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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 (NYSE:LOW) and Home Depot (NYSE: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 (NYSE:WMT), instead of Macy’s (NYSE: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

Source: Why I Sold Lowe's Short