Peloton is positioned for long-term growth — Buying the dip

Summary

Notwithstanding recent earnings being below estimates, Peloton has staying power and remains a leader in the connected home fitness space. We believe it has only just started on its path to disrupt the fitness industry. Peloton is still seen as a hardware company because most of its revenue comes from its flagship products. But the hardware is just what gets customers through the door; long-term growth will come from subscriptions that captivate members once they are in. This subscription model becomes SaaS and recurring, promoting long-term growth. The company has numerous geographies and verticals yet to be tapped, providing it with a tremendous long-term opportunity. Peloton has strong momentum, increasing its market share by ~10x in the past 4 years and has just started its international expansion. The company is widely popular among consumers and has a vibrant and growing community, further promoting user engagement. Peloton’s platform and business model has a significant edge over traditional gyms. The company already had a loyal following before COVID-19 and Peloton’s brand power could allow it to expand into higher-margin products in the future. The TAM for Peloton is likely to become much bigger once the brand is established. With the stock price currently at a 52 week low, we believe PTON to be a great buying opportunity.

Key Points

• Since its IPO in Sep 2019, Peloton has built a community of early adopters and invested in a long-term vision. It is evolving from a hardware provider to a media and retail group with a strong brand image. Peloton’s product mix favors long-term subscription acquisition over immediate product gross margin.
• On November 4, Peloton’s Q1 earnings were below estimates. However, making estimates for 2021 was always going to be challenging given the unusual business environment during the pandemic. We believe the ensuing selloff to be exaggerated in light of Peloton’s solid positioning. The subscription segment shows a 94% YoY growth along with a low churn rate of 0.82% on its 2.49 million “connected fitness” subscriptions.
• Peloton’s drop in EBIT to -$360 million in FY Q1 2022 can partly be explained by its brand building efforts. Marketing expenses went up 148% to $248 million with Peloton promoting its Bike and Bike+. Integration costs related to the acquisition of Precor increased G&A expenses by 121% to $240 million. And R&D increased 12% to 98 million. We believe the efforts Peloton is taking to establish its brand will undoubtedly pay off and open new avenues for growth.
• Peloton is well positioned to be a global digital disruptor. The company brings a USP to the market, combining top quality hardware with interactive premium content. Following the likes of Netflix, Amazon, Spotify or Apple in their respective sectors, Peloton is targeting an industry of 36,000+ health clubs in a new way, pioneering a connected, technology-enabled fitness with an immersive streaming experience.
• The company uses innovative marketing channels. Peloton created a members-first mindset in the fitness industry. Its high-end physical stores showcase test rides and runs. The company has a 3.4% market penetration in the TAM of U.S. 71.5 million gym club members. In its core market demographic cross section, represented by the group aged 35 to 54 with $100,000+ in household income, Peloton shows a 12% market penetration.
• Peloton is expanding internationally. It is present in five markets: U.S., Canada, Germany, U.K., and Australia. These markets represent 90 million of the 182 million gym memberships globally. Its share of revenue from its international markets grew +244% YoY in FY Q1 2021. In April 2020, the company acquired Precor, supporting Peloton in its international expansion efforts through the commercial sale of its fitness hardware.
• The company is repositioning outside the home cycling niche. Peloton entered the treadmill market in 2018. The TAM for treadmills is two to three times the size of the TAM for stationary bikes. Studies show that ~15% of ~60 million Americans who attended workout groups at least once a week were doing cardio (excl. indoor cycling). 19% of Americans in its core demographic segment reported spending over $51 on fitness per month, as compared with a financed monthly cost of $59 for the company’s flagship Peloton Tread.
• Future avenues for growth are massive and Peloton is likely to develop a winning product mix. The company is building brand awareness and seizing opportunities to expand into new TAMs including clothing, apparel and accessories. Peloton does not disclose figures on product mix, but we believe it to be ideally positioned to capitalize on its brand image and expand into these new markets. Other potential avenues for growth could include branded gyms, branded personal trainers, branded supplements and sports nutrition products.

