EX-13 3 exhibit13.htm EXHIBIT 13 - PORTIONS OF LOWE'S 2006 ANNUAL REPORT TO SHAREHOLDERS EXHIBIT 13 - PORTIONS OF LOWE'S 2006 ANNUAL REPORT TO SHAREHOLDERS
Exhibit 13
 
 


FINANCIAL CONDITION AND RESULTS OF OPERATIONS


This discussion and analysis summarizes the significant factors affecting our consolidated operating results, financial condition, liquidity and capital resources during the three-year period ended February 2, 2007 (our fiscal years 2006, 2005 and 2004). Fiscal years 2006 and 2004 contain 52 weeks of operating results compared to fiscal year 2005 which contains 53 weeks. Unless otherwise noted, all references herein for the years 2006, 2005 and 2004 represent the fiscal years ended February 2, 2007, February 3, 2006, and January 28, 2005, respectively. This discussion should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements included in this annual report.

EXECUTIVE OVERVIEW

External Factors Impacting Our Business

The home improvement market is large and fragmented. While we are the world’s second-largest home improvement retailer, we have captured a relatively small portion of the overall home improvement market. We estimate the size of the U.S. home improvement market to be approximately $725 billion annually, comprised of $560 billion of product demand and $165 billion of installed labor opportunity. This data captures a wide range of categories relevant to our business, including major appliances and garden supplies. We believe the current home improvement market provides ample opportunity to support our growth plans.

Net sales totaled $46.9 billion in 2006, an increase of 8.5% versus the prior year. This increase was driven by our store expansion program. The additional week in 2005 resulted in approximately $750 million in additional net sales in 2005. Excluding the additional week, net sales would have increased approximately 10% in 2006. However, comparable store sales were flat in 2006. The effects of a slowing housing market, difficult comparisons to 2005’s hurricane recovery and rebuilding efforts, and significant deflation in lumber and plywood retail prices contributed to lower than expected sales.

At the beginning of 2006, many markets including areas of the Northeast, southern Florida and the west coast demonstrated signs of slowing housing-related demand. That evidence led us to estimate housing turnover would decline in 2006 as these once-hot markets cooled. What was more difficult to anticipate was the decline in home improvement demand that we experienced in many unaffected markets where housing dynamics remained solid, but consumers chose to delay home improvement projects due to well-publicized reports of a slowing housing market and declining home values. As the year progressed, housing turnover slowed more quickly and deeply than we had originally anticipated.  That rapid decline also pressured home prices as speculative demand waned, housing supply grew and home buyers, as well as home improvement consumers, became cautious about spending. We continue to closely monitor the drivers of demand and the mindset of the home improvement consumer as we enter 2007.

Despite the housing-related pressures on the consumer, the job market remains solid and personal disposable income continues to rise.  In addition, the difficult sales comparisons due to 2005’s hurricanes and last year’s commodity deflation are expected to ease in 2007.  While we are not expecting a rapid recovery, the most recent housing data shows encouraging signs of a stabilization of housing supply and a bottoming in total housing turnover. Based on all these external factors, combined with our internal initiatives to drive sales, we believe the quarterly trend of declining comparable store sales performance has bottomed, and we expect to see gradual improvement in comparable store sales throughout 2007.
 
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Managing for the Long-Term

We continue to manage our business for the long-term. Our vision is to provide customer-valued solutions with the best prices, products and services to make Lowe’s the first choice for home improvement. In today’s environment, it is important that we remain focused on customers. This focus on customers drives our operational, merchandising, marketing and distribution initiatives to both capture market share and improve operating efficiency.

Capturing Market Share

Investing in existing stores

We continue to gain unit market share by improving the shopping experience in our stores, and by adding innovative products and services that provide value to customers. In addition, we have opportunities to capture additional unit market share in each of our 20 product categories by ensuring that we meet the needs of home improvement customers better than our competitors.

We have consistently invested in our business, and we will continue to do so to ensure our stores remain clean, easy to shop and appropriately staffed in order to maintain our customer franchise and grow unit market share. In 2006, we remerchandised 150 of our earlier-format stores to make them more closely resemble our current store prototypes, with minimal disruption to our customers. These remerchandising efforts focused on moving entire departments, improving adjacencies, and enhancing the shopability within the appliances, cabinets & countertops, flooring, fashion plumbing, paint, walls / windows, lighting, home organization, lumber and building materials departments. In addition, we replaced or refurbished all of our selling centers, including the returns and customer service areas of these stores. All new interior graphics, signage, and way-finding materials were also added to increase shopability and brighten the atmosphere. Finally, we installed self-check-out in all 150 of our remerchandised stores. In 2007, we expect to complete the remerchandising process in over 100 additional stores. We continuously make these investments to maintain our best-in-class stores and offer customers the shopping experience and environment they expect. As a result, despite the external pressures we faced in 2006, we gained 110 basis points of unit market share among all 20 of our product categories, according to independent measures, a clear indication that more customers are choosing Lowe’s for their home improvement needs.

Specialty Sales

We recognize the opportunity that our Specialty Sales initiatives represent and the importance of these businesses to our long-term growth. Our Specialty Sales initiatives include three major categories: Installed Sales, Special Order Sales and Commercial Business Customer sales, internally referred to as the “Big 3.” In addition, our effort to utilize e-Commerce to drive sales and conveniently provide product information to customers is managed by our Specialty Sales group. Our Big 3 Specialty Sales initiatives had mixed results in 2006. A hesitation to take on large projects by some consumers had an impact on our Installed Sales and Special Order Sales in the second half of 2006. Installed Sales increased by slightly more than the Company average, while Special Order Sales increased less than the Company average. However, sales growth for Commercial Business Customers was nearly double the Company average.

We also continue to refine our offerings, including an ongoing test of an in-home selling model for certain Installed Sales categories, new Special Order electronic selling tools, and many enhancements to Lowes.com, to continue growth in these areas for 2007.

New store expansion

We have considerable growth opportunities and see the potential for over 2,000 stores in North America with our current prototypes. In 2006, we opened 155 stores (151 new and four relocated) in markets around the country, bringing our total to 1,385 stores in 49 states. We plan to open another 150 to 160 stores in 2007, including our first stores in Toronto, Canada in the second half of 2007. We also announced our intention to enter Mexico with plans for three to five stores in Monterrey in 2009.
 
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Improving Operating Efficiency

Store productivity

We are focused on improving store productivity and operational efficiency. The more productive our employees are on tasks, the more time they have to assist customers. The basics of sustaining productivity include assessing the value of tasks performed, accurate planning of sales and hours, ensuring our employees are scheduled when customers are shopping, and monitoring key labor metrics. We will also continue to ensure that our employee base includes tenured and talented people at all levels of the organization to fuel growth and maintain our commitment to service.

We are also working to further enhance our sales culture by continuously providing training for our team and improving our service. Customers tell us that they want knowledgeable sales people, so we will continue to focus on expanding our employees’ product knowledge.

Merchandising

One way we seek to increase sales is by effectively using displays, signage, adjacencies and product packaging as tools to enhance the shopping experience. When customers can easily identify features and benefits, compare product choices and shop for related purchases nearby, they purchase more. When packaging is consistent and informative, when allocated space has enough holding power to satisfy demand and when store employees keep the displays stocked and shopable, our customers’ experience is enhanced. When signage is clear, concise and gives customers information they need to make a buying decision, they will also purchase more. This is the operationally efficient merchandising approach that continues to drive sales in our stores.
 
Distribution network

Our distribution network supports new store expansion and improves operating efficiency. To improve the service and efficiency of this network, our largest initiative over the past couple of years was Rapid Response Replenishment (R3), which encompassed numerous supply chain enhancements that would allow us to more effectively and efficiently move product to our stores in changing demand environments. That platform is firmly in place and is now our standard operating model. Many years of investment in and refinement of our logistics and distribution organization have made it one of our key competitive advantages. The organization is focused on improving service to our stores, increasing efficiency and improving inventory productivity. On average in 2006, nearly 70% of the stock merchandise we purchased was shipped through our distribution network, while the remaining portion was shipped directly to stores from vendors. In the fourth quarter of 2006, we reached nearly 75%. As evidence of the effectiveness gained from our distribution network, both comparable store and distribution center inventories were down slightly versus the prior year.
 
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
The following discussion and analysis of our financial condition and results of operations are based on the consolidated financial statements and notes to consolidated financial statements presented in this annual report that have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates that affect the reported amounts of assets, liabilities, sales and expenses, and related disclosures of contingent assets and liabilities. We base these estimates on historical results and various other assumptions believed to be reasonable, all of which form the basis for making estimates concerning the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates.

Our significant accounting policies are described in Note 1 to the consolidated financial statements. We believe that the following accounting policies affect the more significant estimates used in preparing the consolidated financial statements.
 
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Merchandise Inventory

Description
We record an inventory reserve for the loss associated with selling inventories below cost. This reserve is based on our current knowledge with respect to inventory levels, sales trends and historical experience. During 2006, our reserve decreased $38 million to $66 million as of February 2, 2007, as a result of better sell-through of obsolete or slow-moving inventory. We also record an inventory reserve for the estimated shrinkage between physical inventories. This reserve is based primarily on actual shrinkage results from previous physical inventories. During 2006, the inventory shrinkage reserve increased $16 million to $129 million as of February 2, 2007.

Judgments and uncertainties involved in the estimate
We do not believe that our merchandise inventories are subject to significant risk of obsolescence in the near term, and we have the ability to adjust purchasing practices based on anticipated sales trends and general economic conditions. However, changes in consumer purchasing patterns could result in the need for additional reserves. Likewise, changes in the estimated shrink reserve may be necessary, based on the results of physical inventories.

Effect if actual results differ from assumptions
Although we believe that we have sufficient current and historical knowledge to record reasonable estimates for both of these inventory reserves, it is possible that actual results could differ from recorded reserves. A 10% change in our obsolete inventory reserve would have affected net earnings by approximately $4 million for 2006. A 10% change in our estimated shrinkage reserve would have affected net earnings by approximately $8 million for 2006.

Vendor Funds

Description
We receive funds from vendors in the normal course of business, principally as a result of purchase volumes, sales, early payments, or promotions of vendors’ products.

