Outerwear Goes, Underwear Stays

In its most recent edition, Barron's highlights Limited Brands (NYSE: LTD  ) as a pretty darn interesting investment opportunity. I happen to agree, and not only because Limited Brands is a Motley Fool Income Investor selection.

What makes Limited so interesting is all of the uncertainty surrounding the company and what it could look like a few years down the road. The company plans to sell its laggard apparel brands, Express and Limited. The sales are one of those counterintuitive moves where the company's results should actually improve even as its reported sales decline. The performance of the apparel businesses has been so poor for so long that the sale is seen as a positive for the company.

The sale will allow Limited to focus on its Victoria's Secret and Bath & Body Works brands, which are leaders in their respective categories. Both have posted consistent gains in sales and operating income. The concern many investors have is that Victoria's Secret, by far the larger of the two businesses, is losing steam and potentially sales to Gap (NYSE: GPS  ) , American Eagle Outfitters (NYSE: AEO  ) , and other retailers that are rolling out new lines of undergarments.

The other large negative surrounding Limited is that the company's inventory took a huge jump last year. Sales growth was 10%, which is fairly impressive for a retailer with $10 billion in sales. However, inventory growth far and away outpaced sales growth, with a 52% increase. Such problems are fixable, but rarely good news until fixed. This growth, however, is partially explained by Limited's expansion of its Victoria's Secret stores, its acquisition of La Senza in Canada, and an accounting change.

Offsetting the inventory trend and the uncertainty surrounding the company are a number of positives. Limited is soon to find itself flush with cash from selling most of its Express business. The company has already announced a $500 million share repurchase, which should increase the benefits to shareholders from a future recovery. If the company is successful in selling its Limited apparel business, the cash available for repurchases should only increase. The sales also will allow management to turn its time and attention to its successful businesses.

The inventory increase in the last year and the poor performance of the apparel businesses caused a well-below-normal free cash flow performance for Limited Brands. Eyeballing the company's cash flows, I think something in the ballpark of $500 million a year in free cash flow is closer to the company's true potential. That level of cash flow and potential growth in comparison to the current $10.6 billion market cap makes Limited Brands worth digging into a bit more, and as Barron's correctly points out, Limited Brands only gets more interesting if the shares should slide further. The company's 2.3% dividend yield also provides investors with a nice cushion while waiting for some of the uncertainty to clear. I've already added Limited Brands to my watch list.

Related Foolishness:

Nathan Parmelee had no financial interest in any of the companies mentioned at the time of publication. The Motley Fool has an ironclad disclosure policy. American Eagle Outfitters is a Motley Fool Stock Advisor selection and Gap is a selection of Motley Fool Inside Value and Stock Advisor.

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