Peloton: A Battleground Stock Nearing A Crucial Moment

Seeking Alpha2021-10-18

Summary PTON surprised with poor guidance for FQ1 while keeping full year guidance high, reflecting what would be a string of very high growth quarters. Multiple outlets for growth exist - a unique ...

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Sporepuppy
2021-10-18
Sporepuppy
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2021-10-18
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HappySheep
2021-10-18
HappySheep
[Cool]
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The company surprised with a wider than expected loss last quarter while simultaneously dropping its FQ1 guidance by 20% to $800 million and marking full-year revenues at $5.4 billion, reflecting what the connected fitness manufacturer is expecting to be a strong end to the year, offsetting revenue weakness early on from lowered Bike pricing. The company has faced its share of challenges of the course of the past year, but is still looking ahead towards more growth in revenues and subscribers, although increased losses and other headwinds are on watch.\nMoving Along With Growth\nOne of Peloton's biggest challenges through the pandemic has been meeting demand, with the company seeing significant backlogs and delays - this had served as a headwind to growth, with supply chain inefficiencies limiting shipments and order-to-delivery times and ultimately revenues. The company noted that it has restored order-to-delivery times to pre-pandemic levels, with large investments in its supply chain paying off on that front. Peloton is moving forward with plans for its first US factory, with the investment allowing the company to \"diversify [its] manufacturing footprint, provide additional capacity to support [its] growth, drive production efficiencies through automation and scale, and accelerate [its] speed-to-market.\" Production is expected to begin in 2023.\nBoosting manufacturing capacity can help drive hardware unit sales, demand contingent, which in turn can boost subscriber numbers, where Peloton is seeing strong growth. Connected fitness subscribers rose 114% y/y, with guidance pointing to ~86% y/y growth for FQ1, and digital subscribers rose 176% y/y to 874K, with rising free-trial volumes and improving conversion rates. What's key for Peloton is keeping high growth rates in subscribers and high engagement, two important metrics for sustainability of a subscription-plus-hardware model.\nPeloton recently made an interesting move that could boost members and help engagement trends. The company announced a tie up with UnitedHealth (UNH), offering members a free Peloton digital subscription ($155 value), and for members who already have a Peloton and/or digital subscription, that value can be applied as a credit.\nIt's enhancing the value proposition for both companies - insurance members get an added perk that they do or do not have to use, while Peloton gets exposure to millions of new potential customers that it could possibly upsell to. While these customers aren't paying directly for the service, rather receiving it through an insurance plan, it provides a massive base to which Peloton could acquire customers at little to no cost.\nThe benefits to Peloton could be quite large if it leads to ~1% of UNH's ~50 million covered members becoming interested in the company's products, or ~0.05% actually buying a Peloton product - that could be around $50 million in revenues at the 0.05% figure. While it's purely an estimate, the lack of expenses to tap into such a large customer base and activate new digital subscribers provides a large opportunity.\nGraphic from Peloton\nSome of Peloton's key metrics shown above reflect the trends in engagement and growth - revenues dipped q/q for the first time, alongside a dip in workouts, while subscriber number and revenue growth continued. Peloton pointed the finger at seasonal trends, improving weather and consumer mobility - the bigger question raised here is that demand is simply weakening that home fitness is a fad - the biggest questions surrounding the bear case.\nWhile quarterly and average workouts dipped, engagement trends are still solid, with workout diversification improving. Cycling workouts remain the majority, just under 60%, but new categories are growing quickly, with Peloton noting that \"Connected Fitness Strength workouts grew 256% year-on-year and now represent 18% of the total mix, up from 13% in fiscal 2020.\" Gains in strength, floor and yoga reinforce the proposition that Peloton provides unique value to its users and keeps them engaged across multiple different workout disciplines.\nWhile Peloton has been labeled as another fitness fad, it's showing improving workout mix across all disciplines, pointing to strength in engagement aided by over 90% 12-month retention. The first two quarters of the current fiscal year will provide more clarity and insight into workouts and average workout statistics, and to how engagement is evolving.