Chit Chat Stocks - Peloton (PTON) | Not So Deep Dive

Episode Date: November 9, 2021

Peloton is an exercise equipment and media company. The most well-known product that Peloton produces is their stationary bike. The Peloton bike connects to the Peloton media production providing users with well-rounded exercise material. Listen closely as Ian, Brett, and Ryan go through the history, financials, and future prospects of Peloton. Enjoy the show! Our Tuesday Not So Deep Dives are sponsored by Potential Multibaggers. Multis are looking for stocks that have the potential to go up 10x in 10 years. Check-out the service here: https://seekingalpha.com/checkout?service_id=mp_1308 Want updates on future shows and projects? Follow us on Twitter: https://twitter.com/chitchatmoney Special promotion through the end of 2021: Subscribe to 7investing with the code "chitchat" and get $50 off your annual subscription: https://7investing.com/subscribe/ Interested in more of Ian's work? Follow him on Twitter: https://twitter.com/IanGrayLive  Rather watch us on video? Subscribe to our YouTube channel: https://www.youtube.com/channel/UCG5Ni-SI-jyrEsoNUhqftNQ Contact us: [e-mail] Timestamps Company Background | (2:52) Industry | (8:13) Management & Ownership | (10:59) Valuation | (14:32) Earnings | (15:22) Balance Sheet | (18:49) Our Analysis | (21:16) Disclosure: Chit Chat Money hosts and guests are not financial advisors, and nothing they say on this show is formal advice or a recommendation. Brett Schafer and Ryan Henderson are general partners and portfolio managers at Arch Capital. Arch Capital and its partners may hold securities discussed on this show. Learn more about your ad choices. Visit megaphone.fm/adchoices Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Chit Chat Money. On this show, host Ryan Henderson and Brett Schaefer interview industry experts and riff on the world of investing. As a quick reminder, Chit Chat Money is a CCM Media Group podcast. Ryan and Brett are also general partners at Arch Capital, and Arch Capital may have positions in the securities discussed in this podcast. Anything discussed on Chit Chat Money by Ryan or Brett or any other podcast guests is not formal advice or recommendation. Now, please enjoy this episode. Welcome in. This is the Tuesday Not So Deep Dive episode where we try to go through a stock in about 30 to 45 minutes, give you the basics of a company, what they do, the valuation,

all that good stuff. We have Ian Gray on the show today and we're talking Peloton. I have to ask for both of you guys, do you own a Peloton? Are you into this interactive fitness stuff. Ian, do you have one? I do not own a Peloton. I've, I've considered it. It's just a little, I can't justify the price for me right now, but once I do, yeah. One more price cut and they're going to, you're going to be golden. Uh, Ryan, have you tried one or, uh, I have tried one. I don't own one. Um, I like them. I could see why certain people would have them, but it's just not, I prefer to like go to the gym and stuff. Yeah. All right. Well, I bet we're going to discuss that a lot, the dynamics versus Peloton versus going to the gym.

Probably a lot of anecdotal evidence there. And I'll let Ryan introduce what Peloton is. But first, I have to talk about our sponsor today, Potential Multibaggers. The aim of the Potential Multibaggers service is to find stocks that can go up 10x over the next 10 years or compound at 26% per year. Potential Multibaggers has picked great long-term picks like Roku at $113, Square at $75, Livongo at $24, and plenty of others. If you want to become a multi, you can go to Seeking Alpha and look for From Growth to Value. Google it or go to at From Value on Twitter. And if you have any confusion on that, please just contact us.

We'll make it really easy to introduce you. All right, Ryan, you have another one to talk about the special seven investing promotion. Real quick, we got a Christmas holiday discount. So if you want to do if you've been considering signing up for seven investing at all, this is probably the time to do it. you can get the annual membership for $50 off, which is already a discount from if you did it monthly for a year. I think it comes out to like a 42% total discount from what the monthly would be if you did it for 12 months. So this is the time to do it. Use the code chitchat, not CCM for the $50 off. We've changed it for the $50 deal. So go ahead, use code chitchat. You guys

know and love 7investing if you're a recurring listener. So you know what you're getting. Uh, feel free to use that, but without further ado, let's get to the show. We're talking Peloton. Uh, it's an interactive fitness platform. I think most people know what they do. So I won't like belabor the, uh, I guess the product, but if you don't, uh, it's basically workout equipment paired with interactive classes. So the two big pieces of hardware, the hardware that they have are the stationary bike and

the treadmill. Um, they also sell apparel and they have some accessories that go along with it. So like weights or foam rollers, stuff like that. But the majority of the revenue comes from those two big pieces of hardware and then the sale of subscriptions. So a little more about the logistics behind these. When someone buys a bike or a tread, they almost always go do so directly through the website or mobile app.

