"Peloton stock" has been one of the key trending searches lately. It has continued to be a favoured stock by investors, as a result of the lockdown.
The in-flows into stay-at-home stocks continue to be strong, showing no signs of retreating in the near-term.
Despite being cash flow negative for at least the next two years, Peloton stock price has far outperformed the market. Why is that? Is the market assuming a permanent change in how we exercise? Or that a lockdown will be temporary permanent?
In this article, we dig deep to understand Peloton’s operating model, how they make money, will they ever make a profit and where do we stand on investing in Peloton stock today.
Peloton: The only stationary bike that goes somewhere
Founded in 2012, Peloton is more than just a mounted bike with an iPad attached. According to its IPO prospectus, Peloton is a “technology, media, software, product, experience, fitness, design, retail, apparels and logistics” company. Full coverage is needed, just in case we missed anything.
And no, I’m not making this up. See Peloton's IPO prospectus below.
How does Peloton generate revenue?
The fundamental goal of Peloton is to revolutionise fitness, with Peloton Bike being its leading product.
Peloton sells bikes/treadmills (“Connected fitness products”) and charge a subscription-based fee (“Subscription revenue”) for its on-demand/live workout classes. In addition, it also offers apparels and digital app subscriptions (“Other revenue”) for home workout classes.
Peloton's cost structure
Now we know how they generate revenue, what about the cost? It’s no surprise that Peloton Bike is the single largest revenue generator today. For this reason, this is also where majority of its costs are.
As a relatively young company, most would argue that brand awareness is a concept worth investing in. Consequently, Peloton employs social media ads/commercials and operates retails stores in premium malls as part of its marketing toolkit.
While this is common for start-ups/concept companies, this is also the key reason why the company isn’t cash flow positive today. We’ll discuss about this in more details below.
Common for start-ups, the blueprint is to first spend aggressively on growth. Once it reaches critical mass, then it’s time to reduce marketing expenses and pray very hard that revenue will remain intact/even growing. Voila, profit! That's certainly the consensus of Uber's strategy, which has so far not come to fruition.
So that’s basically Peloton in a nutshell – now for the really interesting stuff on whether we should be investing in Peloton stock (or its bike).
Market competition for fitness bikes
Peloton's success so far did not come without competition. Here’s a table of Peloton’s competitors and what they offer. We exclude Flywheel as they no longer offer bikes for legal reasons.
Optically, Peloton's pricing is in-line with those of its competitors, both its fitness product and susbcriptions.
One of key moat/selling point of Peloton is its intellectual property (IP). One of Peloton’s patent, which was filed and granted in 2016, remains the key to its business model. In short, the patent prevents other from copying its “invention” of displaying live info/stats about cycling classes on a stationary bike
Here’s the full text:
“A method for displaying live and archived cycling classes comprising displaying information about cycling classes that can be accessed by a first user using a first stationary bike via a digital communication network on a display screen at a first location, whereby the first user can select either a live cycling class or select among a plurality of archived cycling classes, outputting digital video and audio content comprising the selected cycling class, detecting performance parameters from the first stationary bike at a particular point in the selected class, displaying at least one of the performance parameters on the display screen, and displaying performance parameters from a second stationary bike at a second location on the display screen such that at least one of the performance parameters from the first stationary bike and at least one of the performance parameters from the second stationary bike at the same point in the class are presented for comparison.”
In fact, Flywheel was forced to shut down its virtual classes after losing the lawsuit. Peloton is no stranger to suing its competitors, here’s a list of them
- Oct 2019: Peloton sues Echelon on infringement
- Feb 2020: Peloton won its lawsuit against Flywheel
- Feb 2020: Peloton settles music publishers’ lawsuit
- May 2020: Peloton sues NordicTrack on grounds of patent infringment
In its prospectus, Peloton has claimed that its IP remains to core to succeeding as a company. Peloton’s top notch UX is unrivalled, but there are always ways to redefine a new product from something. The big question before investing in Peloton stock is “Are lawsuits the only way to protect its underlying business in the long run?”
Peloton's business model
Is Peloton’s products viable in the future? We think the answer is yes. Here’s why.
According to a US survey, average Americans spends ~$155/month on their health & fitness. If we factor in 0% financing (as all at-home-bike products are offering at the moment), Peloton’s monthly charge sums up to $97/month (for the first 39 months, $39/month from then on) for unlimited live and on-demand classes. That’s almost 40% cheaper!
Of course, we may not be comparing like-for-like here. With Peloton, you only get the bike and do not have the luxury of any other equipment/facilities that may otherwise be available in your preferred gym. Even so, an average spin classes in the US will set you back ~$35/session, equivalent to 2.8 sessions if you choose this over Peloton. Clearly, there’re savings to be made for frequent spinners!
