PTON: A Long Given Upheaval

Peloton, PTON ($8.19; 7/3/23)

Idea
- Brief company description
  - Peloton operates one of the largest fitness platforms in the world. They sell top-rated exercise bikes, treadmills, rowing machines, workout guides, clothing and accessories, and produce a variety of fitness content (strength, meditation, cardio, stretching, yoga, cycling, bootcamp, running, walking and outdoor) that can be viewed from a phone, tablet, computer, tv and/or watch. Historically, they focused on hardware (peaked at 85% of total sales) and were huge beneficiaries of the pandemic. After the pandemic benefits wore off, growth faltered, the founders left the company and a restructuring followed. Barry McCarthy, ex-CFO of Spotify and Netflix, took over as CEO and righted the company’s strategy and size. The company’s new focus (taking a page from SPOT’s and NFLX’s book) is growing content and subscribers (59% of FY23 total sales). Barry has said 100M subscribers (vs. the current 6.7M) is the company’s North Star. Notably, the majority of company sales come from North America (92% of FY23 total sales) vs. international. The company has gross margins of 35% (as of FY23) that are bolstered by subscriptions (67%) while weighed down by hardware sales (-11% vs. 40% historically).
- Is this stock a long, a short, or neither?
  - I believe this stock is a long given overly negative sentiment on the stock given the hangover from the historical growth during the pandemic and uncertainty on the go-forward strategy amidst their restructuring despite churn remains in-line with the historical rate, low penetration of addressable market, strong subscription margins, hardware products remain highly rated (via consumer reports), new hardware products have long growth runway, strong network effect, and a CEO that has been a part of the most successful subscription/content businesses in the world.
- Do you have an opinion on the upcoming earnings?
  - PTON is expected to report 4Q23 earnings before market open on Friday, 8/25. I do not have a strong opinion on upcoming earnings. I expect material growth to restart next fiscal year given the company spent the last year restructuring the company, righting the company’s strategy, and focusing on cash flow generation. Given the company generated cash as of 3Q23, albeit slightly, they can now start to refocus on growth.
Thesis
- What information or data justifies each element of your thesis?
  - One of the main reasons for the depressed valuation on the stock is due to the lackluster fundamental performance after material growth during the pandemic and a pivot from hardware to software. During the pandemic, the company, like many others, believed the experienced material growth was secular. However, we now know that the growth was cyclical given product sales declined 64% from FY21 to FY23. Importantly though, subscription sales doubled over the same period and churn remained in line with historical rates albeit higher (peaked at 1.41% vs. the historical average of 0.65%) despite the fact the company raised prices on their subscriptions. Critically, the company’s subscription revenue is more valuable than their hardware sales given the recurring nature of the revenue and the much larger TAM associated with the revenue.
  - The company’s 6.7M members is 10% and 4% of U.S. and global gym members, respectively. In addition, the company’s 6.7M members is 40% of Planet Fitness’ membership, which although PTON has a premium offering and Planet Fitness has a cheaper offering, their target of 100M subscribers is for their cheaper offering ($12.99/month vs. Planet Fitness’ $10/month) so I believe this is a legitimate short-term growth goal for PTON. Both of these stats show a long runway for the company. The company will have to be able to prove that they can re-ignite subscription growth in order for the stock to work. If they can, expect material multiple expansion.
  - The company’s subscription margins remain strong and, in fact, continue to grow (66% vs. the historical average of 54%). The overall margin shows that the company’s subscription product value is strong and the growth in margin shows the operating leverage the company can gain over time as subscription revenues grow. I should note an important caveat here: the majority of current subscribers are via their connected fitness subscriptions ($44/month) vs. their standalone app subscription ($12.99/month). Given the price difference, I suspect there is a difference in margins as well. The company’s goal of 100M subscribers would result in the majority of subscribers having the standalone app subscription. Therefore, subscriptions margins could decline if this is the case. However, I think the market would accept that trade given the potential for much higher operating leverage in the future given the much larger TAM.
  - New distribution deals (Amazon, Dick’s Sporting Goods and Hilton) and new business models (certified pre-owned and the company’s rental service) should increase hardware sales, connected fitness subscriptions and brand awareness. The company noted that there are 500K searches for Peloton on Amazon every month or 7.5% of Peloton‘s total membership. In addition, the company’s rental service and certified pre-owned are currently driving the majority of new users. For example, both programs accounted for 75% of new users in 3Q23.
  - Using Consumer Reports as the barometer for fitness equipment value, the company has the best exercise bike and treadmill products (the only two products measured). In terms of exercise bikes, the company’s Bike product is rated an 88, while the next best is 80. In terms of treadmills, the company’s Tread product is rated at 88, while the next best is 87. In terms of price, the company’s exercise bike is the most expensive ($1,445 vs. $1,000), while, surprisingly, their treadmill is less expensive than the second and third rated treadmills ($3,500 vs. $4,200/$4,177).
  - Using Google search as a barometer for over fitness equipment demand, the most sought after exercise equipment in 2022 are treadmills (294K), dumbbells (90K), exercise bikes (82K), yoga mats (68K) and rowing machines (63K). If I add up all of the categories that can be used with the Peloton guide (dumbbells, yoga, etc.), I calculated 240K searches. Given the above, I believe PTON has a long runway with the current hardware, especially their treadmills, rowing and guide products given their initial success was due to exercise bike sales. Surprisingly, searches for Ellipticals (12.8K) came in at 13th. I would have guessed Ellipticals would be higher, which maybe it is for the U.S.
