Every day, Wall Street analysts upgrade some stocks, downgrade others, and “initiate coverage” on a few more. But do these analysts even know what they’re talking about? Today, we’re taking one high-profile Wall Street pick and putting it under the microscope…

It was a story as old as October.

Much like the tech rout we’ve seen hit Wall Street over the last two months, lululemon athletica (NASDAQ:LULU) stock got punished last week after the company reported strong, estimate-beating revenue and earnings — all because its guidance didn’t wow investors. Lululemon shares plunged 13% on Friday despite a 21% rise in revenue and a 65% surge in GAAP profit.

The sell-off contributed to a 28% decline in Lululemon shares from their Sept. 28 high. This amazing price rollback caught the attention of Citigroup analysts today, who upgraded the stock. Here’s what you need to know.

Woman doing yoga pose in a room with glass doors open to a courtyard filled with plants

Citi thinks Lululemon stock could be worth $152 a share. Is that too much of a stretch? Image source: Getty Images.

What Lululemon said

Let’s begin with a quick review of the quarter’s numbers. As already mentioned, Lululemon saw sales up 21% to $748 million. Same-store sales grew only 6%, so at least some of the growth was from increasing store count — but a lot more came from surging sales over the interwebs.

In its report, Lululemon noted that “direct to consumer net revenue” — internet sales — increased 44% year over year. These high-margin sales now account for more than 25% of the company’s business, helping to drive up gross margin an impressive 240 basis points to 54.4% of sales. Earnings shot up 65% to $0.71 per share. Pro forma earnings, which companies often highlight in order to make weak GAAP profits look better than they actually are, were both stronger than GAAP profits ($0.75 per share) and growing slower (up 34%).

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What investors didn’t like about that

Lululemon’s results exceeded Wall Street’s expectations (pro forma profits were only supposed to have been $0.70 per share, for example). Seeing this, the company dutifully added the extra money to its guidance for the year, predicting full-year sales will come in around $3.24 billion, and GAAP profits will range from $3.61 to $3.64 per share.

That’s good news. What investors rebelled at, however, was the fact that Lululemon didn’t go a step farther and raise guidance even more, so as to promise a follow-up earnings beat in Q4. Guidance for Q4, as my fellow Fool.com contributor Steve Symington pointed out last week, still lies “roughly in line with consensus expectations.”

Hence the sell-off.

Why Citigroup likes Lululemon anyway

And yet, Lululemon did still beat expectations in Q3 — and it didn’t promise that, either. That being the case, it’s possible investors overreacted to the absence of an honest-to-goodness increase in guidance for Q4 last week.

Citigroup certainly thinks so. Doubling down on its insistence that Lululemon shares are worth $152 apiece, Citigroup is interpreting the sell-off as a buying opportunity, and upgrading Lululemon Athletica stock to buy today, as explained in a note on StreetInsider.com (subscription required).

“[F]ears of a macro slowdown have taken the winning brands down with the rest of the group, seemingly painting all with the same brush,” argues Citigroup. Lululemon, however, is not just any old retailer, but rather “a story of improving fundamentals and stand-out growth prospects,” boasting the “strongest brand positioning, comp momentum, int’l prospects, margins and ROIC in our coverage group.”

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Is Citigroup right about this? Possibly so. After all, Fool.com contributor John Ballard expressed similar thoughts when reviewing Lulu’s results last week.

“Lululemon’s business momentum is real and there’s no sign of it slowing down,” wrote Ballard. The company is expanding its product offerings into “everyday wear,” even as it raises prices, expands margins, and ties its customers ever more closely to it with new loyalty programs, such as a $128-a-year subscription service entitling members to “a free pair of pants or shorts, curated Sweat Classes, free fast shipping with online orders, and early access to Sweatlife Festivals and other events the company hosts throughout the year.”

Such offerings may not appeal to everyone, but they do appear to appeal to Lululemon’s most devoted fans. Chief Product Officer Sun Choe notes that Lulu has “not seen price resistance where we’ve introduced [extra features] and priced it at a premium. So we believe that continuing to innovate on solutions for our guest, and if there is value there, we can continue to push prices up.” 

The upshot for investors

At a share price of 40 times earnings, with most analysts still projecting a long-term growth rate of only 20%, Lululemon stock looks pretty pricey today, even after its recent sell-off. Then again, predicting 20% profits growth for a company that just grew revenue alone by 21%, and that sees no “price resistance” to piling ever-stronger profit margin on top of that revenue seems overly conservative to me.

Comments like Choe’s suggest Lululemon could continue surprising investors to the upside for years to come — whether the company officially raises its guidance or not.

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