GoPro  (NASDAQ:GPRO) is facing another challenging year financially, no matter how positive a spin management is putting on the business. The company is seeing strong demand for its products, but that's partially because of promotional discounts and sales and marketing spending ahead of the holidays. 

This is arguably the best product lineup GoPro has had in the last five years, and if GoPro can't make money in 2018, how will it ever make money? Here's a look at the challenge facing the company. 

GoPro's Hero7 lineup.

Image source: GoPro.

Discounts are a killer for GoPro

To make money, any company has to make enough gross profit to cover operating expenses in order to generate an operating profit. Once a company makes an operating profit, tax rates, financing costs, and other non-operating expenses impact net income, but without an operating profit, it's impossible for a product company to make money in the long term.

GoPro has cut expenses to a level where it has about $400 million in operating expenses each year. That means it has to generate over $400 million in gross profit just to break even on operations. 

The two factors going into a gross profit are revenue and cost of revenue, or gross profit margin. The higher the margin, the less revenue that's needed, and vice versa. And this is where GoPro has a big problem on its hands. 

To drum up sales this holiday season, GoPro is discounting cameras to increase volumes, which lowers gross margin. This dramatically increases the number of cameras the company needs to sell to break even. After saying it expected gross margin to be about 40% to end 2018, management reported a 33% gross margin in the third quarter and said gross margin would be about 38% in the fourth quarter. That's why investors were disappointed with the stock. 

Falling gross margins quickly increase the number of units that need to be sold. Below, I've put together a sensitivity analysis of gross margin, revenue, and the resulting units that need to be sold by GoPro assuming a $261 average selling price (ASP), as reported last quarter. 

Metric Low Margin Medium Margin High Margin
Gross margin 30% 35% 40%
Breakeven revenue $1.33 billion $1.14 billion $1.00 billion
Units sold at $261 ASP 5.1 million 4.4 million 3.8 million

Data source: Calculations by the author. 

You can see that a high margin only requires 3.8 million cameras to be sold to break even. But if discounting continues the number can creep over 5 million very quickly. 

What is GoPro to do? 

The table above shows GoPro's problem. It wants to generate a high margin in order to make a profit, but it's proven that customers are price sensitive and it needs to offer promotions in order to drum up sales. That pushes margins lower and increases the breakeven volume level, which GoPro hasn't been able to hit. 

This is why investors were so disappointed with the gross margin guidance for the fourth quarter of 2018. If GoPro can't generate over a 40% gross margin during its best quarter of the year, it'll be difficult to ever generate enough gross profit to make money. 

If GoPro wants to survive and thrive, it needs to find a way to generate higher gross margin, lower operating expenses, or dramatically increase sales. I don't see an easy path to achieving any of those things today. 

Travis Hoium has no position in any of the stocks mentioned. The Motley Fool recommends GoPro. The Motley Fool has a disclosure policy.