Gopro

Image source: GoPro.

Within GoPro's (NASDAQ:GPRO) third-quarter earnings, which sent investors running for the exits, the action camera company also reported a staggering 147% year-over-year rise in inventory -- more than triple its revenue growth for the quarter. Considering its fourth-quarter guidance, which captures the crucial holiday season, calls for sales to decline by 17% year over year at the midpoint, this inventory build could be viewed as a potential problem.

GPRO Inventories (Quarterly) Chart

GPRO Inventories (Quarterly) data by YCharts.

After all, the combination of declining sales and expanding inventories raises a red flag that GoPro may get stuck with excessive inventory that it can't sell before its next product refresh. If this were to occur, it could result in inventory writedowns and negatively impact gross profits -- not an ideal situation for investors.

However, after digging into the details, GoPro doesn't appear to be remotely close to having a serious inventory problem on its hands.

Putting fears at ease
Whenever a company experiences a dramatic rise in inventory in the absence of strong expected sales growth or upcoming product launches, which is currently the case for GoPro, examining the type of inventory held on its balance sheet may tell a deeper story. According to GoPro's quarterly 10-Q SEC filing, the company held the following inventory at the close of the third quarter:

Inventory Type

Thousands

Components

$14,478

Finished goods

$275,043

Total inventory

$289,521

Data source: GoPro.

With 95% of GoPro's inventory sitting in a warehouse ready to be shipped out, it certainly looks like GoPro could be at risk of having an inventory problem, because there's typically more risk associated with the value of finished goods inventory than its components.

Before sounding the alarms, it's essential to put GoPro's inventory into context. The first thing to consider is how quickly GoPro could turn over its inventory on hand relative to its expected sales. For instance, in the upcoming fourth quarter, GoPro expects to generate between $500 million and $550 million in sales, which is roughly double the amount of inventory it currently holds.

The second thing to consider is what management said about its inventory during the earnings call. CFO Jack Lazar highlighted that GoPro didn't have enough inventory in its distribution channel going into the holiday season last year and this year's level is more normalized. Lazar also noted that over $80 million of its inventory is related to new products that didn't exist last year.

Finally, GoPro's 2014 annual report discloses that GoPro's inventory is held at the lesser of cost or market value -- a requirement of GAAP accounting -- which would likely lower the severity of an inventory writedown in the event that one occurred.

Dig deeper
Although GoPro's rapid inventory expansion raises a red flag, closer examination of how quickly its inventory is being turned over, the dynamics of its supply chain, and how inventory is being valued reveals the company doesn't likely have a looming inventory problem.

Ultimately, a headline red flag isn't always a sign of trouble -- it's an invitation to dig deeper.

Editor's note: An earlier version of this article read: "Finally, GoPro's 2014 annual report discloses that GoPro's inventory is held at the lesser of cost or market value, meaning the company takes a conservative approach to how it values inventory on its books, which would likely lower the severity of an inventory writedown in the event that one occurred." The article has been corrected to reflect that valuing inventory at the lesser of cost or market value is a requirement of GAAP accounting. 

Steve Heller owns shares of GoPro. The Motley Fool owns shares of and recommends GoPro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.