Be Careful With This Housing Recovery Play

Nathaniel is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

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 (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. 

Furnishings

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 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. 

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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%.

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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 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. 

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'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. 

Home improvement

If you take look at the rest of the sector you will see Ethan Allen isn't the only housing recovery play with an inflated multiple. Flooring leader Lumber Liquidators (NYSE: LL), has watched its price-to-earnings multiple soar since 2012. 

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While analysts are expecting growth over 20%, I have similar fears with this company. Should we begin to see the housing recovery slow down as a result of interest-rate increases, you would expect to see a decline in the affordability and sales of flooring. Part of the thesis for Lumber Liquidators has been the rising expectations of revenues resulting from home renovation in preparation for resale. However, if homeowners are looking to resell their homes, shouldn't they be looking to install flooring which gives them the best bang for their buck? According to a number of online review websites, flooring sold at Lumber Liquidators is among the least desired, as recent quality issues have hurt the company's reputation. More over, the quality issues have brought about new concerns regarding the safety of the flooring due to high concentrations of formaldehyde. 

I would additionally be wary of the recently offered HD Supply (NASDAQ: HDS), which made its appearance on the public market just last week. The company provides contractors and builders a large variety of stock-keeping units through its 600 locations across 47 states. While shares did price under the expected range, at $18 per share, the company still looks expensive, with a multiple of 30 times earnings. I remain fearful that public demand for the company has been as weak as it has been. The space in which HDSupply operates is competitive to say the least.

Wrap-up

While Ethan Allen may have performed well up to this point, I would be careful investing in the company today as it seems many broad economic headwinds will put the company in a tough position. As exuberance dissipates, I would expect to see multiple contraction as investors price in slowing growth. Investors should additionally avoid Lumber Liquidators and HD Supply as the companies look expensive on a price-to-earnings basis relative to the industry. 

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Nathaniel Matherson has no position in any stocks mentioned. The Motley Fool recommends Lumber Liquidators. The Motley Fool owns shares of Lumber Liquidators. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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