Motley Fool Hidden Gems Investing - “Cash doesn’t lie.” Peloton’s Predicament

Episode Date: August 15, 2022

Peloton announces more layoffs and store closings. (0:21) Jim Gillies discusses: - How challenging Peloton's balance sheet is right now - Why Peloton will almost certainly have to raise money - The retail landscape when some of the biggest companies are set to report earnings - Why Costco is his favorite retail stock (followed closely by Home Depot) (18:41) Some companies are pulling back on investments, but others aren't stopping. Ricky Mulvey and Sanmeet Deo look at some businesses playing offense in a tough environment. Stocks mentioned: PTON, WMT, TGT, HD, LOW, COST, SHOP, AXON, XPOF, NFLX, TTD Host: Chris Hill Guest: Jim Gillies, Sanmeet Deo Producer: Ricky Mulvey Engineers: Dan Boyd, Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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Motley Fool Money starts now. I'm Chris Hill, and I'm joined by Motley Fool senior analyst Jim Gillies. Happy Monday. Thanks for being here. Thanks for inviting me, Chris. Let's start with Peloton, which is cutting nearly 800 jobs, closing some amount of its locations. And along with these moves, Peloton is raising prices on some of its equipment. And I'll just spot you up with the most illuminating comment from CEO Barry McCarthy, who said in a memo to employees, we have to make our revenues stop shrinking and start growing again. Cash is oxygen. Oxygen is life. And I don't disagree with that, Jim,

but when you and I were chatting earlier today, I said to you, when I first saw this story, the immediate thought I had was, this seems like a panic move. Yeah, you're going to get me in trouble, Chris. Oh, it's one of those shows. Good. Oh, Peloton. Yeah, it's a panic move. And yes, he's entirely correct of everything he said. Might have been nice if the founder, former management who ran this truck into the dirt might have actually, I don't know, thought about that once or twice before, as I said, running this truck into the dirt. This is a company, oh, where's my notes for this here?

This is a company that has in the most recent balance sheet, I think they're going to report their fourth quarter fiscal earnings. I think they have a June fiscal year, so they're reporting late August, if last year is anything to go on. Most recent balance sheet, $1.4 billion in inventory moldering on the balance sheet. $1.9 billion in cash burned in the first three quarters of the present fiscal year. Nice of the CEO to tell us that cash is oxygen after starving the business. Not his fault, but the entire management suite starved the business. This is a business where the CFO, I believe last November, the now former CFO on the conference call, oh, no, we don't need to raise capital. And I think eight days later, they raised capital.

This is a company with $880 million in cash on the balance sheet, roughly the same amount as the debt on their balance sheet. Now, fortunately for Peloton, the debt on the balance sheet is all convertible debt, doesn't convert, I believe, until 2026. The convert price is well over $100, there's no danger of this. When we get there, there's certainly no danger of this company needing to put shares, they'll have to pay that back. But hey, you know what, if the fire is not out by then, it won't matter. I don't know what credit line availability. This is a company that's probably going to have to raise capital again, frankly, in the next quarter or two, because they're burning $600 million a quarter the last three or four quarters in a row. They've got

negative product gross margin, which I guess makes sense why they're saying, hey, we're going to raise prices, might be nice to not lose money on every single bike and treadmill they put out the door. Product revenue was down 40% year-over-year, 25% quarter-over-quarter, Q2 to Q3. To put it into perspective, that $1.4 billion in inventory on the books, that's up from $937 million at the started this fiscal year, it's up from $245 million at the end of fiscal 2020. This is a company that has inventory bloated themselves to, frankly, near death. I am reminded when I see what the CEO said, and again, it's not his fault, he came in from, I believe, Spotify, I think it was Pandora before that, which of course was, I believe, purchased by Spotify, or maybe that was Sirius. Anyway,

