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Investment Thesis
Peloton’s been on quite the ride over the past 12 months. Rewind a year ago, the company was free cash flow positive, and demand for Pelotons was through the roof. Fast forward to today, the company’s facing challenges due to its aggressive vertical expansion as it’s established a manufacturing facility overseas and acquired a fitness equipment provider with manufacturing in the U.S., Precor. While this will be beneficial over the long term, this is capital-intensive and the surging demand that Peloton realized due to Covid’s stay-at-home trends is no longer as prevalent as it was 12 to 18 months ago. This presents challenges over the near term for Peloton, but our thesis around Peloton’s opportunity to remain a leader in connected fitness is well intact.
For today’s article, we’ll discuss Peloton’s outlook relating to the following three perspectives.
Foley’s Follies: breakdown of what went wrong for Peloton and the implications over the short term.
The Good: Peloton remains a leader in connected fitness and is well-positioned to launch new products in new verticals and geographies as well as capitalize on its opportunity for commercial expansion.
Market Outlook: Provide an outlook for Peloton’s potential market share over the next five to ten years to illustrate its opportunity, solely for Connected Fitness Subscriptions. To wrap up, we’ll provide an updated fair value and expected return for Peloton using the L.A. Stevens Valuation Model.
Foley’s Follies
The Investments
Peloton doubled its production capacity in 2020 in an effort to meet the pent-up demand the company realized due to Covid and the stay-at-home trends.
In April of 2021, Peloton acquired Precor for $420 million in cash. Precor is a leading designer and manufacturer of world-class fitness products such as treadmills, ellipticals, and other workout equipment. This acquisition will also expand Peloton’s manufacturing network within the U.S. as Precor has manufacturing facilities in North Carolina and Washington State.
Additionally, in May of 2021, Peloton also announced plans to build a manufacturing facility, the Peloton Output Park in Ohio, which will be a ~$400 million investment over the next few years. The Peloton Output Park will produce Peloton Bikes and Treads domestically and will help Peloton become more vertically integrated.
After Peloton doubled its headcount adding more than 3,000 employees in the first half of 2021 and in mid-October, Peloton VP of talent acquisition shared that the company still intended to hire between 3,000 and 5,000 employees over the next year and a half. Then during Peloton’s Q3 earnings call in November, Peloton backtracked and announced it would pause its hiring spree.
Turning to OpEx. In response to our revised sales and margin outlook for fiscal 2022, we have identified material savings across our operating expenses. So, some of these actions may take a quarter or two to show improvement. Some of these identified areas of savings include making significant adjustments to our hiring plans across the company, optimizing marketing spend and limiting showroom development, identifying areas of efficiency, improvement in member support, and streamlining our product development teams, while maintaining a focus on new products and expanding software features.” - Jill Woodworth, Peloton CFO
Source: Ycharts.com
As indicated in the graph above, Peloton’s revenues couldn’t maintain the massive acceleration it experienced during the pandemic as Peloton’s quarterly revenues grew 172% YoY in the second quarter of 2020. Peloton’s products were in extremely high demand due to Covid, but Peloton pulled forward a lot of growth and hardware sales in 2020 and into 2021. Peloton then invested in manufacturing to expand its verticals across supply chains and expand its employee headcount. This resulted in elevated operating expenses while Peloton still faced global supply chain constraints.
The Downfall
Peloton generated $400 million in free cash flow while it had about $2.7 billion in cash and short-term equivalents in the first quarter of 2021. Peloton utilized the increase in hardware sales and connected fitness subscribers to grow its manufacturing overseas, specifically in Taiwan, and further expand its verticals and brand presence in the U.S. by acquiring Precor in April of 2021. Peloton was generating huge amounts of free cash flow and decided to put it in an incinerator to meet the excess demand from Covid and boost its manufacturing across all verticals. This will be beneficial for Peloton over the long term but results in high costs, and Peloton’s already faced with navigating a more complex supply chain environment due to the impact of the pandemic. As a result, Peloton now has $924 million in cash and equivalents and -$1.39 billion in free cash flow, as seen below.
