When the stock market is behaving as poorly as it has recently, high-flying stocks trading at lofty valuations get called into question. Lululemon Athletica Inc. (NASDAQ: LULU) lost nearly one-third of its value and could continue dropping. At a recent price of ~$119.00, LULU stock is still valued at a 34 times P/E.

A pair of upgrades did little to help stop the drop in LULU. Despite a solid third-quarter report, will markets buy the dip in Lululemon stock?

Strong Q3 Report

Lululemon reported store sales growing 6% in the quarter. Sales grew even better, up 17% Y/Y, when online activity is included in results.

Sales growth from China is the strongest data point, rising 71% in the quarter. That impressive result could also hinder LULU stock.

In light of U.S.-China trade wars still lingering, investors may have decided to lock in profits now. That way, if the two countries do not back down on tariffs in 90 days’ time, investors will not have any exposure to Lululemon.

Its high valuations depend on sustained growth, with its presence in China central to achieving that positive momentum.

Related Investments

Lululemon is not the only specialty retailer getting hammered on the stock market. Ulta Beauty (NASDAQ: ULTA) fell from more than $300 at around $236. Ulta reported Q3 earnings of $2.18 as revenue, rose 16.4% year-on-year, an even better pace than that of Lululemon.

ULTA stock has more favorable valuations, trading at a P/E of 20 times and a P/FCF of 22 times. LULU stock trades at a P/FCF of 32.5 times.

Fair Value

Lululemon continues to post product margin expansion that is well above expectations. This enabled the company to speed up its SG&A spending.

In doing so, current profit numbers look lighter but the spending will lead to supporting growth next year and beyond. Wall Street is enamored with LULU stock, which is a cause for concern for investors who look for contrarian plays.

Per Tipranks, the average price target, based on 19 analysts, is $167.88, 47.6% above the recent share price. Below are the analyst calls on Lululemon stock in the last two weeks.

Source: Tipranks

Investors could build a fair value model that assumes a worst case scenario where revenue growth is decelerating over the next five years. Using a 5-Year DCF Revenue Exit model (click on the link to change assumptions), if revenue growth slows to the single digits by FY 2023, LULU stock would have a 20% downside fair value.

Source: finbox.io

The downside target price already assumes a discount rate of just 6.5% – 7.5%.

2019 Growth

Indiscriminate selling in shares of Lululemon creates a better entry point for investors who believe in the company’s growth next year.

The company’s online website is highly effective in converting guest visits to sales. Improved speed and processing during checkout, personalizing the website and other technical enhancements are leading to higher conversation rates. Management expects such gains will continue into 2019.

Circling back to China, Lululemon believes its digital business in China will continue growing. On the conference call, management said Japan and Korea, not just China, are driving online growth in the region:

In China, we continue to see strength within our digital business. Our e-commerce business grew 76%, with a two-year increase of over 200%. I’d also highlight Singles’ Day last month when we saw an increase of over 150% in our Tmall business. Outside of China, we launched our local market ecommerce site in Korea. And at the end of October, we opened our very first store in Osaka, Japan.

Your Takeaway

Lululemon gave up gains from its summer rally and trades at a decent valuation. The stock could entice value investors if shares fall to the $95 – 110 range.

Disclosure: The author does not own shares in any of the companies mentioned.