Investment Thesis

Despite Peloton’s Q1 2022 (covering the period July to September 2021) earnings being below expectations and an ensuing selloff, we see Peloton’s current stock price as an opportunity to buy the dip. Peloton does much more than selling high-end home bikes and treadmills. It offers subscriptions to online classes, accessories including clothing apparel and workout equipment. Peloton can count on the largest interactive community in the world with 6.2 million people that own at least one piece of their main hardware. During the pandemic, the company invested heavily in brand recognition and international expansion and we see this strategy as likely to bring payoffs in the long-term. Once the brand is established, we expect the TAM for Peloton to dramatically increase, creating new avenues for growth. Pandemic lockdowns made people realize they don’t need to go to a gym to workout, reducing the probability of seeing a flood back to fitness and health clubs now that economies are reopening. Peloton will be capitalizing on this.

Background

Peloton started in 2012 with the idea of bringing a high-end studio cycling class into consumers’ homes. Starting from 2016, the company started offering unlimited live and on-demand cycling sessions on a monthly subscription basis. The services quickly evolved into new classes including running, strength, cardio, meditation, yoga and bootcamp. Even though Peloton started off as a hardware equipment company selling home cycles with a touch screen — the Peloton Bike and Bike+ — it adapted and evolved to become much more. Its second hardware equipment product was a treadmill — the Peloton Tread and Tread+ — introduced in 2018. It is rumored that Peloton is developing a weight-training machine along with its already available “Tread Essentials” sports gear sets.

IPO, Covid-19 and brand building

Peloton went public on September 26, 2019, raising $1.16 billion. Co-founder John Foley became CEO. The company was one of the biggest beneficiaries of the pandemic as successive lockdowns forced gyms around the world to close and people started favoring in-home exercise solutions. During that period, Peloton added new fitness modalities to their on-demand classes, increasing both its sales of hardware and subscriptions.

Peloton is now a global content brand yet it is still perceived as a home exercise equipment company. The Hollywood Reporter nicely described the company’s brand building efforts in an article called “The Netflix of Wellness”: Inside the Hollywoodization of Peloton. Peloton is essentially becoming a media conglomerate, engaging artists, publishers, and record labels to license its music tracks. Through its platform, it has brought to fame numerous instructors. The trend suggests that Peloton’s content distribution model may already be as valuable as its hardware business line. In 2019, Peloton continued its transition from a hardware company to becoming the Netflix of fitness. It dropped the price on its mobile app, Peloton Digital, and released apps for Apple Watch and Fire TV.

FY Q1 2022 earnings, FY 2022 guidance, and selloff — buying the dip

On November 4, 2021 Peloton’s FY Q1 2022 earnings were below expectations. The company reduced its revenue forecast for full FY 2022 from $5.4 billion to $4.4-$4.8 billion along with a slightly lowered “connected fitness subscriptions” from 3.63 million to 3.35–3.45 million and a revised EBITDA of -$425/-$475 million instead of -$325 million. The company’s shares tumbled and by Friday had lost ~35%, closing at $55.64, a 52 week low. We believe the selloff to be exaggerated and see it as an opportunity to buy the stock cheap. FY 2022 was already expected to be a challenging year to forecast in light of unusual 2020 and 2021 figures during the height of the pandemic and the consecutive lockdowns. We believe this was already largely priced in with the stock trading at -43% YTD (pre-FY Q1 2022 release) from January’s highs. When looking at the bigger picture, the stock still shows a ~120% positive return since its IPO in September 2019, priced at $25.2 per share, and revenue is still up 6% Y/Y from FY Q1 2021. Also, if looking at the revenue breakdown, sales from the “subscription segment”, which represents the non-hardware and long-term revenue generating side of the business, were up 94% Y/Y at $304.2 million. Given a particularly low churn rate of 0.82% on its 2.49 million “connected fitness” subscriptions, this provides Peloton with a long-term stream of revenue. The subscription side of the business already accounts for 38% of total sales. Revenue from the “connected fitness products” segment was down 17%, reflecting the anticipated decline in hardware sales mainly attributable to the seasonal cycle and the reopening of the economy. Despite these headwinds, we believe the company’s strategy remains sound and focused on long-term subscriber acquisition over product gross margin generation.

