Joe Raedle
I did an initial-interest post about Peloton (NASDAQ:PTON) back in June of 2020. In that article, I discussed the compelling unit economics of their subscription division but decided that the company’s share price was far too high to justify an investment. The stock is down 87% since my article, due to deterioration in the hardware division and poor investor sentiment. The subscription division, however, is stronger than ever. PTON now boasts nearly 3mm connected fitness subscribers and is generating 67% gross margins on subscription revenue. Churn remains low and customer satisfaction remains high. PTON’s new management clearly recognizes the value of their subscription services and is making digital content a priority. The subscription division is a high margin, low cap-ex business that can steadily generate $1b a year in gross profit, but its strong performance has been overshadowed by SG&A bloat and losses from equipment sales. I believe management can use their digital content as a base for a successful turnaround.
Revisiting Peloton’s Business Segments
PTON is most known for its stationary bikes and treadmills; equipment sales accounted for 61% of revenue in fiscal year 2022 (which ended in June). However, the hardware sales division has underwhelming margins, is susceptible to supply chain difficulties, and is sensitive to inflationary pressure. The division had gross margins of 29% in 2021 and negative 11% gross margins in 2022. The particularly bad margins of 2022 were mostly due to over-producing inventory that the company won’t be able to sell above its production cost.
Equipment sale margins aren’t high enough to justify PTON’s operating expenses, which soared in both 2021 and 2022. PTON had operating expenses of nearly $3.5b in 2022, compared to revenue of $3.6b for the year. The caveat here is $1b of the expenses were due to asset impairments and restructuring expenses that are temporary. Management expects restructuring efforts to save $800mm annually by 2024 (source), but it remains to be seen what the total cost of the restructuring will be and what margins will look like when the restructure is complete.
PTON’s bright spot is its subscription business. Customers who own one of the company’s products have the option to sign up for a $44/month subscription service that streams interactive workouts and integrates with the bike/treadmill hardware. Those who do not own a piece of PTON hardware can sign up for a $19/month subscription that allows them to stream live classes and view previous classes on demand. PTON had just under 3mm connected fitness subscriptions as of June and generated ~$1b in gross profit for FY 2022. Gross margins are a robust 67% and have been growing (gross margin was 57% in 2021). Improving margins make sense, as most of the subscription’s expenses are relatively fixed. PTON has to pay their instructors, record/stream the workout sessions, license the music used in their workouts, and pay their film editors and producers, but once the content has been created there is limited extra cost in broadcasting it to additional customers. PTON’s subscription service is popular, with churn averaging <1% for FY 2022, which in theory means that marketing and advertising expenses could be kept to a minimum if PTON wanted to pivot away from growth to focus more on profitability.
PTON is Going Through a Restructuring
PTON has a low-margin hardware division that is losing money paired with a high-margin subscription division that is growing and robust. After some dilution and debt financing, PTON had $1.2b in cash at the end of fiscal 2022 and $1.6b in total debt. Roughly $1b of that debt is in 0% convertible notes that come due in 2026, and the rest is a term loan due in 2027 that carries an interest rate of SOFR +6.5%. The effective interest rate on the term loan was 10.2% in fiscal 2022. This is the base from which management is working to execute a turnaround.
I think PTON has found the right CEO for the job in Barry McCarthy. McCarthy joined the company earlier this year and has a history of working with content companies, most notably as the CFO of Netflix (NFLX) and Spotify (SPOT). He has put a heavy emphasis on PTON’s strength being its content and is prioritizing this side of business. The following quote is from his first conference call as CEO:
” We need to be good at hardware, but being good at hardware is not nearly sufficient. The thing that makes us special, that accounts for the low churn rate that drives the outrageously high Net Promoter Scores is all the magic that Jen Cotter and her team and our instructors who’s into the service, and we need to be absolutely great at that.” (source)
So far, the McCarthy-led management team has announced and begun to implement a sweeping restructuring plan to reduce focus on hardware manufacturing and increase the focus on content. The plan calls for closing all company-owned manufacturing plants, closing distribution centers, reducing the number of physical showrooms, and laying off over 1000 employees worldwide. PTON is going to rely more on 3rd-party logistics companies to transport hardware to customers and is outsourcing manufacturing entirely to their Taiwanese partner, Rexon Industrial Corp. McCarthy has been clear that PTON will be reducing the price of their hardware to work through their inventory backlog and increase unit sales. The plan seems to be that lower margins and profit from hardware sales can be made up over time with more connected fitness subscriptions, a sentiment I generally agree with. There haven’t been many changes yet on the content side, other than the soft-launch of a new strength-training focused subscription service, called Guide.
