Summary

• Is Peloton the next short-lived fitness fad? Peloton has a lasting product with the engagement of a live class and the convenience of a home workout.

• Currently, heavy up-front investments in a new headquarters, its treadmill product, its supply chain, and an international expansion mask a highly profitable business. Profitability will come with scale.

• I see further potential upside to consensus sales, driven by its treadmill product, higher marketing expense, and geographic expansion into Canada, UK, and Germany.

• Sum of the parts valuation, with a 3-4x 2021 sales multiple on the equipment segment, and a 8-10x 2021 sales multiple on the subscription business, points to a $30-34 stock price.

Peloton is a "live fitness" company that combines both fitness equipment and online fitness classes into a seamless workout from home.

There are two key issues around this stock that I'll detail here. The first key issue is the sustainability of sales trends. The bears question the addressable market willing to pay thousands for an exercise bike. The bulls see this as a product with a large market that strongly encourages frequent and intense workouts via convenience, gamification, and social connections.

The second key issue is the profitability of the business. Investor appetite for money-losing tech companies is at near-term lows given recent developments (WeWork, Grubhub, Uber). Bears see another money-losing tech company without a path to profitability in Peloton. Bulls see a company making high-return investments that are masking an underlying, highly profitable business.

My own personal view is that this is a real product with sustainable sales trends and a highly profitable business model. I believe the Peloton product is misunderstood, and that the use of livestreaming as a way to connect people to others will widely grow and become more appreciated by investors over time.

Is this a real product, or the next fitness fad?

The key concern around Peloton is whether the product has lasting power as a product. The fitness space has a long history of producing popular products/regimens that ultimately deflated over time, including 8 minute abs, Tae Bo, Bowflex, and more recently, P90X. As a result, bears have been quick to label Peloton products as the next fad that will ultimately see its end as consumers either move to the next fad, or give up on their fitness goals as they always do.

Bulls argue that Peloton is different because the product is different. Prior fads provided a new workout regimen; once users got tired of it, the value proposition fell apart. Peloton's primary value proposition is the intensity and fun of attending a live class combined with the convenience of being in your own living room.

It's helpful to try to break down each element of the value proposition to better understand why this product is so engaging to its users. The convenience element is obvious; it's a fitness product (bike or treadmill) in your living room. You can quickly finish a workout in 20 minutes, saving yourself on the added time of commuting to the gym. It also saves you the effort - both physical and mental - of getting there. While this doesn't seem significant on paper, I have often heard from coworkers and friends that they have to go to the gym before or after work. If they wait until they get home, it's too difficult to go outside and go to the gym. Removing the commuting barrier is significant in getting people to work out more frequently.

Now, admittedly, this is not necessarily a new innovation; Bowflex, or even simple dumbbells at home, would also provide that same level of convenience, but they're obviously not the next multi-billion dollar product. Peloton's live classes differentiate and raise the quality of the product further by mimicking a live class attended in person.

Why do people like attending live classes in person in general? I would argue that they are compelling because:

• The instructor pushes you to work harder than you might normally do on your own

• Being in an environment where others are also working hard can motivate you to work harder

• The music helps get you in the mood to workout harder

• Having the scheduled class on your calendar, and the money committed, forces you to show up

• Attending with friends can make you work harder and hold you accountable to show up

Note that most of these elements do not fully require attending a class in person. Instead, they can be mostly mimicked through a compelling-enough virtual experience. Peloton's classes do this with studio-quality classes, star instructors, strong social functionality, gamification, and good music. And again, they have the added bonus of doing this at a fraction of the expense of those classes (SoulCycle for example is $35 per class) and without the commute. This entire experience creates a low-barrier, high-quality experience that is engaging and addicting to users.

The company's reported user metrics support this narrative of a highly engaging product. The average user is currently working out 12x per month - an extremely high number for a fitness product. In particular, the company saw a significant jump in workouts once they began to roll out challenges, a product feature that allows users to commit to a fitness goal with other members.

These users aren't just working out frequently and hating the experience, though. Net promoter scores for Peloton are at 91, above those for Apple and Netflix. And this satisfaction is playing out in retention as well. Monthly churn levels are extremely low, with average monthly churn rates of 0.6% over the last two years, and 0.9% in the most recent quarter (more on this later). For context, fitness studios (i.e. group classes) have a monthly churn of 2.0%, while traditional health clubs (i.e. gyms) have a monthly churn of 2.4%. Beyond fitness, Verizon's monthly wireless churn in their latest quarter was 1.1%, while Spotify's latest monthly churn was 1.5%. Peloton’s churn rate of 0.9% in 1Q20 remains extremely impressive.

