The Same Old Competitive Conundrum: GoPro’s September 30 Quarter

I like GoPro’s strategy.  Or at least, I don’t know what other strategy I could choose to pursue as a public company in their space.  Here’s how they describe its evolution in the 10-Q for September 30.  “What began as an idea to help athletes document themselves engaged in sport, GoPro has become an end-to-end storytelling solution that helps the world share itself through immersive and engaging content.”  I’ll quote President Anthony Bates at some length, because it’s important to understand their concept.

“… the world is filled with an increasing number of consumers that are interested in capturing and expressing themselves visually and socially. And that GoPro is at the epicenter of that as a storytelling solution that really is a differentiated way to capture and share one’s life in a manner that you simply just cannot do with a smartphone or DSLR or any other type of camera. And that now with the deployment of auto uploading cameras and GoPro Plus, which makes it easy for you to access your content and edit it using a smartphone and the Quik app, we’ve really made the GoPro experience seamless and contemporary.”

They want their users to be their own personal media companies and to bring GoPro along with them as a media company.  How did they get to this thinking?

They figured out being focused only on athlete’s documenting themselves was growth limiting.  And they knew consumer electronic products tend to become commodities.  With competitors in the camera market better resourced than GoPro, they had to sell capture devices that facilitated editing and sharing as well as capturing.  Ease of use and a streamlined process that leaves the customer in charge from the time they take the product out of the packaging until they share their first created product.

They have to, well, capture this customer with their devices and its accessories, the free software and their brand positioning.  Hmmm.  Wonder what other products might fit this concept?  I don’t have any in mind, but it’s an intriguing thought.

What are the competitive challenges?

1. As already mentioned, staying ahead in technology. Or at least caught up.  GoPro has spent a lot of money on R&D and seems to have gotten some good results.  I am not certain they can (or need to?) continue spending at current levels.  It would be interesting to know what kind of proprietary technology they have.  I’ve never heard any discussion of that.
2. How many people want to embrace the ecosystem GoPro is creating? For some, it’s enough to have a good camera on a smart phone.  There are also cheaper cameras and other software.  Perhaps they are without the GoPro capabilities, but for how many people are they “good enough?”  What is the market size?
3. How important is branding? I tend to believe it’s pretty important to GoPro.  The “cool” factor that differentiates and creates community.  Let’s remember Skullcandy and Quiksilver and Burton.  They all tried to expand into a broader market and found it tough going.  I’d say they damaged their brands in the effort.   As I’ve put it previously, “They may know your brand, but not your story.”  The connection- identifying as part of the community- comes from knowing the story.

Just how big is the market for the brand and the capabilities GoPro is creating?  Think about that as we now move to the numbers.  If there’s one thing I’d like to know (I doubt it’s information GoPro will share) it’s how the new, free, branded software is impacting sales.  Remember, it works with the iPhone.

GoPro reported revenue of $214 million in the quarter ended September 30, down 40% from $400 million in last year’s quarter.  Two customers were, respectively, 21% and 10% of revenues during the quarter.  Sales in the Americas fell from $191 to $136 million.  In Europe, Middle East and Africa, they were down from $157 to $77 million.  The decline in Asia and the Pacific was from $53 to $27 million.  Units shipped this quarter were 1.02 million, down from 1.59 million in last year’s quarter.

The gross margin fell from 46.6% to 40.3% “…primarily reflecting the higher selling price of HERO4 Session in the third quarter of 2015, as well as the allocation of fixed overhead costs across significantly fewer units…”  In last year’s third quarter, 47.7% of revenue was direct and 52.3% through distribution.  In this year’s third quarter, direct had risen to 61.5% of revenue with distribution down to 38.5%.  What I don’t know is how that change impacted the gross margin.  That is, if the channel split had stayed the same year over year, what would the change in the gross margin have been?

CFO Brian McGee noted in the conference call that, “We have not experienced any noticeable pricing pressure in the average selling price of any individual camera model.”  He goes on two paragraphs later to note, “Gross margin in the third quarter of 2015 was 46.8%, which benefited by an estimated 500 basis points from a higher MSRP for the HERO4 Session.  I don’t know- that sounds a little like price pressure to me.  Though perhaps it could be characterized as normal price reduction as newer models replace older ones.  I suppose it’s normal in the sense it’s what always happens in consumer electronics, but that doesn’t make it a good thing for GoPro.

