We’re throwing in the towel on our PTON short. While we dropped it to the bottom of our idea list earlier this summer – meaning lowest conviction of all our ideas -- the reality is that we should have removed it entirely once Covid emerged and changed the game in favor of anything home-fitness related. In addition, management is proving us wrong by successfully evolving the model and the Peloton ecosystem to both create and capture every last bit of incremental demand while keeping churn at an impressive rate of < 1%. Our initial case was 2-fold...
1) We argued that Connected Fitness (CF) was at a peak rate of adoption in the months of Dec 19 to Feb 20, and the market was over estimating the addressable market for the bike CF service (other CF products wouldn’t have the same draw/engagement), as competitors tried to segment out the market. Expected sub growth to slow materially in spring summer 2020 meaning stock would reflect more reasonable addressable market size. Covid meaningfully – and likely permanently -- changed the end-market size beginning in Spring 2020, which nullified this part of our thesis. Management will be updating its own TAM/SAM estimates in an investor event next week.
2) At the same time we thought ‘digital-only’ was not differentiated enough from cheaper or free options in the marketplace to create a viable / profitable business segment. It was barely growing pre-covid, price had to be cut plus extending a free trial offer to get moderate sub additions, and as of last quarter hadn’t really shown big growth numbers. So we felt there should be little to no value ascribed to that portion of the business in the valuation. This part of the thesis is still up in the air. Though the shutdown of gyms sent people searching for home fitness solutions. PTON was smart and gave an extended free trial to people (90days) to try to get the user hooked. Apparently over a million people started using it on the trial. Today the company is at 500k subs, additions are barely keeping up with connected fitness, which seems low given the relative affordability and value. So we need to see how many people actually want to keep paying for this longer term and how many new come in in the coming year or two and whether the company starts marketing it more heavily. Management has signaled that ‘digital only’ allows customers to be introduced into the ecosystem, which is subsequently driving incremental demand for the bike. Also post-covid home fitness likely bring a new willingness to pay for instructor/engaging content content. It may be several more quarters before we get a clear picture on the long term opportunity of ‘digital only’. But again, the real benefit right now is how the company is drawing people in to the eco-system to buy new hardware.
PTON Bull Case
Let’s acknowledge the Bull case from this point…
- In the post-Covid world individuals with the means that regularly exercise will either prefer or will want the backup/optionality of home workouts on a Peloton bike or other device in addition to gym and outdoor workouts. Meaning continued Connected Fitness product and sub growth.
- The company adapts to provide new levels of affordability and price tiering to grow potential sub base, that means lease structure for bikes, certified pre-owned offerings, and lower price point options… the company has already (just this week) taken some steps in that direction.
- Then more middle America households that previously put $50-$100 a month into a gym subscription augment or substitute some their other health/wellness spending to get a Peloton. Meanwhile more people feel compelled to join due to the hype, coolness, and community which draws in more users, not unlike the need to have an iphone or get an HBO subscription to watch Game of Thrones.
- That drives connected fitness subs to be 10mm+ in the US, then international expansion proves to be as much if not more of a market opportunity than the US like some other historical consumer categories.
- ‘Digital-only’ also becomes a huge business driver as digital fitness streaming content becomes a whole new entertainment and consumer category. Meditation, yoga, running, stretch, etc become hours of potential daily content consumption from consumers. The category presents the opportunity again for tens of millions of subs with pricing in the range of video streaming services like Netflix, which people have tended to keep paying, even when not heavily using. As the first mover and brand with highest recognition, Peloton enjoys top market share in a space that is surely to draw competition with no barriers to entry.
- Incremental margins on the Digital only and Connected Fitness subscription revenues become huge, and profit growth drives a company value exceeding $100bn.
We’ve never considered this scenario to be unachievable, rather just highly improbable given the level of continued execution needed in the face of serious competition in a category that has historically been fad prone (people wanted to try the new ‘get fit quick’ device, the new fun workout, etc). The Covid-19 pandemic has definitely increased the probability of this bullish outcome, as has better than expected early stage execution by this management team, though we think more time/info is needed to assess how much that probability has changed and whether the market has appropriately priced it in or not over the long term. Translation is were not yet sure if being bullish or bearish on the tail duration is right, but for now the Trend duration results should remain bullish.
Other Callouts:
The connected fitness sub guide is huge, almost too huge. It implies adding about 400k more new subs than FY20. That seems like a tall order given the tailwinds that 2020 saw. Though the company has visibility to a strong 1Q, and it has levers with the new price level for the old bike, the new low price tread, and the ability to ramp marketing which has been reduced significantly the last couple quarters. So the company most likely hits or beats the sub guide, but this year it will undoubtedly come at some expense in margins. The other consideration on the growth rate is that it implies big new product sales, which is good and likely to happen with the new offerings debuted this week. But sub revenue is only 20% of total, meaning product sales are still the big revenue driver, and there will come a year when PTON isn't selling many more products than the year prior, connected subs are growing healthily, but product revs aren’t, meaning total revenue growth falls off a cliff. That point in time may be years down the road, but just something to keep on eye on with such large single growth years like was just guided.
The profit flow through this Q was crazy good. The incremental EBITDA margin was 43%, that is great, but not sustainable probably for more than about another quarter. Demand is coming at incredibly low cost in home fitness across the industry right now. Retailers can’t keep any kind of fitness products in stock. At some point it will moderate companies will have to ramp SG&A and marketing for the next leg of growth. Multiples should expand when top line is accelerating and incremental margins are expanding. Multiples generally go down when top line is slowing and incremental margins are compressing.
Something strange in ‘Digital Only’. Management continued to downplay the opportunity of digital only this quarter. It seems to us this would be a relevant part of the long term bull case as noted above, but management stated “we expect growth to taper in the coming quarters. Digital fitness is a highly competitive category with higher churn and lower barriers to entry than our Connected Fitness subscription end model… we continue to focus on digital as an acquisition channel and added value for our connected fitness subscriptions”. We agree with the competitive and churn challenges, but in this high fitness product demand consumer environment we’re surprised digital isn’t out-growing (on absolute new subs) connected fitness given the huge price tag variance. At the same time, it seems the company could do a better job marketing the digital product given its low total spend this Q. If the content is as compelling as it seems and management describes, people should be willing to pay for it, so it feels like it could be growing faster right now. At the same time we don’t completely buy management’s narrative that it’s simply lead generation for bike sales. Maybe it’s an arrow in the quiver that management is saving for the future while its attention is focused on scaling the core and more profitable connected fitness business.
