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A few days ago I initiated a small long position in Sara Lee (SLE) at $ 16.10. Sara Lee is a leading consumer products company that has brands in leading positions. However, margins have been hit recently due to increases in commodity prices which make up a large portion of COGS. Performance has also suffered due to mismanagement and bad acquisitions.

It seems to me that the Street is being excessively pessimistic about Sara Lee’s prospects and is putting the entire firm on sale as if the issues facing the firm are going to continue far into the future.

This works in my favour as I would rather buy a business with average earnings prospects for a good (cheap) price than buy a business with excellent earnings prospects for a bad (expensive) price.

At a P/E of 13.24, P/S of 0.86 and P/B of 3.1, Sara Lee is currently selling for well below its own five year averages and also below averages for other firms in the same industry as shown above. EPS for 2005 is very close to the average EPS for the past give years and this suggests that Sara Lee has been able to maintain its earnings power through the business cycle.

I see things differently from the Street. I see an undervalued business that generates strong cash flow which has in place a new, focused management team that has over the last year been conducting an extensive restructuring of Sara Lee. Underperforming businesses have been sold, cash flow has been utilized effectively to buy back shares and pay dividends and the branded apparel business is to be spun off to shareholders shortly as Hanesbrands. Margins should also improve with time as either commodity prices will come down or the foods industry will raise prices.

In You Can Be A Stock Market Genius Joel Greenblat writes:

… companies that pursue a major restructuring are often among the most shareholder oriented… most managements that go ahead with such a plan have their eye on shareholder interests.

I believe that the completion of the restructuring program and the spin-off of Hanesbrands are the short term catalysts which will unlock the value in Sara Lee.

Estimating Sara Lee’s normalized EPS (ex Hanesbrands) at $ 1.50 and conservatively applying a multiple of 11 one arrives at a price of $ 16.5 for Sara Lee. Therefore it seems that the market is attributing no value at all to Hanesbrands which in its own right generates significant amounts of cash flow.

On being spun off, Hanesbrands is to pay a significant amount of cash to Sara Lee. Management plans to use this cash towards it plan to reduce debt by 1.5 to 2 billion and to buy back a total of $ 2 billion in stock over several years which should further increase Sara Lee’s value.

Information in the amended Form 10 filed recently reveals that Hanesbrands generated over $ 500 million in cash flow from operations in the 39 weeks to April 2006. While Hanesbrands will take on a significant amount of debt to fund the cash payout to Sara Lee it seems that Hanesbrands will easily be able to service interest payments out of cash flow from operations and this debt will greatly enhance returns.

Assuming a 1:1 spin off ratio there will be 760 million Hanesbrands shares outstanding resulting in estimated cash flow per share of $ 0.65. Applying a multiple of 7 to this one arrives at a value of atleast $ 4.55 per share.

Adding up the sum of the parts i.e. Sara Lee and Hanesbrands, I arrive at what I feel is a conservative valuation of Sara Lee of $ 21.05. This represents an upside of 30% to my entry price of $ 16.10 with not much more downside risk left if the restructuring program and spin-off stay on track.

Also noteworthy is the fact that Pzena Investment Management and the John Hancock Classic Value fund, both run by expert special situations and value investor Rich Pzena has been buying loads of shares and now own about 4.5% of Sara Lee.

Full disclosure: Author is long SLE

SLE 1-yr chart:

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Source: Why I Bought Sara Lee This Week (SLE)