Under Emerging Issues Task Force Issue No. 02-16 (EITF 02-16), “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,” vendor funds are treated as a reduction of inventory cost, unless they represent a reimbursement of specific, incremental and identifiable costs incurred by the customer to sell the vendor’s product. Substantially all of the vendor funds that we receive do not meet the specific, incremental and identifiable criteria in EITF 02-16. Therefore, we treat the majority of these funds as a reduction in the cost of inventory as the amounts are earned and recognize these funds as a reduction of cost of sales when the inventory is sold.

Judgments and uncertainties involved in the estimate
Based on the provisions of the vendor agreements in place, we develop vendor fund accrual rates by estimating the point at which we will have completed our performance under the agreement and the amounts will be earned. During the year, due to the complexity and diversity of the individual vendor agreements, we perform analyses and review historical trends to ensure the amounts earned are appropriately recorded. As a part of these analyses, we validate our accrual rates based on actual purchase trends and apply those rates to actual purchase volumes to determine the amount of funds accrued and receivable from the vendor. Amounts accrued throughout the year could be impacted if actual purchase volumes differ from projected annual purchase volumes, especially in the case of programs that provide for increased funding when graduated purchase volumes are met.

Effect if actual results differ from assumptions
If actual results are not consistent with the assumptions and estimates used, we could be exposed to additional adjustments that could positively or negatively impact gross margin and inventory. However, substantially all receivables associated with these activities are collected within the following fiscal year and therefore do not require subjective long-term estimates. Adjustments to gross margin and inventory in the following fiscal year have historically not been material.
 
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Self-Insurance

Description
We are self-insured for certain losses relating to workers’ compensation, automobile, property, general and product liability, and certain medical and dental claims. Self-insurance claims filed and claims incurred but not reported are accrued based upon our estimates of the discounted ultimate cost for self-insured claims incurred using actuarial assumptions followed in the insurance industry and historical experience. During 2006, our self-insurance liability increased $79 million to $650 million as of February 2, 2007 as a result of an increase in the number of stores and employees.

Judgments and uncertainties involved in the estimate
These estimates are subject to changes in the utilized discount rate, payroll, sales and vehicle units, as well as the frequency and severity of claims.

Effect if actual results differ from assumptions
Although we believe that we have the ability to adequately record estimated losses related to claims, it is possible that actual results could differ from recorded self-insurance liabilities. A 10% change in our self-insurance liability would have affected net earnings by approximately $40 million for 2006. A 1% change in our discount rate would have affected net earnings by approximately $9 million for 2006.

Revenue Recognition

Description
See Note 1 to the consolidated financial statements for a complete discussion of our revenue recognition policies. The following accounting estimates relating to revenue recognition require management to make assumptions and apply judgment regarding the effects of future events that cannot be determined with certainty.

Revenues from stored value cards, which include gift cards and returned merchandise credits, are deferred and recognized when the cards are redeemed. We recognize income from unredeemed stored value cards at the point at which redemption becomes remote.  Our stored value cards have no expiration. Therefore, to determine when redemption is remote, we analyze an aging of the unredeemed cards, based on the date of last stored value card use. The deferred revenue associated with outstanding stored value cards increased $74 million to $367 million as of February 2, 2007.

We sell separately-priced extended warranty contracts under a Lowe’s-branded program for which the Company is ultimately self-insured. We recognize revenues from extended warranty sales on a straight-line basis over the respective contract term due to a lack of sufficient historical evidence indicating that costs of performing services under the contracts are incurred on an other than straight-line basis as a result of the program being in its beginning stages. Extended warranty contract terms primarily range from one to four years from the date of purchase or the end of the manufacturer’s warranty, as applicable. We consistently group and evaluate extended warranty contracts based on the characteristics of the underlying products and the coverage provided in order to monitor for expected losses. A loss would be recognized if the expected costs of performing services under the contracts exceeded the amount of unamortized acquisition costs and related deferred revenue associated with the contracts. Deferred revenues associated with the extended warranty contracts increased $109 million to $315 million as of February 2, 2007. The liability associated with unpaid extended warranty claims incurred was insignificant as of February 2, 2007 and February 3, 2006.

We record a reserve for anticipated merchandise returns through a reduction of sales and costs of sales in the period that the related sales are recorded. We use historical return levels to estimate return rates, which are applied to sales during the estimated average return period.

Judgments and uncertainties involved in the estimate
There is judgment inherent in our evaluation of when the redemption of stored value cards becomes remote, and therefore, when the related income is recognized.
 
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For extended warranties, there is judgment inherent in our evaluation of expected losses as a result of our methodology for grouping and evaluating extended warranty contracts and from the actuarial determination of the estimated cost of the contracts. There is also judgment inherent in our determination of the recognition pattern of costs of performing services under these contracts.

There is judgment applied in our estimate of historical return levels and in the determination of the average return period.

Effect if actual results differ from assumptions
We do not anticipate that there will be a material change in the future estimates or assumptions we use to recognize income related to unredeemed stored value cards. However, if actual results are not consistent with our estimates or assumptions, we may incur additional income or expense. A 10% change in the estimate of unredeemed stored value cards for which redemption is considered remote would have affected net earnings by approximately $2 million in 2006.

We currently do not anticipate incurring any losses on our extended warranty contracts. Although we believe that we have the ability to adequately monitor and estimate expected losses under the extended warranty contracts, it is possible that actual results could differ from our estimates. In addition, if future evidence indicates that the costs of performing services under these contracts are incurred on other than a straight-line basis, the timing of revenue recognition under these contracts could change. A 10% change in the amount of revenue recognized in 2006 under these contracts would have affected net earnings by approximately $2 million.

Although we believe we have sufficient current and historical knowledge to record reasonable estimates of sales returns, it is possible that actual returns could differ from recorded amounts. A 1% change in actual returns would have affected net earnings for 2006 by approximately $3 million. A 1% change in the average return period would not have had a significant impact on net earnings for 2006.
 
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OPERATIONS

The following table sets forth the percentage relationship to net sales of each line item of the consolidated statements of earnings, as well as the percentage change in dollar amounts from the prior year. This table should be read in conjunction with the following discussion and analysis and the consolidated financial statements, including the related notes to the consolidated financial statements.
 

 
               
Basis Point Increase / (Decrease) in Percentage of
Net Sales from Prior Year 1 
   
Percentage Increase / (Decrease) in Dollar Amounts from Prior Year 1
 
 
 
 
2006
 
 
2005
 
 
2006 vs. 2005
 
 
2006 vs. 2005
 
Net sales
   
100.00
%
 
100.00
%
 
N/A
   
9
 %
Gross margin
   
34.52
   
34.20
   
32
   
10
 
Expenses:
                         
Selling, general and administrative
   
20.75
   
20.84
   
(9
)
 
8
 
Store opening costs
   
0.31
   
0.33
   
(2
)
 
3
 
Depreciation
   
2.48
   
2.27
   
21
   
19
 
Interest - net
   
0.33
   
0.37
   
(4
)
 
(3
)
Total expenses
   
23.87
   
23.81
   
6
   
9
 
Pre-tax earnings
   
10.65
   
10.39
   
26
   
11
 
Income tax provision
   
4.03
   
4.00
   
3
   
9
 
Net earnings
   
6.62
%
 
6.39
%
 
23
   
12
 %
 
 
 
         
 
 
 
Basis Point Increase / (Decrease) in Percentage of Net Sales from
Prior Year 1 
 
 
Percentage Increase / (Decrease) in Dollar Amounts from Prior Year 1
 
 
 
 
2005
 
 
2004
 
 
2005 vs. 2004
 
 
2005 vs. 2004
 
Net sales
   
100.00
%
 
100.00
%
 
N/A
   
19
 %
Gross margin
   
34.20
   
33.56
   
64
   
21
 
Expenses:
                         
Selling, general and administrative
   
20.84
   
20.74
   
10
   
19
 
Store opening costs
   
0.33
   
0.34
   
(1
)
 
15
 
Depreciation
   
2.27
   
2.35
   
(8
)
 
14
 
Interest - net
   
0.37
   
0.48
   
(11
)
 
(10
)
Total expenses
   
23.81
   
23.91
   
(10
)
 
18
 
Pre-tax earnings
   
10.39
   
9.65
   
74
   
28
 
Income tax provision
   
4.00
   
3.71
   
29
   
28
 
Net earnings
   
6.39
%
 
5.94
%
 
45
   
28
 %
 

Other Metrics
   
2006
 
 
2005
 
 
2004
 
Comparable store sales increases 2
   
0.0
%
 
6.1
%
 
6.6
%
Customer transactions (in millions) 1
   
680
   
639
   
575
 
Average ticket 1, 3
 
$
68.98
 
$
67.67
 
$
63.43
 
                     
At end of year:
                   
Number of stores
   
1,385
   
1,234
   
1,087
 
Sales floor square feet (in millions)
   
157
   
140
   
124
 
Average store size selling square feet (in thousands)
   
113
   
113
   
114
 
                     
Return on beginning assets 1, 4
   
12.6
%
 
13.1
%
 
11.6
%
Return on beginning shareholders' equity 1, 5
   
21.7
%
 
24.0
%
 
21.3
%
 
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1 The fiscal years ended February 2, 2007 and January 28, 2005 had 52 weeks. The fiscal year ended February 3, 2006 had 53 weeks.
2 We define a comparable store as a store that has been open longer than 13 months.  A store that is identified for relocation is no longer considered comparable one month prior to its relocation. The relocated store must then remain open longer than 13 months to be considered comparable. The comparable store sales increase for 2006 included in the preceding table was calculated using sales for a comparable 52-week period, while the comparable store sales increase for 2005 was calculated using sales for a comparable 53-week period.
3 We define average ticket as net sales divided by number of customer transactions.
4 Return on beginning assets is defined as net earnings divided by beginning total assets.
5 Return on beginning shareholders’ equity is defined as net earnings divided by beginning shareholders’ equity.

Fiscal 2006 Compared to Fiscal 2005

For the purpose of the following discussion, comparable store sales, comparable store average ticket and comparable store customer transactions are based on comparable 52-week periods.