They have a bunch of showrooms, which look like stores, but you don't buy the bikes in the stores. It's this weird thing that companies decide to do now where you have a physical footprint to show the product, but not actually sell the product. So you can go in there, you can test it and kind of get an idea of whether or not you want a Peloton, but then you go and you order it online and it's shipped out. It's manufactured often by third-party manufacturers, although they are working on getting some of their own manufacturing. And we'll talk about that later, but it's then shipped to the States. So it's manufactured in Asia, shipped to the States or wherever the

target market is that the consumer bought it and then they deliver it directly to your house and they help install it. So they have sort of a last mile logistics network. So if you've ever seen a Peloton truck, they are. I saw one outside my apartment. I was like, all right, there's some bullish evidence right there. Yeah. Right. And so their whole thing is trying to be as trying to control the entire process from manufacturing to delivery, but there is some third party contracting that they have to do as well. As for the content side, they have two production studios, one in London, one in New York. And those studios employ 40 instructors that range in sort of their workout specialty. So it could be cycling, running, yoga, strength training,

meditation, any number of things. Those workouts are stored in a library of content that members get access to, but then there's also live classes. So think of that part as sort of like the Netflix model, except you also have the live classes as well. And then I should also mention as far as pricing goes the standard bike so which is their standard stationary bike costs $1,495 their bike plus is $2,495 it swivels it does swivel that's the bike plus swivels it's currently it's got better uh better speakers but you can turn the tv screen or the ipad screen that's on this bike and do like yoga classes uh you know strength training and stuff like that uh then the Shredmill is $24.95 as well.

All of those include 39 months, 0% APR financing, and the subscription is $40 a month. So it's actually quite affordable for a household, especially after the financing period. So you've got, it's like $39 a month for the hardware. You're paying $40 for the subscription, whatever it is, $79 a month. That's kind of a lot. It's an expensive gym membership. But you've got four or five people or maybe two people after the financing period. It's not that much, 20 bucks a month.

Maybe, yeah. For a family, I guess, yeah. But that's pretty much the business. I think everyone kind of understands that. And then history in 2012, a former Barnes & Noble executive named John Foley had this apparently epiphany that instructor-led classes were better than just working out on your own. And so he decided to bring the experience into the home.

The rest of that year, he spent bringing in some other team members and he raised a $3.5 million series a and by 2013 they had a working prototype by 2014 they began selling to consumers and they opened their manhattan studio all uh kind of all along the way they were raising more funding rounds to help expand their manufacturing capacity because it was pretty capital intensive early on i'm looking back on it now i'm surprised it succeeded i'm surprised they've grown this quickly i thought they would have been founded way earlier than this uh that's That's kind of an interesting note, 2013. I would have thought it would have been before 2010.

I guess that's what venture capital can do. They really, yeah, put gasoline on that fire for growth. I am curious to know how much or how the contracts with the instructors were early on. Like, was it like sort of a class split? Like, did they have incentives or was it just a peer? You just paid the instructors because I imagine that would have been pretty costly for them. But I couldn't find any information on that. And by 2019, they officially became public.

Interesting note, John Foley, the CEO, did an interview with CNBC before coming public where he said that they were surprisingly profitable. They were not. We saw their S1 financials. Maybe he was looking at some other sort of metric like internal contribution profit or something like that. Well, their contribution margin on the – maybe we'll talk about some financial shenanigans because one of theirs, their contribution margin on their subscriptions is higher than their gross margin, which I don't understand, but we'll get to that. I don't know. Yeah, I guess that's sort of the business model. Sell the hardware and then hopefully get them all to be subscribers over time. They really want the subscription to kind of be the selling or the majority of the business, I imagine, over the long run. Yep. And we'll get into more of those details later. I'll hit industry and competition. Pretty easy to understand this one. Competitors are Bowflex, NordicTrack, Echelon. There's a lot of other small manufacturers of these fitness equipment because in reality, the fitness equipment itself is a bit of a commodity.

And then their biggest competitor is probably gyms, which actually have a lot of this fitness equipment in them, but they're competing with gym memberships. So the global fitness industry is estimated to be at about $87 billion globally with 200,000 gyms or studios around the world. And then possibly the most important stat to think about with Peloton, because they are really a subscriber and user-based, that's one of the most important metrics you're looking at. They're an estimated 174 million fitness club members worldwide.

So that's probably their target market that they're trying to go after. I honestly think, and okay, no, this is another note here. I think it's probably a slam dunk to see the fitness industry continue to grow around the world. Because if you look at who is even contributing to the fitness industry, if the quality of life continues to improve and manual labor decreases around the world, I think that we'll get more and more people either subscribing to this at-home stuff or joining gyms, more gyms increasing because fitness didn't really show up until people stopped having to do manual labor.

That was kind of the fitness. I don't think it really showed up as an industry until after World War II. So if that continues, you'll probably see an increase in TAM. I don't have any numbers on that but i hope does that make sense guys that might be a bit confusing the there was kind of like a misconception i think about lifting weights in general prior to like this last by 40 years right yeah it was got it was like almost uh uh taboo like uh it's maybe the topic maybe the way to describe it i remember there was a study that i won't go on with this too long but the college football didn't even lift weights for like, until like 65. Yeah. That's my dad.

If he's listening to his field now, cause he's a big university of Nebraska fan. It was like, they're, some guy revolutionized. He was like, we're going to lift stuff and get stronger. And everyone's like, Whoa, this is insane. That'll slow us down. Yeah. They're like, no, you're going to get slower. It's like, no, we're actually going to get faster and stronger.

