Description

I cannot understand why Value investors love attacking Peloton besides that it is considered a hot stock. I know people will look at this thesis and frown, but I will publish it either way, given the upside.

Peloton is one of those businesses with exceptional characteristics in early innings that we can get at a very reasonable (cheap) price. However, it is tricky to value given that it is not currently or close to normalized earnings power; instead, it is at current losses.

We will framework this analysis to quantify where their cost and gross structure will be soon, showing how profitability is in the near future. We will make some assumptions, perhaps using some of management's reduced forecast. I understand some believe they will lower again. You can adjust how you see fit; it will not move the needle on the thesis.

Then I will discuss the longer-term views on the company though it will be substantially harder to quantify. Just a note: to calculate a company's PE is not something hard for humans or computers. The best investments come from understanding the economics and drivers of a business and the ranges where it could and should get. Peloton, in that sense, is a fantastic investment.

Total run rate subscriber revenue from 1st quarter 2022 is $1.34 billion, and at the current 70% projected margin, they will gross almost $940mm, and at a 73% margin (longer-term), it is closer to $1 billion.

Peloton's year-end sub guidance is at 3.35 mm, assuming 1mm digital-up from almost 900,000-they will have a run rate revenue of $1.76 billion and gross at a 70% margin about $1.23 billion, and at 73%, nearly $1.3 billion.

It is almost impossible to make a good forecast for Peloton, but I will frame things in the best way possible. The idea of the business is currently to drive product sales which drive LTV customers in their subs. So the way we would frame it is that at current year-end run rates grossing $1.3 billion, they should substantially break even on cost structure minus S’’M. This is assuming that they stick with their SGA and RD run rate from the first quarter of 2022, which comes out to slightly more than 1.3 billion. 

Management has confirmed that their cost structure will substantially be stable throughout this year.

 Given the recent lousy quarter and significant negative cash flows, they will start to lower their cost structure bloated from fast growth/acquisitions (double cost structures) and its focus on taking advantage of subs over positive cash flow. In addition, it will not need to increase much in its current markets given the built-up manufacturing, distribution, and showroom network it has built up. 

They grossed about 29% on Hardware last year, which has dropped to 12% for this past quarter and is expected to be at 16% for the entire year (increasing hugely from the first half). On expected revenue of somewhere near last year $3.2 billion, they are expected to gross some $500mm. The expected S"M expenses should come out per managements guide to somewhere near $1 billion, so total loss should come out to somewhere around $500mm with some additional cash being burned from CAPEX on factory switching and building costs. This should substantially change as they get higher gross margins on products in the second half of the year and transition that into the following year, where they expect to come back to break-even+ territory on an S"M-gross on products. This is where the management guide on being profitable is coming from; highly reasonable.

From there, Connected fitness will be growing (though at a slower pace) with incremental margins probably close to 90% (given music variable costs), and their hardware margins should stabilize and increase over S"M in current markets (USA, Germany, UK, Canada, Australia). 

In more detail, their drivers to increase profitability are going to come from multiple sources. 

1. Their supply chain is mainly fixed and not variable. The company built up about seven massive hubs to supply over 100 smaller ones covering 95% of the US within 75 miles. Peloton will leverage its supply chain on a much more cost-effective basis with higher utilization from increased SKUs, cheaper treads, and substantially lower bike prices. In addition, it will have more clear visibility (with the end of Covid demand) on where it needs to transition to more of a variable cost structure and where fixed makes more sense.

2. Their fully integrated manufacturing-almost entirely in-house-and focus on limited SKUs allows them to drive cost efficiencies from multiple sources, including with scale, no manufacturer mark up, increased automation-given they are building new facilities-and with better know-how. This got demonstrated by the companies ability to keep lowering the cost on their first bike. According to management, this came from reducing the cost to 40 cents on the dollar from when they initially hit some scale.

3. They currently have many SKUs and ideas in RD not generating any revenue and being supported by the rest of the business. This will soon transition to each product supporting its own RD enhancement, which will also be cheaper on a dollars basis than developing it at first.

4. Increased Sub-base will be by far the most significant driver where incremental subs will insanely drive profits. This will be a product of where you believe their market position and Tam will be in the future, something that we will discuss.

5. The company's sales transitioning from a first-time buy in the new market to replacement cycles; this will be discussed later.