He was at Netflix at one point. Yeah, okay. I'm reading his bio here off of CapIQ. I think his most recent gig, I don't really know. He was at Netflix as CFO, I think, from 1999 to 2010, it says here. More recently, he was at Spotify. He does have financial chops, so that's good. This is a guy who's going to understand, hey, we're in trouble. I am concerned he's come along a little too late. I'm always reminded, when something like this comes along, I'm reminded of, as I'm often reminded in situations like this, by a quote from Warren Buffett, or Uncle Warren E. Buffett. The quote is, when a management team with a reputation for brilliance tackles a business with a reputation

for bad economics, it is the reputation of the business that remains intact. The economics for Peloton went over the cliff real fast. And like I said, in their most recent quarter, they burned over $700 million. They've got $800 million in cash. So, do you really want to be raising? And I mentioned that prior capital raise that the CFO apparently didn't even have a week's view into her business at the time, or eight days, sorry. They raised capital, I believe, in the low or early $40 per share. Stocks in the low teens right now, the more you have to raise capital via equity means, the more you're going to dilute present shareholders. So, for those who have held through a 90% drop, and I'm sorry I'm so dour out of the

gate, you fed me the disaster going here, we'll be better in a bit. If they do have to raise capital, and I hope they don't for shareholders who still own this thing, but I'm not seeing a lot of turnaround potential. Just to go back to one more point, when they said that we need to raise prices, and they're going to raise prices, they're raising prices on their bikes by $500 a bike, and I think it's $800 per unit by the treadmill. But remember how I mentioned they had negative gross margin? Their move in product is to get it out the door the last three quarters. It's already not selling and now you're raising the price. Good luck. I don't have a lot of sunnier disposition to say here, I'm afraid.

Well, I didn't ask you to come on just for your sunny disposition. Good. Before we move on to retail though, What would you ask McCarthy on the conference call? Assuming they come out with a report that does not indicate some radical reversal of fortune, what is the question you would ask? Would it be around a capital raise? Because when you just run the numbers, it's hard to imagine they don't get money somehow, somewhere. they have to get money somehow, somewhere. I have a difficult time believing, and belief is always a terrible word to use with investing, because I can believe a great many things,

but cash kind of doesn't lie. This is a company that burned about $735 million in the most recent quarter, about $550 million the quarter before that, about $645 million the quarter before that. Like I said, they've got about $880 million cash on the books, pretty much the value of that. Where is your cash coming from, Barry? Where is your next capital coming from? Because I think this is a business that you have to demonstrate you're going to survive next year. Then you can talk about growth and maybe adding to those subscriptions. The subscriptions are actually monetizing fairly well. People who love their Pelotons, the number of fitness sessions after spiking during the pandemic with a reopening world,

the degradation there has trailed off and they look like they're doing fairly decently. It's a small sample set, so I don't want to draw any great conclusions there, but there's some optimism. To get to be optimistic in three years and have this turnaround, and they talk very directly, and which I like, on the most recent shareholder letter, the third quarter shareholder letter, although that's a pet peeve of mine as well, that they talk about, hey, turnarounds are hard, turnarounds are hard, we're a turnaround now. Okay, good. You seem to have a reasonable appreciation of where you are in the pecking order at this point. My questions would circle around, what is your fire suppression plan for the next year? Once the fire is out,

then we can talk about your turnaround, especially heading into a recession, assuming we have a recession. I have some thoughts on that as well. But assuming that the popular opinion of we're heading into a recession is, in fact, true. Jack-at-a-price on a souped-up treadmill that I have to pay $60 a month for to get a subscription is probably not going to clear the books of that bloated inventory. Let's move on to retail then, because it's a big week. Now that I've just killed it. It's a big week for retail. We've got the earnings reports coming later in the week from Walmart, Target, Home Depot. I don't remember big retail being as weird as it is right now.

When I say weird, I'm referring to the fact that in general, the major retailers tend to travel in a pack. The fortunes of one tend to reflect the fortunes of another. This is certainly the case for years now with Home Depot and Lowe's where they report earnings one right after the other. It's much more newsworthy if they don't have similar results than if they do. But at the moment, in part because of what we got three months prior from Walmart and Target with their inventory debacle, I don't have a great sense of the retail landscape, which is why I'm looking forward to this week, because I feel like we're going to get some more clues into things like inventory controls, back-to-school shopping, and possibly even the earliest of indications around

year-end holidays. When you step back and look at retail, does anything stand out to you in particular? We certainly got that negative surprise, negative reporting from Walmart and Target last go around. Neither of those companies terribly excite me. They are certainly bellwethers and we should pay attention to them. It wasn't just Walmart and Target, of course, even going down the quality chain to guys like Big Lots or whatever, it was pretty ugly across the spectrum. Because yeah, inflation seems to have caught them by flat-footed, so everybody had their inventory spike. Inventory spiked because a lot of their expenses also got quashed because the higher-cost inventory is now moving through your system.