But from an investment perspective at Peloton, I think that's a good note that a lot of fitness stuff is trendy. so that's a bit of a worry like something you know in the 80s wasn't it those like workout dance classes i don't know if that was it's kind of just a stereotype i don't know but you know then there's strength there's cardio there's p90x and uh what's the one now crossfit all that stuff it's a bit trendy um but we don't need to harp on that uh ian do you want to talk about management and ownership yeah first i want to touch on that though brett are you saying you're not a regular attender of zumba classes zumba is that the big one i think that's what they call it today

yeah bar right b-a-r-r-e yeah something like that but anyways um john foley like ryan is mentioning is the ceo um i've become a real big fan of this how i built this podcast um and there's another good episode with john foley on there where he talks about a lot of kind of his history and how he how he started peloton and that type of stuff so i'd recommend listening to that but a couple of the highlights are that he worked at mars when he first um actually before he got out of college. And then right after he got out of college, he was working for Mars, uh, working like leading like the Skittles and Starburst, um, products, which is kind of interesting. After that, he went to Harvard business school, uh, later worked for an IAC company and ran one

of their small companies called, um, Evite. Um, his, I think it was his brother-in-law was working, um, as like the, either the CEO or COO of Ticketmaster at the time. And so he kind of had an in at IAC and, um, started, started working there. And so that kind of has continued some of the people that are still around Peloton or, um, originally from IAC. Then after that, he worked on the digital side at Barnes and Noble kind of when they were competing with Amazon. And I think that was a pretty rough, uh, pretty rough go of it for a couple of years, but around that time, he decided to start Peloton and he was about 40 years old at the time. So not one of these super young founders um but also not super old right just a good solid age but uh the the he the story

is that he was kind of looking at these fitness classes and realizing that he couldn't get to the he would try and sign up the night before for some of these spin classes with his favorite instructors at the right time and he couldn't because they were filling up and he thought man if these classes are filling up with 50 people um in new york city i wonder what we could do if we could digitize this would 100 people show up would you know a thousand people show up if we put this around the world would 50,000 people show up for the best instructor at the best time and because of kind of his the technology um background that he had he started that became he became obsessed with the idea and really said i got to figure out how to do this so and and that's come to fruition

right there there are a lot of people who want the best instructors at the best times or on demand is um with their library of classes so i think he had a pretty good vision and did a good job there um one other note is that william lynch is the president and um he's the former ceo at barnes and noble when uh when john foley was there and so and i think william was also at iac um previously and so there's kind of a lot of there's a lot of people from that it seems like there's a lot of people from kind of that iac barnes and noble um kind of lineage that are still part of the company today yeah that's a good note did you figure out who the i know his wife works there what's her role i'm not sure exactly i saw that you noted that um but i'm not sure exactly what

her role is i'll look that up the the business model reminds me a little bit of like evolution gaming and the live casinos just in the way that they're like streaming the events to that minute it unlocks a lot more scale than obviously in-person classes yeah and unless uh and this is more um nice it's not you know coming to be able to gamble thousands of dollars over the internet yes okay she is vp of apparel all right interesting um all right i'll hit valuation market cap of 27 billion dollars ticker is pton pretty good ticker i always got to go on and uh the numbers here just as a note are before the q3 results are released you may be listening to this right after the q3 results not q3 it's uh one technical calendar q3 calendar q3 their q1

I hate those companies. Price to sales is 6.75. Price to gross profit is 18.6. That is trailing. I don't think any other profitability metrics matter yet. They probably talk about adjusted EBITDA. I've tended to just ignore that stuff. Another important note is they have 57.9 million stock options outstanding versus 303 million shares outstanding. So I'd expect dilution to be quite the headwind. They love stock-based compensation, not necessarily a good or a bad thing. That's just how they finance their business. Ryan, you want to hit earnings? Yeah. So as you mentioned, their earnings calendar is a bit strange. Last quarter, they reported was their Q4. So I can talk about the full year numbers because that's the most

recent stuff, but new earnings are about to come out. They will actually come out prior, like a week before everyone listens to this. And so maybe I'll try to give some guidance there, but for the fiscal year 2021, they had just over $4 billion in revenue. That was up 120% from 2020. However, that includes also a big drawback in Q4 of this year from the recall of the tread. So if anyone remembers, I'm sure most people have heard about it, but there wasn't the bar or the gate beneath the treadmill and people would get, some people get sucked under there and the kid passed away. And so they, uh, they had to recall the treadmill. Um, and so that really kind of affected their Q4 financials. Um, they ended the year with 2.33 million connected fitness subscriptions. That's 114% more than a year ago.

As I'd say, as far as metrics to track, that's probably the most important. Um, they have roughly 20 months, 20 monthly workouts per connected fitness subscriber in Q4. That's slightly down year over year, but that's still, I mean, 20 workouts in a month is still pretty good engagement. And it's also off a very tough comp because you're comping against COVID numbers now. And so as far as gross margins go, it's probably best to break them up into two camps. So they have connected fitness gross margin.

That's primarily the hardware. I believe apparel gets lumped into there as well. And then they have subscription gross margin, which is that software component. So last quarter, connected fitness gross margin was 11.6%. A lot of that was because that tread recall. it was 45.3% a year prior. The bikes are expensive, so they aren't just selling these at cost, although they have lowered the price, but it's not typically 11.6% gross margins. And then subscription gross margin was 63.3%. That's actually up from 56.8%. So you're starting

to see some operating leverage there. Fiscal year operating income. Well, not operating leverage would be operating, but- They're seeing more profitability, the more users that are added. And then operating cashflow was, or operating income would have been positive if it weren't for the recall, but they reported an operating loss of about 188 million and operating cashflow was negative 240 million. But inventory, if you remember, was depleted heavily last year. So there was like this huge backlog and they couldn't, they didn't have the manufacturing

capacity to fill it. And so inventory was way down. They spent a lot of money trying to bolster that this year, which decreases the cashflow figure. And then they had $194 million in stock-based compensation for the year. I find that a little unnecessary for this company, but maybe I'm wrong. Maybe there's more engineers on the backside that I'm not thinking about. They talk about, well, why do engineers are, why are the only ones?