Net sales - Our continued focus on executing the fundamentals and providing customer-valued solutions together with our store expansion program drove sales of $46.9 billion in 2006. We opened 155 stores in 2006, including four relocations, and ended the year with 1,385 stores in 49 states. The additional week in 2005 resulted in approximately $750 million in additional net sales in 2005. Excluding the additional week, net sales would have increased approximately 10% in 2006.

Comparable store sales were flat in 2006 versus a comparable store sales increase of 6.1% in 2005. Average ticket for comparable stores increased slightly versus the prior year, but comparable store customer transactions declined slightly.

Although nine of our 21 regions had comparable store sales increases for 2006, sales in many areas of the country were pressured by the slowdown in the housing market. Markets in the Northeast, Florida and California were most exposed to the slowdown in housing in 2006. Sales trends in those areas clearly indicated a cautious home improvement consumer. Also, areas of the Gulf Coast and Florida, which experienced increased demand in 2005 related to rebuilding from the hurricanes, experienced comparable store sales declines in the second half of 2006. We expect the difficult sales comparisons to ease in the second half of 2007 as we pass the second anniversary of Hurricanes Katrina, Rita and Wilma.

Reflective of the difficult sales environment, only 11 of our 20 product categories experienced comparable store sales increases in 2006. The categories that performed above our average comparable store sales change included rough plumbing, building materials, rough electrical, home environment, paint, fashion plumbing, flooring, nursery, seasonal living, and lawn & landscape products. In addition, hardware performed at approximately our average comparable store sales change in 2006. Despite the difficult sales environment, we were able to gain unit market share in all of our 20 product categories versus the prior calendar year, according to third-party estimates.

Outdoor power equipment and lumber experienced the greatest comparable store sales declines in 2006. Comparable store generator sales were down 34% for the year, compared to strong sales driven by the 2005 hurricanes. Additionally, a warmer than normal winter led to comparable store sales declines for snow throwers. However, despite the difficult sales environment, we experienced a 2% unit market share gain in outdoor power equipment in calendar year 2006. Lumber and plywood experienced more than 15% cost deflation and similar retail price deflation in 2006.

Our Big 3 Specialty Sales initiatives had mixed results in 2006. A hesitation to take on large projects by some consumers had an impact on our Installed Sales and Special Order Sales in the second half of 2006. Installed Sales increased 9% over 2005. Our Installed Sales consist of both stock and special order product for which we arrange installation for our customers. Special Order Sales increased 5% over 2005. In contrast, sales growth for Commercial Business Customers was nearly double the Company average.
 
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Gross margin - For 2006, gross margin of 34.52% represented a 32-basis-point increase over 2005. This increase as a percentage of sales was primarily due to positive product mix shifts and a greater proportion of imported goods, which typically have lower acquisition costs. For 2006, we imported approximately 11% of our goods compared to approximately 9.5% in the prior year. These items were slightly offset by higher inventory shrink as a percentage of sales.

SG&A - The decrease in SG&A as a percentage of sales from 2005 to 2006 was primarily due to lower expenses related to bonus and retirement plans. Our performance-based bonus and retirement expenses fluctuate with our sales and earnings performance relative to plan, and decreased approximately $200 million or 50 basis points in 2006. In addition, insurance expense leveraged 12 basis points in 2006, a result of our ongoing safety initiatives and the benefits of regulatory changes in certain states, which contributed to actuarial projections of lower costs to settle claims. These items were partially offset by de-leverage in store payroll. As sales slowed throughout the year, our stores adjusted their hours accordingly. However, because of our base staffing requirements and customer service standards, we chose not to reduce payroll at the same rate as sales.

Store opening costs - Store opening costs, which include payroll and supply costs incurred prior to store opening as well as grand opening advertising costs, totaled $146 million in 2006 compared to $142 million in 2005. These costs are associated with the opening of 155 stores in 2006 (151 new and four relocated), as compared with the opening of 150 stores in 2005 (147 new and three relocated). Store opening costs for stores opened during the year averaged approximately $0.9 million per store in 2006 and 2005. Because store opening costs are expensed as incurred, the timing of expense recognition fluctuates based on the timing of store openings.

Depreciation - Depreciation de-leveraged 21 basis points as a percentage of sales in 2006. This de-leverage was driven by growth in assets and the softer sales environment. At February 2, 2007, we owned 86% of our stores, compared to 84% at February 3, 2006, which includes stores on leased land. Property, less accumulated depreciation, increased to $19.0 billion at February 2, 2007, compared to $16.4 billion at February 3, 2006. The increase in property resulted primarily from our store expansion program as well as our remerchandising efforts.

Interest - Net interest expense is comprised of the following:

(In millions)
   
2006
 
 
2005
 
Interest expense, net of amount capitalized
 
$
200
 
$
186
 
Amortization of original issue discount and loan costs
   
6
   
17
 
Interest income
   
(52
)
 
(45
)
Net interest expense
 
$
154
 
$
158
 

Interest expense increased primarily due to the October 2006 $1 billion debt issuance, partially offset by lower interest expense on convertible debt due to conversions during 2006. Interest expense relating to capital leases was $34 million for 2006 and $39 million for 2005. Amortization of loan costs decreased in 2006 versus the prior year as a result of increased debt conversions.

Income tax provision - Our effective income tax rate was 37.9% in 2006 versus 38.5% in 2005. The decrease in the effective tax rate was the result of increased federal tax credits associated with Welfare to Work and Work Opportunity Tax Credit programs and increased state tax credits related to our investments in employees and property.

Fiscal 2005 Compared to Fiscal 2004

For the purpose of the following discussion, comparable store sales, comparable store average ticket and comparable store customer transactions are based on comparable 53-week periods.

Net sales - Comparable store sales, our ongoing store expansion and relocation program and continued growth in our Specialty Sales initiatives were key drivers of our sales increase in 2005. We opened 150 stores in 2005, including three relocations, and ended the year with stores in 49 states, including our first stores in New Hampshire. The additional week in 2005 resulted in approximately $750 million in sales and impacted 2005 sales growth by about 2.1%.
 
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The comparable store sales increase of 6.1% in 2005 was on top of comparable store sales increases of 6.6% in 2004 and 6.7% in 2003. The comparable store sales increase in 2005 was driven by increases in both average ticket and transactions. Average ticket for comparable stores increased 6.1% and comparable store customer transactions increased slightly.

We experienced comparable store sales increases in every product category for 2005. The categories that performed above our average comparable store sales increase for 2005 included millwork, rough plumbing, building materials, rough electrical, outdoor power equipment, appliances, home environment, paint, flooring and cabinets & countertops. In addition, hardware and fashion plumbing performed at approximately the average comparable store sales increase. Inflation in lumber and building materials favorably impacted comparable store sales for 2005 by approximately 50 basis points, driven by gypsum, roofing and cement products. We also continued to gain market share in key product categories previously dominated by other channels, including appliances, outdoor power equipment and cabinets & countertops.

The appliance category delivered a double-digit comparable store sales increase for 2005. According to independent measures, we increased our unit market share in major appliances by 130 basis points for calendar year 2005 versus calendar year 2004. Our success in appliances is a function of our brand selection and knowledgeable sales specialists. The introduction of Samsung digital appliances in 2005 was evidence of our commitment to enhance our brand selection and competitive offering.

We experienced a double-digit comparable store sales increase for 2005 in cabinets & countertops, which was driven by emphasis on our product offering, as well as a focus on our Installed Sales initiative, which plays a key role in driving cabinets & countertops sales.

Outdoor power equipment delivered a high single-digit comparable store sales increase for the year. According to independent measures, we increased our outdoor power equipment unit market share by 190 basis points for calendar year 2005 versus calendar year 2004.

We also experienced comparable store sales increases in 18 of the 21 geographic regions. We continued to experience strong sales in Florida and the Gulf Coast regions as customers repaired the damage caused by the hurricanes in 2005 and 2004. We experienced comparable store sales decreases in two Northeastern regions that had a slow, weather-affected start in the first quarter and never fully recovered. In addition, certain areas of our North Central division suffered from headline-making layoffs and plant closings, which contributed to these decreases in comparable store sales.

The growth in our Big 3 Specialty Sales initiatives also drove our sales increase in 2005. Our focus on execution under our Installed Sales model led to a 31% increase in Installed Sales over 2004. Our growth in 2005 was driven by sales in cabinets & countertops, flooring and millwork. Special Order Sales increased 25% over 2004. Finally, we experienced significant sales growth from Commercial Business Customers. Strengthening customer relationships, supported by targeted marketing and market-specific merchandising assortments, continued to drive this part of our business.

Gross margin - For 2005, gross margin of 34.20% represented a 64-basis-point increase over 2004. Approximately 40 basis points of the increase in gross margin as a percentage of sales for 2005 was due to the impact of the implementation of EITF 02-16 as it related to cooperative advertising and in-store services, which reduced gross margin in 2004 as these funds were capitalized into inventory and recognized in income when the product was sold. The increase in 2005 gross margin was also driven by growth in imported goods, improvements in inventory shrink and a positive sales mix.
 
11

 
SG&A - The increase in SG&A expenses as a percentage of sales from 2004 to 2005 was primarily due to increased 401(k) performance match contributions as a percentage of sales resulting from our increased profitability in 2005. In addition, there were increases as a percentage of sales in store remerchandising expense, which resulted from our continued investment in existing stores, and rent expense, as we continue to expand into metropolitan markets. These increases were partially offset by a decrease in vendor-provided store-service costs as a percentage of sales. Our ongoing evaluation of in-store vendor service expense allowed us to appropriately adjust the level of vendor service in our stores, which led to the decrease as a percentage of sales. In addition, although there was an increase in advertising expense compared to 2004, we were able to enhance messaging and refine our marketing mix to make our advertising programs more productive, thereby resulting in the leverage of advertising expense as a percentage of sales in 2005.

Store opening costs - Store opening costs totaled $142 million in 2005 compared to $123 million in 2004. These costs are associated with the opening of 150 stores in 2005 (147 new and three relocated), as compared with the opening of 140 stores in 2004 (136 new and four relocated). Store opening costs for stores opened during the year averaged approximately $0.9 million per store in 2005 and 2004. Because store opening costs are expensed as incurred, the timing of expense recognition may fluctuate based on the timing of store openings.

