Making clothing labels is truly an overlooked business. Except to figure out which is the front or back of a shirt, most people don't even realize the tag exists. That's one of the reasons Paxar (NYSE:PXR) was chosen as a selection for Motley Fool Hidden Gems, along with the fact that it can be a profitable business.

It saw strong growth in its apparel business, particularly in the Asian Pacific, where it has been moving most of its operations to lower production costs. Sales there grew more than 23%, most of that organically, while overall sales improved 10% to $230.8 million.

The other part of Paxar's business is in radio frequency ID tags that can track the movement of merchandise. It still represents a small part of the company's business -- just $11 million in 2006 -- but the label maker plans to cleave it to the business like a heat-transferred label to a shirt. After settling a lawsuit against competitor Zebra Technologies (NASDAQ:ZBRA), Paxar expects 2007 revenues in the segment to be in the range of $15 million to $20 million. As it ramps up the business, though, expenses will initially cause a 25- to 50-basis point drag on gross margins.

Though the quarter was solid and full-year sales came in at the high end of Paxar's previously upgraded guidance, there were a couple of wrinkles in the plan.

Inventory management was a particular problem, as inventory growth exceeded sales by nearly two to one. When inventories rise ahead of sales, that can mean a company's products are not selling, which in turn could lead to discounting and lower profit margins.

Part of Paxar's problem was that it's shifting virtually all of its business out of the U.S. and Western Europe and into Asia Pacific and other developing markets. While that transition is underway, it built up its inventory to ensure that it had enough product on hand for its customers, but it seems the company overdid it. Paxar admits that inventory management is a top priority and has included this as part of the bonus plan for its executives in 2007.

Administrative costs grew beyond sales this quarter and consumed a larger percentage of revenues. Much of that was tied to its geographic expansions in Asia, but it also saw new threads develop in Pakistan and Thailand, which should provide a lower cost structure in the future.

Although Paxar benefited from a lower tax rate from various one-time breaks, the quarter was fairly solid even including the few miscues it had. A change to a lower cost environment, supplemented by an expanding RFID business, should enable Paxar to achieve its goal of $1 billion in sales by 2008. And that's not a story made up out of whole cloth.

Paxar is a recommendation of Motley Fool Hidden Gems. A 30-day free trial lets you follow the thread of why label making should equal market-beating performance.

Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.