Brand building, R&D and marketing efforts

One of the things that spooked investors on the last earnings call was the drop in EBIT from $60 million in FY Q1 2021 to -$360 million in FY Q1 2022. While such a drop could be concerning, it is not uncommon for a high-growth company, especially one that heavily invests in establishing its brand. The lower EBIT is largely attributable to a 140% surge in operating expenses. In 2021, Peloton used its large cash reserves to put in place a strong advertising campaign, promoting its Peloton Bike and Bike+, driving marketing expenses up 148% to $248 million. In April 2021, in order to expand its international reach and lower its dependency on the sales of its home-based fitness equipment, Peloton acquired Precor, one of the largest global commercial fitness providers. This deal should allow the company to further establish its U.S. manufacturing capacity, boosting its R&D capabilities with Precor’s highly-skilled teams. Most importantly, this acquisition should accelerate Peloton’s penetration of the commercial fitness market, providing the company with direct access to sell its state-of-the-art hardware to fitness chains and boutiques. The integration costs of the acquisition along with costs of the additional professional services led G&A expenses to surge by 121% to $240 million. Finally, Peloton also had a 12% increase in R&D to $98 million, due to employee-related costs for the research team. This cost breakdown demonstrates an emphasis on long-term brand building and confirms the company’s vision for favoring long-term subscriber gains and customer retention versus near-term gross margin generation.

Leading a global digital disruption

Peloton is well positioned to be a global digital disruptor in the fitness and sports industry, bringing a unique selling proposition. The company brings a new service/product to the market, combining top quality hardware with interactive premium content. The company has direct competitors in each of its business segments but it remains unchallenged in successfully integrating live content subscription services with sports hardware technology. Digital disruption sets in when a company with a new and revolutionary concept changes the way a whole industry operates. In the movie industry, Netflix, HBO, Disney, Apple and Amazon have disrupted the way ~40,000 local and regional theaters operate. In video games, it was Microsoft, Nintendo, Sony and Mobile that disrupted ~13,000 existing local and regional arcades. In music, Amazon, Spotify, Pandora and Apple have challenged the business model of ~3,300 independent records and CD stores. Finally in books, Nook, Amazon and Apple have revolutionized the way ~38,500 local and national bookstores used to operate. In fitness and sports, Peloton is so far the only one that combines these criteria — new product/service and a consolidated industry — targeting a market of 36,000+ health clubs and boutique fitness operators in a completely new way, pioneering a connected, technology-enabled fitness with an immersive streaming experience.

Marketing channels and TAM

Peloton created a members-first mindset in the fitness industry on which the company’s selling strategy is based. It uses a direct-to-consumer sales platform with showrooms, sales and support teams. The company’s typical showroom is 1,500–2,000 square feet, showcasing test rides and test runs for customers. In terms of market penetration, Peloton has a massive TAM to tap into. An estimated 71.5 million people used gyms and other health clubs in the U.S pre-pandemic. Of these, 60 million customers had memberships and another 9 million were attending fitness clubs on a non-member basis. Currently, Peloton has a 3.4% market penetration in the TAM of U.S.’ gym club members along with an estimated 1.8% reach in U.S. households. On a global scale, across the five main markets Peloton addresses — U.S., Canada, Germany, U.K., and Australia -, it has even more room for growth, with a current 1.14% market penetration of the total number of households. In the U.S., which is Peloton’s primary and most highly penetrated market, the company shows a 12% market reach in its core market demographic cross section, represented by the group aged 35 to 54 with a household income north of $100,000.

International expansion and market penetration

Peloton has ambitions of reaching 100 million subscribers globally and envisions itself as a global digital disruptor in the connected and interactive fitness space. Currently the company has 2.49 million paid digital subscriptions and is present in five markets: U.S., Canada, Germany, U.K., and Australia. Those markets are the most active in terms of gym membership, representing 90 million of the 182 million gym memberships globally. By 2025, given the increase in the number of households as well as the natural rise in the company’s core market demographic, Peloton’s potential TAM on its existing international markets is expected to register a net gain of 6.8 million households. Peloton’s strategy is to convert these gym memberships into subscribers. In FY 2020, 93% of its revenue was from the U.S. and 7% from Canada, Germany and the U.K. In FY 2021, the international markets accounted for 13% of Peloton’s revenue. This represents a +244% YoY growth (outside North America) and demonstrates an early but yet massive international opportunity for growth.

