Home Retailers Getting Closer to Good

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Home improvement's big boys are 2 for 2 on the earnings scoreboard. Or possibly 0 for 2, depending on your perspective.

Both Home Depot (NYSE: HD) and Lowe's (NYSE: LOW) beat analysts' estimated earnings last quarter. But those expectations were woefully low, and both companies fell short of last year's comps.

It seems like the initial investor response in both cases was to accentuate the positive and allow for the ill effects of the oncoming recession. I, on the other hand, was prepared to take my ax and start chopping up both companies as if they were firewood.

Then a funny thing happened ...
Lowe's told us Monday morning that it had earned $0.33 per share, topping estimates of $0.28 per share, but falling a dime short of last year's third-quarter earnings. Home Depot followed suit today, reporting earnings of $0.45 per share. That was better than the $0.38 analysts expected, but well shy of the $0.60 per share the company earned during the third quarter of 2007.

Of course, earnings are one thing -- margins are another.

As recent results from retailers like J.C. Penney (NYSE: JCP), Liz Claiborne (NYSE: LIZ), and Nordstrom (NYSE: JWN) have shown, it's clear that the decline in consumer spending is generally hurting bottom lines even more than top lines. For instance, Nordstrom's third-quarter net earnings margin dropped by more than half, from 8.4% last year to 3.9% this year, even though total sales were only down 8.3% for the quarter.

Cash flow is critical for retailers, since margins are typically very thin. That's why quick inventory turnover is so important. If one or the other takes a hit, it can really crimp the business. That, in turn, is why I was worried about Lowe's and Home Depot -- but my assumption was pleasantly wrong.

Making do with less
Lowe's and Home Depot both fared well in terms of profitability last quarter. A decent 4.2% of Lowe's net sales of $11.7 billion made it to the bottom line, following a 1.4% revenue increase. That's not as strong as last year's Q3 margin of 5.6%, but then again, last year we weren't experiencing a credit nightmare.

Home Depot also cleared 4.2% of its $17.8 billion in sales during Q3. That also wasn't as strong as last year's margin of 5.7%, but it's still a respectable figure, especially since total sales fell by 6.2%.

Just to be clear, I'm not saying you should add Lowe's or Home Depot to your portfolio today, just because they both topped estimates or remained more than marginally profitable. I still see challenges ahead for both retailers, which should hurt the dollar amounts of the top and bottom lines.

Home Depot has halted the bulk of its planned new store openings, on top of closing unprofitable stores, as a way to control expenses. Lowe's scaled back its planned store openings in 2009 to somewhere between 75 and 85, far less than 2008's target of 120.

Given that new stores generate substantial sales, I'm not looking for significant top-line increases for either company over the next two quarters. After those two quarters are over, though, I see change for the better.

The bigger picture
I'm simply saying that both of these organizations have proven their ability to remain attractively profitable in a painfully tight economy, and in a ridiculously weak housing market. They're not quite doing more with less, but they've at least held their ground. Running lean now will position them for growth when the right time comes.

And when will that be? Great question.

On Thursday, we're going to hear about October's housing starts and building permits. I fully expect them to be worse than September's numbers, which were already back to 1991 levels. They've been sinking since early 2006, but became really disconcerting about a year ago.

Now that there's no denying that the economy is in shambles, we can at least start the economic rebuilding process. Homebuilders like Toll Brothers (NYSE: TOL) and Pulte (NYSE: PHM) should follow, as should the home retailers. So, to answer my "when" question, I don't think it's an overnight fix ... more like months.

Barring yet another economic/credit setback, I expect both Lowe's and Home Depot to start pushing the top and bottom lines higher again in the second half of 2009. Part of my outlook is rooted in my expectation of a slightly healthier economy then; the other part of it simply recognizes that the bar will be set pretty low.

Lowe's has now posted five straight declines in quarter-over-quarter earnings. Home Depot has done so eight times. It can't be mere coincidence that those time frames coincide with the demise of housing permits and starts. More importantly to investors though, the comps should be easy to top once housing is on the mend.

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