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Peloton was one of the Pandemic stars. It was a hit. It looked like a company that could never fail. Since its high’s in Dec 2020, the stock has fallen on its face. Peloton has lost 91% of its value from its peak. ($171 in Dec 2020 to $14.5 on May 22’2022).
This chart is a nightmare for any investor (excluding the SP500 line in blue 😁). Especially those who bought Peloton at its peak, thinking there is a new high somewhere there. In 2021 Peloton touched $171 per share and reached a market cap of $50B. In Feb 2022, it laid off 20% of the workforce, replaced the CEO, and was considering a potential sale to Amazon, Apple, or Nike. Peloton is currently trading at $14, a 50% discount on its IPO price of $29.
Costs are escalating and Peloton recently got a cash infusion with a $750M loan. The company has decided to go the iPhone route where the cost of the hardware (bikes/treads) will be included with the price of the subscription. Going the subscription route does not solve the core problem that Peloton has, a picture of inflated demand. Are there really these many purchasers of their bikes. The Ohio factory, set to cost $400M, is being sold as Peloton downsizes its operations and cuts manufacturing costs. In this blog, I want to explore what went wrong, the lessons for all of us, and what is the future looking like. But first, What is Peloton?
What is Peloton?
John Foley, Yony Feng, Hisao Kushi, Tom Cortese, and Graham Stanton are the five co-founders of Peloton. John Foley is said to be the idea behind Peloton, he is a boutique fitness freak. In 2013, they launched their first bike for $1500.
Today, with 2.7M subscribers and 6.5M members, Peloton is by no means a massive company. But it has an outsize influence on the fitness industry. Calling it “fitness tech” doesn’t encapsulate it; Peloton has eclipsed the NordicTracks of the past, marrying compelling programming with premium hardware and, yes, capitalizing on the fact that people have been stuck in their homes for two years. Even before the onset of the p-word, Peloton had become the coveted c-word: Many software service providers boast about their online “communities,” but Peloton had achieved full-on cult status.
On one hand, it’s a cult and a closed-knit community, on the other it’s a nightmare for shareholders and investors. Things need to change and change fast for Peloton to survive or even be acquired. A massive balance sheet clean-up of costs is required to increase operating income and reach profitability. But what went wrong, let’s find out.
What went wrong
Peloton has become famous as the pandemic stock. Blackwell’s report (one of the investors of Peloton) smashed the company for careless decision making, not qualified leadership, and lack of financial discipline. To understand these allegations let’s look at Peloton’s financial charts below.
Conclusions from this chart – COSTS ARE WAY TOO HIGH
First, the cost of revenue is increasing at a faster pace than the growth in revenue, especially since 2020. This could be due to cutting down on hardware prices and more recently merging hardware prices with the subscription costs. This is a big red flag, to build a sustainable and scalable business, the revenue has to grow faster than the costs of revenue.
Second, R&D is stable or slightly increasing throughout, which is surprising given the product (hardware – cycles/treads) has not evolved over time. I mean it’s the same bike as 2016. So growth in R&D costs is surprising. SGA costs are on the rise and I am a bit surprised by that too. One probable answer could be an increase in the number of installation personnel. Another could be Sales and Marketing costs. S&M is not presented as a separate line but lumped with SGA, which could also be a reason why SGA costs are rising.
Peloton is banging on the wrong door – Hardware. Let’s see why
Peloton poured hundreds of millions of dollars into its logistics network in recent years to keep pace with demand for its products. It opened new warehouses, bought a manufacturer in Taiwan in 2019, and spent $420 million to acquire fitness equipment maker Precor in 2020. But when demand fell as the company’s pandemic popularity faded, Peloton fell prey to the bullwhip effect, with some employees previously telling Insider that warehouses grew so stuffed with bikes that it became like a jigsaw puzzle to try to find room to fit more. Peloton announced it was scrapping plans to build its own $400 million factory in Ohio and would scale back its number of warehouses and delivery centers in favor of third-party distribution as part of cost-saving measures expected to deliver roughly $800 million in savings per year.