Peloton entered 2021 on a hiring spree while its share price was trading between $140 to $160. Instead of Peloton taking advantage of the rise in its share price and instead of raising capital while its stock had a higher valuation, Peloton waited until they realized the costs and slowdown in demand due to reopenings to raise capital. If Peloton issued shares in the first two months of 2021, at its higher valuation, it would’ve raised capital at a higher valuation which would’ve resulted in less dilution for shareholders compared to issuing shares, thereby diluting, at $46 per share as it did in November. Instead of focusing on short-term-oriented results, Peloton is building the foundations for the future, resulting in the company’s poor performance in the latter half of 2021.
Peloton missed an opportunity to take advantage of its products' raised demand and essentially go the Apple (AAPL) route and slowly scale manufacturing while not burning an excess amount of cash all at once. By slowly scaling, Peloton could’ve kept its hardware at an elevated demand by keeping them scarce as Peloton continues to roll out new products such as Tread+.
In November, Mashable.com released its “scarcity scores” for Black Friday and Peloton’s bikes received a 4, based on a scale of 1-10 with 10 being the highest demand, which is the same score as a Microsoft Surface Duo 2 and Samsung Galaxy S21. Apple products received scores between 6-8, Xbox was between that range as well. Sony’s PlayStation 5 was the only product that earned 9, with scarcity due to chip demands. Most Peloton bike deliveries take less than 2 weeks, which is good for delivering products and aided by the aggressive expansion, but the pent-up demand it saw during Covid couldn’t sustain. As a result, Peloton missed an opportunity to leverage the supply of its bikes and treadmills to create a higher demand for its products while abiding by the current supply chain constraints.
Peloton had ~2.5 million Connected Fitness Subscribers as of their last earnings report, while they had over 1.09 million a year ago. That’s still massive growth in a year's time and it highlights the large opportunity Peloton has as its CEO John Foley envisions Peloton achieving 100 million subscribers.
Foley may have gotten a little too excited and wanted to fulfill this vision faster than possible and it resulted in these short-term headwinds, however, now let’s explore why our thesis for Peloton remains intact.
The Good:
Dispelling The Downfall
The story behind Peloton remains its luxury brand that’s become a household name. Peloton has a significant opportunity to capitalize on its brand through offering new hardware products as well as expanding internationally. Peloton is fully integrated from manufacturing to logistics, but Peloton has also established a social fitness community with fitness instructors who rise to celebrity status and create a real sense of community amongst Peloton users. Peloton has established a strong brand through its live or recorded fitness classes to engage its community through its social fitness platform. Peloton’s rise to a well-known brand was rapidly accelerated by the pandemic and this strong brand recognition won’t go away. Peloton experienced strong growth prior to the pandemic, while it grew at over 100% since 2017. Now it’s time for Peloton to capitalize on its brand in order to increase its Connected Fitness Subscriptions.
International Expansion
Peloton is available in five countries; the U.S., Canada, Australia, United Kingdom, and Germany. The U.S. makes up ~90% of Peloton’s product sales as of its latest 10Q, however, Peloton has a significant opportunity internationally as the U.S. only represents ~35% of its global industry unit sales. Peloton’s international revenue increased to $76 million for the third quarter of 2021 (what Peloton reported as its first quarter of 2022), more than double than it did the prior year, $36 million. While the comps highlight Peloton’s low penetration globally, international revenue represents a great opportunity for Peloton as it’s currently in only five countries.
Peloton recently posted it is hiring for product manager and lead operation roles for their international team, some of the qualifications include fluency in French or Spanish. Peloton must foster a community as well as appeal to cultural norms and preferences in its new regions. By Peloton growing its teams, Peloton could build out content in the U.S. to better appeal to Spanish-speaking communities, as Peloton welcomes more people and grows its brand across the globe. Peloton’s strong brand recognition in the U.S. will enable it to build out these communities and then naturally expand as Peloton’s platform has strong network moats through its social fitness platform.
Globally, treadmills are two to three times more popular than bikes, so this will remain a great opportunity for Peloton to sell the Tread and Tread+ when they're released as Peloton looks to gain international subscribers. Precor is also present in 100 countries which will help provide a boost for Peloton internationally.