I'm not real, like I said, as an investor, I'm not real interested in these large specialty the non-differentiated names. The one I love to watch and love to follow is, which you didn't mention, and maybe I'll hit that before we get over to the home improvement folks, is Costco. They're in a bit of a different reporting schedule. I think they report third week of September, because I believe they're on a June or a September fiscal year. Costco is one of those stories where I think Costco is hitting on all cylinders, to steal a Ron Grossism. Every time I walk into Costco and walk out of Costco having dropped $250 on an order that I planned to be under $50, I was like, man, I don't own enough Costco. The really interesting thing

to me about Costco is for years, a lot of people would talk about how Costco passed on so much. Basically, you were buying most goods close to cost because they were making up all of their profits essentially on selling memberships. For a time, that was true, about 75% of operating profit. I was just looking at this last week. The first half of the last decade, about three-quarters of their operating profit was subscriptions, was memberships. Then it fell to 70 percent, and then it fell to 65 percent, and then the most recent year was 57 percent. Costco is not only growing and doing well in operating profit, I think is up 10% or 11% annualized over the past decade, perfectly acceptable. But they've also started

to actually make a little bit more profit while keeping that hotdog at $1.50. My favorite retailer, both as an investment as well as just on a personal level, is absolutely Costco. A close second is another one you mentioned, though, which is Home Depot. Home Depot and Lowe's, yes, you're right, they kind of walk lockstep. I like Home Depot because, well, first off, they decided about a decade ago that they were kind of done breaking that expansion and they kind of have gone to a couple of stores a year, opened a few retrofitted, but they've really turned that company into running it for cash. And you just have to look at how the dividend has moved has skyrocketed up over the last few years, as well as the share repurchase. When they run

that business for cash, all of a sudden, they are returning all of it to people. I'm kind of remembering the Bob Nardelli days back in late 2000s, when he was just ruining that company because he wanted to apply GE earnings metrics or whatever. Since his ouster, it's just done so much better. Also too, I hold them as semi-Amazon proof because you're probably not buying a couple of thousand square feet of drywall from Amazon Prime and having it delivered. I imagine you're still going through the Home Depots. Am I wrong to assume that out of both Home Depot and Lowe's, we're going to get some color around, presumably, the benefit of commodity prices coming down. That has to help them. All you have to do is look at the cost of

lumber in 2022 and that's got to be accretive for them. I think so. Now, my question is going to be, I don't know the exact number, so I'm going to make them up. Fantastic. Let's just say. It's more about presenting a point. Let's say lumber prices have come down 50%. Has Home Depot passed all that 50% to their buyers? Has Lowe's passed all that 50%? Have they passed 30% back? I am reminded here in the Great White North, we just raised interest rates about a month ago. We went up a full percentage point. The Bank of Canada raised it by 100 basis points. That day, I got an e-mail from my local credit union talking about the higher interest rates they were paying on short-term

deposits, three months to five years. Miraculously, Chris, they went up between 10 and 40 basis points. They didn't pass all those savings on to you? Funny thing, isn't it? I'm wondering if Home Depot and Lowe's, I'm wondering if they've passed all those savings on to you. I'm willing to bet they haven't. Then, of course, Home Depot, we are emerging from pandemic closures. Those are further and further in the rear view, thankfully. And those are going to be, you know, but people spend a lot of time on their houses because they have nothing else to do for almost two years. People spend a lot of time and money on their houses. I kind of wonder if that's going to carry over, or people have kind of

gotten used to continued cocooning, how many companies have gone to a more hybrid work model, so there's more people working from home on a regular basis. Someone like me has been doing it for 20 years, it's irrelevant. But for folks who have been doing it for maybe two years and now have the option to work from home three days a week or what have you, maybe they want some more creature comforts than Home Depot and Lowe's can provide. So, I'm a lot more optimistic about those than I am about the Walmarts and the Targets. Jim Gillies, always great talking to you. Thanks for being here. Thank you.

