Peloton – The inexorable erosion.

Peloton postpones the inevitable.

• Peloton reported excellent FQ1 2020 results as new lockdowns have triggered another surge in buying but this company is still mostly driven by hardware, and as a result, the valuation remains very stretched.
• FQ1 2020 revenues / Net income were $757.9m / $69.3m which was above expectations of $734.2m / $36.0m.
• Critically, Peloton is now in the black and also managed to generate a significant amount of cash from operations thanks to its negative working capital business model and customer deposits.
• Peloton earns revenue both by selling exercise equipment as well as the exercise content that users access when they are exercising.
• Peloton is increasingly falling into the BlackBerry trap which means that it becomes so dependent on hardware for revenue that the hardware ends up defining the brand of the company.
• This is a very dangerous position because the product that it sells is open to substantial competition which is why we are already seeing the profitability of this business line erode.
• Connected Fitness (gym equipment) increased revenues substantially by growing 232% to $601.4m or 79% of revenues.
• This was largely driven by the spike in COVID-19 cases and the extra demand has caught Peloton off guard causing execution issues in terms of delivering new units as wait times are now as much as 10 weeks.
• Subscription grew by 133% to $156.5m and made up 21% of revenues with 1.33m subscribers each paying around $39 a month.
• The idea is that the hardware leads the way for subscription revenue which should take over once the market is seeded meaning that outlook for subscription remains very good.
• However, Peloton remains driven almost entirely by hardware and a lot of the very high valuation hangs on this continuing.
• Gross margins remained strong with Subscription improving 1% point to 64% while Connected Fitness declined 2.5% points to 39.4%.
• Weakness in gross margins at Connected Fitness was the result of a price cut of $350 or 16% of the original Peloton Bike.
• This is a worrying trend and prices will continue to decline given the increasing competition, but Peloton is fighting this trend as hard as it can.
• The result was the introduction of the Bike+ which costs $2,495 and has a 24” rotating screen (Bike has 22”), upgrades to the audio system and integration into Apple GymKit.
• This is a very clever move as all the new features are going into the more expensive product which can also be used as a monitor for the other classes given that it can rotate to face away from the Bike+.
• This ensures that new users who want the best will go for Bike+ and this has worked beyond Peloton’s expectations resulting in the delivery issues observed.
• This should allow Peloton to keep hardware prices and gross margins elevated for longer, but the competition is going to follow.
• The elements that make Bike+ more expensive are not really patentable and the weakness in Peloton’s long-term model is that hardware revenues will slow and commoditize as market penetration and competition increases.
• This is inevitable but Peloton is doing a good job at making this erosion as slow as possible.
• Hence, the long-term story on this company is still the subscription revenue.
• One is able to subscribe to Peloton content without buying the hardware so the Apple trick of charging a high price for hardware in order to get access to the software and content won’t work here.
• It is with this outlook that I consider the valuation of the company and, as usual with pandemic-related technology companies, it is all about fluff and momentum and not about fundamentals.
• Peloton’s valuation is currently around $35bn putting the shares on 145x 2021 EV/EBIT which is high, to say the least.
• Sooner or later the pandemic will end and a good portion of demand will fall away as other activities compete for users’ time meaning that it will be up to Peloton to maintain the engagement of its users.
• I think the blue-sky scenario is already priced into this company and given the hardware gross margin risks, I continue to avoid it.