Peloton: Retethering
Free cash flow breakeven for the fiscal second half? The market doesn't buy it.
I believe Peloton’s fiscal first quarter report, which is a must-read as a case study at the very least, showed the business has turned the corner.
Cash burn has gone from $747 million to $412 million to $246 million over the last three quarters. The business has $939 million of cash and an untapped $500 million revolver. It should reach cash flow breakeven for the fiscal second half, which is the Jan-June period. So liquidity is no longer a risk, in my view. But the market is skeptical and needs more evidence. Here’s how I’m thinking about it.
The Cost Turn
After nine months on the job, Barry has left his fingerprints on every aspect of Peloton’s business. He hired a Chief Supply Chain Officer, Andrew Rendich, to get the company’s arms around its inventory commitments. Prior management essentially panic-ordered inventory during the pandemic—when people were waiting up to 12 weeks to get a new Peloton bike—and did not have a good grasp of how much inventory they had committed to buying. It was a lot. And it tied up about a billion of cash in excess inventory, which was a nightmare for a business that found itself suddenly burning several hundred million of cash per quarter.
Rendich and his team negotiated with their suppliers and reached settlements that have now put this issue to bed. Some more settlement payments will be paid, but the amount is no longer material or concerning in light of the company’s liquidity.
Perhaps Barry’s biggest theme has been undoing Peloton’s vertical integration and converting fixed costs to variable costs. Vertical integration and high fixed costs make sense when you have a ton of volume and can leverage fixed costs to lower cost per unit. But that does not make sense for a business where new hardware demand is less robust than once thought and highly seasonal. Instead, low volumes over high fixed costs create high costs per unit and alarming cash burn during slower periods.
That’s why Barry exited owned manufacturing operations in Taiwan—which prior management had acquired three years ago—letting go of 700 heads, and is now outsourcing all manufacturing. That’s why he exited first-party logistics—letting go of 2,800 or more heads in field ops—in favor of outsourcing. He is now in the process of exiting a large number of showroom leases and effectively outsourcing most of the non-Peloton.com retail strategy to Amazon and Dick’s. The new reimagined Peloton is essentially a software and content business with ultra-high incremental margins that outsources everything else.
Consistent with his view that “talent density is job one,” he has let go and replaced several members of the executive team. Former COO William Lynch and former CFO Jill Woodworth were let go. New CFO Liz Coddington came from Amazon Web Services and prior to that, Netflix. New Chief Accounting Officer Saqib Baig came from Meta and Colgate-Palmolive prior to that. Rendich worked for Netflix for 12 years, since its DVD days, in operations and has since been working in operations, supply chain, and logistics for Walmart.com and several other roles, including as an advisor to other companies. Barry has clearly upgraded several of the most important roles on the leadership team.
Planting the Seeds of Growth
Since day one, Barry has said cost cutting is required but it’s not sufficient. Growth is needed too.
Peloton launched Fitness-as-a-Service (“FaaS”), the rental program that requires no upfront purchase and combines the hardware rental and subscription into one payment. Customers can cancel and have their bike picked up anytime or can buy out their bike at pre-determined prices in the future. FaaS was actually an idea that prior management had been thinking about for years, but hadn’t launched. It appeals to those for whom the upfront purchase creates friction and/or for those who find the flexibility to return anytime valuable because they aren’t sure Peloton hardware is something they will stick with. It certainly expands the addressable market. While the unit economics are still being tweaked, as Barry said on the call, FaaS is too important to not figure it out.
FaaS is now about one-third of new Bike sign ups. Over the two weeks prior to the call, it was averaging about 175 sign ups per day. Barry is “over the moon” excited about its potential and plans to lean into it later this fiscal year.
Peloton now has a Certified Pre-Owned bike program, which is essentially a refurbished Bike for $995. They use this occasionally to boost sales. I wouldn’t be surprised if many of these were actually new Bikes given the oversupply situation.
Peloton is now available to purchase via third-party retail for the first time. The Amazon partnership went live last month and the Dick’s partnership went live in the couple weeks. These broader points of distribution are intended to meet customers where they are. The Amazon partnership has gone better than expected with Peloton being among the best sellers of the Top 100 Deals on the Prime Early Access Sale.
The long-awaited Peloton rower, called the Peloton Row, just went on sale and the first deliveries are expected next week. I have read mostly high praise for the Row. Management said demand exceeds the initial low supply at the moment, but more supply will come.
Management is working on a relaunch of the digital app that will include a multi-tiered freemium offering. Thus far, the digital app has not exceeded one million paid subscribers, which has been disappointing. Barry points out that competing digital apps like Nike Run Club, which is free, and Strava, which is a freemium model, have over 100 million users each. With all the world-class content and music that Peloton has—truly second to none among fitness content—it seems there should be upside to their current 875,000 digital app subscriber base. I would expect Peloton to go to market with a “free, better, best” pricing approach in January.
Barry also mentioned leaning into the commercial business later this year. I still expect Precor to be sold given Barry has consistently said something to the effect of, “If it’s not connected fitness, we’re not doing it.” That would reduce headcount by another ~800.
The Results
Operating expenses, excluding restructuring, impairment, and supplier settlement charges, have come down significantly over the last three quarters.
The F1Q23 figures are actually a bit inflated by a one-time acceleration of the vesting requirement of restricted stock units for certain employees and a one-time repricing of certain stock option awards to certain non-C-level employees. The stock-based compensation expense related to these that was recognized in F1Q was $31.3 million, with the vast majority of that within opex. So excluding that one-time cost F1Q23 opex would have been closer to $390-$400 million.
In the current F2Q23 quarter, sales and marketing are expected to increase sequentially for the holiday season but G&A and R&D should decline “over the coming quarters” partially because 500 employees were let go in October in the last round of restructuring.
My best guess is we’re now looking at something like $1.7 billion of operating expenses excluding non-recurring items in fiscal 2023. In my last published base case, I had $1.9 billion of opex. Clearly, Barry has cut more costs, and cut them faster, than I expected.
This WSJ story from last month discussed the most recent 500 who were let go, but also mentioned there were another 600 let go since June that hadn’t been previously disclosed or reported on. Peloton now appears to have close to 3,800 employees, down more than half from a disclosed peak of 8,976 in F1Q22 (Sept ‘21). That is now back near June 2020 levels when Peloton appears to have been averaging about $250 million per quarter on opex. Certainly, there’s been a lot of inflation, more showrooms, and the company moved into its fancy new New York headquarters since then, so I’m not suggesting opex will get back to $1 billion annually. But I do expect it to continue to decline after this year.
Here’s a screenshot of my model at the moment:
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