The biggest question here is what their TAM is-a topic that is hotly debated. This is very relevant given the haziness in carving out future financials; however, looking at a company like Apple that controls some 10-15% of the smartphone market yet is by far the most profitable (75%) shows how competitive edges are by far more critical (discussed later).

I will try to give some vital data points but of course, coming out with a genuine, reliable number is almost impossible (look at other's past tries). 

1. There are 180mm gym users globally (Pre pandemic). In the first four markets the company launched in (US, UK, Germany, Canada), there are about 90mm. 

2. The average gym membership costs $50-60 though with wide ranges where Planet Fitness is $10-20, and some expensive cities like NY have averages of over $100. 

3. Somewhere around 20% of Peloton users did not have gym memberships.

4. https://www.cdc.gov/mmwr/preview/mmwrhtml/mm6217a2.htm?s_cid=mm6217a2_w#tab1 . 60% of College-educated people (Pelltons most accessible market) complete the required amount of aerobic exercise, with 35% doing the needed Strength. Their average income is $90,000+, and they number about 100mm in the US. People less educated, although they are less prone to working out, still are substantial in numbers.

5. About 40mm US Households are making over $100,000 the most accessible market for Peloton. With another 50mm making $50,000+. Pelotons customer demographic was historically split 50/50 with over and under $100,000 incomes and had been growing (29% in 2014). Most importantly, this 50/50 split was pre the recent massive Bike price drop and cheaper Tread release, which has expanded that demographic massively.

6. They are increasing their younger demographic with those aged 35 and under at 31% of the sub-base in 2020 against 14% in 2014.

7. Peloton's own poll shows about 75mm households in the first four markets which showed an interest in buying a Peloton product, 52mm would buy today's current lineup, which fell to 15mm when shown the price. Again, most importantly, this was at the beginning of the pandemic, before Peloton priced their old bike from the lowest on the market and pre the cheap Tread. The current Tam is substantially larger than back then.

8. The treadmill market is substantially more significant than the bike/spin market and is about $3.3 billion before any Peloton market expansion (5mm treadmills per year). According to Statistica, there are over 50mm treadmill users in the US.

9. The company has the distribution capability to take buybacks when consumers buy an updated version. This will increase their penetration in lower-income households by selling and controlling their used hardware market and will allow updated versions to sell easier because of the trade-in. 

10. As Reed Hasting noted in his recent call, chances are the pandemic had pulled forward a lot of demand which may cause some slowing in rapid current market growth. This is less so in Pelotons case with the long wait times needed than to buy their products and its recent debut. It definitely was not a fad with engagement still over 40% pre-pandemic usage, which also shows the strides made on increasing the platform's value.

Putting this together to form an actual Tam is useless, but I would take out that Peloton's 15mm Tam assumption  is not insane, as some love to say.

A big question that the bears are obsessed over is that a substantial portion of their current revenues comes from Hardware, which is both not the best business and will fall when sales transition from first-time fulfillment to the replacement cycle. Many cite two prominent examples, GoPro and FitBit, which had big 25%+ drops in revenue before stabilizing, officially because of the initial demand's petering out before transitioning to more of a replacement cycle.

There are two things to say on this. First, although a substantial amount of revenue comes from Hardware, that is not the focus. The hardware sales are just a continuing driver of more subs, given that even if Pelotons hardware stopped growing, their subs would with each new customer. The thesis does not rest on this being the profit driver long term.

Second, although it will fall, it will be far more economical by then. The goal now is to grow subs as fast as possible to take the market before anyone else can. This is done with substantial marketing, causing the Hardware side of the business to lag in reported profits. However, as the market transitions to more of the replacement cycle, CAC costs will decrease substantially, given the consumer is already in the Pton universe with a subscription and allow a more predictable order flow. This will cause the Hardware side of the business to be more profitable than before.

The real worry is that if the transition happens too soon, it will cause all the manufacturing/distribution capacity the company built/is building to be underutilized. However, this too is not a worry for multiple reasons:

The actual cycle will probably not happen for some time, given Pton's launching new products and cutting prices on old products to expand Tam. This is seen from the Bike price drop, the latest cheap Tread, the recent strength product (Guide), and the rumored rowing machine. This will keep going as they continue building on these things.

Note: I think there may be a chance they will need to transition some distribution to more variable costs, though even that is uncertain.

