Why did sales grow while the company's core store performance weakened?

Growth came from the store expansion program: 153 stores opened in fiscal 2007, bringing the total to 1,534 and increasing selling square footage about 11%. Comparable store sales, which measure mature stores, fell 5.1% due to a soft housing market, tight mortgage conditions, lumber and plywood deflation, and unseasonable weather including drought. Average ticket fell 2.8% to $67.05, reflecting fewer large projects, while customer transactions rose 5.9%.

What drove the decline in profitability?

Margins compressed on expense deleverage rather than gross margin, which actually improved 12 bps to 34.64% on product mix and imports. SG&A rose to 21.78% of sales, mostly from store payroll that could not be cut as fast as sales declined, plus fixed costs like rent and utilities. Depreciation rose to 2.83% of sales from 2.48% because of the new stores and weak sales. Net interest expense also increased 26% to $194 million on new debt.

Is Lowe's balance sheet and liquidity under pressure?

The balance sheet is more leveraged but still sound. Long-term debt rose to $5.6 billion and the debt-to-capital ratio reached 29.3%. Operating cash flow of $4.3 billion covered most of the $4.0 billion in fixed-asset purchases, but buybacks and dividends were funded partly with new borrowings. The company was in compliance with all debt covenants, and it has $1.75 billion of credit facilities. Fitch's outlook change and lower commercial paper rating could raise borrowing costs, though management said there are no debt provisions requiring early repayment after a downgrade.

What is management's outlook for 2008?

Management expects a challenging year. Sales are projected to rise about 3% on store growth, but comparable store sales are expected to fall 5% to 6%, and EBIT margin is expected to decline about 180 bps. Diluted EPS guidance was $1.50 to $1.58 for fiscal 2008. Management is reducing capital and expansion: 120 new stores instead of the originally planned higher number, about 80 major remerchandising projects instead of 116, and capex of about $4.2 billion gross. Management noted some headwinds may ease as 2008 progresses, including the economic stimulus package and Federal Reserve rate cuts.

What are the main risks to the investment case?

The key risks are continued weakness in housing turnover, home prices, and mortgage availability, along with higher unemployment (forecast at 5.3% for 2008 versus 4.6% in 2007). Other risks include weather volatility, competition from other home improvement and general merchandise retailers, supply chain disruption and import exposure (about 7,000 vendors), product liability claims (self-insured), and execution risk in the expansion into Canada and Mexico. Lowe's is also exposed to a California wage-and-hour class action, though management does not consider it material to the financial statements at this stage.

LOW 10-K FY2008 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed April 1, 2008. Cited figures are marked; the original filing is the authoritative source.

Lowe's Companies (LOW) reported fiscal 2007 (ended February 1, 2008) net sales of $48.3 billion^a, up 2.9% year over year, but the growth came entirely from store expansion: comparable store sales fell 5.1%, with every quarter negative.

Net earnings declined 9.5% to $2.8 billion, and diluted EPS fell to $1.86^b from $1.99. Operating margin pressure was broad-based: SG&A deleveraged 103 basis points to 21.78% of sales, driven mainly by store payroll (67 bps) as stores hit minimum staffing levels in a weak sales environment, and depreciation rose 35 bps to 2.83% of sales on 153 new stores. Pre-tax margin fell 131 bps to 9.34%.

Management described the housing-driven slowdown as continuing into 2008, with a 2008 outlook calling for roughly 3% sales growth, comparable store sales down 5% to 6%, and EBIT margin down about 180 bps. Balance sheet and cash flow shifted toward leverage and capital returns. Long-term debt rose to $5.6 billion^c, the debt-to-capital ratio climbed to 29.3% from 22.0%, and short-term borrowings reached $1.06 billion as the company funded buybacks and expansion.

Operating cash flow was $4.3 billion^d against $4.0 billion of fixed-asset spending, so free cash flow was thin. The company repurchased $2.3 billion of stock, leaving $2.2 billion authorized, and raised the quarterly dividend 60% to $0.08 per share. Fitch cut Lowe's commercial paper rating to F1 from F1+ in March 2008 and moved the senior debt outlook to negative, a signal to watch for financing costs.

Management is responding by slowing growth to 120 new stores in 2008 (from 153), cutting major remerchandising projects, and trimming capital spending, while continuing to gain unit market share (about 80 bps in 2007). Investors should weigh the strong long-term store footprint and market share gains against near-term earnings pressure, rising leverage, and a housing market that management expects to remain challenging through 2008.

