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Why Lululemon Investors Should Watch Profit Margins When It Reports Earnings

Expectations can't be any higher for lululemon athletica (NASDAQ: LULU). The company is expected to report earnings in a few weeks. With the stock trading for a rich valuation and hitting new highs, investors will be eager to see the latest results.

There is a lot going on at the fast-growing athleticwear brand. Lululemon expects to double its men's and digital business and quadruple international revenue by 2023. The company is also expanding into new product categories, including skin care, and launching a new loyalty program.

A group of men and women wearing athletic clothing in a yoga class.

Image source: Getty Images.

That said, I would pay attention to margins when Lululemon reports its fiscal third-quarter earnings. If the company reports strong results across product categories, digital channels, and international growth, it will likely provide a small bump to gross margin.

Here's what you need to know.

Digital sales growth should lead to higher profits

Lululemon has seen exceptional growth coming from digital, international, and the men's category. Specifically, digital comps increased by 31% year over year in the last quarter. Through the first two quarters of the year, the direct-to-consumer channel made up a quarter of total revenue and generates much higher margins than physical stores. That's why investors should want to see digital growth remain strong, as outperformance in this channel represents a significant margin opportunity.

Europe business is trending toward profitability

On the international front, revenue growth has decelerated to 34% as of the last quarter, but management believes it can maintain growth above 30% over the next few years. While all regions are operating at a profit, Europe continues to operate at a small loss, but that will change.

During the last conference call, management reported that Europe is "quickly marching toward profitability." Investors should pay attention to any updates from management about international revenue growth, particularly on the progress in Europe. Lululemon just launched a new e-commerce site in France and Germany. A better-than-expected quarter out of Europe would clearly be beneficial for margins.

How will men's and outerwear sales impact product margins?

Finally, investors should watch the dynamic between men's and women's comp sales growth. Lululemon's goal is to double men's sales. It's making great progress, noted by the men's revenue growth of 35% last quarter. But investors should also pay attention to women's sales, because women's core pant styles generate some of the highest margins for Lululemon.

More broadly, investors should watch whether other product categories like the demand for outerwear get in the way of the higher margins from core products. I don't think this will be the case, because Lululemon has been reporting steady improvement in product margin lately, and the strong demand for outerwear allows Lululemon to command premium prices for those items.

Looking at the bigger picture, Lululemon's roll-out of the new loyalty program could provide upside to margins over the next few years. Also, there is the ongoing costs management is taking out of the supply chain. Management has guided that gross margin "will continue to expand modestly on an annual basis through 2023."

The headline numbers to watch

Management is calling for revenue and earnings to increase by 18.3% and 21.3%, respectively, year over year at the midpoint of guidance. But the stock price might respond more to how the company performs relative to Wall Street's expectations. Analysts currently expect revenue to be $897.31 million and earnings to come in at $0.93 per share.

Expectations are sky high, and Lululemon has been regularly beating analysts' estimates lately. We are at a point that Lululemon will probably need to exceed analysts' expectations to justify the current valuation. We don't want to trap ourselves in playing the short-term game like Wall Street, but it's something to keep in mind heading into earnings.

Lululemon has such a strong brand going for it and such a massive market to grow into that I would look at any pullback in the stock as a buying opportunity.

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John Ballard owns shares of Lululemon Athletica. The Motley Fool owns shares of and recommends Lululemon Athletica. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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