Updated from 10:47 a.m. EDT

Williams-Sonoma's

(WSM) - Get Report

earnings got back on track in the second quarter, but don't expect to see the company's stock soar as a result.

After seeing earnings decline in its first quarter, Williams-Sonoma posted a 25% increase in per-share profits in the second quarter. Driving the bottom-line result were strong sales, particularly at its namesake division.

But the kitchenware and home-furnishings retailer also reported that its huge inventory build continued in the second quarter, hitting its cash and depressing top-line margins. Those blemishes on an otherwise standout report could raise doubts for investors, analysts say, especially since the company's stock is trading at a price-to-earnings multiple of 24.4, which is relatively pricey by retail standards.

"The valuation is extremely rich," said Rob Wilson, who covers Williams-Sonoma for Tiburon Research Group. "The stock has the potential to correct in the back half of the year." (Tiburon Research Group does not do any investment banking.)

The immediate reaction of investors to the company's earnings was somewhat muted. Williams-Sonoma shares were up 24 cents, or 0.8%, to $30.55 in recent trading.

A correction to Williams-Sonoma's stock would come in spite of the bottom-line results the company reported on Thursday.

In its quarter ended Aug. 3, Williams-Sonoma earned $17.8 million, or 15 cents a share. That result compared with the second quarter of last year, when Williams-Sonoma earned $14.1 million, or 12 cents a share.

Overall sales in the quarter increased 17.1% to $580.4 million. On a same-store sales basis, which compares results at like outlets open for more than one year, revenue increased 6.5%, including a 12.1% gain at its Williams-Sonoma chain.

Williams-Sonoma's results beat analysts' projections and its own estimates. Polled by Thomson First Call, Wall Street analysts were expecting the company to earn 14 cents a share on $565.99 million in sales. The San Francisco-based company had previously projected that it would earn 12 cents to 14 cents a share on sales ranging from $557 million to $575 million.

Despite beating second-quarter expectations, the company gave a cautious outlook for the rest of the year. In the third quarter, the company Williams-Sonoma expects to earn 18 cents to 19 cents per share on sales of $615 million to $625 million.

For the full year, the company upped its guidance, but only enough to include its earnings upside in the second quarter. Williams-Sonoma now expects to earn $1.25 to $1.28 a share on sales ranging from $2.677 to $2.723 billion. Previously, the company had projected full-year earnings of $1.23 to $1.27 a share on sales of $2.646 billion to $2.718 billion.

Williams-Sonoma's performance in the second quarter marked a sharp turnaround from its first-quarter results. The company's year-over-year profit dropped in the first quarter as it posted negative same-store sales and rising operating costs. More disturbingly, the company piled up inventory in the first quarter, worrying analysts that it would have to resort to massive markdowns to move merchandise in the second quarter.

The company did have to use markdowns in the second quarter, but it didn't affect the company's bottom line as analysts feared. Although the company's gross margin declined, it was able to boost its profits by holding operating costs in check.

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Compared with the year-ago quarter, Williams-Sonoma's gross margin dropped 30 basis points as a portion of sales to 37.1%. Gross margin represents the difference between what a company charges customers for its goods and services and the direct costs to the company of those products.

On a conference call with analysts and investors, company CFO Sharon McCollam blamed the decline in margin on markdown and increasing costs related to purchasing goods from European vendors using depressed dollars.

But Williams-Sonoma more than made up for the gross margin decline by controlling operating costs. As a portion of sales, such costs fell 60 basis points to 32.1%.

Although the company upped its advertising costs in the quarter, it cut back on employment and administrative costs and saw reduced incentive pay, McCollam said.

Meanwhile, the increased inventory helped boost sales, company officials said. Same-store sales improved at each of the company's divisions, except for its outlets, compared with the same period a year ago.

Pottery Barn for instance, saw same-store sales rise 2.6%, after a posting 1.3% growth in the year-ago period. Comparable-store sales rose 5.7% at Pottery Barn Kids after growing at a 2.6% clip in the second quarter last year.

The same-store sales growth at Williams-Sonoma stores came after such sales fell 1.7% at the division in the year-ago period.

The company continued to pile up inventory in the second quarter. At the end of the first quarter, Williams-Sonoma's inventory was up 47% from the end of the first quarter of 2002. But by the end of the second quarter, the company's inventory was up 50.5% from the same point a year earlier. Just from the beginning of the company's fiscal year, its inventory has risen 17%.

That inventory build had a huge effect on cash in the quarter. Compared to the end of the second quarter last year, the company's cash and cash equivalents were down $8.1 million, or 9%, to $81.8 million. The drop-off is even more dramatic compared with the beginning of this fiscal year, when the company held $193.5 million in cash and cash equivalents.

Thus far this year, the company has invested nearly $57 million in cash on building up its inventory, McCollam said. The company has spent another $72 million in cash on capital expenditures, she said.

That drop-off in cash, coupled with the company's valuation has Gary Farber considering shorting the stock.

"The cash drop kind of interesting. We want to figure that out," said Farber, a partner with hedge fund Nightingale & Farber. "Williams-Sonoma is kind of a cult stock. That's good news if you want to short it."

The problem Williams-Sonoma faced was losing sales by not having enough inventory in stock, said one hedge fund analyst who asked not to be named. That's a similar problem to what Home Depot has encountered in recent quarters, the fund analyst said.

"(Williams-Sonoma's) cash flow is horrible, but they've got to invest in their business," said the fund analyst, who does not have a position in the company.

Meanwhile, another analyst is more sanguine about the company's performance. The inventory build isn't and shouldn't be that much of a concern for investors, said Fran Radano a buy-side research analyst for Gartmore Global Investments.

"Their inventory level was a little higher than their plan, but if their top line is going to show that type strength, I'll take that tradeoff in a second."