Tickers in this Article: HD, TTC, DE, RPM, MAS, UFPI, LOW
I'll start this article by openly acknowledging that there seems to be things about Home Depot (NYSE:HD) as a stock that just seem to escape my grasp. While I have ample respect for the quality of the business and the management team, as well as the prospects for a housing recovery to reignite free cash flow growth, the Street always seems to be willing to pay more for Home Depot than I would imagine. So although I personally won't pay a double-digit EV/EBITDA multiple to buy a mature retailer, I'm not going to suggest that Home Depot's momentum ride is over yet.

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Q3 Marks Another Quarter of Recovery
While the housing recovery is not powerful or ubiquitous (nor universally accepted by analysts or economists), it seems to be real enough for Home Depot. Provided that Congress works to avoid (or at least blunt) the fiscal cliff and that Home Depot management can continue to handle more traffic with minimal incremental spending needs, the near-term growth picture looks pretty healthy.

Revenue rose almost 5% this quarter, with comps increasing 4.2% (after a 4.2% comp increase in the year-ago quarter). Management estimated that Hurricane Sandy added about 40 basis points to comps, while the overall average ticket was up about 2.9%.

Home Depot also continues to deliver surprising profit leverage. Gross margin improved about 20 basis points, while non-GAAP operating income rose by more than 17% and the company logged over a full point of operating margin improvement.

Broad Improvements Still the Theme
To a certain extent, talking about the individual sales categories seems a little superfluous since almost everything was better this quarter. Especially strong categories included mowers, exterior stains/chemicals, paints, lumber and kitchen/bath plumbing.

Drawing straight lines from retailer sales data to suppliers can be tricky, what with the impact of private label sales, promotions and inventory build/rundown. Nevertheless, on balance, I would think this data is good news for companies like Toro (NYSE:TTC), Deere (NYSE:DE), RPM (NYSE:RPM), Masco (NYSE:MAS) and Universal Forest Products (Nasdaq:UFPI). Not coincidentally, most of these stocks are pretty close to their 52-week highs.

How Much Is Left In the Tool Box?
While acknowledging that the estimate was uncertain, Home Depot management's comments suggest that repairs and rebuilding tied to Sandy could add another 100 to 150 basis points to comps for the next quarter. Without getting into a separate discussion of the "broken window fallacy," I think most readers can appreciate how a storm that inflicted serious property damage will be a net positive for companies like Home Depot and Lowe's (NYSE:LOW) in the short term.

Likewise, I don't think there's much controversy on the notion that new housing construction, remodeling and renovation is below-trend and likely to continue improving in the coming years. There's certainly room for debate on the "how much, how soon?" questions, but that is a topic for another day.

Given what should be a supportive sales backdrop, the biggest question I have left on Home Depot is the extent to which the company can continue to wring more efficiency out of its operations. Management has talked about improving its merchandising and supply chain management, but that's not a bottomless well of potential profits. Similarly, that's likely not to be much of an issue for at least the next year or two.

The Bottom Line
As I said in the intro, I'm guilty of consistently underestimating Wall Street's enthusiasm for Home Depot's stock. To be fair, not only is Home Depot a good reflexive play on the housing recovery theme, but the company's management is actually managing to deliver better-than-expected profitability improvements and that always goes over well with institutional investors.

Now, all that being said, it's still not easy to generate a fair value for Home Depot that makes the stock attractive to me. If you take the relatively bullish sell-side analyst estimates, you can generate a long-term free cash flow growth estimate of about 5%, which works out to a fair value in the mid-to-high $50s.

If you go more aggressive and assume that Home Depot can regain prior peak revenue in three or four years, you can push the fair value into the mid-$60s. But to get to a truly attractive fair value (say in the low $70s), you have to be willing to assume high single-digit free cash flow growth, which assumes both new records for revenue (and in relatively short order) and sustained free cash flow margins at levels never before seen in Home Depot's corporate history. That's quite a lot of optimism, but as I said before, I don't expect investors to abandon Home Depot on valuation concerns anytime soon.

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