We Bought a Peloton, then Bought 3 Million More.

September 8, 2023

There’s something there.

That’s usually the hunch that I get when a stock piques my interest. Most days are spent reading the news, parsing data, and turning over investment ideas, but once in awhile something strikes me as potentially interesting. Recently?

Peloton.

You know the one. The company that sells this . . .

. . . an iPad connected to a workout bike. Yeah the COVID market darling that blasted off (TO THE MOON) when we were all locked down and forced to exercise from home. Like a hill climb workout, the stock took off, but what went up came crashing down.

The pandemic accelerated the adoption of the home bike, and led to an explosive growth of Peloton’s connected devices (i.e., the catch-all phrase for Peloton’s installed base of bikes, rowers, treadmills). That growth led to the ultimate supply chain whipsaw. Unable to fulfill orders, Peloton massively expanded its infrastructure for manufacturing and distributing its devices, but when the world unlocked, demand came to a screeching halt.

Revenue and cash flow fell off a cliff, and the company began hemorrhaging cash. The bloated infrastructure, overall strategy and CEO had to change. The founder and CEO of Peloton, John Foley, was ousted, and a new CEO, Barry McCarthy, was ushered in. A new executive team was also put in place.

So let’s start from the top? Why’d it pique my interest?

Well if you think about Peloton, the company basically sells really expensive workout equipment that comes with a subscription. A new Peloton Bike costs $1,245, and a Peloton Bike+ (with a larger screen) costs $2,195. You can save a few dollars by buying a refurbished Peloton Bike+ for $1,995, but you’re basically all-in for at least $1,500/bike if you just buy some shoes and a bike mat if you buy the cheapest bike. If we’re talking about the treadmill or rower, the prices are even higher, both Peloton Tread and Peloton Row retail for $2,995. Each connected device that requires a $500/year Peloton All-Access Membership (i.e., a $44/month subscription) to work, and there are currently 3M such devices in the wild.

Now let’s look at the company. This company is worth ~$3B. That $3B in enterprise value is comprised of a $2B in market cap, and $950M in net debt ($1.75B in long-term debt less the $800M in cash).

So a $3B company with a 3M bike/treadmill/rower installed base. Said another way, we’re basically buying each “connected device” (i.e., Peloton bike, rower, treadmill) for . . . $963. Devices that generate ~$500 of annual subscription fees.

That doesn’t feel expensive does it? Especially when you consider what the devices are selling for. Now we know, it’s not that easy, so what’s the catch? There must be a ton of churn right? Subscribers must be fleeing in droves.

Well . . . not really.

It certainly doesn’t seem that way as turnover has stayed fairly low, especially considering Peloton’s well publicized issues of late (e.g., seat post replacement, Tread+ issues, and overall company turmoil).

Said another way . . . those who Peloton . . . keep Peloton-ing.

So again, $963 per bike, tread, rower that generates $500/year with low churn. That doesn’t seem so bad.

Admittedly, the entire business cobbled together isn’t a cash cow. In fact, the company is still losing money as it continues to restructure. It’s close to break-even though, but not quite there yet. If we exclude the last quarter’s one-time $75M DISH settlement payment (related to an IP infringement issue), Peloton has dramatically reduced its cash burn rate. What was a raging 5 alarm fire has calmed to a controllable stovetop one.

The company, however, doesn’t anticipate it will achieve positive free cash flow for two more quarters as promotion and marketing expenses ramp higher into the holidays, but it does have nearly $814M in cash to sustain the burn (projected at ($170M) for the next six months).

As for Peloton’s debt? There’s essentially two instruments. First, a $1B 0% senior unsecured convertible debt due in February 2026 (“Convertible”), and second a $750M term loan (“Term Loan”) due May 2027. The Term Loan has a springing maturity and will become immediately due and payable in November 2025 if more than $200M of the Convertible is still outstanding at that time.

The Convertible is essentially free money given the 0% interest rate and the conversion price of over $239/share while the stock is currently trading around $5.60/share. Yet, the free money will inevitably end, and Peloton may have to refinance the note, in which case, interest rates will be higher. If, however, Peloton is able to achieve positive free cash flow, then it could conceivably take its remaining cash balance (currently $814M, and assuming a ~$170M burn in the next 2 quarters, ~$670M) and pay down the term loan or Convertible. Paying down the latter, would prevent the term loan from maturing at the earlier date. There are a few options here for Peloton to address the debt, and in the end, we’re not too concerned about the company’s debt load and maturity schedule.

