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Peter Lynch advised investors to buy what they know, so I followed my buying habits to Hanesbrands
Hanesbrands, which was spun off from Sara Lee
In other words, Hanes has a daunting economic moat. Its size and scale gives it the clout to go head to head for distribution with top retailers like Target
Oddly enough, consumers seem to have an enormous amount of brand loyalty when it comes to unmarked and inconspicuous T-shirts and undergarments. I know this from personal experience -- I only buy Hanes white T-shirts or Berkshire Hathaway's
Opportunities for improvement
As anyone who has read Joel Greenblatt's You Can Be a Stock Market Genius knows, spinoffs are a great sandbox to play in when it comes to finding ineffectively run companies that can take off once freed from a parent company's yokel. Hanesbrands fits squarely into this category. In the past, Sara Lee has been notorious for its inability to squeeze profits out of its great stable of brands, and this has been manifested in Hanesbrands' operations.
However, Hanesbrands' management wasted no time in identifying fat to trim in manufacturing and distribution operations, as well as moving toward low-cost labor sourcing. An example of the vast potential for streamlining: Hanesbrands currently uses eight independent information technology systems but plans on cutting this to one.
What to look for in 2007
The great thing about Hanesbrands is that the company, which sells necessities, has little fashion risk. Thus, as you might expect, results hinge on execution and logistical prowess. If management can make good on their cost-cutting initiatives, then they should easily be able to cut fat from a somewhat bloated infrastructure. However, Hanesbrands needs to make sure it fixes the trains without making them run late -- logistical problems and inventory mix-ups would not only be a drag on earnings, but they'd also upset demanding customers like Wal-Mart.
Furthermore, Hanesbrands is almost like a public private-equity investment. The spinoff left the company with about $2.5 billion in long-term debt and $2.3 billion in net debt (subtracting out cash). The company is highly leveraged -- its operating earnings should cover 2007 interest costs by a little more than two times. Although Hanesbrands' cash flows and earnings are very stable, the leverage does add an element of risk, as well as a clear path to shareholder value creation. Hanesbrands can simply use its excess free cash flow to pay off some of its higher-cost debt, which should result in the stock being revalued to a higher multiple as risk subsides.
I believe that 2007 will be the first step in Hanesbrands' path to a more rational capital and operational structure. I just hope Mr. Market will be irrational long enough for me to buy some Hanesbrands shares and enjoy the ride.
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Fool contributor Emil Lee is an analyst and disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.