By Jacob Sonenshine

It was a bad week for home-improvement stocks -- but 2025 could be a good year.

The SPDR S&P Homebuilders exchange-traded fund (ticker: XHB), which has Home Depot, Williams-Sonoma, and Johnson Controls International as top holdings, dropped more than 3% this past week after the Federal Reserve lowered interest rates but said it expected fewer cuts in 2025. That makes sense if fewer cuts mean mortgage rates stay higher for longer.

The selloff seems overdone. The ETF has dropped 14% from its closing peak on Nov. 25. Despite its name, it has far more exposure to home-improvement retailers like Home Depot and Lowe's, and to building-materials companies like Lennox International and Owens Corning. While home builders like NVR, Toll Brothers, and PulteGroup are included, it's the home-improvement stocks that will drive the ETF.

The good news is that home-improvement demand looks like it's improving. Evercore analyst Greg Melich points to his leading indicator for demand, which uses changes in home prices, existing-home sales, certain retail sales, mortgage rates, and consumer sentiment to project home-improvement revenue in six months. Melich's indicator shows that actual sales dollars have risen 1.6% year over year on average in the past three months, after having been in negative territory for most of this year and last, and should increase by 4.8% in April.

What's more, the industry is coming off a period of weak demand, which will make expectations for sales growth easier to reach. Existing-home sales have also shown signs of improvement, and it's those sales that lead to remodeling jobs and other work that sends business to home-improvement companies.

Lowe's looks particularly interesting. Its sales are set to drop in 2024 -- its second consecutive year of declines -- but should grow by 1% next year to $84.4 billion, according to FactSet. From there, analysts expect revenue to grow by about 5% a year from 2025 through 2028.

Those numbers, though, could prove conservative if the housing market does see the recovery some are hoping for, says D.A. Davidson analyst Michael Baker. Lowe's big selling point is its "pro business," dedicated to the contractors who professionally remodel homes for clients -- which has grown to almost a third of its total sales this year from just under a fifth in 2019.

More growth looks likely. The company says total pro spending is about $500 billion annually, and Lowe's only has a fraction of that market share, so there's plenty of room for it to establish a larger presence. This is especially true since it's investing in its digital capabilities, giving employees the technology to better identify products for contractors.

The pro business also has higher profit margins, and analysts forecast that overall margins will rise over the coming years. That should help boost earnings per share, which should also get a lift from stock buybacks. Over the long term, earnings could grow at a 10% annual clip.

With the stock down 12% from its record high on Oct. 16, now looks like a decent time to pick up some shares before the building really starts.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com

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December 19, 2024 01:30 ET (06:30 GMT)

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