Investors didn't abandon Home Depot (HD 2.97%) stock after the company recently warned them about a deteriorating sales environment in the home improvement industry. Shoppers aren't as eager to spend on their homes as they were a few months ago, and the shift caught management by surprise. But Home Depot is still on track to generate much stronger annual sales and earnings in 2023 compared to its pre-pandemic levels.

Still, management's comments in a conference call with investors highlighted a big risk to the business over the next several quarters. Let's take a closer look.

Not as bad as it seemed

Home Depot's comparable-store sales fell 5% through late March compared to a flat result in the prior quarter. But that slump isn't as bad as it might seem at first blush. Extreme weather in parts of the country delayed the start of spring seasonal sales, as Tractor Supply noted a few days earlier.

But the bigger factor dragging sales lower was a slump in lumber prices. This deflation erased more than 3 percentage points from average spending in the first quarter, executives estimated. Framing-lumber prices collapsed by over 60% compared to last year, and that's the main reason spending was flat year over year this quarter after having jumped 6% in the fourth quarter. The deflation lowered overall comps by 2 percentage points.

The red flag for Home Depot

But there's a more fundamental demand challenge, too. Executives said they noticed "broad-based pressure across the business" compared to last quarter. Customer traffic was down 5%, marking no major improvement over trends in late 2022.

HD Operating Margin (TTM) Chart

HD operating margin (TTM), data by YCharts. TTM = trailing 12 months.

And shoppers pulled back spending across several home improvement niches. "We had many departments with negative comps in the quarter, and continue to see pressure in a number of big-ticket discretionary categories," CEO Ted Decker said. This shift is the main reason Home Depot lowered its 2023 outlook on both the top and bottom lines.

Looking ahead

The chain now expects comps to drop by between 2% and 5% this year compared to its prior forecast of flat results. Profitability will decline slightly, and earnings per share will fall by as much as 13% after soaring during most of the past three years, the company says. Falling lumber prices account for about half of this downgrade, with the rest explained by softening overall demand.

Home Depot is still a much larger, more profitable business than it was before the pandemic struck. Even assuming sales reach the low end of the new outlook, the chain is still generating nearly $50 billion of additional annual revenue compared to 2019. Its downgraded profit-margin figure remains above industry peers like Lowe's (LOW 3.79%).

But management said the latest trends have added new uncertainty around consumers' demand patterns. It's possible that spending will slow further, especially if a recession develops in the home improvement industry or the wider U.S. economy.

Home Depot has thrived through many such downturns, but investors are still right to be concerned about the potential for weaker earnings over the next few quarters.