Despite the shortage in demand, Peloton is continuously pouring money into building bikes and the supply chain. On the contrary, Peloton’s subscription model is working fine and there are positives to be taken from this. Peloton is enjoying gross margins of 68% and gross profit is also increasing in this segment. Let’s look at the chart below, which shows the growing subscriber base for the connected fitness program. This is a lack of financial discipline, Peloton should spend money to build a moat around its key product, Software. It’s about what you want to build with the available cash cushion, it’s certainly not more bikes.
Peloton’s aspirational business model – Become Apple of Fitness
Just to keep it simple, Peloton is: hardware – a physical product; and software – the Peloton app. (However, Peloton calls itself much more than that, see image below). Peloton’s business model overall does not allow the user to just buy software or subscribe to the service. A user needs to have the hardware to use the software. I want to use the analogy of the phone industry to draw comparisons. When we talk about phones, we talk about Apple (device + iOS) and Google (Android).
Apple delivers a single package combining hardware, software, and services. Apple even builds its own chips that integrate very well with its products. Apple bars other phone makers from using its operating system. This has helped Apple build a very happy user base of 1.8B paying customers, who happily go and buy an Apple product or a service.
Google has a different approach, the Android OS is available to all consumers that make electronic devices. Whether it’s phones, tablets, laptops, television, smartwatches, home automation, etc. This has been understood to be a less integrated experience but has led to a platform (android) to a global leader that runs on nearly 3B devices.
Peloton’s dream is to become the Apple of the fitness industry by combining hardware, software, and services. Peloton has designed its own bikes and treads, build its own operating system (on top of android), and offers its own subscription service. This model is not easy especially when you have to scale and manage the supply chain of thousands of suppliers and sub-suppliers for building hardware. It can be well understood from the fact that they only have a 6.4% gross margin on their hardware business, compared to 68% on software.
Ask any Peloton user what they like about their bike, and most answers would probably include some reference to a Peloton instructor rather than the bike itself. It’s been written many times before, but it’s worth noting again: Peloton’s big draw is a combination of the instructor personalities, pick-me-up mantras, and music playlists.
Let’s understand this a bit more and especially in relation to the fitness industry and user behavior. Building a Music or Video app on iOS or Android is different than developing a cohesive fitness experience. Music and Videos are what people like to do, it’s different than exercise. Exercise is a forced action and the motivation comes and goes. In such a scenario, selling a subscription plan will result in a huge churn, and keeping the members engaged and motivated will become difficult.
So, how do you keep the member engaged? Well, sell them a bike for $1500. This will be the sunk cost for the user which they will justify by buying subscription plans and keeping themselves engaged. It’s tempting to keep a subscription and use the product where you have invested $1500.
I think I have taken both sides here. Hardware and Software integration is key to a successful business like Peloton. However, hardware can always be outsourced to a third party. It’s not necessary for Peloton to build its own hardware to provide this experience. Partnering with Norditrack or Echelon for their cycles and providing their backend and UI to support UX. Where does that leave us for the future of Peloton?
Future of Peloton – Sell the business, BTW whose interested?
What would it take for Peloton to survive entirely on its own, to not become Peloton Prime (Amazon), Peloton+ (Apple), or Pelotown (Nike)?. “When you look at companies like Ring, Eero, Anki, and Fitbit, they were all large enough to be visible but not large enough to have a cash stockpile to make it through hard times,” says John MacFarlane, the co-founder and former CEO of wireless audio company Sonos. “Companies like Sonos and Roku—and Peloton—all got large enough that they can survive a crunch. Hardware-software companies just need a lot of cash.” Will Peloton exist a few years from now? Will it thrive? Sounds like something one of its instructors might shout about during a live-streamed class. And the bigger question is whether it can go it alone or will wind up like so many high-profile hardware companies before it—as another feather in a tech titan’s cap.
The short answer is – Sell the business. With revamped management and a new CEO Barry McCarthy, Peloton needs to think deeply and hard about its hardware business. It is worth noting that McCarthy is 69, and came out of retirement to take this job. It seems likely that the Peloton board wants him to pursue the sale option and close the deal. Also, I certainly feel the amount of cash required to run a hardware-software business is only available with big tech. They have the know-how of the supply chain and logistics. What are the options?
Amazon and Nike are interested. Amazon will be the front runner and obvious choice to buy the business. Why Amazon?
First, Amazon has a connected home network, it can easily integrate Alexa into the peloton software to make it an enhanced experience.
