Breaking Down What RH CEO Gary Friedman Had to Say

In this podcast, Motley Fool analyst Bill Mann discusses topics including:

• The record year that RH (RH -1.99%) just closed.
• Why RH is doing a 3-for-1 stock split.
• What he made of the CEO's comments.

Bill also answers a listener's question about small-cap stock 22nd Century Group. And Motley Fool analysts Tim Beyers and Andy Cross talk with Jay Chaudhry, CEO of Zscaler (ZS -2.17%), about what other cybersecurity companies are missing and the biggest misconception that Wall Street has about his company.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on March 30, 2022.

Chris Hill: Today we're going to talk with the CEO of a cybersecurity company, analyze the comments of a retail CEO, and explore a small-cap stock that just popped up on our radar. Motley Fool Money starts now. I'm Chris Hill, joined by Motley Fool senior analyst Bill Mann. Thanks for being here.

Bill Mann: Hey Chris, how are you?

Chris Hill: I'm doing well. I'm not a Restoration Hardware [Ed. note: The former name of RH, changed in 2017] shareholder, but I am fascinated with what is happening both with this stock and this company. Let's start with the fact that they closed out a record year -- you wouldn't know it from the fact that the stock is down 12 percent today. Before we get to the comments from the CEO, which a lot of people are focusing on, for --

Bill Mann: Which are amazing.

Chris Hill: Which are amazing, and it is appropriate we should be focusing on these comments. But before we get to that, what did you think of the quarter? Like I said, they closed out a record year.

Bill Mann: Yeah. They did. Earnings were up; they made $5.66 a share if you take out some noncash items, nonrecurring costs -- I'm not quite sure any more what companies consider to be nonrecurring on a GAAP basis -- it was $4.91 a share. Their margins are fantastic. Yes, it was a great quarter by them, but revenues were a little bit light. But then they ended by making the most recent quarter the least relevant part of what we're supposed to be talking about when it comes to this company.

Chris Hill: Right. Before we get to the comments from the CEO, I will just add, this is yet another one of those companies with pricing power. Restoration Hardware makes high-end products for your home. People have been more than willing to buy what Restoration Hardware is making.

Bill Mann: Absolutely. Their margins are up 2,000 basis points over the last decade. They are a tremendously profitable company, both from overall profitability and for the margins of the core products that they sell. Gary Friedman has, and we have given him tons of credit in the past because Restoration Hardware for a bunch of years felt like the second coming of Bombay Company -- a quirky home-goods store that really didn't have that much going on for it, maybe it caught lightning in a bottle in some way. And he came in and he has reformed the company, and he has really turned it into an incredibly credible competitor in that market and in the field.

Chris Hill: Friedman has been the CEO of Restoration Hardware since 2014. He was with the company prior to that. Before that, he was an executive at Williams-Sonoma. I mean, this is someone who has made his career in the high-end retail space. The comments on the conference call, there are really two. The first is, and I'm quoting here: Friedman talked about how the business experienced "softening demand in the first quarter," so this is the quarter they're in right now -- "softening demand in the first quarter that coincided with Russia's invasion of Ukraine." And he talked about how it's prudent for them to remain conservative in terms of their guidance, and I agree with that. But this is the first CEO who has talked about Russia's invasion of Ukraine, not in terms of supply chain, but in terms of softening demand. How are you interpreting this? Because again, nobody else is talking about this. A lot of other companies have come out and talked about the effect on [the] supply chain.

Bill Mann: Right. Well, he's absolutely right. Keep in mind where Restoration Hardware is, maybe in the entire framework of consumer confidence: They are high-ticket, low-velocity items. You're not "well, I've got a couch last week, I think I need another couch this week." For him to come out and say that these high-ticket, low-velocity items immediately dropped off at the point of the invasion, Russia's invasion of Ukraine, and it's important to point out. He's not saying that the two things have a link. He's just saying that the timing was there. So it could be that interest rates have taken off at the same exact time and that's the driver. But what he is saying is that consumer confidence fell off a cliff very suddenly at that moment in time, and perhaps it has to do with the fact that we are now feeling inflation. Perhaps it has to do with the fact that it now costs some people $150 to gas up their car. Who knows what it is? He is not assigning any sort of causality to what he pointed out was happening at the same time. He is really very much wondering, though, if people in Washington really are paying attention.

Chris Hill: Later in the call, he got asked a pretty vague question, an open-ended question.

Bill Mann: "Hey, how are you doing?"

Chris Hill: One of those questions that enables the respondents a lot of directions they can go in, and holy cow, did Gary Friedman go into a lot of different directions. He talked about inflation, input costs for the company, the price of housing, and to top it all off, he invoked the collapse of Bear Stearns in 2008, leaving a number of people including me wondering: Wait a minute, is he trying to rationalize what is happening with his business at this point in time? Or is this someone who can see the future? Because if he is predicting the future and he is right, it means we're all in for a lot more economic pain.