Critically, the new management team has realigned the company’s cost structure, and shifted away from high fixed costs to a more variable and scalable one, outsourcing manufacturing, distribution, and to some extent sales. Ultimately, what will determine whether this investment is successful or not, comes down to recapturing growth. As costs are contained, any revenue growth should fall to the bottom line. Although the 3M of installed “connected devices” support a business that’s breakeven on cash flows, viewed another way, it’s also a $650M sales and marketing machine, the amount it spent last year for promoting the Peloton brand. For comparison, during its heyday, Peloton spent ~$1B in sales and marketing.

In the past few quarters, Peloton has adopted a “throw everything at the wall to see what sticks” strategy to generate growth.

Some of the strategies?

• Re-launch of the Peloton App One ($13/month or $24/month depending on tier). The goal for this category is to represent 27-30% of All Access members (3.1M total today).

• Introduction of Fitness-as-a-Service (“FaaS”) (i.e., rental program) in the US, Canada, and Germany for customers not willing to commit to buying the hardware outright. Using existing inventories of Peloton Bikes ($89/month) and Bikes+ ($119/month), the company is seeing that 62% of the volumes under the FaaS program are incremental (i.e., the rentals aren’t cannibalizing existing sales, and participants are new to the platform). Payback on this program is currently 18-19 months.

• Introduced a refurbished Peloton Certified Refurbished Bike+ program ($1,995 vs. $2,495) for price sensitive customers.

• Relaunch of the Tread+ after sales were halted and the tread redesigned to address safety concerns.

• Launch of the Peloton Row in markets outside of the US.

  

• Shrinking existing company owned retail spaces in favor of wholesale arrangements with Amazon and Dick’s Sporting Goods.

Will it work? Will any of it work? To be honest, we’re not sure. We’re not sure what will reinvigorate growth, and what won’t. What we do know is this. This comment by Barry McCarthy, Peloton’s new CEO, at JP Morgan’s Global Tech, Media, and Communications Conference held earlier in May. Pay particular attention to the highlighted paragraph, which was his response to the question, what has the company learned, thus far, from it’s new rental program?

You see that? If you can measure it, you can control it. Data analytics. Throw all the strategies against the wall, measure the outcomes, and see what sticks. Eventually we believe the management team can and will figure it out. Barry McCarthy after all was previously the CFO at Spotify and Netflix, both subscription based businesses. Similarly, Elizabeth Coddington, Peloton’s new CFO, was previously Amazon’s VP of Finance at Amazon Web Services. McCarthy is certainly incentivized to do so as he’s been granted 8M options on Peloton stock at a $38.77/share strike price (vs. Coddington who’s received 639K options at $9.84/share, and 349K shares of RSUs in ‘22 and another 800K RSUs in ‘23). Most of Peloton’s other executive team members are also fairly new to their roles. Peloton’s Chief Marketing Officer, Leslie Berland, formerly of Twitter, joined earlier this year, and Andrew Rendich, Chief Supply Chain Officer, joined in 2022. As Peloton completes its restructuring, the team can fully turn its attention to driving growth, and with the right cost structure in place, that growth should result in incrementally higher cash flows.

While it’s too early to project which of these strategies will pan out, it’s also fair to say that at $963/per connected device, there’s not much downside. Could the company further melt-down? Sure, if churn rates increase, and Peloton members disconnect their devices, but it’s difficult to imagine that since it “bricks” their bikes/rowers/treadmills. Even more so when you consider that post-pandemic (when people would theoretically tire of/abandon their home workouts), churn didn’t materially increase. What likely happens in a downside scenario is that growth refuses to lift, and the company meanders through the next few quarters/years. In such a scenario, we believe the company would pursue “strategic alternatives.”Frankly, you slice off half of G&A costs alone ($780M in 2023), you’ll already have a fairly attractive valuation for a buyer. If it’s a strategic fit, such as Amazon (bundled with Prime), you could even lower COGS (3PL shipping is no longer “3PL”) and sales/marketing expenses ($650M in 2023). There are significant cost synergies available for the right buyer, and inevitably in a worst case scenario, we think one will emerge. Importantly though, that’s if growth does not recouple.

Here, we’ll have a growth strategy that’s being developed and driven by an E-suite populated by a “who’s who” of leaders in the subscription space. While it’s still TBD if any of it will work, at $963 per connected device, we’ll take that bet.

So buy a bike, heck buy 3M of them.

Join the Peloton.

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