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Tech Turnaround Deep Dive #1: Peloton🚴♂️
Peloton's fall from grace has created an excellent buying opportunity
Since its founding in 2012, Peloton has been on a mission to revolutionize the fitness industry by connecting individuals across the globe and enabling users to workout with the guidance of an instructor straight from their living room. The multi-billion dollar question is whether Peloton will be able to retain its lead in the connected fitness industry, which should meaningfully expand over the coming decade.
Peloton is a prime example of a company that hyperscaled during the Covid-19 pandemic, experiencing a multi-year pull-forward in demand. $218 million in 2017 revenue snowballed into $4.02 billion in 2021, or 18x growth. Unfortunately for Peloton, the years of doubling or even tripling its revenue are likely behind it and we’re now seeing the ugly side of this pull-forward in demand. The profitable Peloton seen in late 2020 has since disappeared, leaving investors with an operating income and cash flow negative nightmare, all while revenue shrinks as gyms reopen and restrictions ease.
At the beginning of the year, activist investor group Blackwells Capital accumulated a 5% stake and pushed for John Foley’s ousting as CEO. Surprisingly, Peloton listened. To some extent. An activist investor buying up shares is typically indicative of major restructuring, which is exactly what Peloton needs. Blackwells’ call for action presentation sheds light exceptionally well on Peloton’s major dilemmas and “abysmal” management.
Back in February, Peloton announced John Foley was stepping down as CEO to be replaced by Barry McCarthy, a seasoned executive who took both Netflix and Spotify public as CFO. Foley will remain part of the company by appointing himself to Executive Chair of the board, leading critics to say he “failed up”. As Mr. Foley correctly pointed out, “[Barry]’s not only recognized as an expert in running subscription business models and helping category-leading digital streaming companies flourish, but he has also had tremendous success in partnering with founder CEOs at other brands. I’m excited to learn from him and work alongside him as Executive Chair.” In parallel to the announcement of Foley’s transition, 2,800 employees were supposedly laid off. Barry, utilizing his subscription expertise and avid Peloton use (he was a Peloton user prior to becoming CEO), is now tasked with turning around what was once a fitness darling among investors.
After peaking at over $160 a share and a market capitalization of $57 billion, the stock has been obliterated due to numerous headwinds. Most notably, the reopening of gyms and easing of covid-induced restrictions. Investors can now pick up shares for $9.74 a piece and a market capitalization of just $3.42 billion. This equates to a forward enterprise value to sales of just 1.13, meaning the company is valued as if a return to growth is implausible and its viability as an independent business is questionable.
I, on the other hand, believe a return to steady growth is feasible as the U.S. economy emerges from what (at the moment) looks to be an imminent recession, Barry perfects the hardware/software pricing, new products are rolled out, and app subscribers are upsold to hardware. In the meantime, the company’s valuation will be derived from progression in the turnaround and the state of the company’s liquidity. During a recession, demand for Peloton’s bikes and treadmills would likely slow materially, even from today’s levels. Yet, Peloton has a massive total addressable market, similar in caliber to that of Netflix, which should enable a massive growth runway. Peloton has the opportunity to revolutionize the fitness industry, take on gyms across the globe, and grow into the dominant connected fitness brand.
Peloton faces two main forms of competition: gyms and slight iterations of its own equipment. The two most notable equipment competitors are Tonal and NordicTrack. These companies face serious liquidity issues given that they remain private and lack immediate access to cash through share offerings. iFit, the maker of NordicTrack, delayed its IPO due to “adverse market conditions”. In attempts to subvert Peloton’s dominance, both companies have been advertising heavily. Without additional capital infusions, these campaigns will likely be halted or reduced significantly. Gyms, on the other hand, are inherent competitors to Peloton given the company’s vision to connect members digitally instead of in person. When you think of connected fitness, you think of Peloton and I would argue that the Peloton brand alone is worth at least half a billion dollars, if not considerably more. Its NPS (net promoter score) of 64, a retraction from the incredibly high 94 in 2020, is still among the highest of any public company and details the cult-like following the company has cultivated. For perspective, Apple’s NPS is 47, Planet Fitness’s is -17, and Netflix’s is 51. Forbes recently stated that, “Peloton has a cult following that some companies can only dream of, and that should eventually provide a road to a profitable future.” I would tend to agree.
