We're still a few weeks away from Home Depot's (HD 0.94%) next earnings announcement, but investors are already getting nervous. The home improvement retailer's stock trails the wider market in 2023 as concerns rise about an impending recession.
Cyclical downturns are an unavoidable part of the housing market. Home Depot has emerged from many prior slumps, including the Great Recession, to set new sales and earnings records.
However, investors should still be aware of any gathering risks to the business. With that in mind, let's look at two potential red flags ahead of Home Depot's Q3 report in November.
Red flag No. 1: Sales issues
Home Depot's revenue was down roughly 3.5% year over year in the first half of 2023, declining to $80 billion from $83 billion a year earlier. Part of that slump is due to transitory challenges like the sharp drop in lumber prices. Management cited this pressure as the main reason why average spending has been flat this year at $90 per visit.
The bigger worry is declining customer traffic. Other large national retailers like Costco and Walmart are seeing higher customer traffic, but Home Depot has catered to 3% fewer guests through the first half of the year. Demand is slowing among both its do-it-yourself shoppers and its professional contractor niche, management said in a recent conference call with investors.
Home improvement shoppers are choosing to spend less on expensive items and large projects right now. Executives believe this shift is mostly due to the pull-forward impact of soaring sales a year ago. You don't replace appliances every year, after all. Many of these lost projects could be simply delayed as well, only to boost revenue in future quarters.
But investors should still watch Home Depot's results over the next few quarters for potentially worsening customer traffic, declining spending levels, or both.
Red flag No. 2: Falling margins
Home Depot's profitability has been uncharacteristically weak lately. The main pressures on operating margin have been higher expenses like wages, plus the demand tilts away from big-ticket purchases. Operating income through Q2 declined a painful 8%.
HD Operating Margin (TTM) data by YCharts
There are good reasons to expect a rebound ahead. Home Depot management predicts that operating income will land between 14% of sales and 14.3% of sales, right in line with its prior 2023 forecast.
Home Depot remains well ahead of peer Lowe's (LOW -0.04%) on this score, partly because of its stronger market share position with professional contractors. Yet if these customers continue seeing shrinking project backlogs, the earnings outlook might darken. Approaching November's earnings update, most Wall Street pros are looking for annual profits to decline to $15.22 per share this year from $16.69 per share in fiscal 2022.
No reason to worry
Even continued weakness in these two areas would be no reason to abandon the bullish thesis for this stock. As the leader in the home improvement industry, Home Depot stands to reap more than its fair share of sales and earnings growth over the coming decades.
And the long-term outlook remains bright for the industry, as both Home Depot and Lowe's recently stressed to investors. Executives in August noted positive factors like aging housing stock and demographic and workplace shifts that are pushing housing demand higher.
These tailwinds won't insulate Home Depot from the negative impact of a recession, but they should help ease shareholders' concerns that somehow this cyclical downturn is more of a threat than all the previous ones have been for the retailer.
