Table of Contents
- 1 Thesis 1: Peloton is revolutionizing fitness routines
- 2 Thesis 2: Strong unit economics positions Peloton to scale
- 3 Thesis 3: “Pedaling” the product and supply engine to grow
- 4 Thesis 4: Long growth runway ahead domestically and globally
- 5 Peloton remains undervalued
- 6 Downside risk
- 7 Upside risk
- 8 Conclusion
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Peloton (NASDAQ:PTON) is revolutionizing fitness routines by combining hardware, software and content into a single connected fitness subscription which generates sticky recurring revenue for multiples years. With strong unit economics and long runway for growth domestically and globally, Peloton could grow multiples times in the medium term.
Thesis 1: Peloton is revolutionizing fitness routines
With just an interactive bike, customers can stream fitness content, track their performance against others, socially connect with other members comfortably at home. Peloton is revolutionizing fitness routines by combining hardware, software and content into a single connected fitness subscription. The number speaks itself: connected fitness subscription workouts grew 333% YoY in 4Q20 to over 76.8m, averaging 24.7 monthly workouts per connected fitness subscription, versus 12.0 in the same period last year. This revolution is built upon disruptive pricing, gamification of fitness through technology and software, and the Professionally Generated Content (PGC) platform for fitness.
At a monthly price of US$88 (including US$49 monthly installment for 39 months towards bike and US$39 towards connected fitness subscription) after the 15.6% price cut this week, customers can take unlimited class on the bike and off the bike anytime at home. This is the most competitive price against other class packages offered by competitors according to Page 13 of the third quarter presentation: Flywheel is priced at $300 per month; Soulcycle is priced at $432 per month and ClassPass is priced at US$159 per month. If family members share the usage of Peloton bike package, the cost differential is even more dramatic.
Gamification of fitness through technology and software
Peloton’s technology-enabled bike turns exercise into a gamified experience that is unfound in traditional fitness routines. Through the Leader Board, members can compare their performance with others just like a game. The creation of “tags” that represent members’ shared interest, geography and career as well as video chat function makes social connection possible even at home. Members can now also integrate Apple (AAPL) Watch with Peloton. In the long term, I fully expect there will be more technology integration with other major technology companies. VR/AR fitness workout could arrive at Peloton when the market is ready. This kind of technology and software enhancement is an critical competitive advantage of Peloton. It does not only keep users engaged as long as possible, but also attracts non regularly-exercised people to the purse a fitness routine that would otherwise have been difficult to implement.
Professionally Generated Content PGC platform for fitness
Peloton’s library of fitness class content does not source from the third-party User-Generated Content (UGC). Instead it is building in-house studios to build a PGC fitness platform. By hiring top fitness instructors to teach at its dedicated studios where members could join both physically and remotely, it reinforced Peloton’s brand as the go-to-platform for fitness. This strategy resembles Lululemon’s community brand building strategy in which high profile yoga teachers are recruited to teach yoga class at its store to promote Lululemon’s yoga brand. In fact, it appears working already, as reflected by the 210% YoY growth in paid digital subscribers to over 316,000 in 4Q20 despite the abundant supply of free digital fitness content. Going forward, the completion of the Floral Street Studio in London by Spring 2021 will significantly increase production of floor content as well as foreign language classes for European members. This should not only better serve the diverse workout needs of members, but also further enhance customer stickiness. As a side note, in-house studio filming also allows fixed cost leverage in studio expense and instructor salaries towards the 70% long term subscription contribution margin target. (As of 4Q20, subscription contribution margin increased by 4.1 percentage points YoY to 64.1% from 60.0%.)
Thesis 2: Strong unit economics positions Peloton to scale
The strong unit economics of Peloton’s business model positions the company to scale. According to the Life time value to customer acquisition cost (LTV/CAC) analysis done by Peloton, the LTV/CAC ratio is 718.6 (3,593/5). Generally the more LTV you can get for each dollar of CAC, the better the business is. While one could argue the LTV/CAC calculation looks too good to be true, the underlying logic still points to an extremely attractive unit economics.
