February 7, 2021

#1 Riding with Peloton

After dizzying growth in 2020, the narrative around the trajectory of Peloton has sobered a bit, recently. Concerns about supply chain constraints, margin contraction, and lengthy delivery-to-order windows (DTO) pervaded Thursday evening’s earnings report, despite another quarter of blistering growth in both revenues and membership. At a higher level, the company also faces an existential crisis as the world evolves away from the very catalyst of its meteoric rise.

As an investor with a long-term focus, I am still extremely excited about Peloton’s potential. I am bullish on the future of the large, growing market of fitness technology that they’re attacking. I believe they have a distinctive product offering that has captured a passionate audience and have built a compelling business model that generates accumulating advantages. On a more micro-scale, I would also argue that what some investors are calling weakness in the most recent release will actually fortify Peloton’s competitive advantages moving forward. 

I rely on the Back of the Napkin VC framework to explain why I’m riding with Peloton below.

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The critical ingredient to Peloton’s success is its audience. Their network of nearly 2 million connected fitness subscribers is an engine of organic growth and enables several flywheel effects for the business.

Anecdotally, it’s easy to see that users love the product. The staggeringly low churn numbers (0.76% average net monthly in Q2) and growing average monthly workouts per subscriber (up to 21 in Q2 ‘21 vs 13 in Q2 ‘20) are evidence of a user base that is highly engaged.

The product is naturally viral. Users post workouts to signal their fitness virtues on social media or invite a friend to participate in a workout together, creating social, belief, and bandwagon network effects. This dynamic drove another quarter of explosive growth (128% in total revenue and 134% in number of connected fitness subscriptions vs Q2 ‘20 last year) on a relatively light sales and marketing expense ($177 million, or ~17% of total revenue). 

In the initial stages of the business’s life, there was concern about how large the total addressable market for a company that made an expensive exercise bike really was. However, over the last several months Peloton has demonstrated an ability and willingness to expand and broaden their total addressable market through the introduction of new fitness modalities, celebrity partnerships and an entry-level digital-only subscription. 

In the last year, the company has introduced new Tread hardware, as well as Strength and Pilates programming. While it’s still too early for the Tread to drive any material top line revenue growth, on Thursday’s call, CEO John Foley, noted that their initial test in the UK market, “exceeded expectations”. Bank of America research analysts estimate that the Tread market could surpass the Bike. 

Beyond expanding their market of fitness interests, the critical result of these efforts has been to further engage their current subscribers. So far, the evidence suggests that the more options Peloton presents, the more workouts an average subscriber completes, and, therefore, the stickier that member is.

The advantages of this highly engaged community accumulate with scale. Beyond the social network aspects, a larger community enables data advantages around new and better content (like Netflix), attracts better instructors and community leaders, and spins off more cash flow to reinvest in critical infrastructure like supply chain or new product development. All of these, in turn, improve customer engagement, reducing churn, and improve the user experience, attracting new members, and the flywheel continues.

Perhaps the most compelling aspect of Peloton’s business is its ability to leverage its "Saas plus a box" model for profitable unit economics. Their subscription customer acquisition cost is effectively negative because their gross hardware profit is greater than the customer acquisition cost. This creates a highly lucrative SaaS business model if churn remains low. On Thursday’s call, CFO Jill Woodworth noted that despite margin % contracting due to elevated pandemic-related supply chain costs, CAC remained negative given expansion in gross profits $, which implies they have a comfortable cushion in terms of sustainable unit profitability.  

Finally, I’ll say that I believe Peloton’s recent obstacles will fortify its competitive advantage moving forward. Their investment in the supply chain in both the US and overseas will solve their DTO issues in the near term and create manufacturing optionality in the long term. This will also enable them to build an inventory for the first time since their rapid expansion, enabling them to spend more aggressively on sales and marketing and pushing new users through that profitable engine we discussed. (Obviously, given the unit profitability and flywheel effects of adding members should encourage Peloton to spend more to acquire customers, which they indicated was their plan for 2021 and beyond.)

Looking ahead, I’m less bearish about the vaccine’s affect on in-home fitness and Peloton, generally. I think they identified a market for convenient, effective workouts that isn’t going away. Also, migration trends away from dense urban areas to dwellings with more space would be more conducive to this model. So far, the churn and growth metrics would confirm there’s no signs of slowing. 

Key metrics I’m tracking for this business are subscription and revenue growth, churn, and average workouts per user. I’ll also look forward to any metrics on the success of the Tread in the UK and of the digital subscriptions effectiveness as an upsell funnel for the connected fitness products. 

Businesses like Peloton, with staggering growth, unit profitability, and flywheels of accumulating advantages in a large, growing market tend to generate momentum as they grow, which is an exciting proposition for an investor. With high quality management at the helm, it’s not a stretch to see them adding products and services in tertiary verticals like meditation, sleep, diet, wellness, wearables and beyond. I’m excited to be along for the ride.