Investor ambivalence toward Peloton is apparent. Some believe it to be substantially undervalued while others see an imminent bankruptcy. Polarizing investments often yield the best returns. Tesla is a prime example given the excessive pessimism around the company’s viability in 2017-2018. This period turned out to be an inflection point for how the company is valued. Peloton isn’t all that different from Tesla, and a shift to profitability (like what occurred for Tesla), thereby proving the underlying business model feasible, would catalyze meaningful share price appreciation. Shown above are two slides from Blackwells Capital (Peloton’s activist investor) quantifying just how undervalued Peloton is relative to other low-churn subscription businesses.
Executional risk, which has had detrimental ramifications for Peloton, still remains, albeit to a lesser extent. As stated in a Peloton news release, management adjustments have been made in order to “position Peloton for sustainable growth, profitability, and long-term success.” Barry McCarthy, who succeeded in creating lucrative and high-retention subscription business models at both Netflix and Spotify, should make investors jubilant. Jill Woodworth, the now former Peloton CFO, did a horrific job in providing investors clarity and failed miserably to keep Peloton on track financially. Her dishonesty, vividly revealed by stating Peloton did not need additional capital and then raising $1.1 billion twelve days later, is shameful. Courtesy of Blackwells insistence, she was sacked. The new CFO, Liz Coddington, was previously the VP of Finance at AWS and was handpicked by Mr. McCarthy two weeks ago. As former VP of Finance at AWS, Ms. Coddington could’ve feasibly gotten the CFO role at a variety of companies. Her choosing of Peloton must signify that she sees an insatiable opportunity to turn the business around. If anything, her hire and background hints at what Peloton is laser focused on perfecting: it’s software. Another recent hire was Andrew Rendich as Chief Supply Chain Officer. Mr. Rendich worked at Netflix for over 12 years, ultimately becoming the Chief Operating Officer in 2009.
Peloton’s leadership team appears quite incompetent and additional changes would likely be applauded by investors given the current team's failure to keep the company growing. This viewpoint was echoed by Mr. McCarthy who stated, "Other talent additions [are] expected in the coming months, particularly as we shift our focus from being hardware to software-centric." John Foley, the former CFO, and the former CSCO should take the brunt of the blame for Peloton’s downfall due to their myopic view that robust demand for their hardware during the Covid-19 pandemic wouldn’t be hindered by the reopening of gyms. Peloton even acquired Precor, a leading fitness equipment manufacturer, for $420 million to gain access to its more than 625,000 of manufacturing square feet. When demand began to “unexpectedly” wane, Peloton was left with excess inventory. Their demand misperception ultimately culminated in halting production for two months. Whether John Foley is innately optimistic or deceptive to investors is unknown. In an Adam Neumann-esque move, Mr. Foley even elected his wife, who had no prior work experience, to the VP of Peloton Apparel. Before strong investor confidence can be restored, the incompetent employees/board members he’s hired must be removed.
Insider ownership remains moderately sizable at 5% of outstanding shares, although this is down materially due to $500 million in insider sales in 2021. The caveat of Peloton’s insider ownership is that John Foley retains over 50% of the company’s voting power, with all insiders combined controlling north of 80% (I’ll talk about why below). This is quite troubling considering insider’s dreadful performance over the past year.
Substantial risks remain for Peloton and investors should vigilantly monitor the company’s next steps. The dual class share structure gives John Foley far too much power. Such a structure is only acceptable under the leadership of a visionary CEO continually making controversial, yet oftentimes correct decisions, such as Mark Zuckerberg. With Mr. Foley’s power, the board is incapable of ousting him entirely. Share pledging (loans using equity as collateral) among major Peloton executives/investors is ubiquitous and could trigger margin calls, resulting in rapid drops in Peloton shares, which is quite startling. Equally frightening is that the majority of members of Peloton’s board of directors are in some way connected to Mr. Foley. The root cause of this stems from there not being a majority vote required to elect a director to the board. Peloton’s current board looks unbearably incapable of advising the company in the right direction and the lack of diverse business expertise is apparent. While these board members are in power, Mr. Foley faces minimal risk of being removed given that he elected all of them. A third risk stems from Peloton lacking performance-based incentives, which motivate employees to hit milestones and thus reward grit.
