Musings on Peloton’s Latest Earnings Release

August 27, 2022 / John Bernstein / Comments Off

Introduction

The following is my summary and analysis of the quarterly earnings report that Peloton released on August 25^th, along with my thoughts and opinions on the same. This is not intended to be a recommendation to buy or sell the stock. It is meant for Peloton enthusiasts who may be interested in some of the challenges and opportunities facing the company, particularly as it relates to the future outlook for Peloton. It also may be of interest to anyone who enjoys business analysis.

Peloton reported results for their fiscal 2022 4^th quarter (calendar 2^nd quarter), which ended June 30^th. The earnings call was conducted by CEO Barry McCarthy and newly appointed CFO, Liz Coddington. Similar to last quarter, there were no formal remarks nor a presentation. They simply went straight to questions.

Progress Toward Operating Improvements

As usual the news media and the interweb are both crawling with Monday morning quarterbacks, who, seemingly, know exactly how Peloton should be or should have been run. Unfortunately, when one reads much of that commentary, it becomes quite clear that it is generous with opinions, but very short on facts, despite them being readily available. I am certainly not a defender of Peloton, but I at least try to be a defender of facts.

PTON reported a loss of $1.2 billion for the quarter. This was quite a bit larger than expected and was largely related to restructuring charges, which are extraordinary (one time) in nature. Restructuring charges accounted for $415 million of the loss.[1] Adjusting for that, the earnings loss was $827 million, compared with a loss of $767 million in the fiscal 3^rd quarter of 2022.[2] My only point here is there has not been the amount of deterioration in the underlying business that the headlines and pundits would suggest.

Cash Flow

Much more important for the near-term is free cash flow, which is defined as cash flow from operations minus capital expenditures and internal-use software development costs. Last February, management announced a plan to reduce expenses by $800 million. $500 million of which would come from lower operating expenses and $300 million that would be from lower cost of goods sold (COGS).[3]

In May, Barry McCarthy said they expected to realize $165 million in operating expense savings in the second half of fiscal 2022 and an additional $450 million in reductions for FY23. With respect to the $300 million in savings to COGS, they expected to realize $30-$35 million in the latter half of FY22, and another $100 million in FY23. From the start, they said that COGS reductions would take longer because it’s tied, in part, to the inventory liquidation.[4] This quarter, they said they are tracking ahead of their $500 million target for operating expense reductions.[5]

Also back in May, they said they expected free cash flow to be “meaningfully better” in the fiscal 4^th quarter versus the 3^rd quarter. In the 3^rd quarter, which ended April 30^th, PTON’s free cash flow was -$746.7 million.[6] For the 4^th quarter that ended June 30^th, free cash flow was -$411.9 million.[7] I don’t think anyone would dispute that a 55% reduction in negative free cash flow could be characterized as “meaningfully better.” They also stated that they expect to be breakeven on free cash flow (meaning no longer burning cash) in the second half of fiscal 2023 (first half of calendar 2023).[8]

To give that some important context, Peloton ended the fiscal 3^rd quarter with $879.3 million in cash and cash equivalents.[9] At the end of the fiscal 4^th quarter, cash and cash equivalents was $1.25 billion, which includes the $750 million 5-year loan they arranged last spring. Additionally, they have a $500 million line of credit that remains undrawn.[10] They also stated that they expect to maintain cash and cash equivalents at about $1 billion.[11] The company has plenty of challenges over the near and intermediate term, but, short of a sudden and unforeseen shift, running out of cash does not appear to be one of them.

Inventory

Inventory has also been a well-known problem. At the end of April, inventory levels were $1.4 billion.[12] By the end of June that declined to $1.1 billion, which includes an increase to inventory reserves of $182 million. The inventory reserve is related to excess accessories and apparel, returned connected fitness products, and raw materials.[13] Adjusting for this increase to the inventory reserve, PTON was able to liquidate just under $500 million of inventory during the quarter, slightly more than a 1/3 reduction in total inventory.

Growth

So far, it appears that Peloton is tracking fairly well in their efforts to bring costs into line with the business. Obviously, this is a key part of the company remaining a viable ongoing concern, but it is not all of it. They also need to grow revenue at healthy levels within the framework of their new cost structure. So, let’s review some of the metrics related to this.

The number of connected fitness subscribers was basically flat from the 3^rd quarter to the 4^th quarter. The technical issue with respect to Canadian subscribers doesn’t change the numbers meaningfully (you can read the details on this in the shareholder letter).[14] Unsurprisingly, total revenue declined by -30% from the previous quarter, and -28% from the same quarter a year ago.[15] Price reductions to help clear inventory played a role in this, but there is more going on. There is meaningful seasonality to the business. As a result, the 4^th and 1^st quarters are typically slower growth, but normally not zero or negative growth. Likely, the most important factor in this recent slowdown is changes in demand for the entire category.