One common pushback to this argument is that the product has likely attracted a hardcore and loyal following in its early years, thus explaining the high customer satisfaction. But as it expands into the next segment of customers, it may not be able to maintain such high levels of satisfaction or retention.

To this I would argue that Peloton's initial customers have been indicative of the future customers they will be trying to attract. Peloton notes that 4 in 5 customers were not previously in the market for an indoor bike. Additionally, one of the largest Peloton Facebook groups is the Peloton Mom group - a group not typically associated with your average hardcore user of indoor bikes. And anecdotally, every Peloton user that I know also does not fit that profile, either.

Another common debate among investors is the size of the market. How many people could possibly afford to pay $2,245 for an indoor bike, or $4,295 for a treadmill?

Peloton claims that the total US addressable market for its products is 67 million households (18-70 with $50K+ in income), and that its serviceable addressable market is 12 million. Peloton notes that they conducted this analysis via surveys of over 1,000 people in each market with questions about Peloton's current price points and products. This was the subject of much debate among investors and sellside analysts. We'll focus on the SAM number here to see if it's a reasonable number. Using Peloton's SAM number, and their sold Connected Fitness Products, it would imply a 5% penetration of the SAM.

We can use a few different approaches to double check those numbers. With financing, Peloton's bike works out to roughly $100 per month ($40 for the classes and $60 for the financing). If the bike is shared (which they often are), it would work out to about $50 per person. In the US, there are 63 million people who have gym memberships. Of the 63 million, there are about 9 million people who pay $100 or more on gyms, and another ~13 million people who pay $50 - $100 on their gym. Combined, there's about 22 million people who pay $50 or more on their gym memberships in the US. One thing to note is that Peloton's estimate was households, whereas these numbers are for individuals.

Alternatively, we can look at the number of people who attend "boutique gyms," which have smaller classes and live instructors. ClassPass, or SoulCycle, would fit into this category. According to the International Health, Racquet & Sportsclub Association (IHRSA), 3.7% of the US population was a member of a boutique gym in 2018, or about 12 million people.

We can also look at the dollars spent in different subsectors. According to IHRSA, $100 billion is spent on gym memberships, with $35 billion of that coming from fitness activities and equipment (i.e. yoga, Pilates, personal training and equipment purchases).

I would argue that these approaches demonstrate that Peloton’s SAM estimates are roughly in the right ballpark. However, to some, Peloton's estimates might seem really high, when considering that, again, this is an expensive indoor bike that can't offer all that a gym might be able to. There are a few things to keep in mind with these numbers, though.

First, the SAM is simply the number of people who might be interested in the product, but not necessarily the number of products that Peloton plans to sell. All that really matters to the stock is the amount of products that are expected to be sold by investors. My read on the sellside estimates that I have seen are that most estimates over the next two years are for a total of 1.5 - 2 million active subscribers (vs. the ~560K subscribers in their latest quarter). This would represent a 17% penetration of the SAM if their targets were hit. In terms of dollars, analysts forecast Peloton to generate roughly $3 billion in sales by 2022, which would represent <10% of the amount spent on fitness equipment and activities mentioned above. 

Second, these numbers are all growing. Specifically, the boutique gym estimate has been growing from 1.5% penetration of the US population in 2013 to the 3.7% in 2018. Boutique gym membership could potentially be 10-20% higher 2-3 years from now.

Third, international numbers look to be conservative. Peloton estimates that there are about an additional 2 million households that might be interested in the product internationally. This looks light given that the three markets they are looking to expand into - Canada, UK, and Germany - have roughly 40% of the gym membership of the US, but Peloton's international SAM estimate is just 17% of the US estimate. Again, Peloton's international SAM estimate was based on surveys, using current Peloton awareness. The 2 million number will be outdated once marketing ramps and awareness grows.

Finally, and perhaps most importantly, Peloton is creating a new category of products that does not map well to existing markets. For example, if one were to base their analysis on the existing market for stationary bikes, Peloton would make up the majority of it already (roughly $1 billion annually in stationary bike sales, according to Sanford Bernstein, vs. Peloton's ~$700M of connected fitness product sales last year). However, with Connected Fitness Product sales growing at 100% in the last quarter, and marketing continuing to grow, it's quite clear that Peloton is not near a saturation point, at least in the near term. Peloton is attracting customers who were not previously in the market for bikes, or even gym memberships. There's some evidence that supports this notion. Again, Peloton has stated that 4 of 5 existing customers were not in the market for a bike. Additionally, a perusal of YouTube Peloton reviews will show people who profess to not having gym memberships, let alone were in the market for a stationary bike.  In order for an investor to believe that Peloton will grow subscribers and cumulative product sales to 2 million and beyond, you must believe that Peloton will attract customers beyond your regular gym goer. Personally, for the reasons highlighted above, I think Peloton has a good shot at doing this.