Depreciation - Depreciation leveraged eight basis points as a percentage of sales in 2005. At February 3, 2006, we owned 84% of our stores, compared to 81% at January 28, 2005, which includes stores on leased land. Property, less accumulated depreciation, increased to $16.4 billion at February 3, 2006, compared to $13.9 billion at January 28, 2005. The increase in property resulted primarily from our store expansion program and an additional investment in information technology.

Interest - Net interest expense was comprised of the following:

(In millions)
   
2005
 
 
2004
 
Interest expense, net of amount capitalized
 
$
186
 
$
172
 
Amortization of original issue discount and loan costs
   
17
   
20
 
Interest income
   
(45
)
 
(16
)
Net interest expense
 
$
158
 
$
176
 

Interest expense increased primarily due to the October 2005 $1 billion debt issuance, partially offset by lower interest expense on convertible debt due to conversions during 2005. Interest expense relating to capital leases was $39 million for 2005 and $38 million for 2004. Interest income increased primarily due to the investment of a portion of the proceeds from the October 2005 $1 billion debt issuance.

Income tax provision - Our effective income tax rate was 38.5% in 2005 and 2004.

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

We believe in our potential for long-term growth and profitability, and while we are focused on growing sales and earnings, we are also focused on cash flow. By making working capital improvements, we expect cash flow from operations to grow faster than earnings. Our long-term goal is to grow inventory at 75% of sales growth. Our largest initiative over the past couple of years was R3, which encompassed numerous supply chain enhancements that would allow us to more effectively and efficiently move product to our stores in changing demand environments. That platform is firmly in place and is now our standard operating model. In 2006, sales increased 8.5%, while inventory growth was 7.7%. The increase in our inventory balance from 2005 to 2006 was the result of new or non-comparable stores. Both comparable stores and distribution center inventories were down slightly versus the prior year. In addition, we are focused on improving working capital through increased days payable outstanding.
 
12


Cash Flows

The following table summarizes the components of the consolidated statements of cash flows. This table should be read in conjunction with the following discussion and analysis and the consolidated financial statements, including the related notes to the consolidated financial statements:

(In millions)
   
2006
 
 
2005
 
 
2004
 
Net cash provided by operating activities
 
$
4,502
 
$
3,842
 
$
3,073
 
Net cash used in investing activities
   
(3,715
)
 
(3,674
)
 
(2,362
)
Net cash used in financing activities
   
(846
)
 
(275
)
 
(1,047
)
Net decrease in cash and cash equivalents
   
(59
)
 
(107
)
 
(336
)
Cash and cash equivalents, beginning of year
   
423
   
530
   
866
 
Cash and cash equivalents, end of year
 
$
364
 
$
423
 
$
530
 
 
Cash flows from operating activities provide a significant source of our liquidity. The increase in cash provided by operating activities in 2006 compared to 2005 resulted primarily from increased net earnings and increased days payable outstanding, partially offset by the timing of tax payments and a decline in deferred revenue associated with Specialty Sales. The increase in cash provided by operating activities in 2005 compared to 2004 resulted primarily from increased net earnings as well as a lower investment in inventory compared to 2004. Working capital at February 2, 2007, was $1.8 billion compared to $2.0 billion at February 3, 2006. The decrease in working capital was due primarily to increased days payable outstanding.

The primary component of net cash used in investing activities continues to be opening new stores, investing in existing stores through resets and remerchandising, and investing in our distribution center and information technology infrastructure. Cash acquisitions of fixed assets were $3.9 billion for 2006, $3.4 billion in 2005 and $2.9 billion in 2004. The February 2, 2007, retail selling space of 157 million square feet represented a 12% increase over February 3, 2006. The February 3, 2006, retail selling space of 140 million square feet represented a 13% increase over January 28, 2005.

The increase in cash used in financing activities in 2006 compared to 2005 resulted primarily from greater repurchases of common stock under our share repurchase program. The decrease in cash used in financing activities in 2005 compared to 2004 resulted primarily from the proceeds from the October 2005 issuance of $1 billion in senior notes and fewer share repurchases, offset by greater scheduled debt repayments. The ratio of debt to equity plus debt was 22.0% and 19.8% as of the years ended 2006 and 2005, respectively.

Sources of Liquidity

In addition to our cash flows from operations, we have a $1 billion senior credit facility that expires in July 2009 that also provides a source of liquidity. The facility is available to support our commercial paper program and for direct borrowings. Borrowings made are priced based upon market conditions at the time of funding in accordance with the terms of the senior credit facility. The senior credit facility contains certain restrictive covenants, which include maintenance of a debt leverage ratio as defined by the facility. We were in compliance with those covenants at February 2, 2007 and February 3, 2006. Fifteen banking institutions are participating in the $1 billion senior credit facility. As of February 2, 2007, we had $23 million outstanding under the senior credit facility, but no outstanding borrowings under our commercial paper program. The interest rate on the short-term borrowings was 5.4%. As of February 3, 2006, there were no outstanding borrowings under the senior credit facility or under our commercial paper program.
 
13


Five banks have extended lines of credit aggregating $486 million for the purpose of issuing documentary letters of credit and standby letters of credit. These lines do not have termination dates and are reviewed periodically. Commitment fees ranging from .225% to .50% per annum are paid on the letters of credit amounts outstanding. Outstanding letters of credit totaled $346 million as of February 2, 2007, and $316 million as of February 3, 2006. 

Cash Requirements

Our 2007 capital budget is $4.6 billion, inclusive of approximately $300 million of lease commitments, resulting in a net cash outflow of $4.3 billion in 2007.  Approximately 81% of this planned commitment is for store expansion and new distribution centers.  Expansion plans for 2007 consist of 150 to 160 stores, including 4 relocations of older stores.  This planned expansion is expected to increase sales floor square footage by approximately 11%.  All of the 2007 projects will be owned, which includes approximately 32% that will be ground-leased properties. 

On February 2, 2007, we owned and operated 11 regional distribution centers (RDCs). We expect to open additional RDCs in Rockford, Illinois, and Lebanon, Oregon, in 2007, and are planning for an additional RDC in 2008. On February 2, 2007, we also operated 13 flatbed distribution centers for the handling of lumber, building materials and other long-length items. We owned 12 of these flatbed distribution centers, and we leased one flatbed distribution center. We expect to open two additional flatbed distribution centers in 2007.

In October 2006, we issued an additional $1 billion of unsecured senior notes, comprised of two tranches: $550 million of 5.4% senior notes maturing in October 2016 and $450 million of 5.8% senior notes maturing in October 2036. Interest on the senior notes is payable semiannually in arrears in April and October of each year until maturity, beginning in April 2007.

From their issuance through the end of 2006, principal amounts of $967 million, or approximately 96% of our February 2001 convertible notes, had converted from debt to equity. In 2006, $118 million in principal amounts converted.

Holders of the senior convertible notes, issued in October 2001, may convert their notes into 34.424 shares of the company’s common stock only if: the sale price of the company’s common stock reaches specified thresholds, or the credit rating of the notes is below a specified level, or the notes are called for redemption, or specified corporate transactions representing a change in control have occurred. There is no indication that we will not be able to maintain the minimum investment grade rating. From their issuance through the end of 2006, an insignificant amount of the senior convertible notes had converted from debt to equity. During the fourth quarter of 2006, our closing share prices reached the specified threshold such that the senior convertible notes are convertible at the option of each holder into shares of common stock in the first quarter of 2007. Cash interest payments on the senior convertible notes ceased in October 2006. We may redeem for cash all or a portion of the notes at any time, at a price equal to the sum of the issue price plus accrued original issue discount on the redemption date.

Our debt ratings at February 2, 2007, were as follows:

Current Debt Ratings
S&P
Moody’s
Fitch
Commercial Paper
A1
P1
F1+
Senior Debt
A+
A1
A+
Outlook
Stable
Stable
Stable

We believe that net cash provided by operating activities and financing activities will be adequate for our expansion plans and other operating requirements over the next 12 months. However, the availability of funds through the issuance of commercial paper and new debt could be adversely affected due to a debt rating downgrade or a deterioration of certain financial ratios. There are no provisions in any agreements that would require early cash settlement of existing debt or leases as a result of a downgrade in our debt rating or a decrease in our stock price.

Our quarterly cash dividend was increased in 2006 to $.05 per share.
 
14


In January 2005, the Board of Directors authorized up to $1 billion in share repurchases through 2006. In January and August 2006, the Board of Directors authorized up to an additional $1 billion and $2 billion in share repurchases through 2007 and 2008, respectively. This program is implemented through purchases made from time to time either in the open market or through private transactions. Shares purchased under the share repurchase program are retired and returned to authorized and unissued status. During 2006, the Company repurchased 56.8 million shares at a total cost of $1.7 billion. As of February 2, 2007, the total remaining authorization under the share repurchase program was $1.5 billion.

OFF-BALANCE SHEET ARRANGEMENTS
 
Other than in connection with executing operating leases, we do not have any off-balance sheet financing that has, or is reasonably likely to have, a material, current or future effect on our financial condition, cash flows, results of operations, liquidity, capital expenditures or capital resources.
 
CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
 
The following table summarizes our significant contractual obligations and commercial commitments:
 
   
Payments Due by Period
 
Contractual Obligations
         
Less than
 
 
1-3
 
 
4-5
 
 
After 5
 
(In millions)
 
 
Total
 
 
1 year
 
 
years
 
 
years
 
 
years
 
Long-term debt (principal and interest amounts, excluding discount)
 
$
7,865
 
$
281
 
$
438
 
$
870
 
$
6,276
 
Capital lease obligations 1
   
644
   
62
   
124
   
123
   
335
 
Operating leases 1
   
5,527
   
323
   
645
   
642
   
3,917
 
Purchase obligations 2
   
2,307
   
1,079
   
834
   
382
   
12
 
Total contractual obligations
 
$
16,343
 
$
1,745
 
$
2,041
 
$
2,017
 
$
10,540
 


   
Amount of Commitment Expiration by Period
 
Commercial Commitments
         
Less than
 
 
1-3
 
 
4-5
 
 
After 5
 
(In millions)
   
Total
 
 
1 year
 
 
years
 
 
years
 
 
years
 
Letters of credit 3
 
$
346
 
$
344
 
$
2
 
$
-
 
$
-
 


1 Amounts do not include taxes, common area maintenance, insurance or contingent rent because these amounts have historically been insignificant.
2 Represents contracts for purchases of merchandise inventory, property and construction of buildings, as well as commitments related to certain marketing and information technology programs.
3 Letters of credit are issued for the purchase of import merchandise inventories, real estate and construction contracts, and insurance programs.
 