In addition, regarding manufacturing capacity, they have a significant runway with international markets that they are not purely betting on current markets. For example, Tread did not even launch in Australia yet because they need to ensure enough inventory.

The actual replacement cycle will probably be more significant than the bears believe for multiple reasons: First, Peloton changed the Hardware to a more tech-driven product; five-year-old products will be considered obsolete. This will drive replacement buying more than historical (Gym owners replace about every 5-7 years based on wear and tear, not obsolete: they will have to change that too).

Second, pelotons' capability(through distribution network) to pick up old devices for a discount on new ones will make it cheaper to upgrade and less of a waste feeling given the prices.

Assuming a total of 8 million machines in Pelton's first four markets, with replacements coming every six years and an average of $2,000, there will be an average of $2.7 billion in revenue per year in replacement machines. Again this revenue stream will come with substantially less or zero CAC costs allowing Pelotns profits to soar.

Peloton has stopped reporting apparel sales through the last three-quarters of reported sales (pre-covid) totaled some $17mm and adjusted for the entire year, probably high $20mms and has probably increased substantially since then. The company was going through third-party partnerships with reduced revenue and margin profile. This will change with the recent reported in-house apparel business. Though some may say it's a dream, it should not be overlooked. Their ability to drive sales here is enormous with their high engagement on their platforms, high customer brand attachment, and high-end brand perception. The results of just two of those characteristics, along with good quality stuff, can be seen with LULU (not to imply they will get there, but....)

All the above is only relevant if Peloton keeps its status at the top of its (literally) industry. I think there are many strong arguments to make that an overwhelmingly high probability.

 To start, I believe strongly that the connected fitness market will be a one-player that wins most (unlike movie streaming). There is no room for two subs in any household besides maybe Apple's, given its bundles and cheapness. In addition, there is no player with a significant content head start like in Movie streaming, with Netflix at a disadvantage.

In such a one-service consumer market where you have one platform scaled across however many subs, the most significant player-especially when combined with innovative and most well-known (share of mind)-will structurally win.

First, they will have the most amount to spend on content that scales across markets, especially English-speaking ones (Uks most-watched content has been American). This will continuously structurally increase the value in its offering over competitors, never allowing them to keep up (similar to Intel).

Second, regarding software, the biggest will outspend to increase UX/UI investments and new features requested by new members, increasing NPS to levels unattainable to competitors. This is not to be under-emphasized with many examples of companies dominating because of significant investment (Booking.com, Airbnb). This takes not only money but time with, for example, a lot of multivariate testing (something Netflix does in spades)

 Finally, those with the most significant scale will out-market competitors by a long shot, keeping the share of mind in non-customers until purchase.

On Hardware, although less so than in software (where scale is of enormous value), their focus on few SKUs and scale allows them to outspend on RD and continuously produce better products. For example, Intel and Roomba have kept being the best in their category for this reason. 

Then the most significant Hardware player, especially when put together with in-house (recently built) manufacturing capabilities, allows them to be the lowest-cost producer (again less so than in their sub-business but substantially). This is incredibly potent when the company (Peloton) keeps taking that cost advantage and gives it back to the consumer for cheaper; this causes them to have the best quality and the cheapest products (not done by Roomba). 

Their scale and high usage in subs will allow them to use data to drive better product innovation (software and Hardware) and more satisfaction/value for subs, something competitors cannot match.

Although they just launched Strength, given that they are way ahead in the leading products and close to 50% of workouts are in other categories, they should substantially catch up in the Hardware there, too, especially with them leveraging their scale from other areas.

Then some other significant advantages Peloton has is the following:

By controlling all of it, their supply chain, especially the last mile part of it, gives them a substantial advantage with delivery times, cost, and service (over time). This is substantially complete with hubs near enough to almost all the US, though it may take some more time internationally (no one else is close). 

Of course, their brand is second to none, with NPS over 90. There are few companies out there with such obsessiveness over their brand (think LULU and Tesla). Foley's obsessiveness and insistence on getting to 100 by fixing every detractor bode exceptionally well for them in the future. These things will lower CAC, heighten barriers to entry, and drive new product/apparel sales.