Because they love stock, I guess. Yeah, why are the engineers the only one that gets stock? It's not as bad as some companies, but it's still not great. The other thing is the recall will also have an effect on the upcoming quarter. I remember them mentioning that. And I believe revenue is expected to decline year over year in Q1 because of that. So once again, I'd pay most attention probably to the connected fitness number or connected subscribers. Anything else? Ian, you want to go balance sheet? Sure. They've got about $1.6 billion in cash and short-term investments. So pretty healthy

amount of cash on the balance sheet. They've also got about $1.5 billion in debt, But about half of that is leases. And then the other half, the remaining $830 million is convertible notes. And they issued these convertible notes back in February of 2021, when the stock was about 75% higher than it currently is. And they're able to get 0% convertible notes with a conversion price, which is $240 a share, which is almost three times what the stock is currently trading at. And so, um, that looks to be genius financing for Peloton at the moment. Right. They really were able to capitalize on a high, high share price and 0% debt. They got to hit that share price or else their hands pay it back. But yeah, but it's at that point, they'll be able to refinance it if they want to. Um, but anyways, they'll, you know, keep going would be best, but anyways, um, inventory

or sorry, one other note on the balance sheet is that inventory is ramping up significantly which is something to watch. Management is saying that it's related to the launch of new products and that they're prepping for the biggest holiday season ever. And so they want to make sure that they're ahead of it. They don't want supply chain issues to really get in the way of a big sales holiday season. So that's something to watch because I think that could be something that could potentially drag the stock down if they're not very good at inventory management. And inventory, like I said, is up dramatically because they have now all these treadmill products. So they've got the two types of bikes and they're trying to ramp up for the

holiday season. So with the supply chain issues going on in the background, so inventory is something to watch if you're investing in Peloton. And they have more capacity or manufacturing capacity now with the pre-core acquisition, which kind of I believe that gives them two big spaces in Washington and North Carolina. Yeah. It's actually right next to us, but yeah, the yeah, hopefully that can help with manufacturing,

although it probably takes a while to onboard all that to like, because they're making pre-cord bikes of those now, but we'll see. The holiday season will be important for them this year because last year they claimed it was depressed. I think it probably was just because of the supply chain issues. So we'll see how big this quarter can be.

Well, they had to cut, if I remember correctly, they had to cut all marketing because they couldn't intake the demand. Yeah, something like that. But yeah, hopefully this is a better season for them. Anything else or should we hit the ad break? Nope, let's hit the ad break and we'll get back for the second half.

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Included with Cox Panoramic Wi-Fi. Advanced security must be enabled in the Panoramic Wi-Fi app. restriction supply all right welcome back in anecdotal evidence up first we got ian what do you have i don't have much um i haven't ever actually used a peloton i have done some spin class type things just on um on my own really but i do i will say that i i am a big fan of working out at home just because of the ease of it not having to drive to the gym just getting getting my workout in and being done and so pelotons are attractive to me in that sense and i don't think that's just related to COVID times. That's for me, at least, um, working out at home always

seems like a better option if I've got good equipment at home. Um, and for now, uh, the Peloton just a little bit outside of, of what I want to, well, I want my price range to be, but yeah. And you have to invest in more than just the bike. Typically you got to get whatever the shoes, maybe you got to get some weights. I don't know. I wouldn't only want to do weight or spin classes. Right. So I'd want to have some other stuff, some other workouts to do. And so it just, it becomes a little, little bigger of an investment. Yeah. It's not the 1500. It's probably a few thousand bucks. Um, Ryan, what do you got? Uh, well, I guess a little bit about me. I don't, uh, I don't use the product. I'm more into like, uh, weight lifting and going to the

gym, which I don't think is the customer base that they're going after really. Um, I do have several family members that have them, or I guess it's one household, but they all use it. And I think as far if you have a household of like three or four people that are going to use it this is affordable and it's practical and it's much more convenient than going to the gym um i think it really if you're just going to do cardio and that type of stuff yeah i wouldn't be concerned if i were like a traditional gym but i have to imagine this has eaten away at like orange theory and some of those cardio based or spin class type uh spots that's probably what's probably going to get hurt soul cycle i think that's popular over here yeah probably um i don't know the i think the clear

way you got to look at is there's that 174 million people around the world that are members of these types of things either digital or fitness the peloton can go after a good chunk of that but it's definitely not all of them if we're looking at us as an example another piece of anecdotal evidence is that people start to get acquainted with a certain instructor. I think that's not that different from like traditional spin classes, but there is sort of an affinity for the actual instructors, which maybe builds a little more loyalty to Peloton. Yeah. All right. I'll hit mine. I mean, similar, you know, the same stuff. I just joined a gym, didn't really think about buying Peloton. It's not something for me, again, that kind of eats

into that user TAM question, but the best anecdotal evidence is probably to look at their workouts chart in the shareholder letter, like Ryan mentioned, that's, you know, that's a really easy way to see how much people are utilizing the product. And if they stop giving that out, that's, you know, probably a red flag, but I doubt they will. All right, future growth opportunities in what do you think for this one? For future growth opportunities, I'm going to say wearables. That's something that I know a lot of investors are very weary of, because it's been or sorry, leery of that. I know that people have seen it as not historically a good category, There's been a lot of failed attempts at wearables, but I think Peloton actually has a good chance and wearables make sense for their business.