15


COMPANY OUTLOOK

As of February 23, 2007, the date of our fourth quarter 2006 earnings release, we expected to open 150 to 160 stores during 2007, resulting in total square footage growth of approximately 11%. We expected total sales to increase approximately 10% and comparable store sales to be approximately flat to up 2%. Operating margin, defined as gross margin less SG&A and depreciation, was expected to decline 70 to 80 basis points. In addition, store opening costs were expected to be approximately $140 to $145 million. Diluted earnings per share of $2.02 to $2.09 were expected for the fiscal year ending February 1, 2008.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our primary market risk exposure is the potential loss arising from the impact of changing interest rates on long-term debt. Our policy is to monitor the interest rate risks associated with this debt, and we believe any significant risks could be offset by accessing variable rate instruments available through our lines of credit. The following tables summarize our market risks associated with long-term debt, excluding capital leases and other. The tables present principal cash outflows and related interest rates by year of maturity, excluding unamortized original issue discounts as of February 2, 2007, and February 3, 2006. Variable interest rates are based on the weighted-average rates of the portfolio at the end of the year presented. The fair values included below were determined using quoted market rates or interest rates that are currently available to us on debt with similar terms and remaining maturities.

Long-Term Debt Maturities by Fiscal Year
 
February 2, 2007
 
                           
 
   
 
 
Average 
 
 
 
 
Average
 
 
 
 
Fixed 
 
 
Interest
 
 
Variable
 
 
Interest
 
(Dollars in millions)
   
Rate
 
 
Rate
 
 
Rate
 
 
Rate
 
2007
 
$
59
   
7.24
%
$
2
   
6.57
%
2008
   
7
   
7.84
   
-
   
-
 
2009
   
1
   
5.96
   
-
   
-
 
2010
   
501
   
8.25
   
-
   
-
 
2011
   
1
   
7.50
   
-
   
-
 
Thereafter
   
3,570
   
5.02
%
 
-
   
-
 
Total
 
$
4,139
       
$
2
       
Fair value
 
$
4,299
       
$
2
       

Long-Term Debt Maturities by Fiscal Year
 
February 3, 2006
 
                   
 
   
 
 
 
Average 
 
 
 
 
 
Average
 
 
 
 
Fixed 
 
 
Interest
 
 
Variable
 
 
Interest
 
(Dollars in millions)
   
Rate
 
 
Rate
 
 
Rate
 
 
Rate
 
2006
 
$
5
   
7.58
%
$
2
   
5.82
%
2007
   
59
   
7.25
   
2
   
5.82
 
2008
   
7
   
7.84
   
-
   
-
 
2009
   
1
   
7.49
   
-
   
-
 
2010
   
501
   
8.25
   
-
   
-
 
Thereafter
   
2,691
   
4.70
%
 
-
   
-
 
Total
 
$
3,264
       
$
4
       
Fair value
 
$
3,574
       
$
4
       

 
Disclosure Regarding Forward-Looking Statements

We speak throughout this Annual Report about our future, particularly in the “Letter to Shareholders” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”  While we believe our estimates and expectations are reasonable, they are not guarantees of future performance.  Our actual results could differ substantially from our expectations because, for example:

• Our sales are dependent upon the health and stability of the general economy. We monitor key economic indicators including disposable personal income, employment growth, housing turnover, and homeownership levels. In addition, changes in the level of repairs, remodeling and additions to existing homes, changes in commercial building activity, and the availability and cost of financing can impact our business.

• Major weather-related events and unseasonable weather, particularly wet and cold weather during the spring and early summer months, may impact sales of seasonal merchandise and products designed for outdoor use on a short-term basis.

• Our expansion strategy may be impacted by environmental regulations, local zoning issues, availability and development of land, and more stringent land use regulations. Furthermore, our ability to secure a highly-qualified workforce is an important element to the success of our expansion strategy.

• Our business is highly competitive, and as we build an increasing percentage of our new stores in larger markets and utilize new sales channels such as the internet, we may face new and additional forms of competition.

• The ability to continue our everyday low pricing strategy and provide the products that customers want depends on our vendors providing a reliable supply of products at competitive prices and our ability to effectively manage our inventory. As an increasing number of the products we sell are imported, any restrictions or limitations on importation of such products, political or financial instability in some of the countries from which we import them, or a failure to comply with laws and regulation of those countries from which we import them, could interrupt our supply of imported inventory.

• Our goal of increasing our market share and our commitment to keeping our prices low require us to make substantial investments in new technology and processes whose benefits could take longer than expected to be realized and which can be difficult to implement and integrate.

For more information about these and other risks and uncertainties that we are exposed to, you should read the “Risk Factors” included in our Annual Report on Form 10-K to the United States Securities and Exchange Commission. All forward-looking statements in this report speak only as of the date of this report or, in the case of any document incorporated by reference, the date of that document. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are qualified by the cautionary statements in this section and in the “Risk Factors” included in our Annual Report on Form 10-K. We do not undertake any obligation to update or publicly release any revisions to forward-looking statements to reflect events, circumstances or changes in expectations after the date of this report.

 
 
Management of Lowe's Companies, Inc. and its subsidiaries is responsible for establishing and maintaining adequate internal control over financial reporting (Internal Control) as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended.  Our Internal Control was designed to provide reasonable assurance to our management and the board of directors regarding the reliability of financial reporting and the preparation and fair presntation of published financial statements.
 
All internal control systems, no matter how well designed, have inherent limitations, including the possibility of human error and the circumvention or overriding of controls.  Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to the reliability of financial reporting and financial statement preparation and presentation.  Further, because of changes in conditions, the effectiveness may vary over time.   
 
Our management, with the participation of the Chief  Executive Officer and Chief Financial Officer, evaluated the effectiveness of our Internal Control as of February 2, 2007.   In evaluating our Internal Control, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.  Based on our management's assessment, we have concluded that, as of February 2, 2007, our Internal Control is effective. 
 
Deloitte & Touche, LLP, the independent registered public accounting firm that audited the financial statements contained in this report, has issued an attestation report on our management's assessment of our Internal Control.  This report appears on page 27.
 

 
To the Board of Directors and Shareholders of Lowe’s Companies, Inc.
Mooresville, North Carolina
 
We have audited the accompanying consolidated balance sheets of Lowe’s Companies, Inc. and subsidiaries (the “Company”) as of February 2, 2007 and February 3, 2006, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the three fiscal years in the period ended February 2, 2007.  These financial statements are the responsibility of the Company's management.  Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company at February 2, 2007 and February 3, 2006, and the results of its operations and its cash flows for each of the three fiscal years in the period ended February 2, 2007, in conformity with accounting principles generally accepted in the United States of America.
 
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company's internal control over financial reporting as of February 2, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated April 3, 2007 expressed an unqualified opinion on management's assessment of the effectiveness of the Company's internal control over financial reporting and an unqualified opinion on the effectiveness of the Company's internal control over financial reporting.
 
 
/s/ Deloitte & Touche LLP
 
Charlotte, North Carolina
April 3, 2007
 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Shareholders of Lowe’s Companies, Inc.
Mooresville, North Carolina

We have audited management's assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting included on page 26, that Lowe’s Companies, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of February 2, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting.  Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.
 
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects.  Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances.  We believe that our audit provides a reasonable basis for our opinions.

A company's internal control over financial reporting is a process designed by, or under the supervision of, the company's principal executive and principal financial officers, or persons performing similar functions, and effected by the company's board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
 
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis.  Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
 
In our opinion, management's assessment that the Company maintained effective internal control over financial reporting as of February 2, 2007, is fairly stated, in all material respects, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.  Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of February 2, 2007, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
 
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the fiscal year ended February 2, 2007 of the Company and our report dated April 3, 2007 expressed an unqualified opinion on those financial statements.
 
 
/s/ Deloitte & Touche LLP
 
Charlotte, North Carolina
April 3, 2007
 

Lowe's Companies, Inc.
                         
Consolidated Statements of Earnings
                         
                           
                           
(In millions, except per share and percentage data)
   
February 2,
 
 
% 
 
 
February 3,
 
 
%
 
 
January 28,
 
 
%
 
Fiscal years ended on
 
 
2007
 
 
Sales
 
 
2006
 
 
Sales
 
 
2005
 
 
Sales
 
                                       
Net sales (Note 1)
 
$
46,927
   
100.00
%
$
43,243
   
100.00
%
$
36,464
   
100.00
%
                                       
Cost of sales (Notes 1 and 15)
   
30,729
   
65.48
   
28,453
   
65.80
   
24,224
   
66.44
 
                                       
Gross margin
   
16,198
   
34.52
   
14,790
   
34.20
   
12,240
   
33.56
 
                                       
Expenses:
                                     
                                       
Selling, general and administrative (Notes 1, 4 and 9)
   
9,738
   
20.75
   
9,014
   
20.84
   
7,562
   
20.74
 
                                       
Store opening costs (Note 1)
   
146
   
0.31
   
142
   
0.33
   
123
   
0.34
 
                                       
Depreciation (Notes 1 and 3)
   
1,162
   
2.48
   
980
   
2.27
   
859
   
2.35
 
                                       
Interest - net (Note 16)
   
154
   
0.33
   
158
   
0.37
   
176
   
0.48
 
                                       
Total expenses
   
11,200
   
23.87
   
10,294
   
23.81
   
8,720
   
23.91
 
                                       
Pre-tax earnings
   
4,998
   
10.65
   
4,496
   
10.39
   
3,520
   
9.65
 
                                       
Income tax provision (Note 11)
   
1,893
   
4.03
   
1,731
   
4.00
   
1,353
   
3.71
 
                                       
Net earnings
 
$
3,105
   
6.62
%
$
2,765
   
6.39
%
$
2,167
   
5.94
%
                                       
                                       
Basic earnings per share (Note 12)
 
$
2.02
       
$
1.78
       
$
1.39
       
                                       
Diluted earnings per share (Note 12)
 
$
1.99
       
$
1.73
       
$
1.35
       
                                       
Cash dividends per share
 
$
0.18
       
$
0.11
       
$
0.08
       
                                       
                                       
 
 
 
Lowe's Companies, Inc.
                             