- What do you believe that is different from the market?
  - Historically, PTON was considered a hardware company first. Given their recent lackluster hardware sales and company restructuring, the market is wary of the company’s switch in focus to software/content vs. hardware/fitness equipment. However, given the company’s low churn, ability to raise subscription prices, strong subscription numbers/margins, I believe they have a strong offering with their subscription/content. As such, I think they will be successful in growing subscriptions materially.
Opportunity
- What do you think drives the market’s mispricing of this stock?
  - As noted above, the market is wary of any pandemic winners and the resulting hangover. In addition, the company is moving from a strategy focused on hardware to one focused on software. As such, the market does not want to catch a falling knife.
Key Metrics
- What are the drivers and metrics/data you would monitor to determine if your thesis is tracking?
  - Cash flow
    - Company has noted that cash flow generation is current priority and growth is the next priority. Therefore, once company generates cash, expect growth to follow.
  - Subscription user growth
    - Key drivers:
      - Standalone app subscribers
      - New distribution partners (Amazon, Dick’s, Hilton)
      - FaaS/PCR
      - International (U.K., Germany, Australia, Canada)
  - Customer acquisition costs
    - Company has called out a target LTV:CAC ratio of 2:1
Expected Value
- My expected value is $12.61, which I calculated via a traditional DCF, and represents upside of 54% vs. the current price of $8.19 on 4/3/23.
  - The main driver of my forecast is connected fitness subscription growth (vs. total or app subscription growth). I used connected fitness subscriptions instead of the other subscription metrics given historically this was the biggest financial driver given majority of subscribers are connected fitness subscribers, and any hardware sales are driven by connected fitness subscription growth. If I used total subscriptions (both connected fitness and standalone app subscriptions) or just the standalone app subscriptions, then I would have had to estimate the margin differential and use a lower per user revenue value and average acquisition costs. This would have introduced a greater likelihood of error in model. At some point, I expect the company to give more details on the two subscription programs financial profiles.
  - In order to estimate revenue, I calculated product and subscription revenue by multiplying connected fitness subscriptions by the respective per user values. I grew subscription revenue per user by 5% per year, which I believe is fair given price increases. I grew product revenue by user by 10% per year for the first six years in order to make up for lost pricing during the pandemic hangover and then 5% year after.
  - In terms of gross profit, I forecasted product and subscription gross margins. In terms of subscription, I averaged the last three years’ margin and then grew that by 50 bps per year due to operating leverage. In terms of product, I increased margins by 440 bps per year for the first six years similar to revenue and then 100 bps thereafter. Again the six years represents a recovery to albeit a much lower value than what the company achieved historically. However, this is to be expected given the shift in strategy to software from hardware with hardware almost becoming a loss leader product for the company in order to capture subscribers.
  - In terms of operating expenses, I grew sales and marketing via net connected fitness subscription additions acquisition costs, which was much less volatile historically than overall connected fitness subscription acquisition costs. For the first four years, I estimated acquisition costs would decline by 10% per year after costs ballooned in FY23. In terms of G&A and R&D expenses, I averaged the last two years’ growth rates and then expected annual growth to fall by 5% per year. As expected, all three line items declined in terms of total sales by the end of the forecast period due to operating leverage.
- Another way to view the business is to value just the subscription part of the business. At a current EV of $4.3B, you are buying the subscription business for 2.2x EV/NTM subscription sales (in-line with SPOT). I believe that valuation is quite cheap for a recurring revenue stream with current gross margins of 66%, churn of 1.1% and a low penetration of its TAM (10% U.S./4% global). The hardware part of the business is a free call option.
Management
- Can you form a view on management?
  - I believe Barry McCarthy is the perfect CEO for this role. His experience at Netflix and Spotify is ideal for a company shifting focus to growing subscribers and content. He has done a great job thus far restructuring the company and righting the ship. His next key task is explicitly laying out the strategy to re-igniting subscription growth. As part of the goal to re-ignite growth, the company is testing out various new business models/products, which although necessary given current lackluster hardware growth, could introduce unnecessary complexities into the business. I expect him to explicitly lay out their go-forward strategy sooner vs. later over the next year.
- What are 3 questions you would like to ask management?
  - What’s the strategy to grow app subscriptions in order to get to 100M users?
  - What is the margin differential between connected fitness subscriptions and the standalone app subscriptions?
  - Of the new business models/products you are exploring, rentals, certified pre-owned, etc, which are you most excited about and why?
Key Risks
- What are the primary reasons you could you be wrong on this investment?
  - Hangover from rampant growth during the pandemic is worse than expected and fundamentals do not recover as quickly as expected, which would show up in higher than expected churn and lower than expected revenue growth.
  - Brand equity is worse than expected due to continued hardware issues, Sex in the City scene, etc. This would result in slower than expected total revenue growth and worse margins given worse pricing power and operating leverage.
  - Fitness subscription market is more saturated than expected and/or content is not as compelling as competitors. This would result in worse than expected subscription growth.
  - Macro environment worsens and coming recession is worse-than-expected, which weighs on PTON given it’s a premium B2C company
Data
- If you had access to data to confirm your view, what would you use?
  - Credit card data
  - Website Visitors/App downloads
  - Marketing/Promotional data
Laterals
- What do you think are the company’s laterals and comps?
  - I think NFLX and SPOT are the best comps/valuation benchmarks for what the company wants to become especially given the fact that Barry was CFO at both companies. In terms of fitness comps, I believe LULU, NKE and LTH are the best comps, while PLNT, NLS and GRMN are good not great comps.