Let's assume your baby dragon is an animation composed of 3 different frames of 3 different colors (one for each number of lives). Set the speed of this animation to 0 (so frames don't go by and a single frame is displayed).
In the condition "Fireball on collision with baby dragon" (however you made it in your project) make sure to remove one HP from your dragon (probably in its instance variable HP) and then add subevents checking out what is the current value of this variable.
According to the value, set the appropriate frame.
You're likely to have a more precise answer if you post/attach your current project to the post asking for help, since it's not easy to guess out what you've made so far.