Note: This article has been amended to correct HD Supply’s name. Motley Fool apologizes for the error.
As of late, the broad market has pulled back substantially as fears of tightening monetary policy in combination with slowing China growth have become increasingly real. If you look at the list of the recent worst performers, many names with exposure to the housing industry and China have underperformed accordingly. Last weekend I came across Ethan Allen Interiors Inc. (NYSE:ETH), a global retailer of high-end housing furnishings and accessories. The company sells a broad range of products including beds, dressers, armoires, tables, chairs, entertainment units, and home office furniture.
When you break down the company’s revenues, you will see two different streams, wholesale and retail. Roughly 77% of company revenues stem from retail locations, of which 147 of the 298 stores are company-owned. While shares have returned almost 10% year to date, Ethan Allen Interiors Inc. (NYSE:ETH) has underperformed more recently, dropping 16.4% off its 52-week highs seen in April. I would like to highlight some of the concerns you should consider before buying this company.
The strong performance seen in many of the housing-related names has been largely due to the rising expectations of a housing recovery. Over the past few weeks, we have watched interest rates rise dramatically as the market attempts to price in Ben Bernanke’s monetary actions. The 10-year Treasury has jumped up to nearly 2.5%, in turn sending the average 30-year mortgage rate up to almost 4%.
While half a percentage point may not sound significant, any rise seems detrimental to the high-end retailer. In the past I have stated my fear that rising interest rates would put a damper on the housing recovery. While this increase may not stop consumers from purchasing a new home, it may be significant enough to push them towards lower-end furnishings. If you compare Ethan Allen Interiors Inc. (NYSE:ETH) to perhaps its largest competitor, IKEA, you can see what I’m talking about. IKEA offers nearly identical products for a fraction of the cost. Lets take a look at the basic queen-size bed, a staple for any new home owner. At Ethan Allen, this bed could run you about $500, while its competitors are offering a more economical alternative for roughly $250. What is the cash-strapped consumer likely to pick? The more affordable option.
What’s been driving this housing rally?
The housing rally has been driven in large part by investor-related demand in combination with first-time home buyers. Should interest rates continue higher, the spread between rental and bond yields narrows, therefore raising the associated opportunity costs for a real estate investor. Should an investor be nice enough to furnish the home, I find it unrealistic he would look to maximize furnishing costs through Ethan Allen Interiors Inc. (NYSE:ETH).
Over the last week, China’s equity markets have stumbled, to say the least, as a slew of economic troubles come together. Many economists have noted the recent credit crunch looks eerily similar to the one seen during the most recent economic meltdown here in the U.S. Should we begin to see a similar housing collapse take place in the region, Ethan Allen Interiors Inc. (NYSE:ETH)’s China business segment would be hit especially hard. The company has 70 branded locations in the country, which its supplies via its wholesale distribution segment. More over, as Chinese GDP growth shrinks, consumers will be more likely to turn to the number of cheaper alternatives. A hit to one of the company’s largest business segments would be especially painful on the bottom line as it drives significant net income from this wholesale business.
If you take look at the rest of the sector you will see Ethan Allen Interiors Inc. (NYSE:ETH) isn’t the only housing recovery play with an inflated multiple. Flooring leader Lumber Liquidators Holdings Inc (NYSE:LL), has watched its price-to-earnings multiple soar since 2012.