Shopify is one company tied to retail that's tapping the brakes on its growth, but some companies are hitting the gas pedal. Ricky Mulvey and Sanmeet Deo look at a few businesses playing offense in a tough environment. You're in a recession, we're not in a recession. Today, we're looking at some of the companies playing offense in a challenging environment. Joining us now is Motley Fool Senior Analyst, Sanmeet Deo. Good to see you, Sanmeet. Good to see you, Ricky. Playing offense is a lot easier when the market is raging upward. That's what Shopify did during COVID, and now some of those companies are feeling a little bit of a hangover.

Yeah. Toby Luecke wrote in a company-wide memo to Shopify, You know, we bet that the channel mix, the share of dollars that travel through e-commerce rather than physical retail, would permanently leap ahead by five or even 10 years. We couldn't know for sure at the time, but we knew that if there was a chance that this was true, we would have to expand the company to match. It's now clear that bet didn't pay off. And so, it's this idea that, you know, you can go on offense when your stock price is soaring upward, interest rates are low, but then it becomes a lot more difficult when

you're in a more challenging market environment. And then, you know, Tobi was very open in saying that, you know, we made these assumptions about the e-commerce market and adoption, and that just didn't play out. And, you know, I guess, is that fundamentally what changed for Shopify? Yeah, you know, it's interesting, because, you know, they made this big strategic bet, like you said, and one of their biggest mistakes, and one of the mistakes that a lot of companies have made during the pandemic was that its industry growth would extend for a long period of time, possibly even be a permanent shift.

So, they grew their headcount expenses to scale up to anticipate that growth. Of course, they didn't take into consideration the effects on e-commerce, Shopify here, from a reopening of the economy and shifting consumer shopping habits once that occurs. So, this ultimately led to a rapid ascent in expense growth, followed by slowing revenue and decline in margins. Now, the company has got to play defense, laying off staff, cutting operating expenses to meet those lower revenue levels. While investors should be happy, Shopify is acknowledging this mistake and right-sizing.

A big problem I see is the company may need to be more aggressive with implementing strategies to grow revenues and gross profits, but because of what's happened, they're playing defense and catching back up. In your view, are they playing smart defense? It's interesting, because I read an interesting take about how their take rates are much lower than the competitors of Amazon, eBay. It's almost like, when I read this analysis, they're almost under-earning. Maybe it's time to close that gap and earn more and take more offense because you can only cut expenses for so long until you really need to ramp that revenue growth. Let's talk about some of the companies

going on offense right now. That's not just an idea that's a good idea in and of itself, but when liquidity dries up, the market's down relative to all-time highs. That's when some companies are really able to grab market share. Any companies you follow that you see going on offense right now? One company that comes to mind is Axon. They make tasers and body cameras. CEO Rick Smith recently told The Wall Street Journal, right now, a small opportunity. He said, yes, winter's coming, now let's embrace it. So, he's buckling down on expenses for business travel and company swag, but he's kind of also encouraging an aggressive mindset in terms of playing offense in their business.

There's a good Wall Street Journal article about it. He's got a swag czar, and he kind of lamented to the reporter that not every single event needs a T-shirt. While the labor market is hot, you're still seeing a lot of these tech companies implement layoffs, and Axon is very much in some ways welcoming that, saying, cool, more computer engineers, that's good for us, let's go find some talented ones for our company. Yeah, there's a lot of shifts happening in the marketplace with companies, maybe employees leaving companies or things happening. Now's the time when you can take advantage of those opportunities. Trade Desk also had a blockbuster quarter recently. That's another company that

that seems to be going on offense in a challenging environment. Yeah. Trade Desk had a great earnings report recently, raised guidance in this kind of environment, which is very impressive, raising guidance when some companies are pulling back or not giving guidance. Many ad tech companies, ad companies like Facebook and ad platform companies are feeling the pinch from advertisers pulling back on spend. Some of those advertisers will pull back on the low-hanging fruit, stuff that they don't really need to do, but things like Google advertising is much more prominent and impactful for them. But with companies pulling ad spend, Apple IDFA privacy changes continue to ripple through the