Is this a profitable company?

The second key issue is the profitability of the company. There's a heightened concern among investors that recent tech IPOs have been structurally unprofitable and sustained only by investor cash. Is Peloton another one of them?

Looking at solely their net income and consensus estimates for this year, it would suggest so. Peloton generated -$196 million in GAAP net income over the last year, vs. -$48 million in net income losses in the prior year. This year, analysts forecast -$294 million net income.

This superficial analysis misses on the much more structurally profitable company hidden by up-front investments. In short, the unit economics are extremely compelling because the company's hardware sales funds the customer acquisition costs. From there, the recurring revenue from the subscription business generates the profit for the company.

Let's dive into the numbers. Last year, Peloton spent $324 million on marketing to acquire 266K gross new customers, which works out to a $1,102 customer acquisition cost (CAC). The monthly churn rate of 0.6% that year implies a 14 year average lifetime for that customer. At $40 per month, and applying the company's subscription GAAP gross margin of 42.7%, we get to $2,847 in customer lifetime value, which compares favorably to the $1,102 CAC.

Taking this a step further, we can take into account the gross profit on the sale of the hardware, which offsets much of the CAC. Last year, that amount was $309 million. This offsets almost all of the CAC, leaving just $53 net CAC.

Admittedly, these numbers are not that reflective of what the company will likely do in the future. So let's adjust these numbers to more realistic numbers going forward (the FY2022 column, in the image above). Starting with the lifetime customer value, the churn rate of 0.6% last year is not likely sustainable as it benefited from a number of factors, including prepaid memberships. Going forward, the company will implement the 30-day free trial, and should also lose its prepaid memberships, which should lead to higher churn rates going forward. I’ll use the consensus 1.3% churn rate for 2022 in my calculations, which in turn lowers the lifetime value. However, we should also apply higher subscription gross margin, as current levels are depressed due to international buildout. Using the consensus values, we get to a $1,794 customer lifetime value (CLV).

On the net CAC side, consensus currently has higher sales and marketing expense in 2022, but this is still mostly offset by the higher gross profit from Connected Fitness Product sales. In particular, gross margin here is expected to expand driven by efficiencies and scale.

In total, we're still looking at attractive customer lifetime value compared to the net customer acquisition costs. Even using a much more conservative churn rate of 2.3% (which aligns more closely with typical gym membership churn rate) would still generate a $1,000 CLV compared to the $70 net CAC. 

With this framework in mind, it's key that the company continue to add new customers so that they become subscribers generating recurring revenue, which generates high margins for the company (and allows for further margin expansion).

If the unit economics look so strong, then why is the company losing so much money? The company is currently investing heavily to build the infrastructure for future growth. Hardware gross margins are being weighed down by the treadmill, which carries lower gross margin. The company is also investing in a new headquarters in NYC, improved supply chain logistics, more marketing in the US and internationally, and new studios for the international markets. All of these are up-front investments, but if they play out as management and bulls believe, then they should generate high ROIC and margin expansion in every year going forward. The street currently forecasts the company getting close to profitability by 2023-2024. The underpinning belief in all of these estimates is that Peloton has a strong product that several million people will want to buy and use, and the infrastructure must be built out to support this.

The company's first quarter as a public company shows just how much leverage there is, and why the CEO is confident that the company could be profitable if it wanted to be. Operating margin of -22.3% was well-above forecasts for roughly -50% in fiscal 1Q20, as well as last year's -50% in fiscal 1Q19. The company saw increased leverage through higher revenue growth. To be clear, management noted that some of this leverage was due to timing of certain expenses. In particular, management noted that $10M of the opex beat would be spread out through the remainder of the year, and some of the capex and other investments might occur later in the year. However, even taking that into account, the leverage was significant, and I sense there is potential for upside here as the company beat significantly on essentially every line item and is likely guiding conservatively following their IPO.

Is rising churn a concern?

As highlighted previously, churn is a key topic among investors, as bears believe it will spike upwards, whereas bulls believe it will rise, but remain at low levels overall relative to other competitors. There are two near-term headwinds to churn.

First, Peloton's churn benefited from prepaid memberships, which will naturally keep members on the subscription for a longer period of time than if they were month to month. As members transition to month-to-month payments, expect the churn to rise over time. Management did note on the conference call that 90% of members were now on month-to-month payments, and that this will gradually rise through the remainder of the year.

Second, churn should be negatively impacted by the company's 30 day free trial. Members that return the bike will be counted as a churn. The 30 day free trial was begun late in 1Q and thus the impact was not largely seen. Going forward, as the company pushes the trial more aggressively, expect to see elevated churn rates from this impact as well.

