Introduction
This is a longer article, so I’ve divided it into two main parts: the first is a discussion of Peloton and the possibility of an acquisition, and the second is a discussion of the earnings release.
The following is my summary of the news announced by Peloton last week, along with my thoughts and opinions on the same. It is not intended to be a recommendation to buy or sell the stock. Instead, it is a broader summary of some of the challenges and opportunities the company faces. You may find it interesting if you are a Peloton user. Additionally, it is hopefully instructive on how to approach analyzing any business.
On February 8th, Peloton released their fiscal 2nd quarter results for 2022[1] (4th quarter 2021 calendar quarter). As a part of that release, they also announced management changes[2] and a major cost restructuring plan.[3] Before I dive into the details of that, I’d like to address all the speculation about Peloton being acquired by another company. I’ll start with some basic, but important facts, and then give you my thoughts about the likelihood of several scenarios.
Peloton Acquisition Rumors
Two-Tiered Share Structure
As disclosed when Peloton went public in the Fall of 2019, the company has a two-tiered share structure. To put it simply, the shares that were sold to the public each have one vote per share, while the shares that were retained by previous owners (when the company was private) and management each have 20 votes per share. Typically, when a company goes public and sells a large proportion of shares to other investors, founders and early investors lose majority control of the company.
This is generally not an issue unless there is a controversial proposal that requires shareholder approval (a vote). As a result of Peloton’s share structure, management and early investors maintained majority control of the company after the IPO and still maintain that control. John Foley controls about 40% of the total votes of both classes of stock combined. Along with other early investors (who are also long-time board members) and other management, that group controls about 82% of the total votes.[4]
The bottom line with respect to these facts is that it’s virtually impossible for an acquisition to occur unless it’s a friendly merger. Meaning that an acquirer approaches PTON, negotiates a deal and together the two companies announce the news. It is highly unlikely that any serious acquirer would do anything other than quietly talk to PTON management, to see if there would be interest in a deal. So the idea that some large company, with cash on its balance that is many multiples of the current market value of Peloton, would attempt a hostile acquisition is just silly, in my opinion.
Fiduciary Duty and Shareholder Value
It is also true that management has a fiduciary duty to do what is best for shareholders. By the way, the same group that controls 80% of the votes also owns about 15% of the dollar value of the company. While much smaller, it is still quite significant, and suggests that group’s interests are actually probably aligned with other shareholders.
When it comes to what is best for shareholders, particularly surrounding acquisitions, that is highly subjective. It is fairly easy to argue that management has the vision to create more value for shareholders over the long term, than the value that would be created by an acquisition and new management. I think it is highly unlikely that John Foley or any of his close associates think that more shareholder value would be created over the long term by selling the company. I also happen to think that is a reasonable assessment.
My conclusion with respect to Peloton being acquired by another company is that, while anything is possible, it is very unlikely to happen in the near term. The only way I see this changing is if the company is not successful over the next few quarters with its restructuring plans. All of the above was my view before the news that was announced with their earnings. I think the announced restructuring plan and management changes further reinforce the fact that management and the board have no interest in selling the company. Finally, only a company that is at risk of going out of business (not the case with PTON) would seriously contemplate selling near its all-time low value.
Earnings Report, Cost Restructuring, and Management Changes
Let’s turn to Peloton’s earnings, released on February 8th. The shareholder letter, which you can find here: https://investor.onepeloton.com/static-files/b0419d52-2795-4c38-a295-ae9c73550b8f, details all the results and the outlook. I’ll review some of them, but for the most part I am going to keep this bigger picture. As usual, there has been no shortage of, dare I say it, uninformed speculation about Peloton. I will address some of the more commonly held misconceptions and concerns, as I go through this.
Management Changes
John Foley is stepping down as CEO, but will continue with the company as the Executive Chairman. He will be replaced by Barry McCarthy who helped lead Spotify and Netflix through difficult periods, as CFO (Chief Financial Officer) in both cases. John Foley described him as perhaps the number one expert in the world when it comes to digital subscription models. It sounds to me as though Foley will still be heavily involved with the company. Toward the end of the call he said, “I look forward to speaking with you next quarter and updating you on our progress.”
Additionally, William Lynch will be stepping down as President (McCarthy will be both CEO and President), but he will remain on the board. Finally, several changes were made to the board. One existing board member is stepping down and two new ones are being added. One of the new additions has a lot of supply chain expertise, and the other has a lot of sales and marketing experience, both areas where Peloton could benefit from additional expertise.
Cost Restructuring Plan
The company also announced that they would be cutting about 20% of the corporate workforce, and about 2800 people in total. That is a very real and unfortunate development for the folks who are impacted. Perhaps there is some consolation knowing that in the current tight labor market, those folks should not have a lot of difficulty finding new jobs. Nonetheless, when discussing numbers and metrics I think it’s very important to be mindful that this impacts the lives of real people. These cutbacks run across almost every area of the business.
I have seen speculation that the cutbacks will include coaches, so let’s get this one out of the way. That is false. Both in his letter and during the conference call, John Foley made it clear that the company considers two areas to be sacred. The first is member experience. That includes, coaches, content creation, software improvements, and hardware development. Those areas will not be impacted by the restructuring. The second is accessibility, meaning the cost and value of the products. This is pure speculation on my part, but among other things, I think that means a change in monthly subscription fees is not likely in the near term.