Honestly, Peloton and Apple might be the only companies that really can do wearables effectively, because I think if you had a wearable, you know, some sort of watch or something that was tracking a lot of your your your heartbeat and your some of your other movement data and things like that, along with your workouts, that that could be really valuable when paired with some of the workouts that they have in their library. And they're reportedly working on a digital heart rate armband, which is kind of sprung out of this acquisition they made in late 2020 of a company called Atlas Wearables. So it's something they seem to be pursuing a little bit, but we haven't seen any real fruits of that yet. They're not selling any wearables currently, but I think that's a future growth opportunity that I think makes a lot of sense for them. Do you think they can beat out Garmin? Yeah, Garmin's pretty big. Look at that stock chart. It's been a forgotten gem.

Um, yeah, I think I have a Garmin and I liked it for a while, um, and, and wore it every day for a long time. But I think if you had, if you had a Peloton, then it would make sense to get the Peloton wearable that fits with that and maps with that. Just like, you know, the Apple watch for any sort of iPhone user, right. It just makes sense to get the Apple watch or to get the AirPods or the things that match with it and sync up real well. Um, and if Peloton did something that was really focused on fitness i think it would be i think that'd be a tough thing for anybody that had a peloton um if it was a if it was a reasonable product and comparable to the garment stuff um i think people would probably go with the the peloton the peloton version yeah i think there is it's

gonna take a lot of r&d though sorry i think there's a larger market for like the accessories and sort of the ancillary products aside from just the subscription and the bikes or the treads like, I think apparel, I actually haven't looked at any numbers. I don't know if they released the numbers on apparel, but I think apparel could be pretty big. And wearables, I'm blanking on any other stuff that they sell. But I'll hit my future growth opportunity. So they announced this last quarter, they launched in June, and it's the Corporate Wellness Program. And they say that it allows employers, insurers, and other partners the ability to offer their employees and members subsidized access to Peloton digital subscriptions, all access memberships and or

connected fitness products. They signed a few big corporations with this. I'm blanking on the names of them, but CFO Jill Woodworth mentioned, and they talked about this throughout the entire conference call, which is they're more focused on maximizing or increasing gross profit dollars than maximizing gross margin. And I think this is one way to do that. They believe that they have a certain lifetime value they have a really high lifetime value and they think it's well worth the investment to subsidize these for big enough corporations um and it seems like just another good way to add subscribers uh and and accelerate this subscriber growth and in turn gross profit dollars yeah creating increasing the value proposition of the subscription is likely very

important or it's not likely it is very important um that hits into my future growth opportunity too which is strength workouts, strength workouts increased 256% in fiscal year 2021 and are now 18% of the workout mix. If those are a good value proposition and they become as good of a value proposition as the cycling workouts, maybe people subscribe just for the strength stuff. And if someone does all multiple stuff, like Ian, you were mentioning, you know, if you're at home workout, you kind of want more than just the bike, this really increases the value proposition of that digital subscription. And if it's 40 bucks a month, that's pretty comparable to a gym. And if it's more convenient and just as good for people, that's great. And it's probably

very sustainable. All right. Highlights and lowlights. Ian, what did you like and dislike about this business? One of the things I really liked is the 92% retention rate. That's super impressive. If they can keep that rate around that level, that's going to be, it should be great for the long-term business. Um, typical, I kind of looked at some numbers and studios and health clubs typically have a, uh, a retention rate somewhere between 70 and 80%. So it's, it's fairly significantly above the average. Um, they've got a cult following and I'd say that I think they're, and I don't want to, they're not Apple. I'm not trying to say that Peloton is Apple, but I think they're the most similar company to Apple in the sense of having a cult

following and being good at hardware and good at software that they've really done a good job of, melding hardware and software and developing that cult following with a lot of people that just love it, rave about it, talk about it. A couple of the lowlights for me is that they are making a lot of acquisitions. And that's something that just concerns me when you start seeing a company make a lot of acquisitions without a history of incorporating those well. And so they've got a lot of cash laying around right now. And the stock was fairly expensive. It still is probably expensive. So I assume they're trying to be aggressive and grow. But just with the uncertainty about the future, I think the acquisitions add a little bit of risk.

And then also the safety piece of it, it seems like they're going to have more safety issues in the future, not necessarily because the company is some horrible company or anything like that. But just with this type of fitness things, things happen, right? People use it improperly or it's not quite perfect for every situation. And so I assume that over time, if you're a Peloton shareholder, that you will see a few of these safety type issues come up. I'd also like to throw a question back at you. And I was just talking about their high retention rate, but do you think it's a, a really sticky service over long periods of time? Because I feel like if I had a Peloton sitting in my house, I probably would feel almost guilted into paying for the subscription. Like people already signed up for the gym and feel, feel bad about ever

canceling their gym membership. They want to like, you know, they do it every single year for, you know, your new new year's resolution. But I feel like the Peloton just adds to that when you go, oh, I've got a $1,500 bike or a $2,500 bike here. I really have to pay this $40 a month so I can really use it. Do you think that's the case? Or do you think people will give up on Peloton even if they've got the bike? Well, I remember seeing a stat that one in two of their members pays for a subscription.

