Peloton – 3rd time lucky?

Peloton is not for the faint of heart. 

• Peloton is a fallen angel whose shares I resoundingly hated (see here) when it was flying high but it has now been treading water for a year at all-time lows meaning that there is a valuation case to be made for taking a 3^rd look at the stock.
• The story of Peloton is relatively simple.
• The pandemic closed all the gyms, and everyone started exercising at home meaning that Peloton could not sell its connected bikes with its service attached fast enough.
• The margins on the hardware were excellent which is what was used to support the outlandish valuation and management thought that demand would last forever and ramped up OPEX for manufacturing capacity and vanity items.
• However, it was obvious to anyone who had been around the block a few times that hardware was going to commoditise meaning that most of the company’s gross profit would evaporate causing cash flow to quickly reverse and go into the red.
• Events were worse than I had anticipated as hardware demand crashed as soon as the gyms reopened but critically the number of users paying for Peloton’s first-rate fitness content remained stable.
• In my opinion, subscriptions have always been the core of Peloton’s business, but it took flirtation with bankruptcy for the founders to see this clearly and step aside.
• This cleared the way for Barry McCarthy (ex CFO Spotify and Netflix) to take over as CEO and President who is tasked with turning Peloton around and returning it to growth.
• In general, CFOs do not make good CEOs (which is why they are CFOs), but Barry’s background in streaming-based subscription services and his experience of working with founders and early-stage companies is a plus.
• It was obvious from the day he started, that the strategy would be to jettison hardware and focus on subscription which is exactly what he has done.
• Unfortunately, it has been harder than expected, the losses greater than expected and the cash flow break-even that I was hoping for this year has not materialised.
• This is why the stock has seesawed from $7 to $17 and back again and it is currently hovering around $7 per share which is where they were about 12 months ago.
• The neutral case for Peloton is one where subscription revenues never grow again but the user base remains loyal (as it has so far) and hardware is fixed and earns a commodity gross margin which ends up being around 0% at the operating level.
• The subscription business has 3.11m subscribers who generate around $1.7bn in revenues per year from which the company earns a 71% gross margin.
• 31% of revenues should be more than enough to support this business meaning that it should generate around $550m in free cash flow.
• At a 10% discount rate and steady state, this values the subscription business at $5.5bn.
• Peloton’s enterprise value is currently $3.3bn meaning that the ongoing problems and losses from hardware are substantially impacting the value of the shares.
• The bull case (which I have chosen to ignore) is that Barry achieves his goal of getting subscribers to grow again which makes it pretty easy to get to $8bn or more.
• The bear case is that the Peloton brand is finished and that subscribers will start ditching the service and going elsewhere.
• This would render the company pretty much worthless but if this was going to happen, I think that it would have started by now.
• Furthermore, the Peloton brand is weathering the current difficulties pretty well and a new strategy to put bikes and services in hotels and enterprises is an excellent way to generate more revenue but mostly to serve as a marketing exercise to bring new users in.
• This is the new Peloton For Business offering that the company announced on 17^th August and I think it makes a lot of sense.
• Hilton, Sequoia, Volvo, Hilton and Dropbox have all signed up and could contribute both to subscription revenues as well as serve to widen the funnel of new users.
• Peloton is due to report FQ4 2023 results before the open on August 23^rd where Barry has already taken a knife to expectations and where I expect that he will dump the last of the clean-up costs.
• This will give a fresh start for fiscal 2024 and a clean company could lead to a substantial upgrade in profit and cash flow forecasts which in turn could lead to a rerating of the shares.
• My neutral case for Peloton gives me around $18 per share on a DCF basis with a discount rate of 10%.
• This is 2.6x higher than current levels which argues strongly that the upside is far greater than the downside making an attractive risk/reward proposition.
• I have looked at Peloton 2 times in the last year and declined to participate each time.
• I am going to have another look at it.