Arhaus ($ARHS): why I passed on or the importance of the “little things”

In Praise of the Proxy Statement

Sep 14, 2023

Introduction

This article was expected to be a normal investment thesis but finally it has become a praise of the Proxy statement and the importance of reading each and every document about a company before making a decision.

I have to admit that the analysis of ARHS has been a rather disappointing journey. There are many many things that I like about them, but I found some “little things” that finally made to decide to move on. I spent many days trying to understand the company, the sector, the context… everything. As I will explain, despite there were some concerning issues, in general terms the more I analyzed it, the more I liked. However at the end of the journey, hidden within the Proxy statement, I discovered some aspects that made me reassess my positive opinion about the company. As you will see, those aspects might be considered “little things” by many, but in my opinion in many cases the devil is in the details.

Arhaus is apparently a good company…

ARHS is a premium home-furnishing retailer that sells high-quality expensive furniture to deep pockets. The founder-led company ipoed in November 2021 but has been operating since 1986 and, to be honest, in general terms seems to be doing things right.

The Company has been steadily growing and outperforming the industry:

(Image Source: Author’s chart, Forms 10-K, 10-Q, Earnings releases & US Census Bureau)

There is no doubt that the furniture industry has been one of the COVID beneficiaries, but ARHS has been constantly able to exceed its industry strength despite the many delivery delays it has experienced. Additionally it is being rather successful keeping its margins high in this post-COVID period and especially if we compare with its main competitor ($RH):

(Image Source: Author’s chart, Forms 10-K, 10-Q & Earnings releases)

During the last years ARHS has been able to leverage its fixed showroom costs thanks to its strong demand and overcome the many inflationary pressures materialized in terms of product and transportation costs and the expenses related to its continuous growth.

The company is profitable and generates FCF enough to fund its growth without drawing upon financial debt. Besides it has recently carried out an extensive investment process to increase its manufacturing and distribution capacities and so it is expected to require lower CapEx levels in the near future.

ARHS has plenty of white space to keep growing. Geographically its stores are still present in just half of the States and it is ramping up its openings. Besides it also present optionality in terms of adjacent markets, as it is the case of the B2B contract business, which is something that is starting to try with some (little) collaborations.

(Image Source: Author’s chart, Forms 10-K, 10-Q, Earnings releases & ARHS Sept. 2023 Investor Presentation)

Finally, despite the challenging macroeconomic backdrop, this is a company that caters to the lucrative and growing high-income household segment and might be expected to be much more resilient in case of downturn (as it was the case during the Great Recession).

Without a doubt we can also cite some concerning issues that may invite to be cautious before investing in ARHS. Just to name a few, this company is part of a sector that probably has been benefited during the pandemic and is still pending to confirm if it has already reached “normalized” levels; the macroeconomic context is still rather complicated (especially for the housing sector, though ARHS claims it is not the most relevant factor for them) and it is not easy to confirm that the worst is behind for this highly cyclical company; delivery delays are improving but it is still a work-in-progress for the company; the recent secondary offer by one of its main stockholders it still not complete and this could trigger an additional selloff… Those are all worrisome issues but I think in no case they are strong enough to throw down the long term thesis. In general terms all of them are temporary issues that are out of the company's control or expected to be remedied soon.

… but the devil is in the details

Having reached this point, what has made me change my mind? As investors I have the feeling that frequently we tend to focus the analytical process in the most “quantifiable” parts of the companies, to the detriment of other “more intangible” aspects. We give much more importance to the numbers and the business model, and this is perfectly fine: we obviously need to deeply understand those issues before being on board. However, these “quantifiable” aspects tend to be much more reliable when the wind is in our backs. It is when things start to get worse that those “more intangible” aspects acquire all their importance and among those aspects the most relevant is the management team.

When things go wrong our conviction will be tested and in my opinion there is nothing that makes a conviction more resilient than a trustful management team with a track record of making meaningful decisions and aligned with the shareholders.

In the specific case of ARHS, after reading many years of its financial statements, calls transcripts, presentations and so on and so forth, my first feeling was rather good, as I explained above. All this info was mainly “quantifiable”, but it was reading the Proxy statement when I changed my mind. Within this document I found some “little things” that probably are not so relevant for many people, but for me they are enough to get a sense of which kind of management is in front of me.

The first issue is the unjustifiable “other benefits” that the Company is providing to its executives. The CEO has a permission “to use the company airplane for personal use” and he spent $212k and $356k in 2021 and 2022, respectively, in this privilege.

(Image Source: ARHS 2023 Proxy Statement)

Additionally he “also received an employee discount for Arhaus merchandise in excess of the discount provided to employees generally” quantified in $46k and $193k in 2021 and 2022, respectively. The CFO and CRO also receive some inexplicable benefits, despite all of them getting paid rather succulent compensations. Does make any sense that a CEO earning $3M+ each year and with $44M in stocks to benefit for an additional discount and get paid its personal travelling in the company airplane ($800k+ between 2021 and 2022!)? In my opinion this is not justified.

The second issue is related to executive compensation. In 2022 ARHS changed “operating income”, as one of the two metrics used to calculate cash-based and equity bonuses, for “Adjusted EBITDA”. The change per se is not a problem but it is the lack of explanation about this change. Not even a word. Adjusted EBITDA is a much more manipulable metric and seems rather convenient when the company is expanding its business and probably depreciation and amortization expenses will start to ramp up.

The last point is related to how demanding are those metrics used to calculate cash-based and equity bonuses. In 2021 and 2022, with regard to the cash bonus, “based on the performance goals established, a payout equal to 200% of Target Incentive was achieved” (the maximum). This is again not a red flag per se but it is something to closely follow-up when the management team always earns the highest bonuses. Unfortunately, as the Company is public just since November 2021, there is only information about the last two years.

As commented previously, all these issues considered in isolation might be deemed not so relevant (even though for me at least the first one is completely unbelievable) or at least not relevant enough to let a good company go. However the point is that all of them head in the same direction: the management team (with a CEO at the helm who controls more than 94% of the voting power) seems not to be aligned with the (minority) shareholders. In other words, the Company seems still to be managed as a private company and with the privileges of unaccountable executives. This kind of companies can perfectly keep outperforming and growing as excellent businesses, this is not incompatible. However, for me it is very important to be comfortable with my investment and this requires trusting the management. Having the feeling that shareholders are one of the last concerns of the management team is rather worrisome and I consider this as a red flag.

It is always annoying to discard a company after spending a lot of time analyzing it. However these situations are always beneficial in the long run as serve to reinforce my commitment with reading as much documentation as possible and my feeling about the importance of the Proxy statement. There are thousands of investment opportunities out there, so let’s look for the next one.

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