Barry McCarthy is 69 years old.
This man really should have retired and he actually did after his last job at Spotify’s CFO. Under his watch, Spotify pioneered a new (and cheaper) was of going public - the direct listing.
However, Barry is most famous for his stint at Netflix.
He joined Netflix in 1999, 2 years after it was founded by Reed Hastings. He left in 2010 after ensuring NFLX transitioned successfully from selling DVDs by mail to streaming. In 2008, this is what he said, “We’d like to be on as many platforms as possible,” he said. “If you buy an electronic platform and you’re able to access Netflix content on your TV because it’s on that set-top box, that’s great.”
During the transition period, McCarthy bundled physical DVD movies with streaming. His reasoning was grounded in finance. Streaming was new, slow and unreliable. Pairing it with DVD rentals would ensure customers remained with the Netflix service long enough for streaming to improve and become the core product.
I like founder led companies, but when they flounder, you need a numbers guy
My bias is to invest in firms that are founder led. My family’s portfolio has 16 holdings. 11 of those companies are founder led. Founders tend to have a lot of skin in the game and a vision that drives a company forward. It’s a perfect alignment of incentives - usually.
Unfortunately, founder-led companies do flounder. Sometimes, a great founder simply doesn’t make a great leader. Fastly was such a company. Founded by Arthur Bergman, he stepped down to focus on his role as a chief architect about a year after Fastly went public. I believe in the long term success of Fastly’s @Edge product suite and continue to hold the shares. However, looking at the cadence of product releases, they are being outflanked and left in the dust by Cloudflare - an execution beast. I don’t own shares in Cloudflare because of valuation risk. Fastly makes $339m and trades at a $3b valuation (roughly). Cloudflare makes $588m and trades at a $33b valuation. Go figure.
But I digress.
When a founder-led company starts floundering, it is often best for the founder to step back and let a seasoned numbers / management / capital allocator step up to the plate.
Was Peloton Floundering?
Yes.
John Foley (founder, ex-CEO) was overly optimistic about demand and committed to a massive capex & hiring spend. They purchased Precor and started building the Peloton Output Park manufacturing facility. They also dropped prices on their 40% margin hardward (taking it down to single digit gross margins) to get more customers into the Peloton subscription service.
Now, considering that those hardware margins paid for the company’s Customer Acquisition Cost, you can start to see how the balance sheet would be torched if demand didn’t increase by over 50% YoY (when I first invested, the company was doubling since 2017).
I assumed (incorrectly) that the management team had correctly forecasted demand & managed finances to ensure this spending spree / discounting was justifiable and would result in a great ROIC.
Unfortunately no.
Peloton has since reported that they have enough inventory on hand to fulfil demand for the forseeable future and are currently planning to wind down their factory plans. They’ve also slapped on a $250 delivery fee on their hardware.
It’s frankly astonishing how quickly a company’s story can change in 6 months. All I can say is - boy am I glad they had a 80+% Net Promoter Score and a 0.79% subscriber churn. Those 2 things alone are enough to convince me to hold the stock long term.
The Silver Lining
Peloton’s product have over 80% Net Promoter Score & an ultra low 0.79% monthly subscription churn. Gross margin for the subscription business is now 67% (it was 60% last quarter).
If Peloton’s hardware sales pays for Customer Acquisition Cost (as before), churn remains low and gross margin on their subscription business continues growing to that magical 80% mark, Peloton will be on fantastic footing exiting the pandemic.
The numbers from the latest quarter (Q2, 2022) actually looks good on the digital subscription front :
66% growth in Connected Fitness Subscriptions ($39 / month)
38% in Digital Subscriptions ($12.99 / month)
Revenue grew 6% (dismal, but expected since the current prime driver of revenue is hardware sales)
On the balance sheet front, things are starting to look good again :
Cash : $1.6b
Credit (undrawn) : $500m
Operating cash flow : $-443m (4 quarters of burn available)
My take - A poorly managed fabulous business
I like Peloton’s business model. A hardware business that pays for its own CAC (before they decided to torch pricing), a sticky subscription business, incredibly high NPS & low churn.
Peloton is a fabulous business. Very few companies can boast a product like this.
I would prefer if Peloton focused on fixing its finances and management gets better at balancing growth with available capital.
I also believe Peloton is a product that will do well outside the US. A great way to fix the excess inventory problem is to figure out a way to distribute products globally without overcommitting to opening stores and warehouses.
Connected Fitness is a great idea. One must not lose sight of the fact that Peloton was growing 100% YoY before the pandemic. This is a clear indication of demand for at-home spin & fitness classes.
We should also go back to the early 2000s when Soul Cycle reigned supreme. Peloton solved a problem Soul Cycle had - a lack of on-demand, infinitely scalable spin classes. Soul Cycle’s instructors are popular, but unless one can get a slot in a specific studio, one simply cannot enjoy their classes.
With a Peloton, you can.
Take a look around the whole Connected Fitness industry. The success of companies like iFit, Tempo, Tonal all point to a strong trend for at-home workouts. It’s simply a better experience than driving / commuting to the gym.
What I am doing with my Peloton Allocation
I have a position in Peloton but am not adding to it until I see signs of financial discipline and capital allocation sophistication from management. I don’t see any reason to sell the position given how popular Peloton’s product is and how it continues growing. 66% growth in connected fitness subscriptions is truly solid growth.
Peloton added 1.1m new connected fitness subscriptions in 2021. Assuming this halves to 500,000 a year, one can expect the following numbers in 2030 (back of envelope) :
Connected Fitness Subscribers : 6.7m
Subscription Revenue : $3.1b
Gross Margin grows to 70% : $2.17b
Gross Margin Multiple : 9x
Company Valuation in 2030 : $18b
I am definitely sandbagging a lot here. Peloton is currently trading at $11b on the back of $1.2b in gross profit. The business is arguably at rock bottom now and has a new CEO who has the chops to build value.
I am genuinely optimistic and in a bull market, I would be adding to my Peloton position. However, in a market where Facebook is down at 16x EBITDA and Zillow is also trading at 7x Gross Margin and EBITDA positive on their IMT business, buying Peloton is tough. My monthly funds are limited and I am forced to pick the best buys at the moment which (as enticing as it is) isn’t Peloton.
Disclaimer : This article is not investment advice and merely for entertainment. I only give opinions, not advice and am not a certified financial advisor. I’m just some bloke on the internet possible shooting my mouth off.
Invest with caution and always do your own analysis. This devaluation in Peloton stock should be a cautionary tale for every investor. It highlights the risk of investing in companies. The story & financials can change dramatically in 2 quarters, resulting in potential permanent loss of capital.