2/22/2010
By Brian Sozzi, Research Analyst

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This morning, home improvement retailer Lowe's Companies Inc. (LOW) kicked off earnings week for companies directly linked to the opening and closing of consumer wallets.  As we indicated in our pre-earnings note on Lowe's and larger rival Home Depot (HD) last week, the set of 4Q09 reports and initial FY10 outlooks were likely to be the most important of those heard from each big box operator in quite a while given the obvious shift of fortunes in the U.S. residential housing market.  Not only were trends in 4Q09 worthy of keen attention but the initial FY10 outlooks could have taken two divergent paths; err on the side of caution despite data suggestive of strengthening future demand from DIY remodelers and contractors, or build in a sense of cautious optimism.  Lowe's decided to pick path number one, partly explaining the stock's downward reaction on the day.

Lowe's reported net sales of $10.17 billion (consensus: $10.01 billion), bringing to the bottom line $0.14 per share (consensus: $0.12).  We had modeled for net sales and EPS of $10.5 billion and $0.11, respectively.  To the Company's credit it surpassed its sales guidance (flat y/y) and EPS range issued 90 days ago ($0.09-$0.13).  However, overall, sales and EPS fell shy of some of the more bullish sell-side estimates we saw heading into the report.  The sales and EPS beats, in our view, could be attributed to 122 bps of gross margin expansion, improved expense leverage on a -1.6% comp (second quarter of sequential comp rebound; -6.6% 4Q08), and share repurchases ($500 million or 21.6 million shares).  Lowe's registered y/y sales growth for the first time in five quarters.

All in all our sense is that 4Q09 was well managed across the key components of the income statement in addition to the balance sheet, where short-term debt was eradicated, inventory was kept at bay (though we would have liked a WMT/HD decline in inventory, but acknowledge Lowe's is not as efficient as those two companies), and cash was left in the business longer through accounts payable discipline.  It was positive that at long last Lowe's big ticket category sales brightened amid momentum in carpet, flooring, and kitchen cabinets.  Installed sales constitute about 6% of Lowe's business, and it's imperative that sales trends in the aforementioned departments increase if Lowe's is to attain gross margin expansion this year per management's FY10 guidance.

For 1Q10, Lowe's outlined EPS of $0.27-$0.29, composed of (1) total sales of -2.0% to flat, and (2) operating margin compression of 90 to 100 bps.  The company's guidance is disappointing in our opinion, considering the external catalysts that include consumers becoming open to home remodeling projects and activity in the existing/new/foreclosed home sales markets.  We do note that FY10 sales and EPS guidance suggests the business will incrementally improve as the year unfolds.  But is that mostly from a new share repurchase authorization?  As we suspected prior to the conference call, the quarter commenced on a rocky footing as inclement weather hampered sales.  The first three weeks of February represent roughly 23% of 1Q10 sales, so Lowe's has ground to make up if it wants to beat its guidance that some are deeming conservative.  We have placed our 1Q10 EPS modeling at the mid-point of management's expectations.

We have used a PE multiple of 15.3x our FY11 est. of $1.47 to determine a price target of $23.00.  This assumed PE multiple values Lowe's toward the lower-end of a nine-year 12.0x to 35.6x trading comp range as we do not expect the company to register outsized operating margin expansion due to a lack of major initiatives to extract efficiencies from existing assets or a material amount of gross margin expansion in light of competitive forces.  While it's encouraging that Lowe's is experiencing renewed demand trends in critical lines of its business, we are left wondering if execution could be better.  The increased level of competition from Home Depot and that retailer's leaner operating model are reasons why we are lukewarm to the prospect of building new positions in Lowe's.

Discussion
* Statistics: comps for tickets +$500: -1%; comps for tickets less than $50: flat; 22 of 23 regions sequential comp improvement; 5 of 20 categories comped positive; total unit market share +40 bps y/y. 

Brian Sozzi
Wall Street Strategies