New Product Verticals
Peloton will expand its total addressable market and grow the Peloton community by adding new SKUs to its product lines. Peloton currently sells two models of its bikes and one model of its treadmill, the Tread, while the Tread+ will be its second SKU in this category. Peloton’s acquisition of Precor will boost its fitness manufacturing capabilities and enable Peloton to naturally leverage its connected fitness community with Precor’s fitness equipment. Precor’s fitness equipment expands Peloton’s SKUs by adding more strength-based gym equipment which Peloton will use to appeal to commercial opportunities, such as for gyms. It also represents an opportunity for Peloton to expand its community of fitness subscribers as Peloton could leverage its community to sell at-home gym equipment, along with training sessions, which will expand Peloton’s offerings when it comes to more workouts and ways to exercise.
As Peloton expands its product lines, it will continue to expand the products which introduce and attract more people to the Peloton brand. Peloton continues to invest in engaging with its members whether through adding more services, like adding 2500 new classes, adding subtitles to workouts, or introducing structured workout plans catered to individual members. Peloton continues to drive engagement amongst its members and inspire them to revisit the platform.
Commercial Opportunity
Peloton has an opportunity to distribute its fitness products in resorts and commercial settings in order to generate more exposure. Peloton will look to utilize commercial businesses whether through resorts or gyms to acquire members and sell more hardware products.
We know that [having] our bikes in hotels and resorts around the world presents a great opportunity for lead-generation awareness of the Peloton product and content,” - Brad Olson, Peloton Chief Business Officer
When some people use a Peloton at a gym for the first time, they then go home and make a purchase. Peloton CFO stated over the Summer that for every bike Peloton placed in a hotel, Peloton sold an additional seven bikes to a consumer. This highlights the opportunity for Peloton to capture more potential subscribers by using gyms as an additional method for distribution. This will benefit Peloton by being present in multiple gyms which will naturally introduce Peloton to people who exercise, Peloton’s addressable market. Precor already sells gym equipment to large resorts such as Marriot, and Peloton could leverage Precor’s preexisting relationships to deploy Peloton and further expand its brand.
Peloton still remains a leader in connected fitness and has multiple levers it will pull to continue to generate elevated growth over the next five to ten years and attract new members. Now, let’s explore the opportunity for Peloton based solely on Connected Fitness Subscriptions.
Market Simulation
Peloton offers two types of paid subscription services; high-paying Connected Fitness Subscriptions which are $39 per month as well as Digital Subscriptions which are $12.99 and don’t require one to have access to Peloton hardware. For the purpose of this article, we’ll explore the potential market opportunity for Peloton to grow its Connected Fitness Subscribers by 20% to 25% annually over the next eight to ten years and illustrate what this segment could be worth alone by 2025 and 2030.
Peloton’s Connected Fitness Subscriptions Outlook:
Source: Author’s Estimates
Given that Peloton is still in its early days, its brand is reminiscent of some of the most popular companies over and should be compared to that of Netflix (NFLX) and NIKE (NKE). Given the massive opportunity, Peloton has to explore new opportunities and capitalize on its strong brand recognition, it’s fair to assume Peloton generates 15% to 20% annualized growth past 2030. Therefore, Peloton’s subscription-based revenue, which will generate 70% long-term gross margins, and is deserving of a 35x price to free cash flow multiple.
Based on this model, Peloton’s Connected Fitness Subscriptions will surpass 5 million in 2025 and 10 million by the end of 2028. Once Peloton surpasses 5 million Connected Fitness Subscribers, this segment is estimated to be worth ~$28.6 billion on a stand-alone basis, assuming Peloton continues to charge $39 per month and trades at 35x P/FCF. At 10 million subscribers, it’d be worth ~$57.3 billion. Peloton currently trades at $11.5 billion in market cap, which means that there’s a significant upside in Peloton based on Connected Fitness Subscription growth alone.
While this exercise is valuable in highlighting that Peloton’s share price is heavily undervalued based on our outlook for Peloton’s potential subscriptions, we will deploy the L.A. Stevens Valuation Model and account for Peloton’s hardware sales and all other revenue streams in order to predict an expected return for Peloton if one were to invest today, trading at ~$35 per share.
Peloton's Valuation and Expected Return
To determine Peloton's fair value, we will employ our proprietary valuation model. Here's what it entails:
- In step 1, we use a traditional DCF model with free cash flow discounted by our (shareholders) cost of capital.
- In step 2, the model accounts for the effects of the change in shares outstanding (buybacks/dilutions).
