GoPro's (GPRO 2.58%) recovery from an abysmal past two years depends on a lot of factors working in its favor. Demand for Hero 5 and Karma need to be strong in the first three quarters of the year, and during the holiday season the next generation Hero camera and (potentially) Fusion 260 camera have to live up to expectations. And cost cuts aimed at reducing non-GAAP operating expenses to below $495 million need to be executed without taking away from the sales of new products.
But strong demand for products and cost cutting aren't enough for GoPro. The company needs to start making more money on each sale to return to profitability. And this is one trend that's working against GoPro right now.
The case of the falling margins
You can see in the chart below that GoPro has seen its gross margin decline rapidly over the past three years to just over 30% in the first quarter. This is down from regularly reporting gross margin near 50% when GoPro first went public.
You can see that gross margin is well below Garmin's (GRMN 3.36%), arguably GoPro's biggest competition after launching an action camera and 360 camera.
Why gross margin improvements will be a challenge
It's a company like Garmin that could have the biggest negative impact on GoPro's gross margin. The company is competing directly with GoPro in almost every major market (except drones) and has an inherent advantage with its presence in smart watches that can connect to action cameras.
If GoPro needs to compete on price to win customers from Garmin, it will be at the detriment of gross margins. And after a holiday season when GoPro cameras were highly promoted and discounted, it's worth worrying about the pricing pressure getting stronger in 2017.
Why GoPro is optimistic about gross margins
There are a few reasons investors should expect gross margin to return to around 40%, where management said they expected the figure to stay long-term.
The product lineup is smaller than it was two years ago with just three Hero cameras, the Karma drone, and the Fusion 360 camera. Two years ago, there were six Hero models alone, which was confusing for customers and GoPro's inventory alike.
GoPro may also see more direct channel revenue, which should be higher margin than retail sales. 52.5% of first quarter 2017 sales were direct to customers, up from 37% a year earlier, and will benefit from Karma being sold directly to customers, as well as the return program instituted earlier this year.
Climbing an uphill battle
It'll be challenging for GoPro to get gross margins back to around 40%, but it's absolutely necessary if the company is going to return to profitability. GoPro has already cut operating expenses as much as it can and doesn't appear to have a lot of revenue or volume growth on the horizon that could offset lower margins. Management has to execute, and after a few years of questionable performance that could be a lot for investors to expect right now.