Though my (and clearly Blackwells’) view of Mr. Foley is quite negative, he undoubtedly deserves a significant amount of respect for founding Peloton and persevering through thousands of funding rejections by venture capitalists. He is ultimately the one who scaled Peloton from 5 fitness-lovers with a revolutionary idea to over 7 million members. Thus, Mr. McCarthy’s plan is unsurprising given his reputation of working alongside visionary CEOs: “If you thought today’s news meant John [Foley] would be scaling back his involvement with Peloton, then let me assure you ... I plan on leveraging every ounce of John’s superpowers as a product, content, and marketing visionary to help make Peloton a success as my partner.” Mr. McCarthy’s financial savvy and subscription expertise combined with John Foley’s deep knowledge of the business might be exactly what Peloton needs.
Peloton’s corporate governance score is nothing short of embarrassing.
Discounting these flaws, Peloton’s underlying business is very compelling. Due to Peloton’s inherently social model of connecting fellow users around the world, the company benefits meaningfully from network effects. Avid users, which seem to be the majority of Peloton members, are likely to refer their friends to the platform so they can workout together. Peloton defies the notion that B2C businesses have lower retention rates, with 92% of members staying loyal. Peloton’s cult-like following will prove incredibly lucrative if monetized effectively. The company has substantial optionality and I can see them successfully expanding into a variety of verticals.
Looking ahead, Peloton has evolved from a high-flying tech giant to a turnaround story, with a high probability of being acquired over the next few years. Given that Mr. McCarthy is 68 years old and came out of retirement to take his role at Peloton, it’s highly improbable he would work for more than 5 years. In Peloton’s FQ3 2022 Shareholder Letter, Mr. McCarthy’s intentions are made clear. He initiates the letter with “Turnarounds are hard work.” Over the next few quarters, evidence of aggressive cost-cutting, sufficient liquidity, and a reimagined value proposition will be imperative to the company’s survival if it wishes to remain independent. Following their FQ3 earnings release, McCarthy cited three primary goals: “(1) Stabilizing the cash flow (2) Getting the right people in the right roles and (3) Growing again.”
While liquidity will remain a substantial risk until Peloton turns free cash flow positive, the recent $750 million debt raise completed in mid-May as well as a $500 million credit facility should lessen the company’s bankruptcy risk. The loan brings Peloton’s cash balance to over $1.63 billion, which doesn’t account for $1.4 billion in inventory that has been accumulating over the past few quarters. This inventory accumulation has had a pronounced negative impact on Peloton’s cash flow. Barry believes this dynamic will soon shift the other way: “As we begin to sell down our excess inventory, the current cash flow headwind should become a tailwind in FY23.” With Peloton cutting annual run-rate costs to the tune of over $800 million by FY24, a bankruptcy looks highly improbable. Blackwells Capital recently stated that $800 million is not nearly enough and CEO Barry McCarthy hasn’t done much since his arrival. I would argue that both notions are quite dramatic given that the $800 million in cost reductions is a minimum which Barry & co will likely strategically exceed. As for the comments about Barry, his track record is pretty flawless and one would be foolish to doubt his ability to turn Peloton into a business of similar caliber to Netflix or Spotify.
Below are a few of the most notable remarks from Barry’s most recent shareholder letter:
“My goal for Peloton is to become a global connected fitness platform with 100 million Members. That’s equivalent to roughly half the world’s global gym memberships. It’s a long, long way from where we sit today. But we sit at the epicenter of technology enabled fitness, a long-term secular growth trend.”
“There likely will be other talent additions across the org in the coming months, particularly as we shift our focus from being hardware to software centric. Talent density is job one if we expect to perform at a high level, and we do. Building on our existing strengths is the goal, but, to be clear, I believe there is a solid foundation of talent at Peloton to build on.”
