Peloton (NASDAQ: PTON) | Riding The Connected Fitness Upcycle



Key Points

  • Peloton is the leading interactive fitness company in the US with a near-perfect NPS of 94

  • It is founder-led, with almost 10 years of track record

  • Tailwinds from the pandemic restrictions accelerated Peloton’s demand as consumers shift to home-based fitness

  • Revenue has grown significantly, expanding at a CAGR of 104.9% from FY17 to FY20

  • Robust balance sheet with current ratio at 2.7

  • Connected fitness subscription surpassed the 2.0 million mark, which grew 90.7% YoY

  • Strategic acquisition of Precor could alleviate its supply chain issues and help penetrate new markets

  • Tapping on growth levers through new product offerings and geographic expansion

Company Overview

Peloton is one of the largest interactive fitness platforms in the world based on net revenue. The innovative company has managed to bring the immersive, entertaining workout experience from the gyms to the users’ homes. As of 31 March 2021 or 3QFY21 (FY end June), it has over 5.4 million members.


Product line

Peloton’s business model comprises selling its connected fitness equipment (hardware) and its digital app subscription platform (software). The hardware currently includes the Bike, Bike+, Tread and Tread+.


Subscription platform

The subscription platform consists of an All-Access membership and the Digital membership. Members can stream on-demand more than 10 different workout classes such as Cycling, Running and Strength Training on the app.



The All-Access membership (US$39.0 per month) is available to hardware owners. Inside this membership, each household only requires one account, and every family member is able to create their profiles and access the entire library of classes.


As for the Digital membership (US$12.99 per month), users do not require any Peloton hardware. In contrast to the All-Access membership, each membership only allows one profile to be created.



Total addressable market (TAM)

Based on Peloton’s 2020 global total addressable market (TAM) study, it has identified that its TAM was 95 million users for the United States, United Kingdom, Canada and Germany market. The penetration rate of its subscription business was low at 7.0% as of July 2020. However, this number is set to grow as it has announced its expansion plans, which are elaborated in the thesis below.




Revenue breakdown


Peloton’s hardware sales make up the majority of the revenue, accounting for 81.0% of revenue. However, this revenue mix will change progressively as its subscription margins growth has been outpacing its hardware margins growth.



Peloton’s revenues continue to see strong growth due to the tailwind of Covid-19, with 3QFY21 reporting a record high revenue of $1,262.3M representing a YoY growth of 141.0%.



Share price movement


Since its IPO in 2019, Peloton’s share price rose significantly from $27.00 per share to an all-time high of nearly $170.00 per share due to the pandemic-induced heightened demand for Peloton’s home fitness equipment. However, its stock pulled back 17.6% from all-time-high levels in February due to the general market dynamics as growth stocks with high valuations saw multiple contractions across the board. In addition, investors were concerned with the company’s inventory and supply chain issues, fearful that it might hurt profits in the near term.

Management

Peloton is led by its founder, John Foley, alongside its diverse team of directors.


Personally, I like how the founder and the management focus on customer experience and retention, which led them to achieve a high Net Promoter Score (NPS) of 94 and strives toward attaining an NPS of 100.

Industry Overview

With the Covid-19 pandemic outbreak, gym closures were announced worldwide, and fitness enthusiasts were forced to exercise at their homes. As a result, home-based fitness equipment and connected fitness products have seen a spike in demand as users adjust their workout habits to what might be the new norm.


According to Fortune Business Insight, a market research company, the global home fitness equipment market is valued to be at US$10.2 billion in 2020. It is forecasted to reach a market size of US$14.7 billion in 2028, growing at a CAGR of 4.6% from 2021 to 2028.



Its direct competitors offer connected fitness products, and its indirect competitors include traditional gyms and physical fitness classes. According to researchandmarkets.com, the global health and fitness club market revenue is projected to be approximately US$96.6 billion in 2024, growing at a CAGR of 7.70% from 2020 to 2024.


Another market research company, NPD Group, reported that health and fitness equipment in the United States (US) saw a spike in demand, with its revenue increasing by more than two-fold to US$2.3 billion as consumers switch to home workouts.


However, traditional gyms and fitness classes are taking a hit in terms of revenue due to the closure of gyms. In fact, many gyms are closing down for good, and an example of that would be Flywheel (who owned chains of spinning studios and is a top competitor for SoulCycle) filing for bankruptcy in late 2020.

