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Why I Sold Lowe's Short

by: Avery Goodman October 09, 2008 | about stocks: HD / LOW    

Avery Goodman

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I’ll never understand why, back in August and September, so many people were buying the home improvement retailers. They bought enough shares to pump the price up into the mid-20s. As far as I can see, the retail business is going to be very difficult over the coming few years, and of all the retailers, the home improvement giants, Lowe's (LOW) and Home Depot (HD), will be among the most severely stressed. 

The discount do-it-yourself home improvement stores saw a booming business during the housing bubble. People were buying homes, for themselves and for investment, and they needed all sorts of things to equip those homes. 

Even small builders shopped at Home Depot and Lowe's, picking up discounted supplies they’d need to pay more for at typical lumber yards. This drove hefty sales increases, and profits, for many years. But, the housing boom is over. Now, it is a thing of the past. It will be decades before we see another one, and, in the meantime, times are going to be very tough. 

Some would argue that, if they can’t afford a new home, people will redecorate or renovate their existing one. However, the truth is that when times get tough, the first thing people do is put off purchases that can be avoided. Home redecorations and renovations are at the top of the list of the most easily delayed desires. That is already happening in a big way. People are cutting down on their purchases of frivolous items. They are cutting back on everything. They are shopping at Wal-Mart (WMT), instead of Macy’s (M), for example, and looking for bargains wherever they can find them. 

But, aside from the general trends, we need to examine some of the facts which directly relate to the home improvement giants, in order to better understand why buying their shares is such a bad idea, and why selling them short is a good idea. In this analysis, I merely repeat hard facts that have been stated elsewhere.

I expect 3rd quarter earnings to be a disaster, when the report finally comes out. Home Depot’s earnings went down by 24% in the 2nd quarter (see conference call transcript). Lowe's did a bit better, with earnings dropping by 8%. Lowe's admitted, on May 2, 2008, in its quarterly report (see conference call transcript), that comparable store sales sank by 8.4%. That is on top of comparable store sales that went down 6.3% the year before, or about 14.7% down in two years. Gross margins are down 30% year over year. Cash resources were down 30% year over year. Even management admits that comparable store sales will decline 6 to 7 percent this year, with operating margins expected to decline by 1.8%. Yet, in spite of this, management intends to open a huge number of new stores. Management is foolishly optimistic, and ignoring reality. 

When that happens, it is a catastrophe for shareholders. Since their 2nd quarter report, Lowe's has scaled back some store expansion plans, but their plans are still excessive. In the 2nd quarter report, they had estimated that the net cost to open the new stores would be $103 million. The company owns 87% of its own stores, and if it continues that way, it must take on huge mortgage liabilities. 

Meanwhile, the commercial real estate market is falling fast, which means that the net resale value of the new real estate will depreciate almost immediately. More importantly, the drain to company’s earnings, from the new stores openings as well as maintaining money draining operations, will be heavy.  

At least Home Depot is smart enough to be retrenching, not opening new stores, and exposing its shareholders to heavy losses at a time of contracting sales. 

Both Home Depot and Lowe's admit that they will show very bad results in the 3rd quarter, but make a ridiculous claim that earnings will be “on target” for the year. Both sets of managers are living in a dreamland. The only way their projection could come true is if the housing market suddenly recovered. 

That is extremely unlikely. Lowe's' management, along with that of Home Depot, is behaving in an irrationally exuberant manner. They appear to be lying to themselves much like bank executives lied to themselves, back in October, 2007. Had Lehman Brothers, for example, not lied to itself about its finances, in October, 2007, it could have raised tens of billions of dollars worth of capital, while its stock price was still $65 per share. That would have saved it. 

Instead, its CEO refused to accept reality. Less than a year later, Lehman declared bankruptcy. The same thing may happen to Lowe's, if it continues walking down the garden path of denial. The earnings projections, for the coming year, are completely unrealistic. In my opinion, earnings will continue to fall deeply, for several years to come, because banks are now going to be strict with lending standards. Residential real estate sales will continue to fall until 2011, and the demand for home improvement products will fall. Home improvement retailers that choose to spend a lot of money on new stores, during that time period, may not survive. That is why I chose to take a short position in Lowe's, rather than Home Depot. 