So I found that, I guess, surprisingly a little low. Maybe some of those members aren't super active. but 19.9 monthly active workouts. I think it's like 22 on average, uh, throughout the whole year. People are very active on these things. So it's, they include warmups anytime you're on it, that counts. So it's a bit inflated, but we'll see if that sticks over time. It seems, seems solid. I, uh, I worry about churn taking up.

It ticked up last quarter and that was a huge number that people were concerned about. Um, it's ticked down the last two fiscal years, which on that face it looks great and maybe uh or whatever years two i mean the periods were two but yeah three 19 20 21 21 um so that's good if that can continue but this last quarter has been a blip and i would be concerned coming out of the pandemic i don't know i also would be concerned about as they mature and they get people off the three trial three month free trial for subscriptions, how that impacts churn and also be concerned, or maybe just would be, uh, wanted to know how, like once everyone stops paying for their bike, how that impacts people's willingness

to pay for a subscription, like, is it going to be good or is it going to be bad as the company matures? Uh, it's, it seems like there's a lot of variables that could either be positive or negative for subscription uh retention what was uh did the churn number factor in the tread recalls because i imagine if you sent your treadmill mac you probably canceled your subscription for a month or two i don't know i know it was like 0.61 for the full year but last quarter monthly was 0.71 so it ticked up and that sounds like a tiny bit but monthly that's a decent uh increase all right ryan what were your highlights and lowlights well it seems like they've got the manufacturing and backlog issues solved and they're building out a big facility in ohio to help with that they

made sure to advertise that on their annual letter it's not coming to 2023 so we're gonna have to wait it was like i mean they were treating it like it was like one of these massive gigafactory type things but they're just manufacturing bikes so i guess it wasn't it was exciting to them talk about engineering um but it's good that they have this kind of done before christmas so they really uh advertise and have a really good christmas season because i know they were sort of well ohio facility is not going to be in no but they they've said that they between the pre-core and i believe there's another acquisition that expanded capacity they said that they're well equipped to meet their man this quarter they're not going to have the problems they had last time

yeah the other thing they received approval on the repair remedy for the tread i think tread can be a big product i also think they can move into something like the rowing uh the rowing machines as well uh i guess maybe that could have been a future growth opportunity really yeah just go outside i don't know what could have said the same thing for the bike no the bike's different because the class like running there's no there's no different experience you just run or you walk i think they're selling treads uh well i wouldn't doubt it may whatever consumer products that i don't, that I think are dumb, like I've said before, usually get, yeah, usually do well. The, uh, the tread should be, I believe it's going to be start being launched. It's going to

be launched again in the U S here in the upcoming quarter. So it's cause they're kind of getting that back on, uh, track. I also just generally really liked the business model. This obviously scales really well if the, those members continue to stay active. Um, so there is clearly operating leverage in the business uh low lights for me though and this isn't i guess the pre-core acquisition felt rushed i know it had to be because they had to expand capacity i don't like i don't but that felt super rushed and then the other one is i'm not overly fond of the management team i can't really put my finger on why um but it's just i don't know gut check wasn't wasn't in love with it. No, I think, yeah. So my lowlights on management, uh, we can talk about

the financial shenanigans. Maybe I found a bit here, but my highlights love the subscription business. I mean, margin profile, that's going to be fantastic. Uh, and if, if there's going to be a winner in connected fitness, like I would bet it will be Peloton that there's no one that can really compete. I mean, Apple is trying, but without the bike, I think they're screwed. However, you know, you can compare it to Netflix when you're like, Oh, there's, there's going to to be this big shift right like for netflix it was so easy to see how there's going to be the shift from um well hindsight's 2020 but it was so easy to see how there's going to be the shift from cable to internet connected uh streaming and you can make the same claim with peloton but

i'm less sure about the transition from like physical gyms and stuff like that to these at home things what are you guys thoughts on that is that trend like really easy to forecast because i think it's almost up in the air like whether that's going to continue i think they put last time we had a show about peloton we were asking is this just some gimmick some like workout gimmick that's that have come before so like p90x they passed that yeah i think they're past that hurdle they added a million subscribers past covid or doubled their subscriber count i think they've shown that it's but is it gonna be is it yeah but what's how many people are going to transition over that's the big question from just like if you're thinking of linear is regular gyms you

know not connected fitness and this is the quote-unquote netflix or internet connected transition that people made how much uh like how many people are actually going to transition over i don't know if that's right like i don't know if that's the right metric to look at people that have existing gym memberships i feel like a lot of these people this is their first time paying for anything fitness related okay so it could expand their own market okay if you kind of that's okay that could be it ian maybe maybe i think that makes sense ian yeah i think i think there is a surprise because i would put myself in this category that i like i said i do prefer to work out at home if i've got all the equipment there so and i've bought a couple over covet i