Then there are the network effects given the connectivity of Peloton, including leaderboards, riding with others, and what they call tags or groups of same-minded/professional people who form groups on the Peloton (there are thousands of these). As everyone knows, the trainers have become a sort of celebrity driving a tremendous amount of stickiness and awareness. This will only exponentially increase, driving insanely better business metrics across engagement/CAC/churn and, of course, profits.

Then the company's 100% DTC/showroom business is enormous from both a customer captivity standpoint and a margin standpoint, given it's more profitable to not sell through third parties. This also gives them better control of brand perception, inventory control, and making add-on sales. 

The nature of the business where the Hardware does not get replaced for some time causes structurally better customer attachment and less churn. It also spurs them to engage a lot given the amount it cost and especially so when financed. This is another reason Peloton is running so fast to get as much share as possible over current profits.

The company's acquisition of Precor gives them both another monetization channel and another edge. Gyms and Hotels will not buy everyone's products but rather focus on the best quality, price, well-known and best service. Peloton will win on all these things, giving them more of an outlet to expose consumers to their products. The only question will be if Gym chains will refrain from buying it due to the fear of consumers moving over to them: that is an excellent problem to worry about.

One last thing is when there is a clear leader in any industry, more competitors coming in as long as they do not overtake them will boost the lead company. This is caused by marketing spending and more consumer awareness, leading to sales from the one with the most mind share (Peloton). This is even more true when the company creates a new industry/need (Tesla).

Now more granularly on the competition.

The three real competitors that are both tech companies that may make a dent are Apple and LULU (Mirror), and Zwift.

The Apple and Zwift service primarily competes with Pelotons Digital, which is substantially their most unimportant segment. Management has long said that the Apple/Android tax and lower stickiness/price cause significantly less profitability. Therefore, they use it as a lead gen for their main Sub. Thus, the main business with fitness products will not be competed away by Apple/Zwift (though, of course, Apple doesn't pay the tax)). In addition, the bundling of Apple's services will cause it to get substantially less utilized as they are not paying directly for it. Zwift is also slightly more niche based so not direct (and Peloton launched game competition).

Even on the App, most will agree that Peloton's excellent head start gives them an advantage with both more extensive classes and higher levels of trainer-driven subs.  

Apple's entrance into this space will also be a big boost for Tam as they can drive substantially more awareness.

On Mirror

They again are not current Peloton big competitors though Pelotons dream of being the one gym sub is challenged through them. They are right now looked at as expensive and unneeded (which they are). In Peloton, at least, the bike would cost hundreds of dollars either way. Again they do not overtake Peloton's advantages cited before. 

However, it must be noted that Lulu's purchase of them is not good. 

Mirror/LULU is something to perhaps watch closely for new products.

Ptons announcement of the Guide is very competitive and meant to take on Mirrors product to some degree. There were some critics on it not being so directly against them, but these are unfounded. A product like Mirrors will be looked at as expensive high-class Hardware, given it is not essential equipment. By coming in with a cheaper, more additive piece to the main parts, Peloton will strengthen the whole portfolio and penetrate current customers.

In addition, there reportedly have been problems with the Mirror on internet connectivity and other things. From wom (a no-no in investing), I have heard bad reports about it too.

The rest are primarily small, non-techy (non-innovative) transitioning companies without any niche or advantage.

The most well known are the following:

Equinox; Their bikes are both more expensive and less competitive on features. Their app at the same price will and does lag Pelotons. 

They have substantially less scale ($6-700mm) than Pton-not a threat. The one thing is that they have sort of a more chilled fun style than the more rigid workout type Pton is.

NordicTrack is perhaps another competitor that investors should watch with revenue of about $1.5 billion (though much of it is from many old SKUs). However, their scale is still substantially less than Peloton, and their reported 200mm raise from investors will not be enough to compete. In addition, they recently pulled back from an IPO reportedly because of a lack of investor enthusiasm on the 4-6 billion valuation, which is very encouraging. This will hold back its ability to take on Peloton in the race to scale as fast as possible.

 Their bikes are relatively priced in Peloton's range, with each having different features. Their Sub is substantially the same price, with Peloton pouring appreciably more resources into it.

Nautilus(about 3rd in the market) is something I do not understand why the bears mention so much. They have substantially less scale than Pton, with much revenue coming from a multitude of SKUs. Peloton was killing them pre-pandemic with them finally trying to transition to connected fitness late in the game. They built up this disastrous Sub/app with many app store complaints that aren't fixed (Their around the world app was really bad). This is substantial because they built it through third-party patchworks and only recently started hiring in-house. They spend a fraction of Peloton on Rd and marketing. The only plus they have is their cheap Sub though there is no way it will be economical and quality in the long run. 

