Peloton – Restless natives

Activism compounds a legion of problems. 

• Peloton is now under assault by an activist investor who makes both fair and unfair criticisms of Peloton which make the task of turning the ship around even harder than it already is.
• Blackwells Capital owns less than 5% but updated its presentation (see here) which bemoans the lack of progress and calls for the company to be sold.
• Its criticisms include:
  • First, change: Blackwells highlights that although the new CEO, Barry McCarthy has been in place since February, very little has changed.
  • There has been very little movement in management in the last two months and no real sign of the $800m cost reduction beyond the announced layoffs.
  • To me, this criticism sounds more like a fit of pique on Blackwells’ part.
  • When one is about to embark on a turnaround of this scale, one needs to be absolutely sure what one is going to do and what the long term strategy for recovery is.
  • This is not something a complete novice to the company can really hope to achieve in such a short period of time and I am expecting that there will be major announcements at the company’s Q3 2022 results currently expected on May 5^th.
  • It is at this point I expect the announcements to be made which need to go far beyond the $800m already announced.
  • Second, governance: Peloton like much of its ilk runs roughshod over the interests of minority shareholders as the founders have only 12% economic interest but control the company.
  • This means that minority shareholders are completely at the mercy of the whims of the founders and will bear 88% of the economic suffering despite having no say in how the company is managed.
  • Blackwells is absolutely correct to point this short-coming out and I have criticised this practice for years but it is not as if this was a big secret or was not widely known before Blackwells became a shareholder.
  • If investors do not approve of this practice, then they should not buy the shares.
  • Consequently, while governance is a major issue at this company, Blackwells does not have a leg to stand on in my opinion.
  • I deal with this issue with an extra discount post valuation on a fundamental basis and in this instance, I would add a further 20-30% discount to a fair valuation in order to compensate me for the extra risk of owning a founder controlled business.
  • Third, Barry McCarthy (CEO): Blackwells opines that Barry McCarthy is grossly overpaid (which he may be) and implies that he has only been appointed due to his relationship with the founders.
  • While they may have selected him as a result of knowing him from previous dealings, I think that there is more to this than that.
  • Barry McCarthy was an important executive during Netflix’s formative years and was the CFO of Spotify from 2015 to 2020.
  • Both of these companies’ fortunes were created on subscriptions and looking at where the value of Peloton is, this is very likely to be where Barry McCarthy is going to take the company.
  • Hence, I suspect that he was chosen for this reason primarily with the fact that he was familiar with the founders helping him to get the job.
  • Fourth, cost reduction: $800m does not go nearly far enough as Blackwells correctly points out.
  • If I take $800m off Peloton’s OPEX, it is still losing money and burning cash meaning that it is not a going concern at the current level of revenues.
  • I expect that at the Q3 2022 results, a far wider plan will be announced that will reduce OPEX substantially and move the company almost completely to a subscription-based model.
  • Fifth, sale: Blackwells claims that a sale of the company will derive the most value for investors, but I am not so sure.
  • It will certainly derive some value for investors who have marked their current positions to market but the most upside is almost certainly to be found if the company is turned around (see below).
• As it stands today, the fundamentals of Peloton are more than fully represented in the equity value which is around $8bn with an enterprise value of around $7bn as Peloton still has a lot of cash on its balance sheet.
• If one considers the two parts separately then a different picture emerges.
• As one astute observer pointed out, Peloton has millions of loyal subscribers who pay $39.99 per month for its services and this has a lot of value.
• At 2.7m users, annualised revenues would be $1.3bn in revenues which with 70% gross margins and 10% of sales in OPEX would yield around $0.78bn in free cash flow per year.
• At a steady-state and a discount rate of 10%, this is worth $8bn in today’s money which is roughly where the company is trading today.
• However, Peloton also makes hardware and spends a fortune on sales and marketing which together overwhelm the subscription business resulting in large losses.
• Hence, the recovery story for Peloton is one where hardware runs at break-even on a free cash flow basis and is what supports steady subscriber growth.
• With 5% growth, the present value of the cash flow from the subscriber business is $15.6bn meaning that the shares could double from here.
• However, this assumes that Mr McCarthy can bring the hardware business into line and get the founders to go along with this plan.
• This is a big if and so I am very far away from calling the bottom on this stock.
• I suspect that Mr McCarthy is going to kitchen-sink expectations with one truly horrendous quarter, and it is at that point that sentiment and the fundamentals may bottom.
• The company is also really bad at communicating with the market and its lack of disclosures and updates in terms of what is happening is probably a big factor in causing the natives to get restless.
• It also does little to lift sentiment from its already rock bottom levels.
• I am beginning to see past the current meltdown (thanks to my astute observer) and have added Peloton to my list of stocks that I watch for an opportunity, but I need a lot more convincing before I get involved.