Consolidated Balance Sheets                              
                               
                               
 
       
February 2,  
   
   
February 3,
   
 
(In millions, except par value and percentage data)
       
2007
   
Total 
   
2006
   
Total
 
                               
Assets
                             
                               
     Current assets:
                             
        Cash and cash equivalents (Note 1)
     
$
364
   
1.3
%
$
423
   
1.7
%
        Short-term investments (Notes 1 and 2)
       
432
   
1.6
   
453
   
1.8
 
        Merchandise inventory - net (Note 1)
       
7,144
   
25.7
   
6,635
   
27.0
 
        Deferred income taxes - net (Note 11)
       
161
   
0.6
   
155
   
0.6
 
        Other current assets
       
213
   
0.8
   
122
   
0.5
 
                               
        Total current assets
       
8,314
   
30.0
   
7,788
   
31.6
 
                               
        Property, less accumulated depreciation (Notes 3 and 4)
       
18,971
   
68.3
   
16,354
   
66.4
 
        Long-term investments (Notes 1 and 2)
       
165
   
0.6
   
294
   
1.2
 
        Other assets (Notes 1 and 4)
       
317
   
1.1
   
203
   
0.8
 
                               
        Total assets
     
$
27,767
   
100.0
%
$
24,639
   
100.0
%
                               
Liabilities and shareholders' equity
                             
                               
     Current liabilities:
                             
        Short-term borrowings (Note 5)      
$
 23     0.1  %  $  -      %
        Current maturities of long-term debt (Note 6)          88      0.3      32      0.1
 
        Accounts payable
       
3,524
   
12.7
   
2,832
   
11.6
 
        Accrued salaries and wages
       
372
   
1.3
   
424
   
1.7
 
        Self-insurance liabilities (Note 1)
       
650
   
2.4
   
571
   
2.3
 
        Deferred revenue (Note 1)
       
731
   
2.6
   
709
   
2.9
 
        Other current liabilities (Notes 1 and 4)
       
1,151
   
4.1
   
1,264
   
5.1
 
                               
        Total current liabilities
       
6,539
   
23.5
   
5,832
   
23.7
 
                               
        Long-term debt, excluding current maturities (Notes 6, 7 and 13)
       
4,325
   
15.6
   
3,499
   
14.2
 
        Deferred income taxes - net (Note 11)
       
735
   
2.7
   
735
   
3.0
 
        Other long-term liabilities (Note 1)
       
443
   
1.6
   
277
   
1.1
 
                               
        Total liabilities
       
12,042
   
43.4
   
10,343
   
42.0
 
                               
        Commitments and contingencies (Note 14)
                             
                               
     Shareholders' equity (Note 8):
                             
        Preferred stock - $5 par value, none issued
       
-
   
-
   
-
   
-
 
        Common stock - $.50 par value;
                             
           Shares issued and outstanding
                             
           February 2, 2007                                                                      1,525
 
 
                         
           February 3, 2006                                                                      1,568
 
 
   
762
   
2.7
   
784
   
3.2
 
        Capital in excess of par value
       
102
   
0.4
   
1,320
   
5.3
 
        Retained earnings
       
14,860
   
53.5
   
12,191
   
49.5
 
        Accumulated other comprehensive income (Note 1)
       
1
   
-
   
1
   
-
 
                               
        Total shareholders' equity
       
15,725
   
56.6
   
14,296
   
58.0
 
                               
        Total liabilities and shareholders' equity
     
$
27,767
   
100.0
%
$
24,639
   
100.0
%
                               
 

Lowe's Companies, Inc.
                         
Consolidated Statements of Shareholders' Equity
                         
                           
                           
 
                           
Accumulated 
 
 
 
 
 
 
 
 
 
 
 
 
Capital in 
 
 
 
 
 
Other
 
 
Total
 
 
   
Common Stock 
   
Excess of
   
Retained
 
 
Comprehensive
 
 
Shareholders'
 
(In millions)
   
Shares
 
 
Amount
 
 
Par Value
   
Earnings
 
 
Income
 
 
Equity
 
Balance January 30, 2004
   
1,574.7
 
$
787
 
$
1,854
 
$
7,546
 
$
1
 
$
10,188
 
Comprehensive income (Note 1):
                                     
     Net earnings
                     
2,167
             
     Net unrealized investment losses
                           
(1
)
     
Total comprehensive income
                                 
2,166
 
Tax effect of non-qualified
                                     
     stock options exercised
               
33
               
33
 
Cash dividends
                     
(116
)
       
(116
)
Share-based payment expense (Note 9)
               
70
               
70
 
Repurchase of common stock (Note 8)
   
(36.9
)
 
(18
)
 
(982
)
             
(1,000
)
Conversion of debt to common stock (Note 6)
   
0.3
         
6
               
6
 
Employee stock options exercised and other (Note 9)
   
6.7
   
3
   
87
               
90
 
Employee stock purchase plan (Note 9)
   
2.7
   
2
   
59
               
61
 
Balance January 28, 2005
   
1,547.5
 
$
774
 
$
1,127
 
$
9,597
 
$
-
 
$
11,498
 
Comprehensive income (Note 1):
                                     
     Net earnings
                     
2,765
             
Foreign currency translation
                           
1
       
Total comprehensive income
                                 
2,766
 
Tax effect of non-qualified
                                     
     stock options exercised
               
59
               
59
 
Cash dividends
                     
(171
)
       
(171
)
Share-based payment expense (Note 9)
               
76
               
76
 
Repurchase of common stock (Note 8)
   
(25.0
)
 
(12
)
 
(762
)
             
(774
)
Conversion of debt to common stock (Note 6)
   
27.6
   
14
   
551
               
565
 
Employee stock options exercised and other (Note 9)
   
15.6
   
7
   
205
               
212
 
Employee stock purchase plan (Note 9)
   
2.5
   
1
   
64
               
65
 
Balance February 3, 2006
   
1,568.2
 
$
784
 
$
1,320
 
$
12,191
 
$
1
 
$
14,296
 
Comprehensive income (Note 1):
                                     
     Net earnings
                     
3,105
             
     Foreign currency translation
                           
(2
)
     
     Net unrealized investment gains (Note 2)
                           
2
       
Total comprehensive income
                                 
3,105
 
Tax effect of non-qualified
                                     
     stock options exercised
               
21
               
21
 
Cash dividends
                     
(276
)
       
(276
)
Share-based payment expense (Note 9)
               
59
               
59
 
Repurchase of common stock (Note 8)
   
(56.8
)
 
(28
)
 
(1,549
)
 
(160
)
       
(1,737
)
Conversion of debt to common stock (Note 6)
   
3.9
   
2
   
80
               
82
 
Employee stock options exercised and other (Note 9)
   
6.6
   
3
   
96
               
99
 
Employee stock purchase plan (Note 9)
   
2.9
   
1
   
75
               
76
 
Balance February 2, 2007
   
1,524.8
 
$
762
 
$
102
 
$
14,860
 
$
1
 
$
15,725
 
                                       
 

Lowe's Companies, Inc.
             
Consolidated Statements of Cash Flows
             
               
               
(In millions)
   
February 2,
 
 
February 3,
 
 
January 28,
 
Fiscal years ended on
   
2007
   
2006
 
 
2005
 
Cash flows from operating activities:
 
 
 
 
 
 
 
 
 
 
     Net earnings
 
$
3,105
 
$
2,765
 
$
2,167
 
     Adjustments to reconcile earnings to net cash provided by operating activities:
 
 
 
 
 
 
 
 
 
 
        Depreciation and amortization
 
 
1,237
 
 
1,051
 
 
926
 
        Deferred income taxes
 
 
(6
)
 
(37
)
 
102
 
        Loss on disposition/writedown of fixed and other assets
 
 
23
 
 
31
 
 
55
 
        Share-based payment expense
 
 
62
 
 
76
 
 
70
 
        Changes in operating assets and liabilities:
 
 
 
 
 
 
 
 
 
 
           Merchandise inventory - net
   
(509
)
 
(785
)
 
(1,358
)
           Other operating assets
   
(135
)
 
(38
)
 
156
 
           Accounts payable
   
692
   
137
   
483
 
           Other operating liabilities
   
33
   
642
   
472
 
     Net cash provided by operating activities
   
4,502
   
3,842
   
3,073
 
                     
Cash flows from investing activities:
                   
     Purchases of short-term investments
   
(284
)
 
(1,829
)
 
(1,180
)
     Proceeds from sale/maturity of short-term investments
   
572
   
1,802
   
1,799
 
     Purchases of long-term investments
   
(558
)
 
(354
)
 
(156
)
     Proceeds from sale/maturity of long-term investments
   
415
   
55
   
28
 
     Increase in other long-term assets
   
(16
)
 
(30
)
 
(12
)
     Fixed assets acquired
   
(3,916
)
 
(3,379
)
 
(2,927
)
     Proceeds from the sale of fixed and other long-term assets
   
72
   
61
   
86
 
     Net cash used in investing activities
   
(3,715
)
 
(3,674
)
 
(2,362
)
                     
Cash flows from financing activities:
                   
     Net increase from short-term borrowings
   
23
   
-
   
-
 
     Proceeds from issuance of long-term debt
   
989
   
1,013
   
-
 
     Repayment of long-term debt
   
(33
)
 
(633
)
 
(82
)
     Proceeds from issuance of common stock under employee stock purchase plan
   
76
   
65
   
61
 
     Proceeds from issuance of common stock from stock options exercised
   
100
   
225
   
90
 
     Cash dividend payments
   
(276
)
 
(171
)
 
(116
)
     Repurchase of common stock
   
(1,737
)
 
(774
)
 
(1,000
)
     Excess tax benefits of share-based payments
   
12
   
-
   
-
 
     Net cash used in financing activities
   
(846
)
 
(275
)
 
(1,047
)
                     
Net decrease in cash and cash equivalents
   
(59
)
 
(107
)
 
(336
)
Cash and cash equivalents, beginning of year
   
423
   
530
   
866
 
Cash and cash equivalents, end of year
 
$
364
 
$
423
 
$
530
 
                     
 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED FEBRUARY 2, 2007, FEBRUARY 3, 2006 AND JANUARY 28, 2005

NOTE 1 - Summary of Significant Accounting Policies:

Lowe’s Companies, Inc. and subsidiaries (the Company) is the world's second-largest home improvement retailer and operated 1,385 stores in 49 states at February 2, 2007. Below are those accounting policies considered to be significant by the Company.

