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Gymboree , the retailer notorious for cladding toddlers in polka-dot headbands and matching skirts, has been growing up. After years of top-line growth driven by expansion into new size ranges, from newborns to the grammar-school set, the company has been experimenting with new concepts to drive incremental growth. Janie and Jack, a high-end infant clothing store, has done well, but is limited in reach. An adult concept, Janeville, was shuttered in 2006 after not meeting profit goals. But management seems to have finally struck a chord with Crazy 8, a concept initially geared to kids aged 8-12 years old.

There is a huge hole in the children’s clothing market for this age range. The Children’s Place owns the low end, while boutique companies, like Mini-Boden, or mail-order houses, like L.L. Bean and Land’s End, dominate the upper end of the pricing spectrum. Crazy 8 was originally positioned as a brand for older children, with prices 30-33% below the premier Gymboree brand, but 20-25% higher than The Children’s Place. After some test marketing, management believed there was little cannibalization of the typical Gymboree customer and added baby and toddler sizes to the Crazy 8 portfolio.

With only 14 Crazy 8 stores open as of the end of Jan. 2008, investors paced the floor and tapped their fingers as they awaited the verdict on Crazy 8’s future. The concept grew to 39 stores, or 4% of overall stores, by the end of FY2008 (year to January 2009), but cost the company $0.18 on the bottom line. With a base of 62 stores by the Oct. 2009 quarter, however, Crazy 8 was able to boast its first profit.

Although management does not disclose sales levels for each of its concepts or quantify the gross margin levels for each one, it commented on the last earnings conference call that “there is quite a spread between the Crazy 8 gross margins and the rest of the brands”. With a lower-end competitor like The Children’s Place sporting 40% gross margins and the corporate average for Gymboree hovering around 47%, one can make an educated guess that Crazy 8’s gross margins are in the low to mid-40s and growing.

Remarkably, GYMB’s overall gross margins haven’t been too traumatized by the addition of these lower-priced goods. After adjusting for a $6 million write-off due to new regulations on children’s apparel in FY2008 (year to January 2009), gross margins are expected to decline 80bp YoY for the year ending January 2010. This decline comprises an overall increase in merchandise margins, offset by negative occupancy leverage caused by negative comp sales. Once comp sales begin to increase, overall gross margins should improve. The arithmetic here shows that gross margins for the basic business are likely flat to improving after the inclusion of this lower-margin business.

Management has pointed to the enormous operating leverage afforded the company by including the Crazy 8 brand. Bulk purchasing offers scale for lower cost of goods, designs are shared for new lines at both stores and, of course, the cost of back-office functions and management is spread over greater revenue dollars. I would argue that Crazy 8 is likely operating at an equivalent operating margin to the basic Gymboree stores and will only improve as the chain grows bigger.

Crazy 8’s store base is expected to grow 77% in FY2010 (year ending January 2011) and will account for roughly 11% of corporate stores compared with 6.8% as of January 2010. With The Children’s Place operating 947 stores, Crazy 8’s still teeny base of 65 stores has loads of room to run. As many speculate that the price sensitivity of consumers is here to stay, Crazy 8 appears to be the perfect tonic for Gymboree’s growth prospects.

Investors have certainly been jittery with respect to Gymboree’s stock. Perversely, one risk I see with the stock is that management has raised guidance marginally five times over the last four months. Instead of celebrating, investors have grown numb to the good news and have begun to panic if management’s tone is less than ebullient. A comment regarding a slowdown in sales for the last two weeks of October caused a 1.5% drop in the stock and at least one sell-side downgrade. While estimates for the fourth quarter have increased from $0.95 to $1.10 over the last two months, the stock has meandered sideways and currently sells at 10x fiscal 2011 estimates.

The reward for buying the stock before the company’s earnings report on Mar. 10 seems to outweigh the risks. GYMB carries a pristine balance sheet with zero debt, $212 million in cash and clean inventory levels. Cash flow from operations was $97 million for the first nine months of this year and should be significantly larger next year due to higher net income. While street estimates assume a gross margin 100bp higher than company guidance for the fourth quarter, the momentum at Crazy 8 and improvements in the company’s boys business could certainly deliver more bang than expected. If management could get gross margins close to the 48% level achieved in FY2007 (year ended January 2008), earnings for FY2011 (year ending January 2012) would be $4.54 versus current estimates of $4.23. With earnings growing at 18%, the stock could leap as high as $70. This is a stock investors could grow old with.