“With respect to the P&L, we announced several cost reduction initiatives last quarter. The goal, then and now, is for the business to generate positive cash flow by realigning spending and revenue, resulting in at least $800 million in annual run-rate savings by FY24. This includes $500 million in operating expense savings and at least $300 million in lower Connected Fitness COGS. The program is a work-in-progress. Through initiatives already in place, we expect to achieve $165 million operating expense reductions in 2HFY22, and approximately $450 million in savings for FY23. In Connected Fitness COGS, we expect our actions will yield $30 - $35 million savings in 2HFY22 and $100 million in savings for FY23.”
“The recent price changes (implemented April 14) also look promising, and may deliver roughly $40 million of incremental revenue monthly. Here’s the math. The price cuts on hardware have increased our daily unit sales by 69% and increased our revenue by more than $25 million per month. And the price increase on our All-Access monthly subscription, which isn’t effective until June 1, has so far driven only a modest increase in churn. That’s a roughly $14 million increase in revenue monthly if churn remains near current levels. These are important incremental steps towards rightsizing our P&L and are additive to the $800 million in cost savings discussed above.”
“Looking ahead, as we play for scale, we’re changing our focus to customer lifetime value (LTV), which is the net present value of the gross profit per subscriber over the expected life of the subscriber. We’re doing this because we maximize profit when marginal cost equals marginal revenue, or in our case when marginal CAC equals our marginal LTV. And although we initially lose money on each new subscriber when they walk in the door because of the cost to acquire them (same as Netflix and Spotify), each new subscriber increases our enterprise value provided their LTV exceeds their CAC. So expect us to lean into growing our base of recurring revenue.”
“We finished the quarter with $879 million in unrestricted cash and cash equivalents, which leaves us thinly capitalized for a business of our scale. Earlier this week we took steps to strengthen our balance sheet by signing a binding commitment letter with JP Morgan and Goldman Sachs to borrow $750 million in 5-year term debt. I want to thank everyone involved for their hard work in completing this important financing and look forward to reporting on our progress in reshaping Peloton’s business in the quarters ahead. As we begin to sell down our excess inventory, the current cash flow headwind should become a tailwind in FY23. Our goal is to restore the business to positive free cash flow in FY23.”
“The app has never been a focal point of our marketing campaigns or growth strategy. We are in the process of rethinking how we go-to-market in order to accelerate its growth. This will require some reinvention on our part. The digital app needs to become the tip of the spear, so to speak, if we’re going to reach 100 million Members.”
“In February, we launched Lanebreak, our first gamified workout experience for Bike and Bike+. Lanebreak delivers high-energy workouts in an immersive, virtual world. Each level features a unique gaming experience with distinct playlists. To date, over half a million members have taken a Lanebreak class, and we anticipate leaning more into gaming content in response to the success of Lanebreak.”
“In contrast to the decline in Connected Fitness revenue, Subscription revenue of $369.9 million grew by 55% year-over-year, and represented 38.4% of total company revenues vs. 19.0% in the year ago quarter. This mix shift to high margin Subscription revenue is a long term trend in the business we are taking steps to accelerate with our hardware price changes and FaaS strategy.”
“Subscription gross profit was $252.1 million in Q3, representing 63% year-over-year growth. Subscription gross margin was 68.1%, up from 64.6% in the year ago period driven by continued leveraging of fixed costs.”
Barry’s goal of achieving 100 million members on the connected fitness platform was actually inherited from his predecessors. The difference now is that Barry has a more comprehensive strategy to make it a reality: scaling the subscription-native app, which requires no hardware, into the prominent fitness as a service (FaaS) platform. He’s not embellishing when he says Peloton “sit[s] at the epicenter of technology enabled fitness”. According to The Business Research Company, the online and virtual fitness market could hit $79 billion by 2026, growing at a 49% CAGR. This leaves Peloton perfectly positioned as the market leader in a long-term secular growth trend.
Barry’s remark that talent density is a priority for the company should be welcomed by shareholders, as should his comments about future talent additions. His price optimization has been a major success and was something the prior leadership team failed miserably at. Peloton’s recent focus on the app will increase profits substantially while lowering marketing costs for the hardware given that a portion of app subscribers will inevitably upgrade to hardware.
