Bottom Up Investments'  Instablog

Tonight, Ethan Allen (ETH) reported Q1 10 results that missed Wall Street estimates by a wide margin.  ETH reported Q1 10 revenue of $136.2 million, missing top-line estimates by 10%.  In addition, ETH reported a loss per share of $0.20 (excluding one-time charges), which was well below the consensus estimate of ($0.08).  Given the Street was expecting FY 10 revenue and EPS of $602 million and $0.21, respectively, we believe estimates will coming down significantly in the coming days. 

Based upon continued sequential deterioration in Q1 revenue, we are now projecting FY 10 revenue of $573 (versus $600 million previously).  Gross margin has shown slight sequential improvement, so our new estimate assumes margin increases from 49.1% in Q1 to a full year margin of 51.0% (as cost savings kick in).  On the operating expense line, we are assuming SG&A bottomed at $73.6 million per quarter.  Annualizing this rate gives us operating expenses of $294.4 million.  Leaving our net interest and tax estimates alone, we estimate the Company will report a loss of $6.2 million in FY 09 (translating to an EPS of negative $0.21). 

Factoring in 10% revenue growth in FY 11, and assuming that 60% of cost savings from restructuring activities are permanent (per management's guidance), we estimate FY 11 revenue and earnings of $630.8 million and $0.10, respectively.

Based upon these estimates, ETH is trading at roughly 130 times FY 11 earnings.  While the market is clearly valuing the Company on a normalized earnings powers, we are concerned estimates may not be considering the shift of its business model to more of a custom model.  In our view, the operating leverage inherent in its old model may be a thing of the past.  Thus, we believe ETH should be valued based upon a blend of its near-term trough earnings estimates and an estimate of normalized earnings power.

Our price target of $10.50 is based upon assigning a 15x multiple to the average of our FY 11 earnings estimate and our normalized earnings estimate of $1.31.

Disclosure: The author is short ETH 

On Thursday after market close, Rady Asset Management CEO, Harry Rady, suggested Morton's Restaurant Group (MRT), worth approximately $60 million at the time, was a "4 bagger" because it was priced at 40% of book value and had $1.50 of earnings power.  At the time the stock was trading at $3.69 per share and Mr. Rady disclosed that he held a position in the stock.
 
The following day, the stock soared 30.9% and closed at $4.83 on a day when 609,000 were traded, approximately 10x the normal average daily volume.  In the two days since, the stock has traded with double the normal daily volume.

It is natural to be optimistic about the value and prospects of the stocks you own; however, we think the statements Mr. Rady made were misleading or false.  First of all, the claim that it was trading at 40% of book value was just untrue.  As of that day, the last reported balance sheet (Q2 ended 3/31/09) reported assets of $245.9 million, liabilities of $164.2 million, and equity of $81.7 million.  As a result, MRT was trading at 75% of book value, not the 40% Mr Rady stated.  In addition, goodwill and intangibles accounted for $92.8 million of assets at the time.  Since they reported a goodwill impairment in FY 08 and have reported very weak cash flow numbers in recent periods (cash flow being a key input in impairment testing), we believe goodwill and intangibles should be excluded from a measure of book value.  As of last Thursday, tangible book value was  negative $11.1 million, not exactly a bargain in our opinion.

Second, Mr. Rady stated that the Company had $1.50 of earnings power.  In FY 06, the Company reported non-GAAP EPS of $0.86, which was the best of the last four to five years.  Given that the MRT success is dependent upon corporate expense accounts that are likely to be constrained for some time, we think his call for $1.50 earnings power is overly optimistic and would be interested to see the assumptions and time horizon behind the bullish call.