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

Chris Hill: God, I can't wait for 90 days from now when they report again.

Bill Mann: No kidding. Here's the thing. Gary Friedman is a great CEO. He really did take Restoration Hardware and transform it from an also-ran, who would have ever noticed if they went bankrupt, to a really reasonable proxy for what's going on in that segment of the market. This is not an excuse-making CEO by any stretch of the imagination.

Chris Hill: It's also not a CEO who is prone to saying things just to get into headlines.

Bill Mann: No.

Chris Hill: Last thing on Restoration Hardware before we move on. Also overshadowed in all of this, they announced a 3-for-1 stock split, the exact date is to be determined. But similar to Amazon, they talked about [how] we're doing this so we can enhance our ability to recruit and retain talent. Sure, why not? I have no problem with this.

Bill Mann: I guess what is definitely true is that high share prices make it hard for them to be precise with these types of grants. I think that there's so much myth-making about stock splits adding any value to companies. And I would encourage people to think about the pizza analogy, like how much pizza, if you've cut the same pizza into four or eight slices, it's the same exact piece of pizza pie. But in this case, I think that they really are trying to be more precise with how they can award their employees. Great, it's news. I don't think that they are doing it right; everybody else seems to get their stock prices to go up a ton when they announced stock splits. So I think Gary Friedman, I'm joking of course, but there's some improvement there that I think he could work on for next time.

Chris Hill: I want to give a shout out to one of our listeners, Steven, who posted a review of the show on Apple, and he included this question. He wrote, "I want to get your thoughts on 22nd Century Group (NASDAQ: XXII). The ticker symbol is XXII. They are the first company to get approval from the FDA [U.S. Food and Drug Administration] to sell low-nicotine menthol and conventional cigarettes, and they are doing a test pilot at Circle Ks [Ed. note: Circle K is a subsidiary of Canadian company Alimentation Couche-Tard.] in Illinois. This company could potentially be the king of tobacco. What are your thoughts?" Thank you, Steven, for the review and for the question. I'd never heard of this company before. Market cap's around $400 million. I am not necessarily someone interested in tobacco companies. But certainly you look at a business like Altria [Group], shareholders have been handsomely rewarded for owning that stock for decades.

Bill Mann: That's very true. It is a low-nicotine product. The product is called VLN [King] and then VLN Menthol King. I am not a smoker though I am from North Carolina, so I can speak very appreciably, authoritatively about smoking. I always thought that the nicotine was at least partially the point of smoking, that that was the draw, so I don't necessarily know what the attraction for low-nicotine smoking is if it's the actual enjoyment of the process. That said, nicotine is the addictive compound within tobacco. So if it is something that would allow people to smoke because they enjoy it, but smoke less and not worry about the long-tail problems from too much nicotine consumption, I think it's great. This is the kind of company that has got a lot of promise out there. There is plenty of time for you to own this company. Like I would absolutely positively wait and see until you see a little bit of traction in low-nicotine tobacco. But if it works and if people are attracted to it, I think you may have something there. But there's plenty of time.

Chris Hill: I was going to say, particularly with the pilot tests they're doing in Illinois, it does seem like the business that -- if you're following it and there probably aren't a lot of people who are following; this is not Apple, there are probably no analysts on Wall Street who are covering this business. But you probably can figure out how the pilot test is going, particularly if you have to assume that the company, if there's any sort of success and they expand the pilot to other states, they're going to make that now.

Bill Mann: You could absolutely positively do what Philip Fisher called scuttlebutt. Once these cigarettes are in the stores, wander in to your local Circle [K] and ask the guy behind the counter how they are selling. I mean, if they're sitting there backed up, you have a little bit of information on what the answer is. Again, I tend to consider, obviously, Altria has been a spectacular investment for people over the last, I don't know, call it 40 years, which is at this point statistically relevant. I'm not sure what the market would be for this, but I understand the theoretical attraction of a lower-nicotine cigarette. It's hard to say for health reasons, but I mean, that's what it comes down to, isn't it?

Chris Hill: Absolutely. Thank you again, Steven, for the question-and-answer posting the review. Again, you can pitch us a stock. Hit us with a question or a topic idea. When you post reviews on Apple and Spotify [Technology]. Bill Mann, thanks so much for being here.

Bill Mann: Hey, thanks Chris.

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Chris Hill: What does cybersecurity mean when you're working from home and doing business in the cloud? Jay Chaudhry is the CEO of Zscaler, a cybersecurity company built on the idea of zero trust. Recently, he talked with Andy Cross and Tim Beyers about what other cybersecurity companies are missing, and the biggest misconception that Wall Street has about his [company]. But Tim kicked things off with a very straightforward question.

Tim Beyers: What is Zscaler? And what is so important about what Zscaler's doing, especially right now? I think there's a lot of people that are interested in what you're doing right now.