Overall, management believes that churn rates will not go above 1.05% for 2Q and for the full year. The point here is that management has thoroughly telegraphed that churn rates will go higher in the near-term due to the headwinds mentioned above, and investors largely appear to understand this. As a result, the key benchmark in the near-term is whether churn rates go above this level. However, I would also note that churn at these levels remain well below the fitness average and still appears impressive.

Finally, churn rates have also been the subject of debate among institutional investors because of the company's aggressive definition. The company allows customers to pause their subscription for up to three months before it counts as a churn. As a result, churn rates will understate the actual number of members who are not paying their subscription at any current moment. The company responded to this concern on the conference call by noting that 1) there are about 0.5% of customers paused at any given time, and 2) churn rates are not any higher for these members who have paused their membership. This will be something to watch and consider, as the way the company deals with paused members could potentially cause a one quarter delay in churn rates. For now, my own opinion is that this doesn't look to be a concern.

Can Peloton stay ahead of competition?

With Peloton’s success, a bevy of competitors have come out with competing connected fitness products, including Echelon, Flywheel, and NordicTrack. Equinox, the owner of SoulCycle, also announced that they would be launching a streaming service. It’s clear that the space is starting to attract more players, and it’s a risk that must be monitored. For now, it appears that Peloton has a few advantages over competitors. First, there are network effects to the products given that many people want to work out with friends, or where there are many users of a similar demographic. Peloton has an advantage here with over 500K subscribers. Second, Peloton has had a several year advantage in building out a content library. A user can choose the intensity, type of music, and instructor, and get multiple live classes as well as archived classes to choose from. Third, Peloton’s product quality is higher. Classes are well shot and lit, and there’s a tight integration between hardware and software that comes from being a vertically integrated company.

For now, Peloton appears to have a head start on the competition but this is a risk that should be closely watched, especially if a large tech company enters the space (i.e. Apple, Google).

Street Forecasts and SOTP Valuation

Tying this all back to the financial model, there's several key line items to focus on. The company's two segments can be confusing, as Connected Fitness Product sales do not always align with a Subscription for a variety of reasons. Connected Fitness subscribers is the key gauge of the business health, as it will largely be driven by Connected Fitness Product sales, and it'll drive the Subscription revenue. In the near-term, quarterly consensus shows a steeper deceleration in the next quarter. With 1Q results showing just a 5 point deceleration, the 14 point deceleration in 2Q looks to be too harsh, considering that the company will have increased marketing spend, the 30-day free trial, the treadmill sales ramping, and international regions ramping. On an annual basis, the deceleration here also looks potentially conservative for similar reasons, with 75% growth in 2020 and 56% growth in 2021. This represents roughly 383K net adds in 2020 and 498K net adds in 2021. For bears, this growth looks aggressive given that bears believe that product sales will eventually drop off a cliff as it reaches a broader audience and the product becomes the next fitness fad to die off.

In terms of sales, this level of subscriber adds represents roughly 62% sales growth in fiscal 2020 and 47% sales growth in fiscal 2021.

Again, my own personal view here is more aligned with the bull camp, although I acknowledge the risks associated with an expensive fitness product.

The other area to watch is the profitability of the company. This is largely a story of adding more subscribers, generating more recurring subscription revenue, and in turn generating higher margins (subscription gross margin was at 43% in FY19 and is expected to expand to 53% in FY20).

With that in mind, we should see operating margin gradually tick higher. While sharply negative currently, and it may prove to be lumpy in fiscal 2020 given the investments underway, there should generally be improvement on this line item over time, especially in 2021.

In terms of valuation, the majority of the street is applying a sum of the parts valuation on the company's different segments. On the Connected Fitness Products side, many sellside analysts are applying a 3-4x FY2021 sales multiple given the 40%+ expected revenue growth from that segment. For context, Technogym, a maker of connected fitness equipment, trades at roughly 3x sales, with mid-single digit sales growth and high-teen operating margins.  On the subscription side, I've seen an 8-10x FY2021 sales multiple justified by the high growth and high margin potential for that side of the business. Summed up, these two segments add up to roughly $30-34 price targets from the street. Obviously, higher sales growth (detailed earlier in this section) would drive a higher price target, whereas lower sales growth would drive a lower price target.

The Story Hinges on Sales’ Lasting Power

In sum, Peloton has a highly popular, and controversial, product on its hands. Bulls see a product that could potentially change the way people work out given its convenience and highly engaging product. Bears see the next 8 Minute Abs product that’s generating too much hype. Ultimately, the company’s product sales and its user retention will determine which side is right.