Fiscal Year - The Company’s fiscal year ends on the Friday nearest the end of January. The fiscal years ended February 2, 2007 and January 28, 2005 had 52 weeks. The fiscal year ended February 3, 2006 had 53 weeks. All references herein for the years 2006, 2005 and 2004 represent the fiscal years ended February 2, 2007, February 3, 2006 and January 28, 2005, respectively.

Stock Split - The Company’s Board of Directors approved a 2-for-1 stock split of its common shares on May 25, 2006. On June 30, 2006, shareholders received one additional common share for each common share held as of the record date of June 16, 2006. The par value of the Company’s common stock remained at $0.50 per share. The par value of the additional shares issued to effect the stock split totaling $384 million was reclassified from Capital in Excess of Par Value to Common Stock on the Company’s consolidated balance sheet. All prior period common share and per common share amounts presented herein have been adjusted to reflect the 2-for-1 stock split.

Principles of Consolidation - The consolidated financial statements include the accounts of the Company and its wholly-owned or controlled operating subsidiaries. All material intercompany accounts and transactions have been eliminated.

Use of Estimates - The preparation of the Company’s financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates that affect the reported amounts of assets, liabilities, sales and expenses and related disclosures of contingent assets and liabilities. The Company bases these estimates on historical results and various other assumptions believed to be reasonable, all of which form the basis for making estimates concerning the carrying values of assets and liabilities that are not readily available from other sources. Actual results may differ from these estimates.

Cash and Cash Equivalents - Cash and cash equivalents include cash on hand, demand deposits and short-term investments with original maturities of three months or less when purchased. The majority of payments due from financial institutions for the settlement of credit card and debit card transactions process within two business days, and are therefore classified as cash and cash equivalents.

Investments - The Company has a cash management program which provides for the investment of cash balances not expected to be used in current operations in financial instruments that have maturities of up to 10 years. Variable rate demand notes and auction rate securities, which have stated maturity dates of up to 30 years, meet this maturity requirement of the cash management program because the maturity date of these investments is determined based on the interest rate reset date for the purpose of applying this criteria. 

Investments, exclusive of cash equivalents, with a stated maturity date of one year or less from the balance sheet date or that are expected to be used in current operations, are classified as short-term investments. All other investments are classified as long-term. Investments consist primarily of certificates of deposit, time deposits, U.S. dollar foreign government securities, money market preferred stocks, municipal obligations, agency bonds, corporate notes and bonds, auction rate securities and money market mutual funds. Restricted balances pledged as collateral for letters of credit for the Company’s extended warranty program and for a portion of the Company’s casualty insurance and installed sales program liabilities are also classified as investments.

The Company has classified all investment securities as available-for-sale, and they are carried at fair market value. Unrealized gains and losses on such securities are included in accumulated other comprehensive income in shareholders' equity.
 
23


Merchandise Inventory - Inventory is stated at the lower of cost or market using the first-in, first-out method of inventory accounting. The cost of inventory also includes certain costs associated with the preparation of inventory for resale and distribution center costs, net of vendor funds.

The Company records an inventory reserve for the loss associated with selling inventories below cost. This reserve is based on management’s current knowledge with respect to inventory levels, sales trends and historical experience. Management does not believe the Company’s merchandise inventories are subject to significant risk of obsolescence in the near term, and management has the ability to adjust purchasing practices based on anticipated sales trends and general economic conditions. However, changes in consumer purchasing patterns could result in the need for additional reserves. The Company also records an inventory reserve for the estimated shrinkage between physical inventories. This reserve is based primarily on actual shrink results from previous physical inventories. Changes in the estimated shrink reserve may be necessary based on the results of physical inventories. Management believes it has sufficient current and historical knowledge to record reasonable estimates for both of these inventory reserves.

Derivative Financial Instruments - The Company occasionally utilizes derivative financial instruments to manage certain business risks. However, the amounts were not material to the Company’s consolidated financial statements in any of the years presented. The Company does not use derivative financial instruments for trading purposes.

Accounts Receivable - The majority of the Company’s accounts receivable arises from sales of goods and services to Commercial Business Customers. In May 2004, the Company entered into an agreement with General Electric Company and its subsidiaries (GE) to sell its then-existing portfolio of commercial business accounts receivable to GE. During the term of the agreement, which ends on December 31, 2009, unless terminated sooner by the parties, GE also purchases at face value new commercial business accounts receivable originated by the Company and services these accounts. The Company accounts for these transfers as sales of accounts receivable. When the Company sells its commercial business accounts receivable, it retains certain interests in those receivables, including the funding of a loss reserve and its obligation related to GE’s ongoing servicing of the receivables sold. Any gain or loss on the sale is determined based on the previous carrying amounts of the transferred assets allocated at fair value between the receivables sold and the interests retained. Fair value is based on the present value of expected future cash flows taking into account the key assumptions of anticipated credit losses, payment rates, late fee rates, GE’s servicing costs and the discount rate commensurate with the uncertainty involved. Due to the short-term nature of the receivables sold, changes to the key assumptions would not materially impact the recorded gain or loss on the sales of receivables or the fair value of the retained interests in the receivables.

Total commercial business accounts receivable sold to GE were $1.8 billion in 2006, $1.7 billion in 2005 and $1.2 billion in 2004. During 2006, 2005 and 2004, the Company recognized losses of $35 million, $41 million and $34 million, respectively, on these sales as selling, general and administrative (SG&A) expense, which primarily relates to the fair value of the obligations incurred related to servicing costs that are remitted to GE monthly. At February 2, 2007 and February 3, 2006, the fair value of the retained interests was insignificant and was determined based on the present value of expected future cash flows.

Sales generated through the Company’s proprietary credit cards are not reflected in receivables. Under an agreement with GE, credit is extended directly to customers by GE. All credit program-related services are performed and controlled directly by GE. The Company has the option, but no obligation, to purchase the receivables at the end of the agreement in December 2016. Tender costs, including amounts associated with accepting the Company’s proprietary credit cards, are recorded in SG&A in the consolidated financial statements.

The total portfolio of receivables held by GE, including both receivables originated by GE from the Company’s private label credit cards and commercial business accounts receivable originated by the Company and sold to GE, approximated $6.0 billion at February 2, 2007, and $5.0 billion at February 3, 2006.

Property and Depreciation - Property is recorded at cost. Costs associated with major additions are capitalized and depreciated. Capital assets are expected to yield future benefits and have useful lives which exceed one year. The total cost of a capital asset generally includes all applicable sales taxes, delivery costs, installation costs and other appropriate costs incurred by the Company in the case of self-constructed assets. Upon disposal, the cost of properties
 
24


and related accumulated depreciation are removed from the accounts, with gains and losses reflected in SG&A expense in the consolidated statements of earnings.

Depreciation is provided over the estimated useful lives of the depreciable assets. Assets are depreciated using the straight-line method. Leasehold improvements are depreciated over the shorter of their estimated useful lives or the term of the related lease, which may include one or more option renewal periods where failure to exercise such options would result in an economic penalty in such amount that renewal appears, at the inception of the lease, to be reasonably assured. During the term of a lease, if a substantial additional investment is made in a leased location, the Company reevaluates its definition of lease term to determine whether the investment, together with any penalties related to non-renewal, would constitute an economic penalty in such amount that renewal appears, at the time of the reevaluation, to be reasonably assured.

Long-Lived Assets/Store Closing - Losses related to impairment of long-lived assets are recognized when circumstances indicate the carrying values of the assets may not be recoverable. When management commits to close or relocate a store location, or when there are indicators that the carrying value of a long-lived asset may not be recoverable, the Company evaluates the carrying value of the asset in relation to its expected undiscounted future cash flows. If the carrying value of the assets is greater than the expected undiscounted future cash flows, and the fair value of the assets is less than the carrying value, a provision is made for the impairment of the assets based on the excess of carrying value over fair value. The fair value of the assets is generally based on appraisals and the Company’s historical experience.

When a leased location is closed, a provision is made for the present value of future lease obligations, including property taxes, utilities, and common area maintenance, net of anticipated sublease income. Provisions for impairment and store closing costs are included in SG&A expense. The store closing liability is included in other current liabilities in the consolidated balance sheets.

Leases - For lease agreements that provide for escalating rent payments or free-rent occupancy periods, the Company recognizes rent expense on a straight-line basis over the non-cancelable lease term and option renewal periods where failure to exercise such options would result in an economic penalty in such amount that renewal appears, at the inception of the lease, to be reasonably assured. The lease term commences on the date that the Company takes possession of or controls the physical use of the property. Deferred rent is included in other long-term liabilities in the consolidated balance sheets.

Assets under capital leases are amortized in accordance with the Company's normal depreciation policy for owned assets or, if shorter, over the non-cancelable lease term and any option renewal period where failure to exercise such option would result in an economic penalty in such amount that renewal appears, at the inception of the lease, to be reasonably assured. The amortization of the assets is included in depreciation expense in the consolidated financial statements. During the term of a lease, if a substantial additional investment is made in a leased location, the Company reevaluates its definition of lease term.

Self-Insurance - The Company is self-insured for certain losses relating to workers’ compensation, automobile, property, and general and product liability claims. The Company has stop-loss coverage to limit the exposure arising from these claims. The Company is also self-insured for certain losses relating to medical and dental claims. Self-insurance claims filed and claims incurred but not reported are accrued based upon management’s estimates of the discounted ultimate cost for uninsured claims incurred using actuarial assumptions followed in the insurance industry and historical experience. Although management believes it has the ability to adequately record estimated losses related to claims, it is possible that actual results could differ from recorded self-insurance liabilities.