Financial Highlights


Revenue


Since its FY17, Peloton has been witnessing healthy growth with the annual topline expanding from US$218.6 million in FY17 to US$1,825.9 million in FY20, growing at a CAGR of 102.9%.


In 3QFY21, revenue further grew at an impressive 141.0% YoY due to the changing consumer’s preference over the recent years coupled with the pandemic restrictions which further fuelled the demand for high tech home fitness equipment. As gyms were closed, consumers sought alternatives to keep them active. Peloton greatly benefitted from the lockdown measures starting from 4QFY20, growing at more than 100.0% YoY over the subsequent quarters.


Peloton is expected to continue to capitalise on the tailwinds of the pandemic restrictions for the current and following year. In the 3QFY21 earnings call, the management is optimistic that the 4QFY21 bike unit sales will triple that of 4QFY19 and growth will likely persist further in 4QFY21.



Gross Margin


Peloton’s products face seasonal demand, with its gross margins hovering around 40.0% to 45.0%. However, Peloton faced supply chain bottlenecks which drove its gross margins down from 1QFY21 till present. This was primarily impacted by the West Coast port delays in the US that impaired Peloton’s upstream supply, resulting in delays in receiving the hardware from overseas manufacturers and thus slower delivery windows to the consumers. To prevent any customer cancellation, Peloton expedited shipping costs to improve delivery times, clearing off its backlog of orders.


Additionally, there was a price reduction of US$350.0 in their bike products from US$2,245.0 to US$1,895.0 to attract more customers, which also caused the gross margins to dip.


Nonetheless, I believe that the decline in gross margins is temporary as they have since increased their manufacturing capabilities through means such as acquiring Precor (will be elaborated in Thesis 3), as well as plans to build their first US factory in Ohio scheduled to open in 2023.



Liquidity Ratios


Peloton liquidity ratios are relatively sturdy, consistently maintaining higher than the Electronic And Other Electrical Equipment And Components (except computer equipment) industry average since the start of 1QFY20 to present. Initially, Peloton did not efficiently utilise its current assets, as seen by the high liquidity ratios in 1QFY20. Its 1QFY20 liquidity ratios were more than two times the industry average due to holding too much cash, which accounted for 78.7% of its current assets.



As seen in the chart above, its cash ratio (Cash / Current liabilities) as of 1QFY20 was 420.0%, indicating that the company is not maximising the use of its cash. Having a high cash ratio might put the company in a favourable position to meet its short term obligation. Still, too much could result in opportunity costs as the cash is not utilised productively. Subsequently, the company used the excess cash to invest in marketable securities, bringing down the ratios to a reasonable range.



Cash Flow


Peloton’s initial operating cash flows from FY17 to FY19 have been relatively volatile as it was still in the early stages of the business. Though, in 2020, the pandemic accelerated the demand as consumers adopted more home fitness regimes. This resulted in a significant outperformance in the fiscal year, and the company’s FY20 operating cash flow shot up to a peak of US$376.4 million.


In FY21, its operating cash flow has been positive for the first two quarters, with the exception of 3QFY21 being negative, attributable to an increase in inventory levels of US$363.7 million. The reason for this swelling of inventory levels was to ramp up supply to meet the increased demand for hardware. With that said, its operating cash flow as of 3QFY21 is US$353.9 million and is likely to overtake the FY20 performance.


Going forward, the operating cash flow might still be volatile due to the increase in inventory levels to facilitate the overseas expansion plans and to introduce new hardware.

Operational Highlights


Customer retention rate


Peloton’s customer retention rate as of 3QFY21 is at 92%, beating SoulCycle’s rate of 85% and the average fitness studio rate of 75.9%. To give more context: The widely popular consumer electronics company, Apple, NPS is at 68 whereas the world’s largest on-demand streaming platform Netflix’s NPS is at 68 too. Evidently, this signifies that Peloton users love its products and services.



Connected fitness subscription


As of 3QFY12, its connected fitness subscribers surpassed the 2.0 million mark, boasting growth of 90.7% YoY.



User engagement levels

Peloton evaluates user engagement through two key measures: Churn rate and Workouts per Subscriber.



Workouts per Subscriber is an important metric that measures user engagement levels. Peloton asserts that the more the workouts per subscriber, the higher the level of engagement, thus leading to a more robust customer retention rate. In 3QFY21, the average monthly workouts per subscriber hit a new high of 26.0, up 46.9% YoY, signifying strong user engagement.



