Don't buy the rosy forecast from Lowe's

By Robert Walberg

The earnings season is often more about expectations than reality. For proof, look no further than today's report from home-improvement retailer Lowe’s (LOW, news, msgs).

The company said it earned $613 million, or 40 cents per share, on sales of $10.41 billion during the fourth quarter. The results beat Wall Street's expectations of 37 cents per share on revenue of $10.36 billion.

Not only is Lowe's the rare company tied to the housing sector to beat estimates, but CEO Robert Niblock added to the enthusiasm: "We are encouraged by indications that our sales trends have bottomed. As a result, we believe our comparable-store sales performance will gradually improve throughout 2007."

On cue, the company's stock rose nearly 5% -- at a time when the broad market indexes were all trading lower.

Margins under pressure

But wait. There's no denying that sales fell 3.7% and earnings were down 11.5% versus the fourth quarter a year ago. Net margins declined as total expenses rose nearly 2 percentage points to 26.3% of sales. Operating margins should fall by 150 basis points, or 1.5%, in the first quarter of 2007, management said.

Margins could come under further pressure because merchandise inventories in the quarter rose by 7.7% even as sales declined. There's a good chance that the company will have to offer discounts to move unwanted merchandise, especially if inventories continue to grow faster than sales for another quarter or two.

Investors should also note the relatively large jump in accounts payable (up 24%). Hoarding cash in a sluggish operating environment may not be the worst thing, but it suggests that the cash-flow numbers are being inflated.

It's true that Lowe's is doing a reasonably good job of holding its own during a difficult period for its sector. The company continues to steal share from industry leader Home Depot (HD, news, msgs) due to superior customer service and its smaller, brighter, more consumer-friendly stores. The cream always rises to the top during the most difficult of circumstances, and there's no doubt that Lowe's is the best-managed of the large home-improvement retailers.

Why is Lowe's special?

Even so, I see no reason for investors to become giddy because the company beat deflated earnings expectations while operating results continue to deteriorate. As much as I admire the company’s management team, I'm not buying the company's rosy predictions.

Home builder after home builder has cautioned that there's no obvious end in sight to the industry downturn, so it's difficult to accept that Lowe's sees nothing but better days ahead. Are we supposed to believe that CEO Niblock's crystal ball is so much clearer than those used by everyone else? If home builders don't see a bottom, and Home Depot's management doesn't see a bottom, how is it that Lowe's believes that sales will start to trend higher?

If sales really have bottomed, then why is the company forecasting a 2%-to-4% decline in same-store sales for the current quarter? That doesn't seem like a bottom to me, especially not for a company that has historically delivered positive same-store sales growth.

Frankly, there's a lot of wishful thinking but no real evidence that the end is near for the housing sector's woes. With inflation remaining stubbornly high, there's also no compelling argument for a decline in interest rates. Consequently, operating conditions for Lowe's are likely to remain somewhere between difficult and miserable for at least six more months.

If there is a positive, it is that comparison periods will begin to get much easier by midyear. However, that's not enough to entice me to pay 17 times next year's earnings for a stock that has already rallied nearly 34% from its late-summer low (closing just below $35 today). Don't get me wrong: I like Lowe's. I just wouldn't be a buyer at this price, under these conditions.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.