Income Taxes - The Company establishes deferred income tax assets and liabilities for temporary differences between the tax and financial accounting bases of assets and liabilities. The tax effects of such differences are reflected in the balance sheet at the enacted tax rates expected to be in effect when the differences reverse. A valuation allowance is recorded to reduce the carrying amount of deferred tax assets if it is more likely than not that all or a portion of the asset will not be realized. The tax balances and income tax expense recognized by the Company are based on management’s interpretation of the tax statutes of multiple jurisdictions.

25


The Company includes interest related to tax issues as part of net interest in the consolidated financial statements. The Company records any applicable penalties related to tax issues within the income tax provision.

Revenue Recognition - The Company recognizes revenues, net of sales tax, when sales transactions occur and customers take possession of the merchandise. A provision for anticipated merchandise returns is provided through a reduction of sales and cost of sales in the period that the related sales are recorded. Revenues from product installation services are recognized when the installation is completed. Deferred revenues associated with amounts received for which customers have not yet taken possession of merchandise or for which installation has not yet been completed were $364 million and $377 million at February 2, 2007, and February 3, 2006, respectively.

Revenues from stored value cards, which include gift cards and returned merchandise credits, are deferred and recognized when the cards are redeemed. The liability associated with outstanding stored value cards was $367 million and $293 million at February 2, 2007, and February 3, 2006, respectively, and these amounts are included in deferred revenue in the accompanying consolidated balance sheets. The Company recognizes income from unredeemed stored value cards at the point at which redemption becomes remote.  The Company’s stored value cards have no expiration. Therefore, to determine when redemption is remote, the Company analyzes an aging of the unredeemed cards, based on the date of last stored value card use. 

Extended Warranties - Lowe’s sells separately-priced extended warranty contracts under a Lowe’s-branded program for which the Company is ultimately self-insured. The Company recognizes revenue from extended warranty sales on a straight-line basis over the respective contract term. Extended warranty contract terms primarily range from one to four years from the date of purchase or the end of the manufacturer’s warranty, as applicable. Deferred revenues related to the Company’s extended warranty sales were $315 million and $206 million at February 2, 2007 and February 3, 2006, respectively. The Company’s extended warranty deferred revenue is included in other long-term liabilities in the accompanying consolidated balance sheets. Changes in deferred revenue for extended warranty contracts are summarized as follows:

(In millions)
   
2006
   
2005
 
Extended warranty deferred revenue, beginning of period
 
$
206
 
$
86
 
               
Additions to deferred revenue
   
148
   
130
 
Deferred revenue recognized
   
(39
)
 
(10
)
               
Extended warranty deferred revenue, end of period
 
$
315
 
$
206
 

Incremental direct acquisition costs associated with the sale of extended warranties are also deferred and recognized as expense on a straight-line basis over the respective contract term. Deferred costs associated with extended warranty contracts were $81 million and $54 million at February 2, 2007 and February 3, 2006, respectively. The Company’s extended warranty deferred costs are included in other assets (non-current) in the accompanying consolidated balance sheets. All other costs, such as costs of services performed under the contract, general and administrative expenses and advertising expenses are expensed as incurred.

The Company’s liability for extended warranty claims incurred is included in self-insurance liabilities in the accompanying consolidated balance sheets. Reductions in the extended warranty liability for payments made under the extended warranties were $16 million, and increases in the liability for accruals related to preexisting warranties were $17 million in 2006. Reductions in the extended warranty liability for payments made under the extended warranties and aggregate changes in the liability for accruals related to preexisting warranties were not significant in 2005, as the program was still in its beginning stages.

26


Cost of Sales and Selling, General and Administrative Expenses - The following lists the primary costs classified in each major expense category:
 
Cost of Sales
 
Selling, General and Administrative
§  Total cost of products sold, including:
-  Purchase costs, net of vendor funds;
-  Freight expenses associated with moving merchandise inventories 
        from vendors to retail stores;
-  Costs associated with operating the Company’s distribution
        network, including payroll and benefit costs and occupancy costs; 
§  Costs of services provided;
§  Costs associated with delivery of products directly from vendors to customers
         by third parties;
§  Costs associated with inventory shrinkage and obsolescence.
 
§  Payroll and benefit costs for retail and corporate employees;
§  Occupancy costs of retail and corporate facilities;
§  Advertising;
§  Costs associated with delivery of products from stores to customers;
§  Third-party in-store service costs;
§  Tender costs, including bank charges, costs associated with credit card
         interchange fees, and amounts associated with accepting the Company's
         proprietary credit cards;
§  Costs associated with self-insured plans, and premium costs for stop-loss
         coverage and fully insured plans;
§  Long-lived asset impairment charges and gains/losses on disposal of assets;
§  Other administrative costs, such as supplies, and travel and entertainment.

Vendor Funds - The Company receives funds from vendors in the normal course of business principally as a result of purchase volumes, sales, early payments, or promotions of vendors’ products. Based on the provisions of the vendor agreements in place, management develops accrual rates by estimating the point at which the Company will have completed its performance under the agreement and the amount will be earned. During the year, due to the complexity and diversity of the individual vendor agreements, the Company performs analyses and reviews historical trends to ensure the amounts earned are appropriately recorded. As a part of these analyses, the Company validates its accrual rates based on actual purchase trends and applies those rates to actual purchase volumes to determine the amount of funds accrued by the Company and receivable from the vendor. Amounts accrued throughout the year could be impacted if actual purchase volumes differ from projected annual purchase volumes, especially in the case of programs that provide for increased funding when graduated purchase volumes are met.

Under Emerging Issues Task Force Issue No. 02-16 (EITF 02-16), “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor,” vendor funds are treated as a reduction of inventory cost, unless they represent a reimbursement of specific, incremental and identifiable costs incurred by the customer to sell the vendor’s product. Substantially all of the vendor funds that the Company receives do not meet the specific, incremental and identifiable criteria in EITF 02-16. Therefore, the Company treats the majority of these funds as a reduction in the cost of inventory as the amounts are earned and recognizes these funds as a reduction of cost of sales when the inventory is sold. There is no impact to the timing of when the funds are received from vendors or the associated cash flows.

Advertising - Costs associated with advertising are charged to operations as incurred. Advertising expenses were $873 million, $812 million and $740 million in 2006, 2005 and 2004, respectively.

Shipping and Handling Costs - The Company includes shipping and handling costs relating to the delivery of products directly from vendors to customers by third parties in cost of sales. Shipping and handling costs, which include salaries and vehicle operations expenses relating to the delivery of products from stores to customers, are classified as SG&A expenses. Shipping and handling costs included in SG&A expenses were $310 million, $312 million and $255 million during 2006, 2005 and 2004, respectively.
 
27


Store Opening Costs - Costs of opening new or relocated retail stores, which include payroll and supply costs incurred prior to store opening and grand opening advertising costs, are charged to operations as incurred.

Comprehensive Income - The Company reports comprehensive income in its consolidated statements of shareholders’ equity. Comprehensive income represents changes in shareholders' equity from non-owner sources and is comprised primarily of net earnings plus or minus unrealized gains or losses on available-for-sale securities, as well as foreign currency translation adjustments. For the year ended February 2, 2007, foreign currency translation losses were approximately $2 million, and net unrealized holding gains on available-for-sale securities were approximately $2 million. For the year ended February 3, 2006, foreign currency translation gains were approximately $1 million and unrealized holding losses on available-for-sale securities were insignificant. For the year ended January 28, 2005, unrealized holding losses on available-for-sale securities were approximately $1 million, and there were no foreign currency translation adjustments. The reclassification adjustments for gains/losses included in net earnings for 2006, 2005 and 2004 were insignificant.

Recent Accounting Pronouncements - In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109.” This Interpretation clarifies the accounting for uncertainty in income taxes and prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This Interpretation also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The Interpretation is effective for fiscal years beginning after December 15, 2006. Management is continuing to evaluate the effect that the adoption of FIN 48 will have on the Company’s consolidated financial statements.

In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157, “Fair Value Measurements.” The Statement provides a single definition of fair value, together with a framework for measuring it, and requires additional disclosure about the use of fair value to measure assets and liabilities. SFAS No. 157 also emphasizes that fair value is a market-based measurement, not an entity-specific measurement, and sets out a fair value hierarchy with the highest priority being quoted prices in active markets. Under the Statement, fair value measurements are required to be disclosed by level within that hierarchy. The Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently evaluating the effect that the adoption of SFAS No. 157 will have on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities.” The Statement provides entities an option to measure many financial instruments and certain other items at fair value, including available-for-sale and held-to-maturity securities previously accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” Under this Statement, unrealized gains and losses on items for which the fair value option has been elected will be reported in earnings at each subsequent reporting period. The Statement is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the effect that the adoption of SFAS No. 159 will have on its consolidated financial statements.

Segment Information - The Company’s operating segments, representing the Company’s home improvement retail stores, are aggregated within one reportable segment, based on the way the Company manages its business. The Company’s home improvement retail stores exhibit similar long-term economic characteristics, sell similar products and services, use similar processes to sell those products and services, and sell their products and services to similar classes of customers.

Reclassifications - Certain prior period amounts have been reclassified to conform to current classifications.
 
28


NOTE 2 - Investments:

The Company’s investment securities are classified as available-for-sale. The amortized costs, gross unrealized holding gains and losses and fair values of the investments at February 2, 2007, and February 3, 2006, were as follows:
 
   
February 2, 2007
 
Type
   
Amortized
 
 
Gross Unrealized
 
 
Gross
Unrealized
 
 
Fair
 
(In millions)
 
 
Cost
 
 
Gains
 
 
Losses
 
 
Value
 
Municipal obligations
 
$
258
 
$
-
 
$
(1
)
$
257
 
Money market preferred stock
   
148
   
-
   
-
   
148
 
Corporate notes
   
26
   
 -
   
-
   
26
 
Certificates of deposit
   
1
   
-
   
-
   
1
 
Classified as short-term
   
433
   
-
   
(1
)
 
432
 
                           
Municipal obligations