Yacht Club in detail, use Bored Apes as a lens to understand how NFT projects are creating strong membership communities, and explore the tools projects are using to differentiate themselves.
Understanding Nubank - Tanay Jaipuria