Source: Williams-Sonoma.

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Shares of Williams-Sonoma (NYSE:WSM) crashed by more than 11.2% on Wednesday after the market close, as the specialized retailer of home and furnishing products delivered disappointing earnings guidance for the third quarter of the year. Is this just a bump in the road for Williams-Sonoma or a sign of harder times to come for the company?

The numbers
Total sales during the quarter ended on Aug. 3 came in at $1.039 billion, a 5.8% increase versus $982 million in the same period last year, and roughly in line with Wall Street analysts' expectations based on data compiled by Thomsom Reuters. Comparable brand revenues grew 5.7% during the quarter.

Direct-to-consumer revenue increased 9.4% to $523 million during the quarter. The segment represented 50% of total sales, an increase versus 49% of total revenue coming from the direct-to-consumer segment in the second quarter of 2013. Williams-Sonoma has done a great job at building a successful online sales channel, and the latest earnings report confirms that the company continues doing quite well in that crucial area.

ConceptQ2 2014 Comp Sales GrowthQ2 2013 Comp Sales Growth 
Pottery Barn 4.4% 9.9%
Willams-Sonoma 3.4% (0.4%)
Pottery Barn Kids 5.6% 8.2%
West Elm 16.7% 16.5%
PBTeen (1%) 16.3%
Total 5.7% 8.4%

Source: Williams-Sonoma earnings report.

Gross margin declined to 36.8% of revenue versus 37.6% of sales during the same quarter last year. On the other hand, sales, general, and administrative expenses declined as a percentage of revenue, falling from 29.6% of sales to 28.6% during the quarter. This allowed Williams-Sonoma to deliver increased operating margin, at 8.2% of sales versus 8% during the same quarter in 2013.

In all, earnings per share came in at $0.53, an 8.2% increase from $0.49 per share in the second quarter of 2013 and also in line with Wall Street forecasts according to estimates compiled by Thomson Reuters.

The context
As fellow Fool Sara Hov wrote in her earnings review for the previous quarter, Williams-Sonoma had reported piping-hot results for the first quarter of the year, and the stock was trading at all-time highs leading to the second-quarter report, so perhaps investors got too carried away in their optimism. When expectations are too high, reporting in line with analysts' forecasts is sometimes not enough for the market.

On the other hand, guidance for the third quarter of the year was materially lower than expected, and this seems to be the biggest reason for concern in the report. Management expects revenue during the third quarter to be in the range of $1.1 billion to $1.13 billion, while Wall Street analysts are on average forecasting $1.13 billion in revenues for the quarter, according to data compiled by Thomson Reuters.

If the company delivers sales in line with its own guidance, that would imply an annual growth rate of between 4.6% and 7.4% from $1.052 billion in total revenues during the third quarter in 2013. Although this is quite a wide range, the middle-of-the-range number would represent 6%, hardly a reason to panic. 

Earnings guidance looks quite weak, though. Williams-Sonoma expects earnings per share during the coming quarter to be between $0.58 and $0.63, while analysts polled by Thomson Reuters are on average forecasting $0.66 in earnings per share during the third quarter.

Williams-Sonoma reported earnings per share of $0.58 during the third quarter in 2013, so the middle-of-the-range number would represent an annual increase of only 4.3%.

It´s important to note that inventory increased steeply during the quarter. Merchandise inventory as of the end of the quarter stands at $895 million, a big 21.4% increase from $737 million at the end of the second quarter last year.

Management attributed a considerable part of this increase to the fact that Williams-Sonoma began taking ownership of its inventory earlier in the supply chain during the second quarter in 2013. Still, inventory increased 17% when adjusted for these considerations.

The fact that inventories are growing much faster than sales could indicate that Williams-Sonoma is getting stuck with too much merchandise, and it could be sign of increased pricing discounts, and lower profit margins, in the middle term.

Key takeaway
Performance during the second quarter was not all that dismal, and investors tend to overreact to disappointing news when expectations are particularly high. Keeping this in mind, the short-term decline in Williams-Sonoma may turn out to be buying opportunity for long term investors.

On the other hand, rising inventory levels in comparison to sales may indicate that the company could need to improve its merchandising strategy, and it could also be a sign of lower margins in the middle term as the company cuts prices to accelerate sales and streamline inventory levels. The market may be overreacting to negative news, but that doesn't necessarily mean that everything is going well at Williams-Sonoma.