The gamification of fitness has existed for centuries in the form of sports. A similar phenomenon is occurring digitally and Peloton wields the power to lead the way. Their recent launch of Lanebreak, a gamified, high-energy workout experience, was a major success. As mentioned in the Q3 report, “To date, over half a million members have taken a Lanebreak class, and we anticipate leaning more into gaming content in response to the success of Lanebreak.” A rollout of a variety of games within the Peloton subscription would materially strengthen its value proposition, analogous to Spotify’s move to build up an extensive selection of Podcasts.
The second to last quote on Peloton’s revenue makeup shifting to “high margin Subscription revenue” and rapid growth of this revenue (55% YoY) will have a profound impact on Peloton’s bottom line. As mentioned in the last quote, subscription gross margins have been expanding rapidly and should materially elevate the overall gross margin of the company.
Dissecting Peloton into three separate businesses, hardware, apparel, and subscription, the company’s sheer undervaluation becomes apparent.
Peloton’s hardware, which has historically made up the vast majority of its revenue, has relatively unflattering margins that have contracted over the last few quarters. Mr. McCarthy is keen on optimizing Peloton’s pricing to make the equipment accessible to as many potential buyers as possible, which I view as the correct strategy given the company’s minimal churn and high customer lifetime value. In order to do so, prices on Peloton’s two main products (the Bike and Tread), have been reduced in excess of 20%. The beauty of Peloton’s hardware business, despite its low gross margins, is the fact that it acts as a gateway to the tight-knit Peloton community and endless classes. You need the hardware to effectively utilize many of the classes and without the software, you can only perform three rides a month. Once you purchase a Bike or Tread, you’re essentially locked into the Peloton ecosystem. Making the purchase even more compelling is the fact that Peloton equipment holds its value quite well.
As seen in the chart above, Peloton had $594.4 million in Connected Fitness Products (hardware) revenue, down substantially even with the inclusion of Precor’s revenue of at least a few hundred million dollars. While this is troubling, Peloton’s hardware revenue should stabilize and potentially grow as pricing is optimized. A retraction in hardware margins is simply not something to worry about given the increasing subscription price that will offset the decrease in profitability and high customer LTV.
While Peloton has been designing clothes in partnership with major brands like Lululemon since 2014, it launched its own private label brand in September of 2021. Given the loyal following the company has amassed, selling fitness apparel is a natural extension of its business. Yet, their hope is to go much broader than merely serving Peloton members and to someday compete with the likes of Adidas and Lululemon. Along with John Foley’s transition to Executive Chairman, Jill Foley (his wife and former VP of Peloton Apparel) was let go of, likely as a result of investor criticism. While I couldn't find any media on who Peloton plans to replace Mrs. Foley with, it’ll hopefully be an executive from one of their major clothing competitors (Nike, Adidas, Puma, Lululemon, etc. ). Revenue for Peloton Apparel has multiplied over the past few years: $41 million in FY20, $107 million in FY21, and $150+ million expected in FY2022. Forecasted 2022 revenue was lowered from $200 million due to “macro factors”.
These numbers give some color to a segment Peloton does not break out from its overall sales. Instead, apparel revenue is included in its connected fitness division, along with its Bikes and Treads. Though this business is likely not even factored into the overall valuation of the company, it may be a minor catalyst for revenue growth over the coming years. Ultimately, it will depend on hiring the right person to lead the division.
Now it’s time to dive into Peloton’s bread and butter: the Subscription business. While both overall and Connected Fitness revenue has been shrinking, Subscription revenue has been exploding. In FYQ3 2022, it was $369.9 million, up 55% YoY. In FY2021, it was $872.2 million, up 140% YoY. This growth should accelerate over the coming quarters and years as Barry shifts Peloton’s focus to this portion of the business. The $12.99/month no hardware Peloton app should be the center of attention for diligent investors. The fitness as a service model seems to be in a nascent state, similar to Netflix pioneering the movie streaming service industry when no others existed. I expect this to change over the next decade. Due to the low churn of Peloton’s subscription business and high predictability of future revenue, the segment demands a higher multiple. At a 5x sales multiple for the Subscription business alone, which should do over $1.2 billion in revenue this fiscal year, the segment would be valued at $6 billion alone. Slapping on a 10x multiple, given the rapid growth, yields a $12 billion valuation.