Jay Chaudhry: We all know that technology is changing over time. It's changing the way we live, the way we work, where we work for. There are incremental changes that happen, and there are disruptive changes that happen every 20 to 30 years. For the last 30 years, the world has been doing networking and security in the old way we called castle-and-moat security. The new way is "zero trust" which says: Trust no one, there's no castle to hide inside. Your applications are everywhere in the cloud, SaaS [software as a service] or wherever. Your users have left the castle, they're working from everywhere. In this world, a new paradigm was needed.

Just like we've seen disruptive changes in other parts of technology, for example, DVD players used to be wonderful to play music, then Netflix streaming came; it was a totally different way of listening to music. In another example, think of our traditional cars. That internal combustion engine car was built about 100 years ago. It has slowly been refined and gotten better and better. But when Tesla came with electric vehicle[s], EV engine[s], life was very different. In the same way Zscaler came in and said, [the] old way of doing security no longer works, we need to do a new way, the zero-trust security, where we securely connect the right user to [the] right application, not the network. That's the most disruptive part of it, and that's really what's needed to secure our customers, their data and their applications. That's why just under 40 percent of Fortune 500 companies are Zscaler customers, and just under 30 percent of Global 2000 companies are Zscaler's customers -- because they need this new type of security. That's what I started in 2008 to build from a clean slate.

Andy Cross: Jay, building on that, I've always been impressed by the fact that you've recognized this opportunity and taken it, but also wondered why isn't everyone else thinking zero trust? Or maybe that they are now, but why is it hard to innovate and adapt in the security environment, such that you were able to step in with your team and your innovation, and your foresight? Essentially you didn't create or invent the term "zero trust," but you really have brought it to the forefront.

Jay Chaudhry: Andy, the answer is actually pretty simple. It is said that technologies that make you successful in a given paradigm, hold you back from being successful in the new paradigm. Think of many examples. You think mainframe companies could ever build a new kind of computers? Not really. Think of [the] software world. We all know CBO software used to dominate in the Salesforce[.com] area. Salesforce, a tiny company, came from nothing but with a clean slate; they built a cloud-native multitenant architecture. PeopleSoft used to dominate the HR [human resources] system space; Workday came from a clean slate that built it.

In the same way, we have so many legacy network security companies building firewalls, VPNs [virtual private networks], and all that type of stuff, and they keep on adding features after features, but it's the wrong architecture. The reason we became successful is because we had no legacy security to worry about. I could dream with a clean slate of paper and said if applications are in the cloud, users are everywhere, where are you going to keep on putting your firewalls? There's no place to build the moat. So let's build a switchboard, the opposite of [a] moat. You come to the switchboard, you say, "I want to talk to someone." We stop: You say, who are you? Show me your credentials. Where are you going? Are you allowed to go there? If all those conditions [are] met, we connect you. If they don't, we don't let you connect. There's no such thing as you're inside my network; you're outside a network, you're always untrusted. You're trusted to connect to one thing at a time, and then that trust has gone. New architecture, new mindset.

Now, the question is, if things are hot, why aren't some of these big network security and firewall companies jumping in? Well, building new architecture is not easy. Let's use the auto example. How long ago did Elon Musk start Tesla? About 10, 12 years ago? All these car companies are watching; do you think they wanted to build these cars? Well, for a long time they're hoping that this thing goes away, this won't work. In the same way, network security vendors were hoping that what Zscaler's doing will never happen, odd boxes will always be needed. And then later on they said, if I need to get there, let me bolt on a few things on top of my firewall, spin them in the cloud, and call it cloud security, because building a new architecture takes a long time. Architecture [is] like the foundation of the building. If you build a building for two-story building, architecture and foundation is different. If you need to build that 20 or 30 stor[ies], it's a very different foundation, and you can't keep on building on top, you need to start from a clean slate. That's what we've done. That's our barrier to entry, and others can't easily come and catch up.

Tim Beyers: If we could wrap up on this one. Let's do a quick thing here because it's inevitable that all companies have a story. What is it that folks who are following you, [on] the Street or otherwise, don't really yet understand about Zscaler that you wish they understood?

Jay Chaudhry: I think the Street and investors sometimes think that old technologies can be bolted on to become new architecture. The Street doesn't understand that architectures need to start from a clean slate. You can't bolt on an electric engine on top of a traditional car and say "I got the best electric car." In the same way, you can't build zero trust on firewalls and VPNs. That's why these customers are buying us, deploying us, and they are speaking about how well Zscaler helped them to realize these business goals. It helps the businesses, and it helps the professional career of these IT leaders.

Tim Beyers: Awesome. Jay, thank you so much for joining us today. We really appreciate it. We are going to be watching Zscaler with keen interest and obviously we hope you come back. We'd like to keep having these conversations, if you wouldn't mind.

Jay Chaudhry: Of course, Andy and Tim, thank you for the opportunity.

Chris Hill: That's all for today, but coming up tomorrow, we'll answer a straightforward question of our own: Why does the stock market go up?

As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill; thanks for listening. We'll see you tomorrow.