We believe Peloton will benefit from its large addressable market with significant growth opportunity. In addition, it has a through-the-cycle value chain platform allows it to add value and differentiate itself relative to competitors.
Going forward, we expect Peloton to continue to focus on growth rather than profitability. The strategy of building a sticky customer base may have its setback. However, we believe this is strategically sound, backed with a path to profitability.
Subscribers first, bikes second
Interestingly, the core of the business is to grow subscribers, not selling bikes (although they go hand-in-hand). Given Peloton’s subscribers benefits from its unlimited live and on-demand classes, its costs is fixed, regardless of its users. For this reason, this continues to have the highest margin expansion potential going forward. On the other hand, connected fitness products’ margin are largely dependent on the cost of raw materials and FX, which should remain fairly stable.
Here's a comparison of the latest revenue growth and gross margin of big techs and Peloton.
Can they actually make money?
The most important question of them all: Can Peloton actually make money? Again, yes, in our view. We think Peloton have a palatable proposition in revolutionising the future of fitness. Our pre COVID-19 expectation assumes Peloton will only start making positive cash flow post June 2024. In a way, the pandemic accelerated the process of getting there. Consequently, we now believe there is a path for Peloton to be cash flow positive by June 2023.
Our forecasts are built upon that the company needed to focus on growth which will peak in 2020, leading to a gradual and more normalised operating cost base. The peak in capital expenditure in 2020 is led by further investment and expansion in New York and London.
Here’s a summary of Peloton’s historical financials.
Marketing: Spend it Till you Make It
Spend it till you make it.
Peloton is well-known for its marketing campaign, with well-designed showrooms located in premium shopping malls being one of their initiatives.
In addition, Peloton also leverages on its social media influence. With celebrity devotees like David Beckham and Leo DiCaprio to celebrity trainers, Peloton understands the effectiveness of reaching out to its target audience. With enough followers, one can also achieve celebrity status as a Peloton instructor: Robin Arzon has close to half a million followers on Instagram.
Speaking about instructors, Peloton has actually been draining top-talent from their competitors. Here’s an excerpt from Prof Galloway’s write up on its instructors.
“Accelerant: Peloton attracts premier talent from top fitness studios to exclusively teach within the Peloton ecosystem. These instructors are poached from the likes of Soul Cycle, Equinox, and Barry’s Bootcamp. Peloton pays instructors $500 per class (over 3x that offered by Soul Cycle and 9x Equinox) and awards instructors equity in the business, giving them a vested interest in the firm’s growth. In turn, instructors achieve celebrity status, some building social audiences well over 300,000.”
In our previous article, we highlighted the importance of insider ownership. We estimate the insider ownership of Peloton's senior management team to be ~25%. This includes ~20% in shares and 5-6% in options.
Obviously, given the proportion, senior management's incentives are strongly aligned with those of shareholders'. We would highlight that the diluted share count is key here due to the large amount of vested options.
No great investment thesis should end without a key risks section. We conclude our case by going through these for Peloton.
First, legal issues, in particular, its patent. A black box, we’re unable to quantify the risk should its patent be invalidated because of its broad remit.
Also, should the patent remain in-force, would competitors try and invent new ways to circumvent the precise description of the patent or possibly redefining a whole new niche within this segment?
Secondly, Peloton continues to be perceived as a luxury good. While Peloton may be thriving in big & affluent cities / countries, what about the rest of the world? The monthly 0% refinancing is a step forward, but we have no visibility how well it can scale beyond that, for now.
Lastly, approximately 87% shares are now free from its IPO lock-up period. This means that insiders and early stage investors are now able to publically sell or place shares, in blocks if they choose to do so. While it shouldn’t affect the company in the long run, but given the enormous proportion to its total outstanding shares, we’re expecting some pressure on its stock, nonetheless.
In short, we are bullish Peloton. Balancing its key risk and challenges, we are optimistic that this would be one of the quickest start-up to turn cash flow positive in recent history. Peloton has a world class management team with marketing excellence and a proven track record of managing similar businesses. We’re excited for its growth story, but are cautious of its emerging risks as well.
Now, would we invest at the current price? A difficult one, but will be looking to add on dips.
At the time of writing, we value the company at around $40-44. At today’s price, this implies ~20% above our target price. It’s challenging even for a growth investor to invest in a stock that's already trading at a rich valuation!
We will continue to monitor its developments and looking forward for Peloton to join the ZagInvestor Portfolio.
Finally, to answer the title of the article – we would be investing in both a Peloton Bike 🚲 and its stock.
And with this, we leave you with this quote by Robert Arnott.
“In investing, what is comfortable is rarely profitable.”
Together we go far.