By virtue of continuous efforts to engage the consumers, churn rates have been kept low and even achieved a new low of 0.3% in 3QFY21.


The sustained low churn rates combined with an increased number of workouts per subscribers indicate that Peloton’s level of engagement is advancing. Therefore, the rise in workouts per subscriber and sustained low churn rates reflects the effectiveness of its engagement strategies.



Efficiency ratios


From FY18 to FY20, Peloton’s cash conversion cycle increased largely owing to the swelling of inventory levels. The increase in inventory levels was attributable to the introduction of new hardware (Bike+ and Treadmill product lines) as well as their expansion into the United Kingdom and Canada. Days payables and days sales outstanding have been steadily maintained within 40.0 ~ 42.0 days and 5.0 ~ 8.0 days respectively.


Even though days inventory outstanding rose to a record high of 83.9 as of the trailing twelve months, Peloton has nullified the inventory bloating by substantially extending its days payables outstanding to 99.0 days, which led to a negative cash conversion cycle of -10.4 days.


Overall, Peloton has managed its working capital effectively in spite of the expansion plans.

Theses


1. Tailwinds from a secular shift towards home fitness

I believe that the shift in consumers’ behaviour toward home fitness is likely to be a long-term secular trend, and as such, it will continue to fuel the demand for Peloton’s hardware and software.


The pandemic has altered the way consumers exercise, forcing consumers to exercise in their homes due to the closure of gyms. This has led to a sharp increase in demand for home gym equipment as consumers adapt to stay-home restrictions. According to a study by Mckinsey, 65.0% of the consumers in the United States who tried digital home fitness machines say they will continue to use them even after the gyms open. This supports the narrative that the home fitness movement is likely to persist post-pandemic.


Moreover, Peloton could serve as a cheaper alternative for fitness enthusiasts who frequent gyms or fitness classes. Peloton has this cost calculator that allows users to compare their gym or fitness classes to Peloton’s monthly bike instalments and subscription costs.



The average costs of spin classes cost around US$175.0 for 10 sessions. Compared to Peloton, its Bike+ monthly instalment costs US$64.0 per month for 39 months, and the subscription costs US$39.0 per month, totalling up to US$103.0 per month. In essence, this represents a cost saving of US$72.0 per month (or US$864.0 per year) and the bike pays for itself after 1 year and 6 months. That said, this cost-saving assumes that the Peloton Bike+ and subscription platform are only being used by an individual, and the cost-saving could be greater if there are other family members using it.


Hence, Peloton is in an advantageous position to benefit from the shifting consumer behaviours and could stay dominant in the home fitness market if it continues to execute well.


2. Sustainable recurring revenue model


a. Network effects achieved through cult-like community

Peloton’s passionate community enables the company to benefit from the network effect, enhancing its recurring revenue model. This strong community was made possible by having a clear vision of putting members first and constantly refining the customer experience.

According to JP Morgan research, Peloton has “pioneered this shift” in the direction of interactive home workouts and has the first-mover advantage. Since its initial launch of the stationary bikes, it has effectively built an online community, which various news outlets often cite as having a cult-like following. The pandemic further boosted this as consumers enjoyed the social aspect of working out with the online community as they are restricted to their own homes.



Furthermore, Peloton has a strong brand moat, scoring an impressive Net Promoter Score (NPS) of 94, outperforming the fitness industry’s average of 74 and SoulCycle’s estimated NPS of 50.



To top it off, Peloton has a strong customer satisfaction of 97%. It is no surprise that the company is ranked second in 2021 for brand relevance by a consultancy firm, Prophet, which specialises in measuring companies brand relevance.


For this reason, Peloton was able to leverage the network effects built on its online community, who effectively promoted the product for free. Hence, with the secular trend of home fitness, this network effect is set to amplify over time, fortifying its stream of recurring revenue.


b. Scalable subscription model and high customer retention rate affirms earnings quality

The sustained low churn rate, increasing level of engagement and rising number of subscribers signify that Peloton has high-quality earnings, with recurring revenue expected to grow annually. The subscription model is highly scalable due to a couple of reasons.


Firstly, a large portion of the subscription cost is fixed. These include studio rental costs, instructor and production-related expenses. Its variable costs consist of content costs, third-party streaming platform costs, payment processing fees and a vast proportion being music royalty fees. Since subscription cost mainly involves fixed cost, its gross subscription margin is expected to climb gradually as Peloton acquires new subscribers.


