I've not looked at the decision, nor do I know much about the arguments, and I am not commenting on whether it's the "right" decision, which is likely to be the subject of some debate. But on the surface, I think the 4th District Court of Appeal in Riverside, CA was correct in holding that a Lutheran Private School has a right to expel two lesbian students.
The purpose of education is to teach students, but the purpose of religious education is to teach students according to the principles of that religion. Homosexual orientation, whether it be natural or a choice, is viewed as a wrong in the Lutheran religion, and as such, I think it's perfectly acceptable (and in keeping with the Separation of Church and State) for them to determine whether to accept students who violate this principle, just as one who might steal, or cheat, or blaspheme.
Perhaps there might be a different question if this school was receiving vouchers, or being compensated by the State for their teachings - a "bitter with the sweet" situation, but there's been no evidence (in the article I listed above, and time restraints preclude me from following up at this time) to suggest that this is, indeed the case.