Second, Amazon could bundle Peloton services with its prime subscription plan at no added cost to the user/subscriber. This will enhance the subscription base enormously.
Third, Considering the scale and scope of Amazon, they are a perfect candidate to manage the Peloton hardware supply chain and logistics. They would need to bring the cost of the product down. With Amazon’s expertise in the supply chain, they can build the bikes offshore in China or Vietnam. This would provide them access to other economies and China as a big market for high-profile clients.
Fourth, Peloton would allow amazon to expand the Amazon care profile and the range of hardware they want to bring to the market in the fitness segment. Halo fitness watch will be a good example to integrate workout sessions. Holding this data will be key in identifying other key opportunities.
Nike exited its Fuelband wearable-hardware efforts in 2014, since then they are fishing for a sizable acquisition that will provide them the entry into the tech fitness industry. Peloton’s acquisition may fit with the brand’s data-led digital transformation being guided by John Donahoe, CEO, since the start of 2020. Mr. Donahoe on a December quarterly call stated, “We are in an era where that is the liquid gold for any brand is to have a direct connection with the consumer.” Nike according to the sources did consider buying Peloton before it went public in 2019. Not sure what was the price then, Peloton today, is more digestible for Nike to purchase. With a market cap of less than $5B and considering a premium of 20%, a $6B price tag is easily doable for Nike.
The Peloton will provide Nike with a hardware and training ecosystem they have been trying to build for ages. There are lots of captivated Nike fans that want to buy Nike branded fitness equipment. Nike needs a hardware partner especially as competition builds with Lululemon buying Mirror and Apple introducing Apple fitness+. Nike could bring in their powerful line of Athletes to sponsor the product and make it a lifestyle brand company.
Big tech is pushing for metaverse as the future, Nike has already entered Metaverse by building a NikeLand in Roblox’s metaverse. Considering current technology and growth in computing power in the next 5-10 years, fitness can be easily integrated and made available in the metaverse. Blackwell, a key investor in Peloton, thinks Metaverse is the future of fitness.
Having said that, Metaverse’s future opens a lot more doors for Peloton than just Nike but let’s just not go there.
I want to start by saying, Apple has become very strategic in what they purchase lately. Gone are those days when Apple would be a company every other month or fortnightly. Another point is that Apple is already a brand, it does not need a branding win by acquiring Peloton. The only case that will make sense for Apple to buy Peloton is to enhance their fitness+ subscription by acquiring high-end users. Acquiring Peloton would also provide Apple with a ton of user-health data which could result in another apple product. Without a doubt, Apple’s supply chain would come in handy and reduce the costs of building bikes.
If Peloton was acquired by Amazon or Nike this would propel the winning bidder on the health and fitness front as well as gain a major foothold into the living rooms of consumers globally. With the Peloton bike and roughly 3 million subscriptions in tow, cross-selling other consumer services into the Peloton ecosystem would make a ton of strategic sense for the likes of Disney, Nike, Amazon, or Apple.
Even if there is no acquisition and as the company wades through the hardware muck and a massive corporate restructuring, its special sauce—and source of recurring revenue—is still its software platform. The idea of becoming the android of the fitness industry is not bad. There is a lot to gain from being in the software industry and letting go of the hardware. It is evident from the costs of Peloton. There are plenty of companies that are building fitness machines. Peloton does not need to be one of them. Peloton should partner with them and put their operating system (which is world-class). Peloton could make money from the operating system royalties and subscriptions. There is an urgent need for Peloton to cut down its costs and increase gross margins. Hardware business for peloton has a gross margin of 6.4% while software business has a gross margin of 68%. If the sale is not the option, peloton should seriously consider going the Android route and shutting down the hardware business.
Bonus – Peloton is introducing LaneBreak
As I conclude, I want to throw out the idea of gamification and metaverse are not bad either. Software is the key sauce of the success of Peloton. Peloton somewhere knows this and is bringing out a gamification feature, called Lanebreak. Lanebreak makes the rider pedal around a virtual track, encountering prompts and challenges all along the way. The Beta version is available to some subscribers. This is a great way to make subscribers interact with the Peloton software. We all know gamification works when you engage the user to achieve certain goals that they want to reach anyway. Will Linebreak help achieve Peloton the breakthrough they want to reduce the churn and bring back subscribers?