I have been pushing them hard for them to transition to more spending and less focus on their margins and cash. The result was the following statement in the last earnings call: 

''Do we choose to remain profitable by pausing or reducing our North Star strategy investments? Or do we capitalize on our progress and continue to invest with confidence using our balance sheet? Faced with this choice, our board and management team have made the strategic decision to not only stay committed to North Star but to accelerate our investment in the second half of the year.''

I doubt anything will come of this with the expanded spend of less than $20mm (significant for them)

The VeloCore, I agree, is a good product but is not competitive on price (cheaper version more expensive than Pelotons). 

Again the best way to look at all this competition is not through the short-term lens. Instead, in the long run, Peloton is structurally better suited to substantially stay ahead in everything, including quality, cheapness, international scale, and Sub experience/value. 

I have seen some reports by bears where they start using Nautilus historical numbers as a proxy of where Peloton can get in terms of profits. I do not think I have ever heard such a lousy bear argument. I do not even have to explain how insanely different they are regarding business models, scale, and competitive position; it is ridiculous.

Note: I do not mean to say there is no chance they will survive. Take Nautilus, for example; they may succeed in a small niche in the market and in doing things Peloton would never do. First, they are substantially cheaper on the Sub (though worse exp). Second, they allow movie streaming (Netflix, HBO Max, Disney+) through their app, which Peloton would never do, given it takes away platform engagement. Finally, their distribution channels through retailers will allow them some amount of sales. Peloton not doing these things is the smartest for them but will enable Nautilus to survive and perhaps profit (we may invest in them at the right price).

On its liquidity position, the company will probably burn operationally some 200-300mm with an additional perhaps $400mm in CapEx, giving them a lot of breathing room with their almost $1 billion in cash and an additional nearly $300mm revolver. In addition, should the need arise, I doubt it would be hard to raise more debt capital, especially if through converts. I heard some worrying about this/ it is unfounded.

Now onto valuation; this will be very tricky. I was never fond of the times sales valuation unless used to compare two of the same business with different current profit profiles (Home Depot and Lowes). Valuations are about profits, not sales. 

The company's capital structure is about $15.1 billion worth of a-b shares with a trading price of $50 (some will want to adjust for controlling stakes). There are 1.7mm RSUs outstanding, so another $85mm and then some 60mm options outstanding with the exercise of $18, about $2 billion of in the money value and then some. Assuming they pull their entire line (and burn cash balances) together with their convertibles, it adds some $1.1 billion. So together, we are in the $19 billion range for enterprise value.

The company has to earn some $800mm sometime soon at 25 times to justify valuations. However, considering that they will have only to grow another 2mm subs in current markets. Or just one more 60% growth in subs from year-end guidance (without assuming other revenue covering any Opexp besides marketing and extra costs), it is not that far-fetched. 

Then we have international expansion, which will be possible even at lower subs cost. They will leverage content across all markets and with subtitles for non-English ones. They will also be the first to go global in foreign languages giving them a massive head start.

Even perhaps, more importantly, Peloton will leverage their entire tech platform with practically no additional cost across markets. No other competitor will get profitable on their scale and have the ability to do this any time soon. So I do not understand why people are so skeptical of their international expansion plan as it is a viable strategy.

Given the smaller footprint in some smaller non-English markets, Peloton will for sure be the dominator by being the first to launch there. All the above will also allow them to launch at lower prices (similar to Netflix) where needed.

Even if you do not believe this is a cheap price (which I do), it is fair enough to get into a company with such optionality in creating future value in ways you cannot model with an engaging dominant platform and value building management. Most companies are very limited in monetizing their business in new ways throughout time; when you have one at a reasonable price, you grab.

The controlling stakes that the founders have, I believe, are essential in such a company. Look at Nautilus, who cannot focus long term and must deliver the profits Wall Street foolishly demands. They have a short window to scale to a place competitors cannot reach for a worldwide scale.

I think it's generally wise to invest with founders; there is no comparison between an owner and a CEO running their respective companies, something I learned long ago.

Catalyst

Growth and profitability