bought a few pieces of equipment, um, which was not the right time to buy it because everything was super expensive. But, um, but I think, uh, I think there's a larger percentage of people than we would give credit for that do prefer that. I don't think it's everybody and I don't think it has to be everybody, but it wouldn't surprise me if someday we had about half the population, um, of the, the workout population going to physical locations and about half doing connected fitness. I don't think that's an unreasonable number to assume we're going to get to someday yeah yeah um what are other low lights i mean i don't like the acquisition of pre-pour yeah it gives you manufacturing capacity but those products are not great i don't know it's

not a good it doesn't you can tell it's not a good business because they don't have the subscription thing and if peloton didn't have the subscription thing it would be a lot tougher um churn creeping up is a concern and i think they may be stuffing some cost of revenue into sales and marketing so it looks at their definition of the 10 K and yeah, it's probably technically right. You know, like it passed the audit, whatever, and they can put it in there, but they have store leases, payment processing, digital app costs, and property, some property depreciation in their S and M spend, which I think, yeah, they can put it in there. They probably were approved to put it in there, but those are going to like, some of those are fixed, but those are

not sales and marketing, I don't think. And some of those are going to scale. So I would be worried about their gross margin being a bit inflated versus what their true operating margin can be. I do not like the founder's wife having a role in the business. If it was a woman founder, just to be clear, I would not like the husband being in the business as well. That stuff just never, it rubs me the wrong way. Even if they're good at their job, it just, I don't like that type of stuff. Here's a quote that scares me though. it's it might at first you might not think it's anything but it says we did not have any undisclosed off-balance sheet arrangements as of june 30th 2021. usually a company says we do not

have any off-balance sheet arrangement but these ones in their 10k and i couldn't find it they says we do not have any undisclosed off-balance sheet arrangements and you apparently have to look at the proxy statement which i don't know if that's out yet so that that just kind of feels like you know as ryan said earlier they said they were highly profitable in 2019 they weren't um It feels like they play a bit of the financial shenanigans game, and that concerns me, although it might not matter. And then they also had a material weakness with inventory, unvaluating inventory as of June 30th. They still haven't fixed it. So I'll add all that up. And that's a low light for me on the accounting standpoint.

All right. Bull case. Ian, what's your bull case for Peloton from here? The bull case, I think, would be that Peloton is not just a COVID company, that it continues to grow its subscriber base and people relate to the brand for more than just these spin classes. I think that they probably need to grow revenue at about 25% to 30% for the next 4 or 5 years to keep pace with the market over that time. And I think if additional product lines catch on, whether that's baked into that 25% or 30% or that adds to that 25% or 30% growth, if they can start connecting on some of these other product lines and these other types of workouts, I think that the valuation will reward them for that. And it probably is a market beater

over the next few years if they can do that. Yeah, they got to keep the high revenue growth rate for sure. Ryan, what's your bull case? Well, I can totally see like a reasonable bull case and it would come from growth and connected fitness subscribers or subscriptions. You can increase the lifetime value in other ways, like we've talked about with like maybe apparel and Maybe customers are worth more than the market's currently giving them credit for. But based on their current guidance for fiscal year 2022, they'd be generating a little over $1.1 billion in gross profit from subscriptions, if you assume similar gross margins to this year. And that's about nine months forward, right? Yeah, roughly.

So I think you at least need to get to about 10 million subscribers. If you can get to 10 million subscribers or subscriptions, this looks like it's probably going to be a great investment. I also think it's possible if you introduce new product lines like the rowing machine or just find new ways to get them into the subscription, whether it's strength training, at-home stuff, stretching, yoga, whatever those types of workout classes are that people used to do. If you can bring them into the house or into the home, that's another way to add subscribers. Yeah. I typically just, I don't ignore the revenue from the hardware products, but when doing the valuation, I'd kind of want to ignore that if they're going to maybe break even around that. I think they mentioned they want the hardware gross profit to cover sales and marketing spend, which means they're not looking to really generate outside cashflow from that. So I honestly

would value it on the subscription gross profit only, at least at this point. And that's my bull case is kind of subscription gross profit gets to somewhere around $5 billion, which is a big increase from here, probably within the next, I don't know, five to seven years, something like that. You really got to expect something big. That would probably be 10 times, maybe the connected fitness subs. And then, well, I mean, right now trailing is 500 million, something gross profit subscription. So, I mean, that's 10 X below less. So the, uh, I don't know really if anything else matters. Churn is definitely important. If that continues to tick up, that would be hugely concerning because then everything breaks. But bear case, Ian, what's your bear case here?

My bear case would be that Peloton wastes a bunch of money on acquisitions and product development for things that don't end up ever contributing to the bottom line, that they hit it out of the park on this Peloton bike, but that the rest of the stuff people don't really care about. And so that Peloton is stuck is just this one product brand that you know, finds a market, but I think it's currently being priced for a company that's really going to win the connected fitness space. So I think if they get stuck in this one product and waste a bunch of capital on things that aren't related to this product, that's going to be, the stock's not going to perform very well if that's the case.