\nGraphic from Peloton\nOther catalysts include Precor's acquisition aiding growth outlets in commercial streams, such as hotels, additional hardware/machines, and international expansion. Commercial outlets could unlock bulk orders of Peloton's machines, while unveiling new hardware products like a rower can spur demand with existing customers and other interested customers. International expansion could be one of the largest long-term drivers, with the geographic segment barely contributing 11% of revenues, with penetration much lower than the domestic market. The UK and rest of Europe provide compelling growth outlets over the next few years for both hardware and subscribers.\nRunning Towards Trouble\nAlthough Peloton is making strides with growth and pushing forward with subscription revenues (to 30% in Q4 while FY totaled 21.7%, up from 19.9% the prior year), the company is facing some margin pressures and a weakening balance sheet as it works to boost growth.\nThe prior quarter saw the Connected Fitness segment suffer a sharp gross margin decline, by 33.7 percentage points to 11.6% - Peloton attributed this to Tread recalls, increased logistics expenses, and lower pricing mix. Peloton recently released the all new Tread, and announced a $400 price cut on the Bike to \"maximize the number of Peloton Bikes, Treads, and future products in households.\" However, this move is likely another hard headwind for margins to deal with, given that pricing has already proven to be detrimental to margins.\nLogistics expenses again are likely to cut into margins, as global shipping rates have only just started to fall after spiking and remaining quite high during Peloton's fiscal quarter. Container shortages and port congestion have hurt numerous retailers, and Peloton's manufacturing concentration in Taiwan exposes it to those heightened shipping costs.Rates soaring to far over $10,000 for cross-Pacific routes are likely to have a big impact on Peloton's revenues as ~90% stem from North America.\nIn addition, Peloton is seeing large cash outflows, about $600 million in Q4. The company is stepping up investments to build out capacity, but at a time when revenues are facing a bit of a crunch sequentially and as margins are taking a large hit. FQ1 is projected to post approximately $285 million negative EBITDA, and likely another substantial cash outflow. Adjusted EBITDA profitability is expected to come by FY23, with the gap narrowing with a strong 2H '22 driven by Bike demand.\nOther issues arise within Peloton's guidance - while it's guiding some strong take rates for the Bike and new Tread, is that guidance achievable? For FQ1, guidance sits at $800 million, while for the full year, guidance sits at $5.4 billion; this is projecting q/q growth rates nearly on par with the heart of the pandemic, over 30%, for three straight quarters. The main question here - will volumes be able to offset price cuts, and will subscription and apparel revenue be enough to meet guidance? Peloton has a lot to prove through Q1 and the end of the year, leaving itself a tough mountain to climb to reach these lofty goals.\nPeloton has come under fire from requiring users to have a paying All-Access membership to use the Bike or Tread, as users simply are not able to run or bike without paying that $39/mo fee. Equipment pricing is already at the higher end of the industry average, and while pricing is decreasing, the extra monthly subscription adds up quickly.\nThe commercial growth story does raise additional questions. Peloton has built its model by creating a unique user experience, and to translate an individual user experience to a commercial setting could be difficult. The payoff to a commercial enterprise, for example a hotel, could be limited due to usage - how often are those gyms frequented, how long are workouts, what type of travelers frequent the gym, etc - is it worth the cost to pick Peloton over a cheaper alternative, and what exactly would those enterprises gain? Peloton has been decreasing prices to make products more available for everyone, but it does not provide a drastically compelling value proposition to back up that price point for commercial use.\nA Battleground\nPeloton offers numerous reasons for both bulls and bears to set up camp, with the stock quickly becoming a battleground as growth and struggles come to a head. Large cash outflows, questionably strong guidance and execution risk, logistics expenses, margin pressures, sequentially weak revenues, ability to continue rapidly growing subscribers, holes in the commercial growth outlook, and competitive forces (such as that from Nautilus (NLS), Apple (AAPL), Amazon (AMZN), Fitbit(NASDAQ:GOOG)(GOOGL) and more) offer multiple compelling reasons to see extra downside to a valuation just under 5x FY22's projected sales.\nOn the other hand, Peloton could still be in the early innings of gaining ground in connected fitness - the company can push out more products, more workout disciplines, a health and wellness segment, or find growth in commercial areas, tremendous opportunities internationally, and strong recurring high-margin subscription revenues. If Peloton can reach annual guidance, it's setting itself up for high rates of successive growth, which can help prove that the pandemic was not a one-time surge, and the model is here to stay.\nOverall, the company is at the beginning of a very important year, with high targets that would lessen fears of dissipating growth, and multiple headwinds that could in fact limit such growth. 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