Description

Position: We recommend buying the $750m May-2027 PTON Term Loan that is currently paying 11% (SOFR + 660bps). This TL sits at the top of the capital structure secured by ~3m Peloton subscribers that pay $44 per month and churns at a monthly rate of 1.1% (as of 1Q23). The TL position is protected by $1.6B of subscription ARR that generates $1B of run-rate gross profit (66% gross margin) and a bloated operating structure undergoing restructuring. The capital structure is simple with $750m of senior secured TL, $1B of zero-coupon convertible notes, and $4.2B of diluted market cap, which provides strong capital protection with the tranche covered 6.7x.

Equity / Credit Thesis 

Equity:

Equity investors are excited by a turnaround story that involves shifting away from a capital intensive vertically integrated business model to an asset-light subscription model. Additionally, Barry McCarthy, the former CFO of Spotify and Netflix, has been appointed as the CEO of PTON; Barry is known for his financial acumen and investors believe that he can right size PTON’s bloated organization still suffering from its post-COVID hangover (Excessive inventory, overinvestment into manufacturing and in-store distribution). Bulls are also excited by PTON’s strong brand affinity in the fitness space and believe there are opportunities to release new subscription products that cater to different demographics and use cases. The company has ~$939m of cash remaining on its balance sheet and Barry has successfully reduced cash burn from >$1B a quarter to $246m in the latest quarter. For equity investors to generate a positive return from today’s prices, they must believe: 

1. Connected Fitness Subscription churn doesn’t accelerate materially beyond its current 1.1% monthly churn. Its existing subscriber base is currently keeping the company afloat as operating costs are taken out and the company looks to achieve FCF breakeven. Additionally, if PTON is to be a potential M&A target, the brand needs to convince strategic investors that the product is not a fad.

2. AMZN partnership and future wholesale deals will set a precedent as an alternative channel that will drive high LTV / CAC. PTON can generate gross margin on wholesale product sales, but more importantly, acquire a subscriber base with attractive retention characteristics. It is unknown whether PTON is sharing subscription revenues with retailers, but it is a more capital efficient approach to acquiring customers than operating their own stores. The AMZN partnership will likely accelerate subscriber growth for the Christmas season.

3. PTON is attempting to roll-out a “no upfront cost” model where they rent out bikes to subscribers and expand their target market beyond affluent customers who spend >$1k to own the bike upfront. Progress has been slow and are signing up ~175 per day, but the new rental market should expand the addressable market beyond the current 3m subscribers who own or are on a payment plan for the PTON bikes.

4. PTON is releasing several new products (treadmill and rower) that will complement its bike product. Providing fitness alternatives gives PTON the option to both widen and increase engagement from its existing subscriber base and grow its subscriber base. 

5. The current price for PTON’s core subscription and bike is unaffordable for most demographics. PTON needs to leverage its brand and digital content to create products at different price tiers to expand the TAM and come closer to their 100m subscriber target. 

Term Loan:  

The PTON TL is yielding an attractive 11% (at ~4.2% SOFR today) supported by subscription revenues with annual retention of ~85% and is protected by ~$5B of total enterprise value ($4.25B below our TL). 

1. Unique for a consumer subscription business, retention has been strong with monthly churn ranging from 0.5% to 1.4% (Ticked up in 4Q22 driven by price increase from $39 to $44 per month). Assuming annual retention remains at ~85%, 3m subscribers pay $44 a month, and a 66% gross margin, the undiscounted LTV off the current subscriber base is ~$7B of subscription gross profit. This stream of cash flows can grow as other fitness products are sold (e.g. treadmill, rower, bike rental, digital-only subscription). Additionally, as PTON outsources their manufacturing, their business should become more capital efficient.

2. Equity investors have assigned a diluted market capitalization of ~$4.2B defended by the above equity thesis, which suggests investors believe in the turnaround story of PTON. This market capitalization also implies that PTON could raise additional dilutive equity capital, which can help keep the company afloat and pay its interest burden to TL holders. The TL is covered by 6.7x of capital below it ($4.2B of equity, $1B of convertibles), which suggests value to protect our principal.

3. The TL provides protective negative covenants that prevent >$75m of TL debt to be raised at an earlier maturity date than our term loan. This limits the amount of additional debt that may prime our term loan. 

4. PTON acquired Precor, a major provider of workout machines to gyms and hotels, for $420m in December 2020. Precor no longer has strategic value to PTON’s new asset-light business strategy and will likely be divested. Precor has 625k square feet of manufacturing capacity in the US. The sale of Precor should generate >$250m of proceeds as the largest commercial provider network of fitness equipment. There is also an Ohio factory that we believe PTON can sell (we estimate it could generate $50m of proceeds).

Downside Risks

As discussed above, the main risk to the TL is PTON’s failure to execute PTON’s turnaround strategy. 

1. After Barry McCarthy was appointed the CEO, he set goals to slash ~$800m of annual costs, cut 2.8k jobs (20% of corporate positions), and reduce capex by $150m. McCarthy has successfully reduced burn from ~$1B per quarter (in 3Q22) to $315m per quarter (in 1Q23). However, he has likely taken out easy costs by reducing sales & marketing (-51% YoY), G&A (-19% YoY), and R&D (-10% YoY). In the latest quarter (1Q23), McCarthy indicated that he is finished reducing headcount and is optimizing the business for revenue growth. Continued cost optimization balanced alongside McCarthy’s growth initiatives may be a difficult task. Although PTON is targeting FCF breakeven by 2H23, McCarthy’s growth initiatives may negatively impact the company’s path to profitability. 

2. Although we have several years of subscriber retention data, most of the retention data has been through a global pandemic that prevented fitness substitutes (e.g. in-person gym) from operating. This may obfuscate true unit economics and, combined with the wide range of outcomes that come with consumer technology businesses, could result in accelerated subscriber churn that differs from historical. Acceleration in churn could significantly impair LTV and it remains the largest risk to both PTON’s cash flow and potential take-out value. We have conservatively assumed that monthly churn ticks up to 1.4% over the forecast period.

3. The TL’s covenants protect the tranche’s collateral well by limiting the amount of additional debt PTON can raise pari passu and risk of being “primed” to $75m prior to the term loan’s maturity (May 2027). Additionally, if the 2026 Convertible Notes outstanding is >$200m on November 16, 2025, the term loan has a “springing maturity” provision that forces maturity on November 16, 2025 with the convertibles.

There’s prepayment risk if PTON emerges from restructuring as a higher quality credit. The term loan currently pays an attractive floating rate that may not be tenable for a restructured PTON. The term loan has a make-whole premium if repaid in the first year (Remaining 1st year interest payments discounted to prepayment date + 3% prepayment premium), if repaid between first and 2nd year (3% prepayment premium), and no prepayment penalty after 2 years.

Catalyst

Cash burn reduced or FCF breakeven is reached

Convertible notes could be interesting opportunity to have a more attractive r/r bet on a PTON acquisition