Peloton – Spring cleaned

Barry completes the clean-out.

• Barry McCarthy has completed the clean-out of Peloton meaning that the turnaround can begin in earnest but this remains a risky proposition and there are plenty of other options out there arguably with a better risk/reward trade-off.
• Peloton has announced that the two founders Hisao Kushi and John Foley are leaving the company they created but also arguably after they ran it into the ground.
• This is one of the key risks with founders as when things go wrong, they are often emotionally attached to their creations and are unable to make the hard choices that are required to rectify the situation.
• Jon Foley is famous for refusing to see that the pandemic-related revenue growth was temporary which is pretty much what led to the company being in its current predicament.
• John Foley is being replaced as chairman with existing board member Karen Boone who was previously CFO and CAO of luxury furniture seller, Restoration Hardware.
• This substantially completes the clean-up that began when Barry McCarthy was hired as the new CEO, and so all attention now needs to go to the outlook for a turnaround.
• Peloton will no longer be a hardware company as this has now been completely outsourced with the fitness equipment being made available on Amazon where it will be self-installed.
• Consequently, when the negative cash flow that surrounds this shift has been completed (H2 2023 planned), the focus can turn to the subscription business which is where all the value of this company lies.
• This is something I have argued pretty much since the IPO and given Barry McCarthy’s history at Netflix and then Spotify it was obvious that this is where the company is going to go.
• Hence, the discussion to be had is what is the subscription business worth, and can it return to growth.
• Peloton now has around 3m so far very loyal subscribers who are paying $44 per month giving annualised revenues of $1.56bn.
• With a 70% gross margin and 10% OPEX, this would yield around $937m in EBIT and around $750m in free cash flow after tax.
• At a steady state with no growth and a discount rate of 10%, this is worth $7.5bn in today’s money which rises to $15bn if growth of 5% can be achieved.
• However, Mr McCarthy thinks he can grow this to 100m subscribers meaning that there is a great deal of upside if he makes only a tiny dent in this target.
• The downside depends entirely on customer churn, and should users suddenly decide they don’t like the new company, they could evaporate as quickly as they materialised.
• Frankly, I think this risk is pretty low as Peloton has pulled out all of the stops to keep this alive and there has been no meaningful sign of an increase in churn despite the recent price increases.
• Furthermore, should things not go very well, and the company stagnates, it could make a good acquisition for one of the big digital ecosystems looking to expand its coverage into fitness and wellness.
• Apple is an obvious one, but I could also see a scenario where Google or even Amazon buys it.
• Hence, I think the downside risk is reasonably limited and with no growth in subscribers, I can price the shares at $23 on a DCF basis with an 8% cost of capital.
• This looks attractive but there are plenty of other propositions to think about.
• The Peloton question begins with if but the question for nuclear power and Uranium begins with when which is a much higher quality question.
• Furthermore, there are a number of SPACs which have been hammered for no other reason than that they are SPACs and over time they could offer 300-400% upside.
• Against this backdrop, 100% upside looks much less attractive for the risk being assumed, but I suspect that acquisition is the worst-case scenario.
• Hence, I am considering whether to allocate capital to Peloton or simply increase the positions I already have which have not done much other than bounce around the bottom since I bought them.