Peloton – Backwards pedalling.

Peloton should be moving out of hardware.

• Peloton’s move deeper into hardware will benefit the company in the short term, but as the value in this sector moves into software and the content, hardware manufacturing will rapidly become a liability that will likely crash the company’s valuation.
• Peloton has announced that it will invest $400m in the construction of a factory in Ohio, USA to manufacture its fitness equipment beginning in 2023.
• The idea here is to cut down lead times, reduce geopolitical risks and allow Peloton to expand its service more widely across the world.
• While this is great for Ohio as it will create 2,000 jobs, I think that it is exactly the wrong strategy and that Peloton should be doing the opposite.
• The reason is simple: Peloton is not Apple.
• The difference between the two is that Apple does not make its user experience available on 3^rd party hardware, but Peloton does.
• This means that if a user wants to use the service, he does not have to pay a high price for the hardware but can instead use something else.
• This is the secret of the iPhone’s 50%+ gross margin because, without exclusive access to the iOS ecosystem, RFM has estimated that iPhone’s gross margin would be around 20%.
• Unless the Peloton user experience is exclusive to its fitness equipment, the high margins that it has enjoyed to date will continue to come under relentless pressure.
• Hence, Connected Fitness gross margin will continue to decline until it is not far from break-even or even loss-making.
• This can already be seen in Peloton’s FQ3 2021 results that were released on 6^th May 2021.
• Connected Fitness posted revenue growth of 140% YoY but its gross profit grew by just 54% YoY as margins fell by 15.9% points to 28.4% from 44.3% in FQ3 2020.
• This was due to Peloton making investments to expedite shipping from its factories in Asia where lead time has been a major problem but also due to price cuts and a mix shift to treadmills.
• Peloton (and the market) are obviously expecting margins to begin rising again once this difficult period is passed, but I think that the opposite is true.
• Fitness equipment does not have high barriers to entry meaning that hardware without an exclusive service attached to it will see its margins erode as others come in to compete.
• This is already well underway.
• If Peloton wants margins on its hardware to rise, it must restrict access to its service to the hardware that it makes because that is the only way that its premium price can be supported in the long term.
• The alternative is to stop making hardware altogether and instead focus on spreading its service as widely as it possibly can.
• It still has the best service and the more users it has, the more of the best fitness instructors it will be able to attract.
• This will improve the service further, accelerate its growth and support a premium subscription price in the longer term.
• The problem of course is that if Peloton were to abandon hardware now, its revenues would fall by around 85% which would take the valuation of the company with it.
• In the long run, Peloton needs to choose one of these two options, but I suspect that it will dither and prevaricate not wanting to further dent its already tarnished valuation.
• This will eventually lead to a crisis where the company has a horrible profit warning and the shares crash.
• It is at this point that management will find itself backed into a corner and will be forced to choose one of these two options.
• I suspect that by that time, its hardware margins will have already eroded and so it will abandon hardware and go for software.
• BlackBerry has shown that abandoning hardware and doing software can work, albeit at a much lower overall valuation.
• Looking at the share price of BlackBerry over the last 20 years leads me to think that Peloton is now where BlackBerry was in late 2008 / early 2009.
• Hence, I would not want to be holding this when the business model begins to fail and management is forced into a corner.
• I would sell it now and maybe look to pick it up once the storm has passed and the hard choices have been made.