Investors should be doing their homework and not buying blindly, but anytime you get such a bullish call on a relatively illiquid small market cap stock, there is bound to be a significant pop just driven by the increased attention.  Looking at the Top 10 holders, we do not see Rady Asset Management, but there are interlocking relationships with two of the top 10 holders, American Assets Investment Management, LLC and Insurance Company of the West (Mr. Rady's father founded American and is Chairman of the Insurance Company of the West).  Together, the two investment firms own over 500,000 shares of the Company.  The optimist in me thinks these two firms added to their positions given that the stock remained undervalued relative to the younger Mr. Rady's expectations, but the pessimist in me can't help but note that a significant share price move and heavy volume trading would provide excellent cover to reduce one's holdings.  I guess we'll have to wait until 13F's are disclosed to know for sure.

On Friday, MRT filed its Q2 10Q, which provided a balance sheet and cash flow statement (not provided in earnings releases).  According to its filings, the Company has used $13.4 million in free cash flow in H1 09.  It currently has $3.7 million in available borrowing on its senior credit facility of $75 million.  At the end of the year, the revolving credit facility is reduced to $70 million.  Given the cash burn and liquidity constraints, we are concerned MRT may need to raise equity.  This recent share price pop may provide a great opportunity to do so.

Disclosure: short MRT

Ethan Allen (ETH) reported Q4 09 Rev of $138.7 million and EPS (ex-one-time items) of negative $0.23, which was more or less in-line with its July 21st pre-announcement.  Conference Call is tomorrow at 11AM EST.

Key takeaways:

1. Not only did Q4 09 revenue decline 41.2% year-over-year, but revenue declined 1.1% sequentially.  Moreover, comparable store sales deteriorated relative to Q3 (Q4 comp store sales declined 43.5% y/y versus 41.8% in Q3).  Thus, it appears the Company received no benefit from the stabilization in home sales.  Considering new home buyers also received an $8,000 rebate from the government, we would have expected home furnishing retailers to at least show a marginal benefit.

2. Inventory declined 16% in FY 09, but remained elevated relative to revenue and cost of sales.  Until the Company reduces inventory commensurate with the drop-off in demand, we believe gross margin will continue to be pressured (gross margin declined 550 bps y/y in Q4). 

3.Receivables increased slightly despite the significant drop-off in sales.  In the last quarter, the Company stated that it was financing weaker customers. 

4.  The Company's believes its recent restructuring initiatives are expected to cut $120 million in operating costs and $30 million in manufacturing costs, most of which will be realized in FY 10. 

What to listen for on the Call:

- We will look for an update on whether or not the Company continued to finance weak customers and, if so, whether the company increased its allowance for debts to compensate for the extra risk.

- We will look for additional details on the two press releases issued since pre-announcing on 7/21.  In particular, we would like to see if the Company addresses the revenue impact of the reinvention of its American-made case goods division to a custom operation.  It is our hunch that some of the cost savings outlined are merely reflecting a shift from a higher volume business to a lower volume custom business with lower revenue potential.  Thus, the Company may not be able to have the capacity to grow revenue if the economy recovers, and if that is the case, some of the earnings leverage being priced into current valuation may no longer be attainable. 

Bottom Up's FY 10 Estimates Revised

Once again, we'll start with revenue.  Previously, we expected $600 million in  FY 10.  However, the sequential deterioration and potential implications of the shift in business model suggest that revenue could come in materially lower.  Until we have more clarity, however, we will leave our estimate as is.

Operating costs are expected to be reduced by ~$150 million annually in FY 10.  We estimate the Company realized about $55 million of the benefit in FY 09.  Thus, we lower costs by the remaining $95 million to $585 million.

Operating profit is equal to $15 million, less non-operating expenses (net) of $7.5 million and a tax rate of 37%, which leads to net profit of $4.7 million, or $0.16 per share.

Valuation
ETH is currently trading at 86 times our estimate of FY 10 earnings and 100 times the Street's FY 10 consensus estimate.  For FY 11, the Street is anticipating earnings of $0.60, so investors looking past the upcoming year are still paying ~24 times earnings.  We believe a company in this position should be trading at closer to its historical multiple of about 15 times earnings.  Applying the Streets FY 11 estimate to its historical multiple would imply a valuation of $9.00.

We will update our thesis if anything material is disclosed on the Conference call or in the 10K filing.

Disclosure: short ETH