For obvious reasons, connected fitness as a category became more popular during the pandemic, so much so that consumers who, in normal times, may have never purchased a connected fitness product did so. This caused a tremendous amount of demand to be pulled forward. That is all settling out now. Demand is returning to more normal levels, which will likely mean a couple of years of lower demand than would have otherwise occurred. It’s not just Peloton; it’s connected fitness broadly.

Some folks would have you believe that as many people return to their favorite gym, connected fitness is dead. I do not believe that. I think connected fitness is here to stay and for many people it’s a great complement to the gym. It will, however, take time for demand to settle into a more normalized annual growth rate for the whole category and Peloton specifically. While that is happening, Peloton is being quite proactive in its efforts to enlarge the total addressable market (TAM), and how to position the company and its products.

Management Style

I’ve heard and seen many comments suggesting that PTON management is desperately throwing spaghetti at the wall to see what sticks. While I think it’s true that the company is acting with a healthy urgency, in my view, the rest of the implications of that statement are not accurate. Management is proactively and thoughtfully testing many different ideas to position the company for future growth. Some of these include the certified pre-owned program, strategic use of the digital app, and fitness as a service (FAAS), which is an equipment rental program. I’ll quote a statement from Barry McCarthy during the recent earnings call that explains their approach:

“…so [use] your intuition to figure out what to test, then use the data to inform you about how to react to the test results you’re seeing, and take risk, and move fast and don’t be afraid to break stuff.”[16]

I think it’s fair to say that the future success of these efforts is the most uncertain piece of the Peloton story, and I believe company management would agree. This is the part where it also makes sense to assess the ability of management to attain these goals. Barry McCarthy has a pretty good track record from his time at both Netflix and Spotify. He is also surrounding himself with people he believes are capable of helping him achieve these goals. I think his previous experience also has a lot of implications for what Peloton may look like in a few years. Specifically, a fairly nimble software/content focused company that will probably still offer hardware, but not as a primary focus.

Miscellaneous Observations

Churn increased in the most recent quarter to 1.41% from 0.75% in the previous quarter. The $5 subscription fee increase went into effect at the beginning of June, and is likely responsible for at least some of the elevated churn. Management did say that July churn rates declined from June, and were also below the average for last quarter.[17] Nonetheless, this bears watching over coming quarters.

The agreement to begin selling PTON products on Amazon was announced the day before the earnings release. Contrary to the belief of many, I do not think this is any indication of whether Amazon may try to acquire Peloton. Using that line of logic, there are quite a few companies that AMZN would have acquired. Peloton management specifically said that this is not a replacement for their own retail strategy.

Rather, it’s simply a new distribution channel that allows Peloton to reach consumers they may not have otherwise. It also helps lower distribution costs and simplifies logistics, as they pull out of last mile delivery. Amazon prime members can choose to have the bike delivered from one of three options: to their door in the box, to a specific room in the box, or to a specific room with expert assembly. There is no additional charge for any of those options. So far, just the original bike, Peloton Guide, and accessories are available. Peloton would like to add the bike+ and tread, but both will require a redesign so that self-assembly is an option before they can be sold through Amazon.[18]

Here are a few other interesting tidbits from the call:

They are hopeful about introducing a rower for the holiday season. They said it’s going to be expensive, but they expect it to revolutionize the market and be a better user experience than anything currently available.
They see marketing and branding opportunities in local markets using the celebrity brand power of the instructors.
Pricing was lowered in the spring to help clear inventory. The recent price increases are, according to the company, intended to retake their premium brand position.
They believe there is opportunity in brand promotion. Unaided awareness of the bike is 53%, but just 21% for the tread, and only 4% for the digital app.
The announcement of retail store closings is not a cost saving measure. The intent is to redeploy $50 million annually into more efficient marketing strategies. There were no further details about the closings.[19]

Valuation and the Future Outlook

When Peloton first went public almost three years ago (well before all the pandemic-related events), I thought the stock was overvalued. That was because it was being valued like a software company with a recurring revenue stream. At that time, and until recently, that stream only represented about 20% of revenues. The other 80% was hardware sales, which is typically valued at much lower levels. The company should have been valued using a blend of both of those valuations. Ironically and for the first time, as a result of slowing hardware sales, subscription revenue was more than half of total revenue in the most recent quarter. Given Barry McCarthy’s background mentioned above, I would expect this trend to continue. He even said on the call that the long-term trend is toward subscription margin and away from hardware margins.

Moreover, in discussing the future, Mr. McCarthy talked about developing software with a front end that understands the likes and dislikes of each consumer, based on how they use the content, and then serves content to that customer accordingly. He went on to say that is why Netflix beat Blockbuster, and how Spotify became the largest streaming music service. While it’s unclear what Peloton will look like in an a few years, I think his remarks provide some very clear indicators of the direction.[20]

Conclusion

Peloton has made very meaningful progress toward turning things around over the last few quarters, but their work is far from done. However, based on the progress to date, and the road map that management has outlined, I am guardedly optimistic about the future of the company.

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