He goes on to note, “Our camera ASP [average selling price] is expected to improve sequentially, with the HERO5 Black camera accounting for the majority of the camera shipped in the fourth quarter. Gross margin for the fourth quarter is expected to be 40%, plus or minus 100 basis points.”  The gross margin in last year’s fourth quarter was 41.6%.

Total operating expense was up 33.75% compared to last year’s quarter.  R&D spending rose 42.6% from $67 to $96 million.  Sales and marketing was up 38%, rising from $66 to $92 million.  The increase was the result of “…higher advertising and promotional activity costs of $19.9 million and $41.6 million [over the nine months], respectively, associated with expanded corporate branding campaigns to improve worldwide brand awareness and support the launch of our HERO5 cameras, Karma drone and related products.”

General and administrative expense was approximately constant at $25 million.  They project that operating expenses will be around $780 million in 2016, but will fall to $650 million in 2017.  I’ll be interested to see if they can do that.  Given their competitive imperatives as they describe them, it might be a challenge.

Pretax income fell from $27.6 million to a loss of $116.4 million.  For the first nine months of the year, the pretax loss was $303.3 million compared to a pretax profit of $93.6 million in nine months the previous year.

Now we’ll move along to the balance sheet.  Cash and marketable securities fell 56% since September 30 last year from $513 million to $225 million.  Receivables fell 23.5% from $121 to $92 million, consistent with a sales decline.  One company represented 27% of receivables at the end of the quarter.  Inventory followed a similar trajectory, falling from $290 to $145 million, or by 50%.

I’d note big increases in goodwill and other long term assets as the result of a couple of acquisition.  The former rose 156% from $57 to $146 million and the later 180% from $49 to $137 million.

Accounts payable were constant at $159 million and accrued liabilities rose a bit from $166 to $184 million.

The current ratio declined from 2.90 to 1.42.  Total liabilities to equity increased from 0.46 to 0.78 largely on a 39% decline in stockholders’ equity.  The changes in the balance sheet and operating results are reflected in the cash flow, where we see net cash used in operations of $120 million for the first nine months of the year.  In the same period last year, GoPro generated $137 million.

The decline in cash and overall balance sheet strength were partly the result of their developing and launching the Hero 5 and Karma drone.  It was necessary given their strategy and, hopefully, turns out to be well spent.

As you are probably aware, the HERO5 capture devices and Karma drone only started shipping in in late September, so they had limited impact on the quarter.  There were some factory production problems, now resolved, that made it impossible for GoPro to completely fill its channels.  I suspect that explains a chunk of the inventory decline discussed above- they would probably have preferred inventory was higher and full of HERO5s.  Per CEO Nick Woodman, the production delay will “…have a negative impact on results for the second half of the year.”

You may also have seen that GoPro recalled something like 2,500 of its Karma drones a couple of days ago because of a few cases of power loss in flight.

I hope they made lemonade out of lemons here and used the temporary scarcity as a brand building tool.

GoPro has spent a lot of money creating some new product which, by their description, are way better than anything out there in terms of functionality and ease of use.  Can they continue to be a technological leader against better resourced competitors?  Or does the quality of the ecosystem/community they are creating mean they don’t have to be?

In discussing risk factors, the 10-Q notes, “We believe that we must continually develop and introduce new products, enhance our existing products and effectively stimulate customer demand for new and upgraded products to maintain or increase our revenue.”

“The success of new product introductions depends on a number of factors including, but not limited to, timely and successful research and development, pricing, market and consumer acceptance…”.

I recognize that risk factor statements are created partly as legal constructs using an “abundance of caution” approach.  However, it’s still a true statement for GoPro.  But they project cutting operating expenses 17% next year as a critical part of returning to profitability.  I’d rather they accomplished that through revenue and margin increases (so do they I’m sure) because I am concerned that their strategy requires the spending they are going to cut.

I wonder if there were significant expenses this year that were unique to the HERO5 and Karma development and introduction.

I find myself ending with a speech I’ve made about various other public companies in our industry.  Is there a solid business here?  Yes, though it’s stumbled a little.  Can it be long term successful as a public company if they keep to the market they can defend, are cautious in distribution, and potentially sacrifice some growth?  We’ll see.