Unlike most businesses which require spending marketing dollar to acquire customers upfront, and then hoping they will be hooked up in the service, followed by sufficient purchasing to cover the customer acquisition cost, Peloton’s payback is almost immediate This is achievable because products are priced high enough so that the gross profit can largely offset the total CAC (sales & marketing expense).
The true beauty of the business model lies in the post-sales engagement from customers. Once customers have purchased the bike, they need to purchase the connected fitness membership at US$39 per month to maximize their Peloton experience on the bike and off the bike. Given that they have already committed to the equipment at relatively high price, they are heavily incentivized to keep the fitness subscription as long as possible. Hence the average net monthly churn rate is extremely low at just 0.65% as of FY19, implying 154 months of average duration of subscription (12.8 years). Of course this is the perfect scenario without factoring in product defect or deterioration relative to competition. But it is safe to assume the subscription will last for at least 3 years given the ongoing enrichment of class content and constant need for exercising. This will yield US$840 per subscriber and a LTV/CAC ratio of 168x, still an attractive level.
In my opinion, there could be upside in the LTV/CAC ratio both in the near term and the long term. In the near term, strong brand awareness of the brand coupled with the COVID-19 catalyst and product supply delay should allow revenue to grow at minimal marketing expense. Revenue grew by 172% YoY in 4Q20 even when the company paused marketing expense in the US. In the long term, there should be an improvement in marketing efficiency when multiple new products (treads and bikes) are marketed together in the same campaign. Additionally, the enormous growth of digital subscribers could become a low cost lead-generation channel for connected fitness subscription conversion, especially after the new product launch announced this week (to-be discussed next).
Thesis 3: “Pedaling” the product and supply engine to grow
Given the strong unit economics, Peloton is “pedaling” the product and supply engine to get it to grow.
On Tuesday, Peloton launched a premium bike, Peloton Bike+, at US$2,495 to make the screen rotatable for bike and non-bike workout, enhancing the value proposition of all-in-one fitness workout on the bike. In addition, Peloton launched a smaller Peloton Tread at US$2,495 (41.9% cheaper than the original Tread at US$4,295, which is renamed as Peloton Tread+) to penetrate to more households who prefer Tread to Bike or simply prefer a smaller Tread. Management believed Tread as a portal for full-body workout could offer multiple times of the bike opportunity post FY22 as production ramps up.
Peloton placed great importance in supply chain investment as it is the foundation for scaled production over the long term. Peloton acquired Tonic Fitness Technology, a manufacturing company located in Taiwan, for US$45.0bn in October 2019, to better control its destiny. It is currently investing in a new factory in Shin Ji, Taiwan, which is to be completed in 20 December with additional 1.5mn unit production capacity per year, a substantial capacity expansion considering Peloton has just 1.09mn connected fitness subscribers as of FY20. This is probably why management believes the delay in order-to-delivery window in multiple geographies due to supply-demand imbalance should normalize by the end of 2Q21, despite production capacity has already doubled in recent months. As Peloton makes continued investment and automation in its production facilities, the company is likely to address materially higher demand to support global expansion.
Thesis 4: Long growth runway ahead domestically and globally
Low household penetration in the US
Given that connected fitness household penetration in the US is just 0.8% (1.09m subscribers over 129m US household), I believe Peloton is still in the infancy stage of growth towards fitness routines revolution. Note that number of US household is used here rather than the US gym membership number to reflect Peloton’s product focus towards household rather than the individual fitness guru.
International markets remain untapped
As of 9M20, only 3.5% of revenue was generated from international market (UK and Germany) while 96.5% of revenue was generated from North America (US and Canada). International revenue increased by 181% YoY in 3Q20, offering a glimpse of the tremendous potential of international growth over the long term.
With the pandemic sweeping in 2020, Peloton’s value proposition has never been more resonant to consumers. Gyms are closed but the need for fitness maintenance has only grown stronger. As of 4Q20, connected fitness subscribers grew by 113% YoY to over 1.09mn and total revenue grew 172% YoY. As COVID-19 looks increasingly difficult to contain quickly, even when gyms are reopened, high growth should continue (factoring growth tapering off gradually from the peak of COVID-19) in the next two years. It is important to note that recent stellar quarters are not purely COVID-19 driven. Prior to COVID-19, company grew revenue at 104% CAGR across FY17-FY19, reflecting the fundamental value proposition of Peloton.