Regardless of what semi-positive claims of future earnings that the home improvement CEOs may now make, the market will become more and more aware of reality. Management’s lack of realism will eventually take a heavy toll. Short positions can be taken with less risk, in the form of puts, but these are currently subject to what have become hefty premiums for short expiration dates. In any event, subject to a few false rallies that I see on the horizon, we’re going to continue to see a drop in share price, for both Lowe's and Home Depot, that is bigger than the market as a whole.

Disclosure: Author holds a short position in LOW

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This article has 10 comments:

  •  
    Oct 09 03:48 PM
    Good Idea to short it now..before you are not allowed as in the financials... btw.. what other suggestions might you have???? Seems the whole market is tanking? Let me and the members of myinvestorsplace.com know ... thanks
    Reply
  •  
    Oct 09 06:38 PM
    Not sure I agree. As a department manager for a new Lowes store, I have seen an increasing amount of traffic over the past year as customers react to the housing market slump. While it is true that sales are not stellar, our gross sales on higher margin product such as nursery and seasonal goods is up as much as 20% over expected performance. Sales ARE down on lower margin raw materials like lumber etc but contractor sales are holding strong. Hard goods like appliances continue to be very strong. Lowes has reacted well in choosing to have a flexible product mix within the 'big box home improvement' theme. We ain't just another hardware store...My advice: buy!
    Reply
  •  
    Oct 09 07:05 PM
    The Lowes here is still doing a really good business. But our banks are also still loaning money, financing various activities, and growing deposits. They are not involved in swaps, and CDO's, but banking. Houses are still being sold and bought. However, noone is going to a SPA in California.
    Reply
  •  
    Oct 09 09:01 PM
    More propaganda from short seller's, True Lowes will have some declines
    in sales, But they will be around in 10 years...
    Good time to buy small positions in Company. Do not let the shorts kill this economy more!!!!
    Reply
  •  
    Oct 10 10:07 AM
    I feel sorry for people who own Lowes. The additional store building is a bluff.And the CEO should be put under oath when talking about fiture earnings.
    There will be fewer home owners in 2010 so where will they get their sales from - banks renovating distressed properties?
    Reply
  •  
    Oct 10 12:50 PM
    As an employee of Lowes, I would have to fully disagree with this article. This article appears to be written by someone who has no knowledge of how the economy or markets work.

    Where I live, most of the Lowes stores are doing great. Lowes stores that are marginal are typically in buildings that Lowes purchased very cheap, yet still gaining profit. I like Lowes for those reasons. Look into the finer details like any good investor would do. Look at how a company thinks and conducts themselves. Soon Lowes willl knock HD off its block. HD will be closing stores while Lowes continues to strategically open them. Lowes is building in great developing areas where HD did too early. Lowes is jumping the gun in a good way to see that those HD's fail. And it will work based solely on great customer service. HD dumped that back in 2000.

    As I write this, Lowes stock is at $16 per share. I think that is great, because now i am buying more of it. Long-term, I will see huge gains.

    Remember, no matter what, there is a huge amount of people from current generations that will be buying homes soon. Including myself. Don't jump the gun like every other no-brainer and sell. That will be a costly mistake. Think long term, not short. I know it's hard for 85% of people to do that.
    Reply
  •  
    Oct 10 01:34 PM
    Both Home Depot and Lowes control the Home Improvement Business, people will always remodel their homes, some might delay it for awhile but its evitable. Many of the houses on the foreclosure market will need repairs, thus both will benefit. Their stocks are a great buy for the future under $20 per share and some are below 10 times earnings now, think long term and you will get huge profits.
    Reply
  •  
    Oct 10 10:01 PM
    I work for one of the retailers menioned and I have made my monthly sales bonuses each month for the last 6 months. Soo if these cpmpanies are down in the market it isn't due to sales. If people aren't building new homes they are fixing up old ones I assume.
    Reply
  •  
    Oct 11 10:51 AM
    I stongly agree that people will delay improvements.... That is what has been going on for the last two years.... I tough economy will encourage folks to clean up their home so they can sell it. As home equity lines of credit start to free up; seems like these retailers will do well....
    Reply
  •  
    Oct 15 11:57 AM
    Good ideas. Just remember home builders and retailers are the ones that move first early in the cycle. The market has discounted most of your points, reflected in the stock prices. The best time to buy LOW and HD is 3 months into a recession. They will be the first to move. Consider buying in a month or two...
    Reply
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