Mortgage rates climbed above 4% for June. Tapering, which most economists are predicting to occur in September or December, will further increase mortgage rates, likely weakening the housing market. The bull-case is that there will be a large surge in home buying before the FOMC meeting in September to lock-in rates, leading to strong sales from home retailers like Ethan Allen Interiors (ETH), Bed Bath and Beyond (BBBY), and Pier 1 Imports (PIR). However, the fundamental relationship is that higher mortgage rates will lead to lower home sales. On top of this, higher monthly payments will reduce consumers' disposable income. The home retailers are in a bearish space, and investors should prepare for significant downside.
Ethan Allen Interiors is a small home furnishings retailer with a market cap of $788 million. Despite being around since 1932, ETH has only 295 stores, and is eclipsed by companies like BBBY (1471 stores) and PIR (1062 stores). Since the S&P 500's low point in 2009, ETH's stock price has appreciated almost 300%. I believe the home retailers, particularly ETH, are set for a downturn as mortgage rates increase.
Within the three aforementioned home retailers, I believe Ethan Allen Interiors has the most to lose while mortgage rates increase. ETH is trading at the highest P/E of its peers despite its weak trends, low economies of scale and a half-empty stock buyback program.
Returning Earnings to Shareholders
ETH has had a history of returning earnings to investors. As a smaller company, I would like to see profits reinvested to spur high growth, not used for stock buybacks and dividends. Regardless, in the short to medium term, this strategy may support ETH's stock price. At the lows of 2009, ETH was paying a 5 cent quarterly dividend. This amount was increased in 2011 to 7 cents; and in 2012 it was 9 cents. Moreover, ETH's friendly-nature towards shareholders was shown when it issued a special 41 cent dividend ahead of the expiration of Bush-era tax cuts at the end of 2012. ETH is currently yielding 1.46%. The dividend yield is nothing spectacular, but ETH's willingness to return money to shareholders shows that they may be open to buying back shares if their stock price falls significantly.
Although ETH has a share repurchase program that will allow it to purchase over 1,101,490 shares (3.8% of shares outstanding), no shares were bought back by the company since June 2012. With share-based compensation, ETH's shares outstanding have increased by almost 1% since 2010. Conversely, BBBY and PIR have, respectively, reduced their shares outstanding by 11.8% and 9.5%. I would expect a company that is not buying back shares to have a high growth story. However, this cannot be seen with ETH's performance.
Below is a summary of some of ETH's key financial metrics over the past few years.
COGS (% of Sales)
SG&A Expense (% of Sales)
Earnings before Tax
First, let's take a look at net sales. It appears that ETH's sales growth has stagnated. Supported by the housing growth and lower mortgage rates, sales increased from $590 million in FY 2010 to $729 million in FY 2013. However, most of the sales growth took place in 2011. Even with the Fed supporting the housing market, ETH's sales in 2013 remained flat. By comparison, BBBY and PIR have had much stronger, and less sporadic, revenue growth.
As illustrated, ETH's sales growth has been on a downward trend while BBBY and PIR have kept their growth momentum. This may have been due to ETH's inability to keep up in its competitive environment. The main takeaway is that ETH is losing market share to its much larger competitors.
Moreover, with rising mortgage rates, consumers will have less disposable income to spend on furnishings. ETH operates in this bearish sector. As disposable income falls, consumers become more price-sensitive and more receptive to promotions. Price competition will increase, driving prices of all home furnishings down. Furthermore, as a smaller company, ETH naturally has a smaller advertising and promotional budget than its competitors. This disadvantage will likely cause ETH's stock price to fall more than its peers given the weakness in the housing market.
One bright spot for ETH are their high gross margins. Over the past four years, ETH has consistently had a lower COGS to sales ratio than BBBY and PIR. Not only that, but ETH's margin premium has been growing. I'd just like to ask: With slowing sales, can ETH's margins keep expanding? When does ETH need to markdown their inventory to increase top-line growth? This margin premium does not seem sustainable: ETH's margins will most likely need to decrease. As mentioned in the previous section, margins for the home retailers are likely to fall as mortgage rates rise. Currently, ETH's products are significantly higher-priced than its peers. For example, a standard four-post mirror at BBBY is $200. The cheapest comparable one at ETH is $255. As consumers become more price-sensitive, ETH, which has the highest gross margins, would need to cut their prices significantly more than its peers to attain top-line growth in this competitive sector. Why would cash-strapped consumers pay a 25% premium at ETH when they can get a similar product at BBBY?
It seems ETH is in a lose-lose situation. To compete in a rising mortgage rate environment, ETH can do two things: Cut prices, which will reduce margins and consequently gross profits; or keep prices high, thus maintaining its high margins, and reducing sales. It seems ETH is particularly stuck between a rock and a hard place when mortgage rates increase.
Despite ETH's lower COGS, its SG&A expenses are significantly higher. Given the more expensive inventory and slower sales, it makes sense that depreciation expense (categorized in SG&A) is higher than those of BBBY and PIR.
When the analysis of the SG&A expense is combined with each company's return on invested capital, it can be inferred that as each of these home retailers grows, they gain economies of scale. Why invest in a small company when you can invest in BBBY, which has much more efficient operations due to its size? BBBY's capital is almost four times as productive as ETH's.
Finally, I'd just like to point out the earnings before tax figures. EBT growth seems impressive, at 21.67% last year. With EBT margins so low, any small increases can have a large effect on earnings growth. Since this figure will be sporadic, changes in sales and expenses should be analyzed separately.
With lower growth trends than BBBY and PIR, one might expect ETH's P/E to be lower than its competitors'. This should be fundamentally correct. However, this is not the case.
This leaves ETH with more downside potential than its peers. Overvalued to its peers and with lower growth prospects, ETH will be hit harder than its competitors if and when the housing slowdown occurs.
If I can, I like to use one non-conventional rating scale to determine a stock's attractiveness. Fortunately (for my thesis), this rating backs-up my short position on ETH. By googling "Bed Bath and Beyond ratings Yelp," "Pier 1 Imports ratings Yelp," and "Ethan Allen Interiors ratings Yelp" and taking the average of the ratings (out of 5) from the first two search pages, I was able to determine the general consumers' sentiment on these companies.
Lower ratings will correlate with slower sales. ETH's stock price has not been able to catch up to its ratings. This is just one other bearish factor towards ETH's stock price.
Furthermore, ETH is at a disadvantage to its competitors due to its relatively small size. Just as large companies may deserve to trade at a premium to its competitors, ETH should trade at a discount. When consumers want furniture, they will first go to the larger stores such as Bed Bath and Beyond, IKEA, or Sears. ETH, with only 295 stores, will find it more difficult to grow its customer base.
Given the higher mortgage rates and a potential upcoming Fed tapering of mortgage-backed securities, housing and housing-related sectors should prepare for weakness. Ethan Allen Interiors is one company that is particularly poised for a downturn for several reasons:
- Small stock repurchase program
- Mortgage rates reducing homeowners' disposable incomes
- Stagnant sales growth
- Gross margins that are expected to fall
- Lack of economies of scale
- Relatively more expensive than competitors such as BBBY and PIR
- Low consumer sentiment
The most likely upside case for ETH is a surge in home buying. This could be because people, who fear higher mortgage rates, could rush out to buy houses, leading to increased sales in related products such as furniture. This would be factored into the October earnings report. Regardless of this potential one-time upside for the housing market, I believe Ethan Allen Interiors is overvalued, given its current fundamentals.