- In step 3, we normalize valuation for future growth prospects at the end of the ten years. Then, using today's share price and the projected share price at the end of 10 years, we arrive at a CAGR. If this beats the market by enough of a margin, we invest. If not, we wait for a better entry point.
Assumptions:
FWD 12-Month Revenue [A] (conservative estimate) | $4.75 billion |
Potential Free Cash Flow Margin [B] | 20% |
Average fully-diluted shares outstanding [C] | ~331 million |
Free cash flow per share [ D = (A * B) / C ] | $2.85 |
Free cash flow per share growth rate (conservative estimate) | 18% |
Terminal growth rate | 3% |
Years of elevated growth | 10 |
Total years to stimulate | 100 |
Discount Rate (Our "Next Best Alternative") | 9.8% |
Source: L.A. Stevens Valuation Model
Based on conservative estimates of Peloton’s free cash flow margin and free cash flow growth rate, Peloton is significantly undervalued with an intrinsic value of closer to $110 per share. Before we determine whether or not Peloton is a good investment, we’ll use the second component of our model to predict an expected return for Peloton over the next 10 years.
Our model calculates a projected FCF per share value in year 10 and multiplies it with an assumed price to FCF multiple (30x here), thereby generating a 2031 price target. Using this price target, the model generates an expected CAGR return for a ten-year investment.
Source: L.A. Stevens Valuation Model
Peloton is expected to generate ~26% annualized returns over the next 10 years while its share price is expected to 10X over the same period. Hence, I am bullish on Peloton and view it as an opportunity to invest in one of the staple consumer brands that will be at the forefront of connected fitness trends. Peloton is growing in so many verticals and with an opportunity to expand the Peloton brand across the globe, the company is still in its early innings.
Margin of Safety
For this model, we used extremely conservative estimates to create a margin of safety using conservative growth and margin rates.
For Peloton’s free cash flow margin, we used 20%, which is highly conservative because Peloton’s long-term value will be its fitness subscribers which is a higher margin business, as highlighted above. A 20% free cash flow margin will be conservative in determining Peloton’s expected free cash flow over the next 12 months. Over the long term, Peloton’s free cash flow margin could be closer to 30% as it looks to take advantage of becoming fully vertically integrated.
For Peloton’s free cash flow growth, we used 18%, which will be attainable because of the variety of opportunities Peloton has to develop revenue streams as it continues to explore new verticals and digital fitness trends. Peloton resembles the Nike or Netflix of connected fitness, and digital fitness trends will become more popular over time, especially amongst younger generations.
Peloton trading at 30X price to free cash flow should also prove conservative given its margin profile as well as the opportunity to generate substantial revenue growth past 2030.
Risks
Peloton bears will claim that competition is a risk, however, competition is to be expected given the massive market opportunity. Peloton will face lots of competition from companies such as NordicTrack, Tonal, Bowflex, or iFIT (IFIT), but Peloton isn’t threatened by its competition because Peloton has the first-mover advantage and will rely on its brand. The Peloton brand and social media platform for connected fitness will result in strong network effects to help establish Peloton's network moat. This type of community combined with Peloton’s brand recognition will go a long way in cementing Peloton as a long-term winner in the connected fitness category.
Peloton is operating in short-term headwinds, especially given its recent negative publicity as well as the supply chain impacts from the pandemic. However, management will need to prove that Peloton can still operate at a high level given its expansion during the pandemic. John Foley is a visionary CEO that has a lofty vision to create a $1 trillion company with over 100 million members. Peloton invested a lot over the last 18 months and will now need to execute in the current environment. More on our thesis around Foley’s vision can be found here.
Conclusion
Today, there’s a great amount of pessimism priced into Peloton. There are so many opportunities for Peloton to continue to develop its brand and enter new segments. Peloton has a lot of opportunities to branch off and develop additional revenue streams with its recent acquisition in Precor. I believe the Peloton brand remains the story while Connected Fitness Subscriptions will be the key for Peloton to accelerate free cash flow growth which will ignite the share price. Whether Peloton attempts to expand its brand and increase its subscribers by adding more hardware products and then more subscription offerings, or if Peloton expands to new regions, there’s an abundance of opportunities. Moving forward, Peloton’s brand will be a staple across the globe and continue to evolve over the next couple of decades.
Final Takeaway: I am bullish on Peloton trading at ~$35.
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