A lockdown winner, we look at whether the stock is trading on substance or hype
Thursday 14 Jan 2021 Author: Steven Frazer

NASDAQ-listed Peloton Interactive (PTON) established itself as one of Wall Street’s darlings this year as gyms closed their doors during worldwide lockdowns.

The connected fitness business has flourished as people were forced to rethink how they live, work, travel, and exercise. The pandemic crafted almost perfect conditions for Peloton to thrive as people looked for ways to workout in the relative safety of home.

As a result, the company has been posting record numbers and can’t make its famous exercise bikes fast enough to sate demand.

We salute Peloton’s lofty ambitions but remain very sceptical of its ability to meet them, or match investor’s already stratospheric expectations. We suggest that buying one of its bikes will be better for you in the long-run than the stock.

BOLT FROM OUT OF THE BLUE

Peloton appeared to come out of nowhere as Covid-19 plunged the planet into pandemic chaos, emerging as one of the biggest success stories of 2020.

Founded by entrepreneur John Foley in New York in 2012, Peloton went public in September 2019, pricing its initial public offering (IPO) at $29.

The ambition is to shake-up the fitness industry much like Amazon has disrupted buying stuff.

Its flagship product is a £1,750 ($1,895) internet-connected exercise bike with touchscreen, or there’s a connected treadmill (from £2,295 or $2,495) also with touchscreen. In both cases users can stream or download fitness classes for a monthly £39 ($39) fee which allows them to interact with instructors or other members, without having to leave home.

The company believes it could hit 100 million subscriptions with its bikes, treadmills and digital-only app, a £12.99 ($12.99) a month service for equipment-free classes.

POSITIVE DRIVERS

Fans see Peloton as a lifelong lifestyle choice, with dedicated customers committed to the brand that creates a valuable ecosystem of semi-predictable revenues. The overall experience of spin classes and fitness lessons are highly dependent on the quality of instruction, and Peloton’s team of instructors have, in some cases, become minor online celebrities.

Being one of the first movers in the connected fitness space, Peloton has built significant brand value and user loyalty, as shown by churn of less than 1%. The company is also building social features which could help to engage users and build a sense of community around its platform.

Peloton saw connected fitness subscriber numbers jump 137% year-on-year for this year’s first quarter to end September 2020 to more than 1.33 million, continuing two years of rapid growth. That meant sales surged 232% to $757.9 million from $228 million a year ago, topping expectations for $748.1 million.

That saw earnings rise to $69.3 million, or $0.20 per share (EPS), from a loss of $49.8 million ($1.29 EPS) a year earlier, versus $0.11 expected. This is a big deal for a company that has yet to post an annual profit but is forecast to make that breakthrough this year to 30 June 2021.

COUNTER-ARGUMENT

The obvious objection to Peloton’s long-run growth potential is the high cost of the kit. Even its cheapest bike plus subscription will set consumers back £2,218 in year-one, then nearly £500 each year after that.

While that makes for high switching costs which will keep churn low, a bog-standard exercise bike can be bought for as little as £50 (according to Amazon). Even better-quality ones with accompanying apps and tablet holders are available for £500 or so, likely making Peloton’s albeit high-end equipment prohibitively pricey for most people, even with its no-interest monthly payment plan.

The pandemic will also eventually end (even if it doesn’t feel like it now), allowing people to return to gyms as normal. Not everyone has the space for bulky fitness equipment at home and gym memberships give access to lots of different machines for a more varied workout. But it also offers that face-to-face human experience that most of us have missed so much during lockdown, the chance to workout with friends.

Building that vast ecosystem of subscription revenues is key to Peloton’s future but what if its rapid growth so far is low-hanging fruit picking? It might be that the forced closure of gyms during lockdown has sparked a rush of easy sales and that attracting new customers will become incrementally harder.

Gym memberships are often cheaper than Peloton’s £39 a month and can be cancelled hassle-free with a months’ notice. The UK’s largest operator PureGym, for example, offers a contract-free, 24/7 access plus membership from about £20 to £25 a month with classes thrown in.

There’s also masses of free workouts available online for those not fussed to go to a gym. A simple ‘workout’ search on YouTube returns tons of free content for fat-burning, muscle-toning, high cardio, with and without weights, and even plenty of bike fitness sessions. Just look at what Joe Wicks has been doing through lockdown, making Peloton’s app-only memberships look like a growth red herring.

COSTLY SCALABILITY

A capital-light online platform business model would not sell any physical products and have zero marginal costs to serve increasing users with a digital-only offering. But by designing, manufacturing, delivering, and installing high-end fitness equipment Peloton requires more capital as the company grows to greater size.

It has also seen Peloton struggle to up manufacturing to meet demand spikes in recent months. This issue saw the company buy US fitness kit company Precor just before Christmas in a $420 million deal, upping its manufacturing capacity and providing new expansion opportunities. Perhaps a connected rowing machine is the next obvious product to develop.

That may solve the latter problem but the cost of scaling up remains.

Over the past three years hardware revenues have been stable at around 80% of turnover with content subscriptions making up the balance. Gross margins are also relatively stable with equipment earning roughly 42% to 44%, while the rise in subscription margins in 2020 to 57% was presumably thanks to app-only subs, which you would expect to be at much higher margins due to the limited cost of running online workouts alone.

Research and development was 5% of turnover last year while sales and marketing was 26% of revenue. There was also another $351.6 million of general admin expenses, more than 19% of sales. Overall costs relating to sales jumped 71% in the 2020 full year (to June), versus 99.6% growth in revenue. This probably suggests that vast marketing and admin costs will continue to race higher in future because the proposition needs to be constantly visible to win new customers, a bit like it does with gambling firms.

The stock’s 462% 2020 rally is right up there with other ‘Covid winners’ Zoom (+406%) and Moderna (+435%), the drug developer behind one of the three successful vaccines.

The stock is currently changing hands at $158.88, which means that even if the company hits the $1.21 EPS forecast by analysts in the year to June 2023, the price to earnings (PE) multiple is still at a scorching 131. Even with most analysts firmly in the buy camp (only one sell and three holds of 26 covering the stock) the consensus target price remains at $150, below the current price.

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