Thoughts on Peloton’s Latest Earnings Results

February 3, 2023 / John Bernstein / Comments Off

Introduction

This is my summary of Peloton’s quarterly earnings results, which the company released on February 1^st. In addition to providing many of the facts from that release, I also provide my own thoughts and opinions about the results. This is not a recommendation to buy or sell the stock. Moreover, when I discuss the future outlook of the company, I am referring only to the operations of the company, not the stock. While I may address valuation in a broader context, I specifically avoid getting into the details of the stock’s valuation, which should be an integral part of any decision to buy or sell the shares. This is meant for both Peloton enthusiasts who may be interested in the challenges and opportunities facing the company, as well anyone interested in business analysis.

Peloton reported results for their fiscal 2023 2^nd quarter (calendar 4^th quarter), which ended December 31^st.[1] As in past quarters, the call was conducted by CEO Barry McCarthy, and relatively new CFO Liz Coddington. The format was the same as the last few quarters with no formal remarks or presentation from either executive, just questions and answers.

Restructuring Substantially Complete

Earnings

For the past 12 months, the biggest concern Peloton has faced was whether they could get the losses under control and continue as a viable, standalone business. For the quarter, PTON reported an earnings loss of -$331.4 million compared with a loss of -$408.5 million in the previous quarter, and -$1.255 billion two quarters ago.[2],[3] Obviously, the company needs to get to profitability, and they are continuing to make reasonable progress on that.

Free Cash Flow

Much more importantly, for the near term, is getting free cash flow (FCF) back to breakeven. FCF is a non-standard accounting metric which Peloton management defines as cash from operations minus capital expenditures and capitalized software costs. For the most recent quarter, FCF was -$94 million compared with -$246.3 million, -$411.9 million, and -$746.7 million over the previous three quarters, respectively.[4],[5] Management reiterated their goal to reach FCF breakeven by the end of fiscal 2023, which is this coming June.[6] Given the trend over the past year, this seems very reasonable, and, in my view, may happen by the end of this quarter. I think this is very good news for anyone concerned about the company’s ability to stay in business as an independent entity.

Other Metrics and Goals

One goal that the company has not met is selling their manufacturing facility known as Peloton Output Park (POP), which they had planned to build in Northwest Ohio. The goal was to have that sold by the end of 2022. They have delayed that by 6 months, and stated that it’s a goal not a guarantee. Liz Coddington, Chief Financial Officer, said, “we just have to find the right buyer.”[7]

While it’s important to get this off the company’s books, it’s also important to not to sell it for substantially less than it’s worth. Hopefully, management will do a good job of balancing those two goals, which could potentially be at odds with each other. This will continue to be a drag on performance, but continuing improvement in other areas should help offset this.

On that last point, Barry McCarthy did say that the ongoing inventory reduction will continue to be a tailwind into fiscal year 2024.[8] Since the restructuring began, PTON has reduced gross inventory by $580 million. That does not include inventory reserves. Over that same period, they have also reduced annualized expenses by $830 million.[9] While this part of the restructuring is not fully completed, it is getting close. I think it’s safe to say that, barring a dramatic change in the environment, or at the company, they will have successfully completed the restructuring by the end of June.

Return to Growth

It’s great that management appears to have successfully guided the company through a very difficult period. However, for the company to be successful over the longer term, they must have a sustainable growth strategy. This is something that they are committing more resources to as the turnaround progresses. It’s no secret that Barry McCarthy is focusing the company on growing subscription revenue, not hardware revenue. Having said that, the fact that they released the rower this past fall under his watch, makes it clear that they do not intend to exit the hardware business.

Instead, I think they view it as one of several channels for acquiring and keeping new subscribers. They have added a refurbished bike program and a rental program. The latter is referred to as fitness as a service (FaaS), and now has about 28,000 subscribers. It’s still small, but its growing fast. Interestingly, management said that business doesn’t exhibit the same seasonality as hardware sales.[10] Specifically, equipment sales are strong in the 4^th and 1^st calendar quarters, and much softer in the 2^nd and 3^rd calendar quarters, whereas FaaS seems to be more steady.[11] I think it probably makes sense if you think about it. During the holiday season, to the extent folks are gifting Peloton equipment either to themselves or someone else, they are more likely to do so with a purchase rather than a rental.

