It looks like the momentum trade is back "on" for lululemon athletica (Nasdaq:LULU) as investors cheered a solid second quarter and encouraging third quarter guidance. With lululemon's comps remaining in the double-digits and demand continuing to outstrip supply, the biggest challenge for this company may simply be living up to expectations. Although this remains one of the strongest-growing and most productive stories in retailing, valuation and expectations look more than a little breathless.

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A Solid Print for Second Quarter
Results for lululemon's second quarter was more or less right on target relative to Wall Street expectations. Revenue rose 33% from last year (though falling 1% from the first quarter), matching the average estimate. Comps rose 15% - likewise in line with expectations (though down from 20% a year ago and 25% in the first quarter). Direct-to-consumer sales jumped 91% to more than 12% of sales.

Profits were also right on target. Gross margin fell about two and a half points from last year, but the 55.1% result was just a little bit ahead of sell-side estimates. Likewise on the operating line, where the company's $70 million result represented 18% year-on-year growth and was within $1 million of averaged estimates. While lululemon did report a sizable per-share earnings beat, that was driven almost solely by lower-than-expected taxes. On an operating basis, this was an in-line quarter.

Operating Challenges Don't Seem to Be Having Much Impact
There have been a few challenges for lululemon here and there, though not really from its competitors. Product quality issues have garnered some negative attention, as customers have reported issues with color bleed, pilling and fraying seams, but it seems that most customers are satisfied with the company's response. While bulls rightly observe that every apparel company has periodic issues with defective product, managing its image is critical for lululemon, so they cannot afford to screw up here.

At the same time, the company is still playing a delicate game of balancing inventory levels and product availability. Quarter-end inventory levels rose more than 15% this quarter, but the company is still seeing high sell-out rates through its online store. While this is a relatively high-class problem to have, it can backfire if not managed carefully - if customers are constantly frustrated in their attempts to buy your merchandise, eventually they go elsewhere.

Competition Still Playing Catch-up
Lululemon is also looking to get more aggressive would-be competitors. The company has vowed to enforce its patents, and the company has filed suits against PVH (NYSE:PVH) and G-III Apparel (Nasdaq:GIII). While lululemon management is talking tough, enforcing IP has never been easy in the apparel trade. I remember when Abercrombie & Fitch (NYSE:ANF) unsuccessfully pursued similar litigation against American Eagle (NYSE:AEO) for allegedly knocking off their style, and barring cases of outright trademark theft. I think lululemon is wasting their time and money here.

Whether lululemon can win in court or not, they still seem to be well ahead of the rivals. Nike (NYSE:NKE) and Under Armour (NYSE:UA) just don't have the same appeal to the core affluent female audience, and brands like VF Corp's (NYSE:VFC) lucy (as a side-note, can we please stop with the lower case branding?) and Limited's (NYSE:LTD) La Senza likewise aren't taking over the market. While Gap (NYSE:GPS) does seem committed to supporting its Athleta brand, a quick look suggests that even undercutting lululemon on pricing hasn't been enough to really grab much buzz.

The Bottom Line
Lululemon has built a very well-loved brand and a great retailing business. I have no qualms with that. Where I have my problems is with the expectations out there. There are sell-side analysts calling for the company to deliver 30% year-on-year sales growth out in 2016, and that just seems way too optimistic. Likewise, even if 2022 finds lululemon bigger than Abercrombie & Fitch is today and the company generates a virtually unprecedented free cash flow margin in the low 20%'s, the stock is still not worth $65, let alone $75.

Said differently, even if lululemon can match Coach's (NYSE:COH) free cash flow generation (and Coach is one of best around at that), the company will need over $5.5 billion in revenue by 2021 - a level of growth that I just cannot project barring a broader, more diversified business. Said differently, even if the estimated number of yoga participants increases 10% a year for a decade, they'll all need to buy about $136 a year in clothing (each) from lululemon to support that sort of revenue base. In my mind, that's an incredible level of expected growth, and one that I just cannot support. Consequently, I continue to admire what lululemon management has built in terms of a business, but I just cannot get similarly excited about the shares.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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