Peloton: Some Notes

I recently had a conversation about the business and listened to Barry’s remarks at the J.P. Morgan conference. Here are some of my thoughts on a few topics.

Inventory

One of Peloton’s biggest problems to work through has been its purchase order obligations that prior management entered into before they realized their mistake. As a result, the company has had an inflated level of inventory for a while now because of these purchasing obligations. Essentially, the bathtub is draining (units out) but too much water is still coming in from the faucet (units in) because of these commitments. This is the root of the supply chain issues that management somewhat vaguely discusses.

This is from the F2Q (Dec) 10-Q:

And this second section is from the F3Q (Mar) 10-Q.

Essentially, Peloton’s new head of supply chain Andy Rendich and their lawyers have been working to split the $550 million into two parts—1) the amount they are legally on the hook for, and 2) the amount that may be subject to negotiation. As of March 31, 1) is $120-$280 million and 2) is $180-$470 million. Their lawyers made them use these very wide ranges in the 10-Q, but the mid-point of both essentially sums to the $550 million referenced at December 31. They are not technically obligated to purchase the amount in 2) but playing hardball with your suppliers is a good way to permanently damage the relationships. What they will ultimately have to pay will be determined by their current negotiations. This topic is their number one priority right now.

As for cash flow, inventory was a $128 million source of cash in F3Q. That may have been something like a $500-$550 million source of cash from inventory sold mostly offset by maybe a ~$400 million use of cash from inventory purchased. Those inventory purchase obligations are beyond what Peloton actually needs and are the result of prior management interpreting Covid levels of demand as secular demand. This is frustrating for a business that is working hard to get back to free cash flow positive.

But I think things are improving. Despite some prepayments, inventory should be a larger source of cash in F4Q than it was in F3Q. That is a contributing factor to why Jill said to expect F4Q cash burn to be better than the monstrosity it was in F3Q.

And then into Fiscal 2023, how much cash should we expect to come out of inventory? That depends on what a normalized level of inventory is for this business. At the end of March, inventory was a bloated $1.4 billion. Just before Covid, Peloton was running with $200-$250 million and was able to meet demand. That said there are some big differences between then and now. Back then, its hardware products were just the original Bike and the Tread+ (then called Tread). Now its inventory includes Bike, Bike+, Tread, Tread+, Guide, and soon a Rower. It has also launched in Australia since then. Perhaps shocking to some, the company is still selling more hardware units than it was pre-Covid. Inventory needs for apparel and replacement parts have grown considering the CF subscriber base is up over 4x since pre-Covid. It also acquired Precor, which as you can see had $99 million of inventory at the time of the acquisition.

So it’s clear that normalized inventory should be substantially more than $200-$250 million. During the 2020 fiscal year (ending June 2020), Peloton had 90 days of inventory on hand on average. Only the final quarter was influenced by Covid, so that is probably not too far from normalized. Using Fiscal 2022’s (June) product demand along with 90 days of inventory suggests normalized inventory would be something like ~$460 million. If it’s 100 days, it would be ~$515 million. But if FaaS is viable, then inventory needs would be higher because they’d hold the rental units on the books. More on FaaS later.

The company has not given a specific number for normalized inventory but said they could certainly take out $500 million. That would imply $900 million of normalized inventory. That seems conservative. Or maybe it leaves room to carry more inventory on the books to support FaaS. Either way, I think there’s probably somewhere between $500 and $900 million of cash that can come out of inventory versus the March-ending level.

And on the last call, Jill said it will take to the end of Fiscal 2023 (June ’23) to work through the excess inventory.

So this $500+ million inventory tailwind is a big factor in getting the company to free cash flow positive by the second half of the fiscal year (calendar 1H ’23).

FaaS