The company plans to reduce its annual expenses by about $800 million. $300 million will come from reduced cost of goods sold on hardware (bikes and treads). The majority of this will come from better efficiencies in procurement, manufacturing, and logistics. The most immediate reductions will come from overhauling the logistics network.
Specifically, this means getting rid of some warehouses and relying more on third party logistics companies like XPO. They directly addressed the poor service experiences that many folks have experienced with XPO. They stated that they are working with their partners on this. If you live in a larger city, the logistics will likely continue to be owned and operated by Peloton. If you live in a less populated area, you will likely have third party providers. Before the restructuring, PTON owned 60% of their logistics network and outsourced 40%. After the restructuring, that will flip to 40% owned and 60% outsourced.[5]
They are winding down their investment in Peloton Output Park, the planned manufacturing facility in Ohio. There will be more expenses associated with that wind down, which they expect to recoup when the land and shell buildings are sold in fiscal 2023. Additionally, they expect to incur one-time charges associated with the overall restructuring plan of $210 million, of which $80 million is non-cash. Importantly, they expect to end this fiscal year (in June) with $1.2 billion in cash and cash equivalents, which will be down from the current level of $1.6 billion, but stabilizing. They also have an untapped $500 million line of credit.
Over the next few years, they expect their Tonic plant in Taiwan, and their third-party partners to be able to supply their manufacturing needs. The inventory draw down of bikes and treads will take time, in part because they do not want to completely shut down Tonic, nor damage their relationships with third party manufacturers. They did point out that there will be no inventory write downs, as their inventory is non-seasonal and non-perishable. Stated more simply, it won’t become obsolete in the time that it will take them to normalize inventory levels.
Agitation by Activist Investor
Some of you may have heard about the activist investor who owns 5% or less of the stock. He has been making quite a bit of noise, and there is an extensive document circulating on the internet that attempts to make the case about why Peloton should fire management and the board, and put the company up for sale. The level of exaggeration, misstatements and downright false statements in that document is astounding.
I’ll give one example from that document: he complains about the two-tiered stock structure and the resulting super voting shares that I explained at the beginning of this article. I agree that it is not an ideal structure from the perspective of an outside investor. However, for someone who claims to be a professional investor to complain about that suggests that this individual didn’t do his own minimal due diligence before investing in the company. The fact that PTON has that structure is readily available, public information that is clearly outlined in multiple SEC filings, said another way – caveat emptor.
As I have mentioned before, sometimes good companies have poorly performing stock and vice versa. There are two major aspects to investing. One is identifying good companies with business models that will generate sustainable future profits. The second is correctly valuing that future stream of profits. Doing so accurately, will lead to appropriate purchases and sales based on that analysis.
To pick on that activist investor again, I presume that firm bought into the stock at much higher prices than recent levels. Unless PTON management has deliberately misled investors (no reason to believe this is the case), the decision that this activist investor made to purchase the shares are his, and if it didn’t work out, he is to blame. The notion that he or anyone else should attack PTON because they overpaid for the stock is just laughable. A rough analogy would be, you buy a used Chevrolet truck for $30,000 and then discover that it is only worth $10,000, so you try to go after Chevrolet for that loss.
Conclusion
I’ll leave you with a basic summary of my sense of what happened to Peloton. To be clear, this is speculation on my part so take it for what it’s worth. When the pandemic hit and demand went through the roof, the company spent money like crazy to try to keep up with demand. All of those added expenses underwent much less scrutiny and justification than they should have because the company was so focused on trying to keep up with demand. When demand began to dry up suddenly, the company was left with high fixed costs without the sales to support those costs. Now, they are in the midst of the painful process of scrutinizing and reducing their cost structure back to a level that fits with expected levels of demand.
In conclusion, I still believe that Peloton, as a business, has a bright future. They entered the pandemic with 700,000 subscribers, and they are projected to end fiscal 2022 (at the end of June) with 3 million subscribers. Their retention rate remains around 92%. They continue to introduce new products and will do a soft launch of the previously announced Peloton Guide on April 5th. As Foley said, they have made some major missteps, there is no question about that. To quote him, “We own this, I own this, and we are holding ourselves accountable. That starts today.”
In the investment business, PTON is now what we call a Missouri stock, a reference to that state’s license plate slogan – the Show Me State. Over the next two to three quarters, Peloton will need to demonstrate excellent execution and follow through with the restructuring plan that was announced. If they fall significantly short of that, all bets are off, including what I said at the outset about being acquired. I believe they will succeed, but time will tell.
[1] https://investor.onepeloton.com/static-files/b0419d52-2795-4c38-a295-ae9c73550b8f
[2] https://investor.onepeloton.com/static-files/3d257b1a-3e7c-4af9-a0bc-f251d23edf8d
[3] https://investor.onepeloton.com/static-files/7103f15e-88e7-4f6f-9921-ac93da2f56ef
[4] https://investor.onepeloton.com/static-files/c039f53f-c8a0-48dc-ae5e-11754afad389
[5] https://investor.onepeloton.com/events/event-details/peloton-interactive-2q22-earnings-call