industry. Trades is playing the offense, and they have been for a while with their new UID2 ad platform, which is gaining tractions, gaining partnerships and integrations with companies like Disney and AWS. It's showing in the results. They're very bullish on connected TV advertising and where they play in the market and how they can capture share. Speaking of companies playing offense, I think one frame to use is you look at a growing industry, take a little bit of a macro view, and then you look at the specific companies that are poised to take market share. A few months ago, we looked at a company called Exponential Fitness, and you see a lot of fitness companies that are able to use COVID as an excuse, or you see some companies shrinking

their footprint. This is one that his CEO, Anthony Geisler, has really never leaned on COVID as an excuse, and he's also very much leaning into an international expansion for exponential. Yeah. When COVID hit, he was very aggressive and fought very hard for his franchisees when it came to rent abatements, fighting the government to get COVID relief and pausing royalties for his franchisees and launching online platforms and digital platform for his franchisees. He did a very good job of, instead of blaming COVID, kind of going on the offense. And that's kind of continued, especially now with them signing more international agreements, master franchise agreements in Japan and all across the world. One interesting story that

recently came out that was very impressive to me was on July 26th of 2022, its competitor F45 Holdings came out with some rough news announcing a departure of its CEO, reduction in global workforce, sharp cut in its full year guidance for revenue and earnings, and a removal of financing facility for its franchisees. Stock cloned over 60% in a day. Usually, this would be not such a great read-through for the boutique fitness industry. The next day in the morning, Exponential announced, quote, it expects to deliver strong results for the second quarter of 2022 and has continued to reinforce its position as a leading provider of boutique fitness globally. Additionally, quote, it's on track to meet or exceed guidance metrics for the year. In that press release as

well. They announced their preliminary second quarter results, strong member growth, store visits, sales, AUV, average unit volume growth for their stores. Very offensive move after F45's disaster, reassuring investors that we're okay. I'm an investor in it myself, and I was very pleased by it as well. I own shares as well. The only way you can play offense in a tough environment is if you have the balance sheet to back it up. Some of the companies we've talked about, Axon, Exponential, Trade Desk, any balance sheets there stand out to you for companies that could continue to play offense in a tough environment? Yeah, absolutely. Trade Desk, which we were talking about earlier offline about how you wouldn't think tech companies

or some of these kinds of companies might have super strong balance sheets, but they have $1.2 billion of cash on their balance sheet, no debt. They're well-positioned to continue to play offense like they've been doing. Axon as well, no debt on their balance sheet, $377 million in cash. Again, strong balance sheets that put them in a position to take these offensive maneuvers. Exponential's balance sheet has some debt, and it's okay. The main advantage for Exponential as a franchisor. So, you know, launching in international markets, you know, growing their stores as a franchisor, those costs are typically, typically, um, um, on the franchisees to open up the store. So, so they can grow and expand in an environment without taking on too much heavy

costs in this kind of environment. Now we've talked about some of the companies with strong balance sheets playing offense, um, which companies would you like to see play offense, but maybe their balance sheet is holding them back. They don't have the ability now to go out and make smart acquisitions or really expand into new territories. The first thing that came to mind is Netflix. They're in a very competitive space. They're looking to find their next leg of growth. They've done very well in streaming. Now, there's a lot of competitors out there. You saw Disney recently report that they have, in combination, more streaming subscribers than Netflix. They have plenty of cash on

their balance sheet, but they have about $14 billion of debt, and they have a large content spend annually of about $17 billion. Management recently said that that's where they're going to tap out at, and they're not going to continue to go higher. But I feel like the obligations that they have is going to keep them from making any big splash on the acquisition front kind of build its ad platform or grow its gaming business. Now, they're working with Microsoft for their advertising platform, and that's probably going to be good. In fact, Trade Desk actually mentioned that that would be a good move for them. But the gaming business, they've made some small acquisitions, but to make a bigger acquisition to really drive home their position in that industry,

they might be held back a little bit, and they'd have to grow it more organically than otherwise. It's on me, Dale. Thank you for your time. Thank you, Ricky. As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow. Thank you.