Description

Ethan Allen (“ETH”) designs, manufactures and sells furniture and home decorations in company owned stores and through franchisees. The company’s core customer is middle aged or older, with income typically above $100,000 per year. Ethan Allen is vertically integrated: it designs all of the products that it sells, manufactures approximately 70% of goods in the United States, and operates its own distribution and retail networks.

Farooq Kathwari, the company’s long-time Chairman and CEO, has made a long-term commitment to manufacturing in the U.S., which places Ethan Allen at a significant cost disadvantage with respect to competitors sourcing overseas. The Ethan Allen brand is stodgy and poorly situated in the middle of the market—not a low cost provider, yet not a luxury good. ETH is making an effort to expand the reach of its brands to less affluent and younger customers by offering cheaper products and modernizing its advertising. This strategy is unproven and, even if successful, could further dilute the brand for the existing core customers. 

Kathwari is an all-encompassing CEO who makes all material decisions at the company, from product design to merchandising to advertising. His compensation with a salary of ~$1.15mm per year with an additional variable cash bonus (~$2.3mm if the company were to earn EBIT of $70mm in FY12) and equity (granted a total of 700k options and 296k restricted stock awards between 10/10/07 and 10/01/2011) and other perks is far above the pay of his deferential executives (the highest other compensation package in 2011 was $370k). It is worth noting that Farooq signed a new employment agreement in September 2011 which lowered the threshold above which he would receive an incentive bonus to $25mm in operating income, from the $100mm-$130mm operating income threshold in his 2007 contract. When asked about the change, Farooq answered that the environment post-recession was “a very different world,” and that “five years back” making $100mm in operating profit “was more possible.”

Despite its weak competitive position and lackluster management, Ethan Allen is trading at 23x consensus FY6/2012 earnings and 10x EBITDA  and 17x consensus FY2013 earnings and 8x EBITDA (~$70mm operating profit). While sales have rebounded since the recession, estimated FY13 revenue is still 25% below 2006 sales. We estimate that the company could earn over $3 per share at peak sales levels. However, we believe that it is unlikely that Ethan Allen will match its results from the overheated real estate market of pre-recession bubble years.

Ethan Allen’s core high-end clientele emerged from the recession in a position of relative strength and has already resumed spending. ETH removed significant capacity during the recession and, according to the VP of Finance (there is no CFO) the company is currently operating near capacity on current lines. While the company can add more capacity relatively easily, incremental margin improvement opportunities should be limited from here.

While Ethan Allen has generated better than expected gross margins over the last several quarters, the improvement is in large part due to a temporary shift in the company’s retail / wholesale mix (which varies based on the timing of shipments and other events). The retail segment generates higher gross margins along with higher operating expenses. Management expects that with a normalized mix, gross margins should be closer to the operating profile that management has laid out (52.5% GM for a sales level of $800mm / 53% at $1bn—note that Wall Street research estimates are generally materially higher). Additionally, we believe that the company’s margins will erode over time given Ethan Allen’s weak competitive position relative to low-cost producers such as Ikea and well-managed higher end retailers such as Pottery Barn, Crate and Barrel and Restoration Hardware.

Catalyst

-          Normalization of gross margins

-          Multiple compression from slowing growth

-          Deterioration in competitive position