1 Company Serving Up Good News

Almost every investing article about lululemon athletica (Nasdaq: LULU  ) is full of workout puns. That's been driving me absolutely crazy recently, so this article will instead be using food metaphors. Away we go.

Lululemon announced its second-quarter earnings on Friday last week, and it looks like things have taken a spicy turn. Revenue, same-store sales, and earnings all moved in the right direction. Not only did things turn out well, but they turned out better than the company had forecasted. The surprise pushed the stock back up, finishing the week just $4 shy of its 52-week high. Is this a sign of more good things to come, or has Lululemon pushed into way-too-expensive territory?

Michelin star quality, Michelin star pricing
Lululemon isn't fooling anyone. With its forward P/E of 37, investors thinking about placing an order has to know what they're in for. But there's a reason for the price, and it's summed up in one word -- growth. In its second quarter, same-store sales increased 15%, revenue jumped 33%, and earnings per share grew 50%. That's a treat, no matter how you serve it up.

Investors were even happier because, while they got steak, they were expecting grilled cheese -- or perhaps a nice, juicy burger, to be more precise. In its first-quarter earnings statement, Lululemon predicted a slowdown, with earnings per share coming in below $0.30. That was based on an estimated revenue of $278 million. So when this quarter showed up with $0.39 per share, people got excited.

To put just a little water on the flames, a lot of the jump in earnings came from a lower-than-anticipated tax rate. If the company had been right in its earlier prediction, earnings per share would have come in at $0.31. That still beats the estimate the company provided, but it's a little less dramatic.

The fly in the soup
There were a few bitter mouthfuls to swallow, along with the good news. The biggest was the continued suppression of gross margins. In the first quarter of this year, gross margins fell to 55%, from a strong 2011 position at 59%. The second quarter followed in the first's footsteps, and margins hit 55% again. While this is a fall from earlier greatness, it's still a strong result and beats out competitors Gap (NYSE: GPS  ) and Under Armour (Nasdaq: UA  ) . Gap's last quarter came in with a 40% gross margin, while Under Armour hit 46%.

Part of this drop was attributed to better inventory management. In 2011, Lululemon suffered from a glut of demand and a dearth of supply. That led to constant consumer demand for items that could be kept on the shelf and probably hurt revenue overall. This year, the company has managed the flow and production of goods into a steadier stream, leading to fewer empty racks. But that also means leftover items had to be marked down for sale. The markdowns damaged overall margins, but the accessibility of merchandise probably did more good than harm.

Lululemon expects to maintain that 55% position for the long term, and that would be a definite win for the company. While the forecast for the third quarter is slightly below that mark, it looks like the company should be able to hold on to it for the full year. That will keep it in a very strong position when it comes to price and could help the longer battle that may play out with Gap and other competitors.

The final course
The bottom line is that Lululemon beat expectations laid out in the first quarter but didn't move beyond what investors were looking for earlier in the year. It seems safe to say the company is back on track, after a small setback. But that doesn't make it a perfect dinner. I still think the stock is too rich and would rather get in on the relatively lean Gap. I think Lululemon has a long way to grow, and I don't doubt its potential. I just worry about the opportunity cost.

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Fool contributor Andrew Marder owns none of the stocks mentioned in this article. Thank you to Rachel and Jose for letting him write this in their living room. The Motley Fool owns shares of Under Armour and lululemon athletica. Motley Fool newsletter services have recommended buying shares of lululemon athletica and Under Armour and creating a bear put spread position in Under Armour. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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