02—Key points

Key Highlights

Net sales rose 2.9% to $48.3 billion, but comparable store sales fell 5.1%, with all four quarters negative (Q1 -6.3%, Q4 -7.6%).
Net earnings fell 9.5% to $2.81 billion and diluted EPS fell to $1.86 from $1.99; pre-tax margin contracted 131 bps to 9.34%.
SG&A deleveraged 103 bps to 21.78% of sales, mainly from store payroll (67 bps) as weaker sales per store pushed stores to minimum staffing hours.
Total debt rose sharply: long-term debt reached $5.6 billion, the debt-to-capital ratio rose to 29.3% from 22.0%, and short-term borrowings reached $1.06 billion.
Fitch downgraded commercial paper to F1 from F1+ and moved the senior debt outlook to negative in March 2008.
2008 guidance: about 3% sales growth, comparable store sales down 5% to 6%, EBIT margin down about 180 bps, and 120 new stores versus 153 in 2007.
Shareholder returns continued: $2.3 billion in buybacks in 2007 with $2.2 billion remaining, and the quarterly dividend was raised 60% to $0.08, though the 2008 outlook assumes no repurchases.

03—One dollar

04—Financials

Financial Highlights

10-KFY2008filed April 1, 2008

Revenue$48.28B34.6% Gross Margin Net Income$2.81B5.8% Net Margin EPS (Diluted)$1.86 Cash & Equivalents$281.00M Free Cash Flow$337.00M

Financial Statements

Revenue	$48.28B
Cost of Revenue	$31.56B
Gross Profit	$16.73B
SG&A Expenses	$10.52B
Operating Expenses	$12.22B
Interest Expense	$194.00M
Net Income	$2.81B
EPS (Basic)	$1.89
EPS (Diluted)	$1.86

05—Questions

Frequently Asked Questions

Why did sales grow while the company's core store performance weakened?
Growth came from the store expansion program: 153 stores opened in fiscal 2007, bringing the total to 1,534 and increasing selling square footage about 11%. Comparable store sales, which measure mature stores, fell 5.1% due to a soft housing market, tight mortgage conditions, lumber and plywood deflation, and unseasonable weather including drought. Average ticket fell 2.8% to $67.05, reflecting fewer large projects, while customer transactions rose 5.9%.
What drove the decline in profitability?
Margins compressed on expense deleverage rather than gross margin, which actually improved 12 bps to 34.64% on product mix and imports. SG&A rose to 21.78% of sales, mostly from store payroll that could not be cut as fast as sales declined, plus fixed costs like rent and utilities. Depreciation rose to 2.83% of sales from 2.48% because of the new stores and weak sales. Net interest expense also increased 26% to $194 million on new debt.
Is Lowe's balance sheet and liquidity under pressure?
The balance sheet is more leveraged but still sound. Long-term debt rose to $5.6 billion and the debt-to-capital ratio reached 29.3%. Operating cash flow of $4.3 billion covered most of the $4.0 billion in fixed-asset purchases, but buybacks and dividends were funded partly with new borrowings. The company was in compliance with all debt covenants, and it has $1.75 billion of credit facilities. Fitch's outlook change and lower commercial paper rating could raise borrowing costs, though management said there are no debt provisions requiring early repayment after a downgrade.
What is management's outlook for 2008?
Management expects a challenging year. Sales are projected to rise about 3% on store growth, but comparable store sales are expected to fall 5% to 6%, and EBIT margin is expected to decline about 180 bps. Diluted EPS guidance was $1.50 to $1.58 for fiscal 2008. Management is reducing capital and expansion: 120 new stores instead of the originally planned higher number, about 80 major remerchandising projects instead of 116, and capex of about $4.2 billion gross. Management noted some headwinds may ease as 2008 progresses, including the economic stimulus package and Federal Reserve rate cuts.
What are the main risks to the investment case?
The key risks are continued weakness in housing turnover, home prices, and mortgage availability, along with higher unemployment (forecast at 5.3% for 2008 versus 4.6% in 2007). Other risks include weather volatility, competition from other home improvement and general merchandise retailers, supply chain disruption and import exposure (about 7,000 vendors), product liability claims (self-insured), and execution risk in the expansion into Canada and Mexico. Lowe's is also exposed to a California wage-and-hour class action, though management does not consider it material to the financial statements at this stage.

06—Continue

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