GoPro's (NASDAQ:GPRO) terrific showing in the third quarter doesn't come as a surprise. The action-camera maker exceeded the higher end of its own guidance range on both the top and bottom lines thanks to solid demand for its premium cameras. But that wasn't enough to satisfy investors, as the stock crashed 24% the day after the report came out.

The problem was GoPro's guidance. The company slashed its outlook for the holiday period by a good $20 million, citing a shift of revenue from the fourth to the third quarter. It now expects $370 million in revenue this quarter at the midpoint of its guidance range, which would be good enough for a 10% increase over the prior-year period. The bigger issue, however, seems to be the stronger promotional activity that GoPro plans to run during the fourth quarter.

GoPro Hero 7 camera splashing on water.

Image Source: GoPro. 

The root of the problem

CFO Brian McGee pointed out on the latest earnings call that GoPro plans to "initiate more promotions during the fourth quarter, which will have a negative impact on both Q4 revenue and margins." He said such a strategy will help the company exit the year with low inventory levels, while also allowing it to achieve profitability in the fourth quarter.

Given that its latest flagship action camera is a runaway hit at the sales counters, it is surprising to see GoPro stepping up its promotional activity to boost sales at the cost of margins. But GoPro is probably following that strategy because it is finding it difficult to sell its low-priced cameras. The HERO7, HERO6, and HERO5 Black cameras accounted for 60% of the 1.1 million cameras that GoPro shipped during the third quarter.

This means that GoPro's older premium cameras are still driving sales, as the HERO5 Black was launched over two years ago in September 2016, followed by the HERO6 Black last year. So, the company's budget cameras, such as the HERO7 Silver and the HERO7 White, have probably received a lukewarm response from customers, forcing GoPro to clear inventories by reducing prices.

If one reads between the lines, CEO Nick Woodman seems to concede this: "We received feedback from our retailers that this was going to be a very promotional holiday, and they encouraged us to be more promotional and we took their advice and decided to be promotional on both Silver and White in addition to HERO7 Black, which we already had planned promotions for."

In simpler words, retailers have conveyed to GoPro that the lower-priced cameras aren't selling well, and they need to be discounted to move more units. The company agreed to cut prices to move inventory.

Investors seem to be worried that GoPro's sales are mostly restricted to the premium action-camera market. But this isn't entirely surprising, as customers have good reason to go for cheaper action cameras from Chinese vendors that pack premium features on a budget. However, there's an upside as well that investors shouldn't miss.

The silver lining

The stronger performance of GoPro's premium cameras is expected to give a nice shot in the arm to the company's margin profile. The company anticipates its fourth-quarter gross margin to land at 38%, marking a terrific improvement over the year-ago quarter's gross margin figure of just 24.8%. As a result, the company expects non-GAAP earnings in the range of $0.21 to $0.31 per share, which would reverse the year-ago period's loss of $0.30 per share.

So there is an upside that GoPro investors are possibly missing. Moreover, another potential upside to an aggressive promotional campaign for the cheaper offerings is that the company will be able to attract new customers into its ecosystem. Eventually, GoPro will have a chance to sell its more expensive cameras to those users when they upgrade.

So the company seems to be following the right strategy by discounting its budget offerings to bring more users into its fold, while the premium cameras ensure that its margins improve.

Moreover, GoPro's discounting will also lead to leaner inventory levels. The company ended the third quarter with $123 million worth of inventories, the lowest level it has recorded since the third quarter of 2014. Assuming that it manages to move a sizable volume of cameras thanks to its promotional efforts and lowers the inventory level further, GoPro will be in a nice position to replenish its channel inventory with a new set of products next year.

Investors have overreacted

In all, GoPro's latest performance doesn't warrant such a big stock price crash because there are concrete signs that the company is moving in the right direction. It is all set to return to top-line growth next quarter for the first time since the bad times began in the fourth quarter of 2017, while the bottom line will also receive a solid boost.

Finally, GoPro seems to be laying the groundwork for long-term growth with an intention of capturing more market share. This is the right thing to do considering the massive growth potential of the action camera market, which is expected to exceed $7.6 billion in revenue by 2023, according to one estimate.

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