There's a Lot to Like in Lululemon Athletica's Most Recent Quarter

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If investors had been waiting for that one quarter that will validate lululemon athletica's (NASDAQ: LULU) strategy to reach $4 billion in revenue by 2020, despite a very slow retail sales environment, this was that quarter. The yoga specialist started off fiscal 2017 (which ended in January) slow, but steady gains were made each quarter to finish the year on a high note.

It wasn't necessarily the strong revenue growth of 18% for the quarter that should make investors feel good about the business right now. It's how that growth rate was accomplished. This performance is a culmination of everything management has been working on over the past few years, including growing the men's category, shoring up weakness in women's tops, building a strong direct-to-consumer (DTC) channel (which includes online sales), and making the supply chain more efficient to firm up margins and speed up the innovation cycle.

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All of these improvements came together perfectly in one quarter, leading to a blowout. Let's dig in.

Lululemon's online strategy is working

While Nike and Under Armour are struggling to adapt to consumer shifts toward online shopping, Lululemon is showing how it's done, with an impressive 42% year-over-year increase in DTC revenue in the fourth quarter. This is a dramatic reversal for a company that reported no year-over-year growth in the DTC segment in the first quarter of the fiscal year.

Early last year, management took swift action to fix the problem, which it identified as being rooted in inefficient teamwork within the company across merchandising, brand, technology, and e-commerce operations. Also, there were major improvements made to the technology behind the website to allow management to make faster changes to the website in the future. In the past, changes would take months.

By the time the holidays rolled around, the website had been freshened up with new photography, a better layout, and new checkout processes that made it much easier to shop. All of these improvements led to a blowout holiday quarter on the DTC side.

This tells me two things: First, Lululemon's brand has been severely underperforming its potential over the past five years when growth dramatically slowed down following the Luon pants recall in 2013. Second, Lululemon probably has the best digital strategy of any apparel retailer, in which management is seamlessly blending the in-store and online shopping experience, which is improving store traffic and helping the company firm up margins.

Margin expansion opportunity

One way Lululemon uses its website business is to clear excess inventory under its "We Made Too Much" discount page. Now, with added services like the ability to have orders shipped direct to the customer from a store, Lululemon is helping its physical stores clear slow-selling items much faster. This is having a positive impact on adjusted operating margin, which expanded 2.9 percentage points to 27.8% in the fourth quarter.

DTC includes no store payroll or other store-related expenses, so as DTC continues to grow faster than the rest of the business, Lululemon should be able to see its operating margin expand. The digital channel was only 25.4% of total revenue in the fourth quarter, but generates a 40% operating margin -- much higher than the 25% margin for company-operated stores.

Momentum is expected to continue

Of course, the strong performance in DTC wouldn't happen if there wasn't attractive merchandise pulling customers to the Lululemon brand. Management reported strong responses to new product styles, especially with men's ABC pants and women's overall. Here's how Senior Vice President of Merchandising Sun Choe explained it during the late March conference call with analysts: "In January, we excited our guests with new product flows that previewed our spring color palette, and we are encouraged by the response thus far to a greatly improved balance of color, print, and pattern, now in-store and online, relative to our offering this time last year."

Strong customer response to new merchandise contributed to lower markdowns, and the ongoing improvements management is making to the supply chain led to lower product costs. Both had a positive impact on gross margin. In fact, Lululemon's gross margin of 56.2% for the quarter is the highest since the fourth quarter of fiscal 2012.

With this much momentum, it shouldn't come as a surprise that management expects a strong year. For fiscal 2018, executives' early guidance calls for revenue growth of 15% and adjusted earnings-per-share growth of 17% over fiscal 2017. This would bring revenue to $3 billion and adjusted earnings per share to $3.04 (plus or minus a few cents).

With innovation clearly striking the right note with customers, and the DTC business kicking into higher gear, Lululemon is definitely returning to growth form.

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John Ballard has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends NKE, UAA, and UA. The Motley Fool recommends Lululemon Athletica. The Motley Fool has a disclosure policy.