Market Reaction to Recent News

The stock seems to have reacted quite positively after the earnings were released. In most cases, I think it’s a bit of a fool’s game to try to attribute specific news to the price action of a stock on any single day. I have never forgotten something I heard a wise and more experienced colleague say early in my career in the investment industry. When asked by a portfolio manager why a particular stock was up that day, his response was, “because there are more buyers than sellers.” While that may sound a bit flippant, at its most basic level it couldn’t be more accurate. On any given day, there could be a very wide range of reasons that someone is buying or selling a stock. It could be based on a fundamental judgement about the company, and it could have absolutely nothing to do with that.

Merger & Acquisition Rumors

That was all a long-winded caveat before offering my thoughts on the following. It seems there were two pieces of news floating around after the company released earnings. One was the resurrected rumor that Nike or Amazon, or some other large company was going to acquire Peloton. While that is certainly possible, I think it is highly unlikely anytime soon. I wrote a lot about this a year ago, including the dual class share structure. Since my view hasn’t changed, you can read about it in one of my previous reviews here: Ponderings on the Latest News from Peloton. Some of the numbers that I cited in that report a year ago have changed, but not enough to alter my conclusion. John Foley’s voting power is down to about 34%, but combined with other likely allies it’s still well over 50%. That information is current as of last October, when the most recent proxy statement was released.

Quarterly Results

The other news was that the company had done better than expected for the quarter on most major metrics like subscribers, revenue, etc.[12] While this is true, I think it should be viewed more cautiously. The company stopped giving most of the guidance it used to provide before the restructuring began. In my view, the guidance they are giving is being done very carefully. That means they are trying hard not to overpromise. As a result, and by its nature, that means they are setting the bar low. It’s certainly good that they are meeting or exceeding those expectations, but it’s probably not as positive as the market reaction may imply.

A major reason why management is not giving out much guidance is because they have been transforming the business model for the past year and that is still in process. At the moment, that means management has much less ability to know how they will perform in a given quarter. In fact, Barry McCarthy was specifically asked about how well management was able to project future results. His response was, “[our] ability to forecast is still evolving,” and he went on to add that, [we] don’t quite have our arms around consumer behavior.”[13]

Future Growth

I think the bottom line is that the company has done a commendable job of restructuring, and the end is in sight for that phase of the turnaround. It’s now time for the company to focus on a return to growth. As noted above, they are already working on this, and they will continue to do so. For the near term, I suspect the area to watch is the digital app.

In referring to the app, Barry McCarthy said, that it’s the “path to the promised land.” It’s no secret that management intends to use it differently than it’s been used in the past. They’ve already mentioned a tiered pricing structure for the app, which is coming soon. Barry McCarthy said on the call that the end goal with the app is to expand the TAM. TAM stands for total addressable market, and just means the total number of potential customers. Given his previously stated goal of getting to 100 million users, it’s clear that they need to grow the TAM to have any chance of meeting that ambitious goal.[14]

Conclusion

Since the company began its restructuring efforts a year ago, they have been progressing at a steady, incremental pace that matches what they promised to deliver. A year ago, I said that I was optimistic that they would be successful in large part because of Barry McCarthy’s track record at Netflix and Spotify. However, I also said that the company was at the point where they would have to prove it with solid execution. To date, they have done that and, as a result, my confidence has increased, and my outlook for the company has become more positive.

As mentioned earlier, they are now entering the next phase of this turnaround – a return to growth. During the restructuring phase, their survival depended on showing solid improvement each quarter. A major misstep, that used up too much cash, during that period could have meant the end for the company, at least as an independent entity.

As they enter this next phase, and become FCF breakeven and eventually FCF positive, there won’t be a guillotine hanging over the company any longer. This is not to say that management has stopped addressing the company’s problems with urgency. I think the best analogy is that over the past year every step needed to be forward. As they move into the return to growth phase, I think it may more reasonably be two steps forward and one step back, as some initiatives may be highly successful, and others may not.

Nonetheless, I continue to have an increasingly more optimistic outlook for the company, as management continues to deliver on the goals they have set forth. I want to conclude by underscoring again that this is not a stock recommendation. The fact that I have a positive outlook for the company does not speak to my view of the stock. A key missing component is what the stock is actually worth at any given time. I am deliberately omitting any views I may have about that, expressly because this is not a report that should be used to make investment decisions.

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