Perspectives on Peloton from the Latest Earnings Results

May 18, 2022 / John Bernstein / Comments Off

Introduction

The following is my summary of the quarterly earnings report that Peloton released last week, 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 Peloton remaining an independent, going concern. It also may be of interest to anyone who enjoys business analysis.

Peloton released their 2022 fiscal 3^rd quarter (2022 calendar 1^st quarter) earnings report on May 10^th.^[1] The call was conducted by new CEO Barry McCarthy, and CFO Jill Woodworth. In a notable change from the past, they dispensed with any formal presentation or remarks and went straight to questions. This seems to fit with the no nonsense, straightforward approach of McCarthy.

Cash Flow and Peloton as a Going Concern

Peloton, as previously announced, is in the midst of a major restructuring from both a cost and systems perspective, and also with respect to their business model. Since the financial press and the gaggle of armchair quarterbacks seem to be most focused on PTON as a going concern, I’ll address that first. Peloton used almost $750 million in cash in the previous quarter, which leaves them with about $880 million in cash and cash equivalents remaining, before the new financing arrangements described below. The number one priority for the company is to stabilize free cash flow, which is defined by PTON as the cash provided from operations minus capital expenditures and development costs for internal-use software. They clearly need to stop hemorrhaging cash, and the rate of cash burn must drop dramatically this coming quarter.

To that end, they arranged a debt agreement with two large banks that will allow them to borrow $750 million for 5 years. Additionally, they still have a $500 million credit facility that remains undrawn. They seem to believe that they are now appropriately capitalized to get through the rest of the restructuring period. Importantly, it appears they were able to do this without selling equity (stock), which would have diluted existing shareholders. As a result, and though they did not address it, I presume they are no longer seeking an outside an investor to take a stake in the company, as was rumored in the Wall Street Journal.^[2]

One of the major drags on cash flow is the excess inventory of equipment that they are still working down. The good news about that is there is very minimal risk of obsolescence, meaning that it would become unsellable. They specifically said that they expect inventory to go from being a use of cash, to a source of cash in FY (fiscal year) 2023, which begins July 1.^[3] They are guiding for a substantial improvement in free cash flow next quarter. This will be an important indicator for the long-term health of the company.

I’ll conclude the discussion of free cash flow and PTON’s ability to survive with a statement made by McCarthy during the earnings call: “…the objective here is to get the business to positive free cash flow in FY2023 just full stop, and with the money that we’ve raised in the term loan, I’m very confident we’ve got plenty of capital to do that regardless of the economy, full stop. So, to the extent that there are any concerns amongst investors about our ability to do that, I don’t share them, and I want to be clear about that.”^[4]

My last point on this topic is that I believe that the chances of Peloton being acquired in the near- to intermediate-term are close to zero, and I actually think that is a good thing. Of course, implicit in that assumption is that there are no further major mistakes that change their ability to operate independently.

Business Model Realignment

The other two priorities for management are getting the right people in the right roles and getting growth back on track. McCarthy mentioned that the “talent in the building” was better than he expected, and the company says both initiatives are progressing well.^[5]

Customer Complaint Issues

When a company undergoes as much difficulty as Peloton has in recent quarters, it’s easy to get caught up in anecdotal information. Sometimes that is direct personal experience, the experience of friends, or complaints that can be read on social media. I’ll say a couple of things about this. First, the general rule is that when someone has a good experience with a business, they tell one friend. On the other hand, when someone has a bad experience, they tell ten friends. Clearly, we are more likely to hear about bad experiences than good. I like to stay more focused on the numbers, but I don’t completely ignore anecdotal information either, as it can certainly be an indicator of problems.

McCarthy addressed several things that relate to the anecdotal information about customer service and deliveries that I found reassuring, largely because I believe the company is very aware of these problems and they are being addressed. First, they switched to a new third-party provider. When they did this, there were 10,000 customers in the previous system for deliveries and/or customer service issues who had to be transferred to the new system. When that switch occurred, all 10,000 people had to be rescheduled and PTON’s existing systems were not capable of allowing them to inform customers appropriately.^[6] That’s a lot of potentially upset customers that would certainly explain the many stories of bad experiences that are circulating. At the same time, 10,000 customers represent one-third of 1% of the almost 3 million connected fitness subscribers, and less than one-sixth of 1% of the 7 million members that Peloton has currently.

These anecdotal problems are real, but I think it’s important to put them in context, as I just did. Nonetheless, left unaddressed, these issues could severely hamper the business in the future. Management is fully aware of the deficient computer systems at PTON, and steps are being taken to fix the problem. McCarthy gave a specific example that relates to this issue. Currently, a customer service agent must wade through about 16 different screens to see all the history on a customer account.^[7]

Moreover, he discussed this problem as one he has seen before at some of the other companies he has helped turn around. He mentioned that it is typical for high growth tech companies to focus on product development and engineering at the expense of internal computer management systems, including customer service and accounting platforms.^[8] This problem was particularly acute for Peloton as they grew from 700,000 subscribers to 3 million during the pandemic.

Subscription Revenues and Future Growth

In previous write ups, I have discussed that I think Peloton stock was not valued correctly by many investors because they were treating the company as though the primary source of revenue came from subscriptions. In fact, historically, only about 20% of revenues came from subscriptions, the other 80% came from hardware sales.

It is very clear that McCarthy is focused on switching that mix to a much higher contribution from subscription revenues. This quarter, subscription revenues were about 34% of total revenues. However, this is mostly because there was a large decline in hardware sales. Nonetheless, the company is shifting to a stronger focus on subscription revenues, but it does not sound like they will completely move away from selling hardware, certainly not in the near term. To this point, McCarthy said they need to be good at hardware, but they need to be great at the magic that happens on the tablet (meaning the content).^[9]

McCarthy has also made it clear that if they have any chance of getting to 100 million subscribers (an aspirational number he has mentioned previously), the digital app will play a key role, along with FaaS (Fitness-as-a-Service).^[10] FaaS is the new program they are piloting in certain markets where a consumer agrees to pay the monthly subscription fee along with an additional charge of $20 to $40 per month to lease the hardware.

Management also mentioned that, longer range, they have better growth prospects in international markets. New market introductions are not likely to occur in the very near term because of the up-front costs associated with this, as they are focused on becoming free cash flow positive.^[11]

Conclusion

Unquestionably, Peloton has significant problems that must continue to be addressed over the next 12 months. The new CEO seems to have an excellent grasp of the major issues the company faces, and he appears to have experience with many of them from his past employment. I am an optimistic person by nature, but I feel realistically confident that Barry McCarthy will succeed in turning around Peloton. This is based both on his remarks on the earnings call today, and his track record with other well-known companies (Netflix and Spotify). Peloton has very little room for any major missteps. Ultimately, over the next 12 months, time will tell if they will remain on track to recover from all of their difficulties.

Legal disclaimer