The most compelling aspect of Peloton’s Subscription segment is the high and rapidly expanding gross margin, visualized above. Given Peloton’s current $3.42 billion dollar market capitalization, the stock trades at roughly 4x Subscription gross profit! The Peloton app, which offers myriad fitness classes, has a few main competitive advantages over both alternative services and gyms. First of all, the Peloton app enables you to take classes from and engage with Peloton instructors who have all become celebrities. No other competing service turns instructors into celebrities. On a side note, this should attract the most talented instructors and enhance the quality of the workouts. Additionally, Peloton offers social aspects and a tight-knit community that other platforms simply haven’t cultivated. And third, the Peloton app is far cheaper than taking fitness classes in person, while giving you the convenience of taking classes whenever you please.
Peloton’s main competitors in this space appear to be Nike Training Club and Apple Fitness Plus, both of which offer digital classes that one can watch anytime. NTC is priced at $14.99/month while Apple Fitness Plus is priced at $9.99/month. While Peloton is currently the leader in the space, Apple Fitness Plus will be a fierce competitor given Apple’s massive reach and deep pockets. Yet, Mr. McCarthy has beaten Apple before; Apple wanted to prevent Spotify from ever growing larger than Apple Music. Thankfully, Spotify was able to develop a better service, which Apple then tried to copy. If Peloton is able to do the same, the business and stock alike will flourish.
The app store rating for the Peloton app is among the highest I have ever seen with 4.9 stars and nearly 700k ratings. The app gives users access to the coveted Peloton ecosystem for a fraction of the price of the hardware.
Product innovations and constant feature additions will be necessary if the company hopes to retain its leadership over a growing list of competitors. The One Peloton Club, which allows people to lease a Bike or Tread, should generate additional subscription revenue and increase the affordability of Peloton’s hardware.
Due to inability to accurately forecast Peloton’s future cash flows, I’ve refrained from performing a DCF. Regardless, I compiled a valuation for each business segment. Until Connected Fitness returns to growth, it should be valued at 1-2x sales, or $2 billion (when discounting apparel revenue). Peloton Apparel should garner a 3x sales multiple or $450 million. And finally, the subscription segment, as mentioned above, should trade at a 7.5x sales multiple, or $9 billion. Thus, based on market-consistent multiples for each portion of the business, I believe Peloton is worth at least $11.45 billion, or 334% above the current stock price of $9.74. Buying shares today, while inevitably volatile, should yield substantial gains over a 2-3 year time frame, granted that the company isn’t acquired.
Acquisition rumors have been ubiquitous since Blackwells Capital announced its 5% stake in the company and pushed for a sale. Potential suitors vary from Apple to Amazon to Alphabet. Peloton’s acquirer has to be one able to effectively mitigate the recession while retaining an extensive cash balance. Therefore, I believe Alphabet is by far the most probable due to its push into the fitness segment with the acquisition of Fitbit and its endless cash supply. Alphabet has garnered a reputation for acquiring relatively small companies and substantially broadening their reach, thus generating incredible ROI figures. Peloton’s $3 billion dollar valuation appears to be within Alphabet’s sweet spot for acquisitions. With Peloton, Alphabet would deepen its rivalry with Apple by competing with Apple Fitness Plus.
Until Peloton reaches free cash flow profitability, I find an acquisition improbable. No company, especially during a downturn, wants to deplete its cash supply. Additionally, Mr. McCarthy has repeatedly expressed his intent to perform a full-scale turnaround. Consequently, a mid 2023 through 2025 acquisition appears most plausible.
To conclude the deep dive, here’s a quote from Mr. McCarthy’s first email to the Peloton team:
“And now that the reset button has been pushed, the challenge ahead of us is this ... do we squander the opportunity in front of us or do we engineer the great comeback story of the post-Covid era?”
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