Could There Be an Easy Explanation for GoPro Inc.'s Falling Sales?

Shares of GoPro Inc. (GPRO -1.12%) have been slammed in 2015 as investors became disenchanted by a floundering growth story and a mismanaged launch of the Hero4 Session. There are a lot of negative narratives for the company this year, as some of my fellow Fools have correctly pointed out.

But one dynamic I don't see discussed much is how inventory could be playing a big role in GoPro's declining sales toward the end of this year. Now that the company is no longer in a buildout of its sales network, it's not rapidly building channel inventory that makes sales look better than they really are. Let me explain how this could be playing out at GoPro.

GoPro Hero4 Session has been the cause of a lot of investor angst in 2015. Image source: GoPro.

How inventory drove GoPro's sales growth
One of the strange secrets of product sales through retail channels is that an expanding network boosts sales without ever-growing consumer demand. If GoPro added 5,000 new retail locations in 2015 and each location needs 20 GoPro units for their inventory, the company will sell 100,000 units before one ever reaches a customer's hands. And GoPro's revenue doesn't depend on an actual sale to a user; it only requires a sale to a retailer or distributor. So, GoPro's sales numbers really tell us more about a retailer's demand than it does about how much consumer demand is growing. This is important for GoPro this year. 

Consider that the 25,000 retail locations GoPro says it is selling through around the world will need inventory. If we assume that each retailer needs 20 units of inventory, there's demand for 500,000 GoPros that haven't hit consumers' hands yet. When you compare that to the 6.97 million GoPros that have been sold over the past year, it's a big, big percentage of the company's business. As the retail network is growing, these sales are called "filling the channel" and it make sales look great for a while. 

Below, I've created a table that shows what filling the channel can do for sales in a fast-growing retail network. The number of retailers in the table grows from year 1 to year 3 and inventory builds correspondingly. Consumer sales are flat for each of the four years. But GoPro would see them rise to 700,000 units and then crash by 29% in year 4, to 500,000. Not coincidentally, this is the true demand for GoPro's cameras in this example.

Calculations by author.

You can see that filling the channel helps boost both sales and growth beyond what real end market demand is. For a fast-growing business, this can make growth look even better than it is. But when the channel is full, the good times can stop quickly.

The inventory problem for GoPro
Filling the channel isn't a catalyst that can drive sales forever, and there are indications that retail partners may already be playing a smaller role in GoPro's business. In 2014, sales direct from GoPro to customers were 59% of sales, up from 52% in 2013. Another data point that supports this thesis is that accounts receivables were flat in the third quarter, which wouldn't be the case if GoPro were adding a significant number of retailers.

If direct sales are growing, it actually make sense that the number of retailers carrying GoPros is steady, if not falling, which could make GoPro's revenue fall even if end consumer demand is flat. With that in mind, look at the chart of GoPro's trailing-12-month revenue. It has some of the same characteristics as the channel-filling dynamic I pointed out above.  

Data source: GoPro's earnings releases. Chart by author.

Could inventory be GoPro's problem in 2015?
GoPro's disappointing fourth-quarter guidance of $430 million to $445 million in revenue was what freaked out investors and slammed the company's shares over the past couple of months. But there could be an easy and logical explanation for some of the disappointment. The lack of new retailers with inventory to fill in 2015 may be a driver of that weak guidance.

I'm not saying this is the only reason GoPro's sales are going to be down in the fourth quarter, and this isn't to suggest it won't have challenges growing now that it's selling the Hero4 Session for $199. But understanding how inventory has helped drive sales growth over the past few years and why it may now be a drag on revenue, even if consumer demand is flat, is important for investors.