Though PTON still has a long way to go to complete their restructuring, I think the plan is feasible and has a reasonable chance of success. I like that management has identified PTON’s core strength (its content) and isn’t afraid to make deep cuts in other areas to better play to their strengths. A content-focused company will end up being a smaller company than one focused on both hardware and content, but I would be happy to see PTON sacrifice total revenue potential to focus on their much more profitable and cheaply-scalable content business.
PTON’s Valuation is Fair But Not Overly Appealing
Valuing PTON in a time of company transition is difficult and will rely heavily on estimates and assumptions. Right out of the gate I’m going to make what might be a controversial statement and say that I think the hardware side of the business is virtually worthless as a standalone business. Despite strong brand recognition and high customer satisfaction with the product, I haven’t seen evidence that the gross margins from their hardware sales are enough to outweigh the SG&A costs associated with running a hardware-centric business. The division has value in that it is a vehicle to drive connected fitness subscriptions, but if PTON was a pure-play hardware company with no subscription service I wouldn’t be interested in owning that business at almost any price. Management’s shift to lower hardware prices in order to drive unit sales backs up this thesis; the hardware is a loss-leader to drive subscriptions.
The subscription division generated $1.4b in revenue in FY 2022, with gross margin of 67% leading to ~$1b in gross profit. PTON doesn’t break down SG&A expenses between the two divisions, so I took two rough approaches to making these estimates and they came out pretty close to one another. First, I looked at a blended average of operating margins across some relevant companies in the entertainment and broadcasting industries, which would suggest an operating margin somewhere around 15-18%. A conservative 15% operating margin would result in $210mm of operating income. Alternatively, hardware sales currently make up about 66% of PTON’s revenue, so if we assume that the hardware sales make up 66% of current SG&A then the remaining 34% of SG&A can be attributed to the subscription business. 34% of current SG&A comes out to roughly $800mm, resulting in estimated subscription operating income of $200mm.
I will conservatively assume that the subscription stand-alone business still needs to service PTON’s debt (about $43mm annually) and that the division would need to pay a blended tax rate of 25% on their income. This results in net income of ~$120mm. From here you can pick an earnings multiple that feels appropriate. If we are assuming that the hardware business doesn’t exist, then subscriber growth is likely to remain flat (the small amount of churn being offset by some growth in non-hardware-owning subscriptions) and I wouldn’t put more than a 10 or 15 PE multiple on net income. This would put the value of the division somewhere between $1.2b and $1.8b. If we assume that the hardware division still exists to drive subscriber growth, a PE of 20 to 25 feels more appropriate for a market cap between $2.4b and $3b. At the time of this writing PTON’s market cap is $2.45b, which is fairly priced if you use my assumptions and estimates.
I admit that this assessment is conservative and doesn’t take into account potential profitability from hardware sales, nor does it give any credit to PTON’s nascent merchandising and accessories business. I always prefer to be conservative in my estimates to build in an additional margin of safety to my results.
Risks
First and foremost, turnarounds are difficult and success is not guaranteed. PTON has already incurred about $1b of restructuring and impairment charges, and without any history of profitability it is difficult to say if PTON can reach profitability even if the turnaround is successful. As described above, I think a sustained focus on the subscription division will bear fruit, but PTON is still be in “prove it” mode when it comes to profitability. An uncertain macroeconomic environment is not going to make the turnaround any easier, and it is worth noting that PTON is in the middle of a recall affecting their Tread+ product line. PTON’s debt doesn’t come due for another 4-5 years and the company has a comfortable cash cushion for now, but PTON burned over $2b in cash operating the business in fiscal 2022. I expect that number to improve dramatically in 2023 without restructuring cash charges and with lower operating expenses, but companies that burn cash are inherently more risky than those that don’t. Finally, as noted in the valuation section, I don’t think PTON is trading cheaply enough to provide much of a margin of safety to investors, despite an over 90% drop from its peak share price.
Conclusion
Despite a nearly 90% drop in share price since my last article, I’m not yet comfortable saying that PTON is a buy at its current share price. I think the company’s turnaround is being built on a solid foundation and has a decent chance of being successful, but there is still tangible downside risk and limited upside potential (absent a return to investor euphoria).
Be the first to comment