Peloton has been heavily investing in international expansion, increasing its brand awareness, physical stores presence and adapting its content to local markets. To demonstrate its commitment to local specificities and better serve its customers overseas, the company featured numerous British, German, and one Australian instructors. It also offers its classes in English, German, and, as of April 2021, Spanish. Earlier this year, Peloton enhanced its international reach by acquiring Precor, a major global commercial fitness equipment provider. Precor sells in 100+ countries. Precor’s marketing and manufacturing capabilities are likely to support Peloton in its international expansion efforts, offering an additional TAM through the commercial sale of its fitness hardware. In March 2021, Peloton announced its plans to expand into Australia. The company’s research uncovered many years of strong growth pre-COVID for boutique fitness classes in Australia and Peloton believes its products would be a good fit for the Australian market. The Bike and Bike+ products were initially introduced through both retail locations and e-commerce platforms, followed by Peloton Digital for Australian members. In October, the company opened its first showrooms in strategic locations across the country. Peloton is currently in the process of identifying additional international markets for future expansion.

Repositioning outside the home cycling niche

Peloton has been quick to reposition itself outside the confined niche of home-based cycling. Starting from January 2018, the company entered the treadmill market, showcasing its first Peloton Tread in Las Vegas. In all of its existing markets, Peloton has a substantial TAM in the fitness equipment space outside the company’s initial indoor cycling niche. According to the company’s estimates, the TAM for treadmills, which Peloton addresses with its Tread and Tread+ flagship hardware, is approximately two to three times the size of the TAM for stationary bikes. Recent studies suggest that ~60 million Americans attended workout groups at least once a week, and of those an estimated 15% were doing cardio (excluding indoor cycling). Mindbody, in a 2020 report on the fitness industry, found that 19% of Americans aged 39–54 — Peloton’s core demographic segment — reported spending over $51 on fitness per month. This figure interestingly compares with a financed monthly cost of $59 for the company’s flagship Peloton Tread, suggesting a realistic substitution model and an enormous potential for customer acquisition. This was confirmed by a positive early consumer reception of the company’s treadmills with industry-leading Net Promoter Scores (NPS) of 85. In the company’s 10-K filing, Peloton estimates that approximately 5 million treadmills were sold in the U.S. each year and approximately 35 million American homes owned a treadmill. In the same filing, the company estimates that 75 million people were using treadmills across its international markets, excluding Australia.

Future avenues for growth and potentially winning product mix

Beyond its hardware products and subscription services, the company is actively building brand awareness and seizing opportunities to expand into new TAMs including clothing, apparel and accessories. Peloton does not disclose figures on product mix, which would include sales of add-ons, apparel revenue, as well as total units delivered. However, given the company’s recent effort to establish itself as a brand and its impressive line of accessories and sports equipment — Peloton offers full lines of clothing and clothing accessories for men and women as well as an assortment of workout equipment — we believe Peloton to be ideally positioned to capitalize on its brand image and expand into these new markets. Other potential avenues for growth could include branded gyms, branded personal trainers, branded supplements and sports nutrition products. The sports apparel market is expected to reach $248.1 billion globally by 2026 while the sports nutrition market, the fastest growing with a CAGR of 12.2%, is projected to reach $35.5 billion. Expansion in both these markets is likely to provide substantial tailwinds for Peloton and could reinforce its image as a global media company and a fully recognized sports brand, competing with the likes of Nike and Adidas.

On November 9, Peloton launched Guide, a camera system for strength training. This new product creates another opportunity for Peloton to extend its TAM by entering the market at a lower price point. Guide will be the company’s most accessible product. Priced at $495, the new device costs a third of Peloton’s entry-level stationary bike. Peloton Guide comes with a TV set-top-box with a camera, guiding consumers through strength exercises. It uses wide-angle cameras and AI to provide live feedback to users. The company’s management reported strength training to be its fastest growing content sector, with more people training for strength at home than for cardio, and leading to the development of this dedicated hardware product. Guide is also likely to boost subscription revenue, providing its own content library for a monthly fee, further expanding Peloton’s prospects for long-term revenue generation.