All right, Ryan, what's your bear case? I think that was a good bear case. They do tend to be slightly wasteful, I guess, with the money that they have maybe maybe they're just trying to be innovative oh we're investing for growth yeah well it might they might just be exploring what works like maybe the treadmill could be bigger than the bike and so they're like why not try it out i guess but i don't know some of that seems wasteful to me uh i i think the biggest bear case is that the tam is smaller like the amount of people that want to be subscribers to peloton in their home is smaller than what is estimated like maybe they're closer to saturation than we already than most people

think if that's the case this will be an underperforming investment even if the subscribers today are worth a lot and they stick around it's already pricing in some growth obviously so if they're you know if they don't if they don't hit their growth metrics or if they underperform their upcoming guidance for connected fitness subscriptions like full year guidance that's a red flag yeah and they would have to the this would also include basically those new business lines aren't as big as people expect i really doubt that apparel can be meaningful for them if you look at like lululemon lululemon does something like five billion dollars a year in revenue and they're probably the best when she has agreed the best apparel company in the world

from a shareholder kind of perspective um nike shoes you know different for non-shoes maybe not you know nike's number one if you include shoes but okay little lemon does like five billion dollars if peloton gets to a billion dollars in apparel revenue at what probably how much of that to 20 billion 20 200 million and true profits from that at scale i mean that's not that meaningful for a market get 27 billion i want to think about it like that i would think about it, like tacking on $50 to the annual value of a customer, like let's say they add a coat or a shirt or yoga pants each year. Yeah. It's not going to be Lululemon, but it can increase the lifetime value. Sure. Yeah. But I just don't, is it a, is it a needle mover for a stock that's

this big? Uh, maybe, maybe I'm underestimating it. Um, my bear case is the same as you guys, you know, churn creeps up addressable market. If addressable market, like Ryan said, and you, I think you said it too. If it's not as big, I mean, it's just not going to happen. It's kind of a, it's kind of a, it's a really black or white scenario, which is makes it so interesting, which leads us into the last part here, more or less interested in what are your final thoughts on Peloton? I'm a little less interested and I think the business is, is good. It wasn't a business that I went, that blew my mind with how good it was, but I think it's a good business. um i'm just there's just enough uncertainty in the future here that i i would kind of like to

see how it plays out a little bit see if they have any success with see how treadmill or tread um works for the next couple of quarters and uh and see where this wearables things goes you know you get you obviously if if they're if they're successful on all of that you get a bigger return if you invest today but um for me i'd like to i'd like to see a little bit more proof that they're going to be successful with those types of initiatives before i invested all right ryan I am more interested. The thought in the back of my mind is that I'm not necessarily that interested at its current price, like the price and growth. But I couldn't think of a better time in terms of PR to get in. I mean, it's down, what, 60% or 70% from its highs. And a lot of that is attributable to mistakes that they've made, like the treadmill recall. And the tread is going to be fine. Like, okay, well, kid died. That's, that's, that's bad. A lot of people got injured, but they'll probably be fine.

It's not going to matter. Yeah. I mean, if they can make the repair remedy that they need, it should be fine. Yeah. It, uh, I just, I don't know. The price for me, maybe it's one of those things that I just constantly say, like it's just not good enough yet. There's a lot of uncertainty and you're paying up for uncertainty. It's kind of tough.

Yeah. I don't know what the cashflow margins will be at scale. I mean, of the subscription, it would be probably high, but of consolidated, I think it will be pretty low. I'm still more interested, but I don't even need it on the watch list because you'll probably hear about it. It's one that's so far. You don't even need it. Yeah, I'm more interested, but yeah, not at this price. If there's a lot of uncertainty with something and if there's a lot of quote unquote optionality, ability to expand into apparel, wearables, stuff like that. If it's uncertain, I want to get paid for that.

So at this premium valuation, which if someone's listening and you're like, what do you mean premium? It's 40% off the highs. It doesn't matter where the stock was. It matters what the price is now. You also have to factor in probably a 2% to 3% dilution per year. So add that on top. The valuation isn't that crazy if it meets its projections, but there's a lot of unknowns. Exactly.

The unknowns. I think they have a good chance of succeeding with their vision of 10 million. And I think Foley one time said 100 million subscribers, which, you know, all right, if they hit it, then this will be amazing. But it's not. It's nowhere near guaranteed. This is not like a utility type aspect like music streaming, video streaming, stuff like that. Like it's not something that you're, you can see that it's not as forecastable, which gives people the opportunity if the investment works out, but it adds on that level of risk.

So I don't know. It's such an interesting one. It'll be, this is the one I love to follow. It's kind of similar to Facebook where I love to follow the company, even if I'm probably won't invest in it. All right. Stock for next week. I think it is Ryan's turn, right?

I just, I forgot that it was my turn. Oh, I got a, I got one for you that someone said. if you want but i yeah i know you want to choose your own i have okay i have one in mind but what was yours it was someone recommended remitly that could be a good one kind of close to money gram right yeah money gram who talked with uh if you're interested in that cross-border payments we talked about the louise about but there's money gram we could all or sorry there's remitly and there's also wise we could do a pair with that I don't know if we force Ian to do that one, but Wise is also interesting.

I'll throw up a vote then. Allbirds? I don't know if they're technically publicly traded yet, but they released an S1. I think they're public, yeah. Are they? They're about to. Maybe it was this week. Okay.

Remitly or Wise? Ian, do you have a vote? Any of those sound good to me. They all sound interesting. Allbirds, you need to see them. I'm going Remitly. I'm going Remitly. Remitly sounds good.

That's what the guy recommended. That's all great. All right. That's going to do it for this episode. Thank you all for listening. Remember, we are not financial advisors. Anything we say on this show is not formal advice or recommendation. Ryan and I are general partners at Arch Capital. Arch Capital clients may hold securities discussed in this podcast. Thank you all for listening. We'll see you next time.