Peloton remains undervalued
After the stock price tripled year-to-date, Peloton is trading at 184.3x FY22 P/E, 58.0x FY22 EV/EBITDA and 5.0x FY22 EV/sales. Investors might find the valuation uncomfortable, particularly when NASDAQ is recently correcting. However, based on the implied market valuation of Peloton’s business by parts, the stock remains undervalued. I assume 20% of the FY22 revenue consensus estimate of US$4.667bn will be generated from subscription (i.e., US$0.933bn) and 80% of that will be generated from the connected product (i.e., US$3.734bn).
While subscription business accounts for just 20% of revenue, based on the unit economics explained above, this business should be where the majority of value is from. I ascribe the entire current Enterprise Value to the subscription business alone excluding product sales to reflect this understanding. Dividing the current enterprise value of US$23.5bn by FY22 subscription revenue of US$0.933bn, the subscription business is trading at 25.2x FY22 EV/sales. This is a reasonable SaaS valuation given that subscription revenue is expected to grow at 60.1% CAGR across FY20-FY22. As a reference, Shopify (SHOP) is trading at 22.8x FY22 EV/Sales but with 34.0% revenue CAGR across the same period.
Connected product business
This business is a bonus to shareholders rather than the core business shareholders pay for. Assuming this is a standalone business, it is essentially a niche e-commerce company selling bike which has benefited from stay-at-home workout trend. Applying 2.0x EV/Sales multiple (typical e-commerce valuation) to the FY22 product revenue of US$3.734bn, this segment is worth US$6.7bn, representing 28.5% of current EV.
What this market implied valuation of Peloton by parts is that investors are paying 25.2x FY22 EV/sales for a fitness subscription business growing at 60.1% revenue CAGR across FY20-FY22 while receiving 28.5% rebates (upside) from its connected product business. In other words, the stock is least 28.5% undervalued and the fair value should be at least US$108.
Note that the above revenue consensus estimate implies 60.1% revenue CAGR across FY20-FY22. Given the compelling value proposition of Peloton, which is amplified by intermittent COVID-19 outbreak, the only constraint to upside surprise in revenue growth is if Peloton’s capacity is ready. Since the opening of Shin Ji factory in December will provide additional 1.5m unit production capacity per year, representing room for 138% growth versus 1.09m connected fitness subscribers as of FY20, and foreign language class production will increase “substantially” at the new London Studio in Spring 2021 for European expansion, the current market consensus revenue growth expectation of 95.9% YoY for FY21 appears to have underestimated Peloton’s capacity to grow.
In the medium term, I believe PTON could grow multiple times from here. An additional 3% US household penetration (i.e., 3.87mn) represents 3.6x of current connected fitness subscriber base.
Supply chain bottleneck
As discussed, the biggest constraint to growth is to keep up manufacturing capacity with the elevated demand. Peloton could lose potential customers when their orders cannot be met quickly enough.
Due to the infancy growth stage of the connected fitness market, there will be more competitors entering the space to steal market share from Peloton. If competitors are able to offer cheaper and better products, Peloton could be under pressure. However, Peloton’s recent price product reduction should address the risk.
Large tech companies might acquire Peloton before it gets too big, capping the upside of shareholders.
On top of the market growth opportunities outlined in the above thesis, there could be upside risk should Peloton find growth in new dimensions. As Peloton’s loyal customer base grows, there is the optionality to
- sell ancillary health-related products;
- aggregate third party content (fitness content or even Netflix (NFLX)); and
- be the platform of choice for VR/AR fitness game partners.
Peloton is revolutionizing fitness routines by combining hardware, software and content into a single connected fitness subscription which generates sticky recurring revenue for multiples years. Strong unit economics coupled with expanded product offering and production capacity positions Peloton to grow substantially in the US and abroad. The stock is worth US$108 based on analysts’ estimates. I see further upside since the 95.9% FY21 consensus revenue growth is well below the 138% capacity addition from the factory. In the medium term, Peloton could grow multiples times in the medium term. Investors should buy on dip presented by market volatility.
Disclosure: I am/we are long PTON. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.