Secondly, the network effect that was pointed out earlier reinforces its subscription model, strengthening earnings quality.


Lastly, the company has a remarkable track record of maintaining a low churn rate in conjunction with mounting engagement levels. Thus, with the points mentioned above, Peloton has the potential to uphold market share and scale its subscription model over time.


3. Additional revenue streams

I believe that Peloton has more revenue levers to pull in the form of new product offerings and expansion to new markets. With the latest acquisition of Precor, Peloton could benefit from its production capabilities as well as global presence, speeding up its growth plans.


a. New product offerings

Peloton CEO John Foley has announced its plan to launch new hardware in the next fiscal year, sometime between 1 July 2021 and 30 June 2022. Although Peloton did not officially announce the new hardware format, I speculate that they could be working on complementary fitness products aside from cardio machines. CEO John Foley has mentioned that Peloton "(doesn't) just want to be cardio" and have strength training devices and rowing machines on the product roadmap. Besides, they have made forays into wearables and interactive fitness mats via recent acquisitions, which could further bolster their hardware product line-up.


To keep up with the growing demand, the company has announced that it will build its first US factory, the Peloton Output Park. The manufacturing plant will sit over 200 acres and have more than one million square feet of manufacturing, office and amenities space.


Additionally, the acquisition of Precor upgrades its existing manufacturing and R&D capabilities, adding a team of approximately 100 R&D experts and 625,000 square feet of US manufacturing capacity. Consequently, the Peloton Output Park together with the Precor acquisition, will ramp up the manufacturing space to over one and a half million square feet just in the United States, strengthening its supply chain.


With a strong brand moat and high NPS score, these new product offerings could be well received by its existing members and potential new members, thus broadening its income streams.


b. Geographical expansion

Peloton has announced that it will be launching in the Australian market in Mar 2021, citing that "Health, fitness and sport is a central part of Australia's DNA, which is why it was a natural decision to launch Peloton in Australia as our first foray into the Asia Pacific region." At this moment, Peloton’s products and services are only available in the United States, U111nited Kingdom, Canada and Germany.


According to the Australian Industry and Skills Committee, the thriving fitness industry has experienced substantial growth and is poised to continue over the next five years. This commensurate with a study by Statista, illustrating a CAGR of 5.9% from 2010 to 2019.



As stated by Peloton in their 3QFY21 earnings call, they have identified an attractive total addressable market (TAM) of 3.3 million households. They also reported that Australia has had both high awareness of Peloton and purchase intent, all these without doing any in-country marketing yet.


In this overseas development plan, Precor could contribute its expertise as it has a robust global presence, supplying gym equipment to over 90 countries worldwide. Australia is currently one of the many markets that Precor serves. With the help of Precor, its regional knowledge will likely streamline Peloton’s international expansion plans.


Therefore, this strategic acquisition could facilitate Peloton’s plans to expand its geographic footprints and increase its TAM.


c. New sales channel

Apart from geographical expansion, Peloton aims to tap into Precor’s existing client base and leverage its commercial market expertise to grow its commercial presence in hotels, schools, corporate campuses and multi-unit residential areas. The commercial market size also presents an enticing growth potential, with its market size similar to the home fitness equipment market. Globally, the commercial fitness equipment market is valued to be at US$2.2 billion as of 2018 and is forecasted to reach US$3.1 billion by 2026 (CAGR of 4.6% from 2019 to 2016). As pointed out earlier, the global home fitness equipment market is valued at around US$10.2 billion, and by targeting the commercial market, this adds ~20.0% to Peloton’s TAM.


Hence, the additional revenue levers extend Peloton’s growth runway and its long-term prospects remain promising.

Valuation


As Peloton’s net income and EBIT are still negative, the EV/GP multiple was used here for the comparable analysis. Peloton is currently trading at 15.0x EV/GP, which is higher than the peer average and median. This might be explained by the following reasons:


1. Peloton has a relatively sticky business.

The lowest price for its hardware starts at nearly US$2,000.0 and the cost of changing to another company’s equipment is too high. In addition, it provides consumers with cost savings after a certain period of usage, saving time travelled on top of the price savings. Beyond the price related benefits, it has a high NPS score of 94, which strongly suggests its users love its products and services.