A PR Disaster Followed by a Brilliant Pivot Are a Sideshow to the Real Drama at Peloton

Unless you've been in a media blackout the last five days, you've probably heard about the drama at home fitness company Peloton (PTON)... SPOILER WARNING! This article refers to major plot points in the first episode of Just Like That, streamer HBO Max's reboot of the popular HBO series Sex and the City. If you've […] Not rendering correctly? View this e-mail as a web page [here](. [Empire Financial Daily] A PR Disaster Followed by a Brilliant Pivot Are a Sideshow to the Real Drama at Peloton By Berna Barshay Unless you've been in a media blackout the last five days, you've probably heard about the drama at home fitness company Peloton (PTON)... SPOILER WARNING! This article refers to major plot points in the first episode of Just Like That, streamer HBO Max's reboot of the popular HBO series Sex and the City. If you've gotten this far, you probably know (or don't care) that protagonist Carrie Bradshaw's (Sarah Jessica Parker) fictional husband Mr. Big (Chris Noth), dies from a heart attack at the end of the first episode of Just Like That, shortly after finishing a livestreaming ride on his at-home Peloton bike with his favorite instructor, the fictional Allegra, played by real-life Peloton instructor Jess King. It's the kind of PR that no company dreams of... While the death was fictional, the last thing a company committed to enhancing health wants is to be associated with the sudden death of a beloved character that has lived in the public consciousness since 1998. Peloton bikes and treadmills are particularly popular with consumers old enough to remember the original series. Not since a Crock-Pot slow-cooker indirectly killed a beloved character on NBC's This Is Us has a product suffered such bad PR... In an initial attempt at damage control, Peloton rolled out a member of its health and wellness advisory council, cardiologist Suzanne Steinbaum, to explain that Mr. Big lived "an extravagant lifestyle – including cocktails, cigars, and big steaks – and was at serious risk as he had a previous cardiac event in Season 6." This all makes sense, and every year, many athletic, fit people will, unfortunately, suffer heart attacks during intense exertion due to preexisting conditions, genetics, or bad luck. Most fitness industry veterans have at least one horror story to share... But that didn't stop PTON shares from falling 11% on Thursday, the day the episode debuted, and 5% on Friday. Over the weekend, however, Peloton struck back much more effectively... On Sunday, it dropped an ad suggesting the fictitious Big had not, in fact, died but instead faked his demise to run off with his beloved instructor Allegra. The ad features actor Noth, instructor King, and a fantastic voiceover from actor, entrepreneur, and marketing genius Ryan Reynolds, who previously translated his knack for snarky, tongue-in-cheek advertising into a nine-figure windfall when he sold his Aviation gin brand to spirits giant Diageo (DEO). You can watch the brilliant comeback [here](. Peloton claims it had no prior knowledge of the plot point (although it had signed off on King's appearance as an instructor), and both Peloton and Reynolds' Maximum Effort ad agency, which produced the spot, said the response was put together in just 48 hours, building on a prior relationship between the two companies. Ironically, it was [Maximum Effort that had masterfully spoofed Peloton's disastrously received ad from the 2019 holiday season]( (click [here]( to view it), with an advertisement for Aviation gin featuring the same actress from the much-maligned Peloton spot (click [here]( to view it). Peloton running into the arms of the company that mocked it so ruthlessly turned out to be a crucial move in its next PR crisis. --------------------------------------------------------------- Recommended Links: [Supreme Court Judge rules in Americans' favor]( During President Trump's term, Supreme Court Order No. 16-467 overruled a federal law. Within days of the court order, a $516 billion industry was unleashed. While much of the money is going into the coffers of various states and businesses... Regular Americans can take immediate action and position themselves perfectly for massive profits. For once, the U.S. government has officially leveled the playing field. Don't miss cashing in on this historic ruling. 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I continued to update my thoughts on Peloton periodically, but on January 22 of this year, [I changed my tune and wrote the following](... PTON shares probably fully reflect the company's bright future at this point and could see a pullback later in the year, as Peloton catches up to its backlog of orders and investors look to post-COVID recovery plays and sell some of the big winners of the pandemic... which the stock clearly was. While I turned bearish on the stock in January after it had more than tripled from the $47.64 price it traded at on June 9, 2020... it has frankly shocked me how quickly things have unwound at Peloton...  With PTON shares now trading hands for around $40 – below the price where I was enthusiastic about them – people are, of course, asking me if I would buy them there. Before I answer that question, let's look at what has happened at the company. On November 5, PTON shares dropped 35% in a day on a first-quarter earnings report that was an unmitigated disaster... While results for the first fiscal quarter, which ended September 30, were largely in line with the company's guidance and just short of analyst estimates, the forward guidance given by Peloton was terrible. Peloton lowered its full-year revenue outlook for 2022 to a range of $4.4 to $4.8 billion, at the midpoint a 15% haircut to the $5.4 billion it had guided to just 10 weeks earlier. Every other metric was guided worse as well. The adjusted earnings before interest, taxes, depreciation, and amortization ("EBITDA") loss was raised to a range of $425 to $475 million from $325 to $350 million previously. Gross margin guidance was lowered as well to 32% from 34%. Essentially, Peloton warned investors to expect bigger losses on lower revenues. Not good. While the number of Peloton subscribers continued to climb, the number of equipment buyers plummeted. With Peloton's signature bikes priced at $1,495 to $2,495 versus subscriptions costing just $468 per year, billed at $39 per month, there was no way that revenue growth wasn't going to slow here. With the world reopening, gyms available, people spending less time at home... if you wanted a Peloton bike or tread, why wouldn't you have ordered one earlier in the pandemic? Or when the price on the original bike dropped from $2,245 to $1,895 in September 2020? Or when Peloton dropped the price again to $1,495 this past August? As suspected, we now know that Peloton had pulled forward a lot of future growth into its fiscal 2020 and 2021 years. While I had expected things to slow down dramatically for Peloton, this was a much harder landing than I – or most people – expected... Clearly, management was caught off guard as well, as inventory really ballooned from June 30 to September 30, with inventory up $332 million or 35%... just as sales were slowing down. Marketing costs ballooned in the first quarter, up almost 150%, when it proved – surprise, surprise – much harder to get people to drop big bucks on home gym equipment when gyms are open again. The combination of lower product margins following the price drop on the bikes, higher marketing, other operating expenses, and money burned building inventory left Peloton with just $1.2 billion in cash on hand and money available on its credit line. Given it burnt nearly $600 million in cash in the first quarter and profitability is far off, the company was forced to shore up its balance sheet. On November 16, Peloton raised just under $1.1 billion, selling 24 million shares at $46. Shares actually railed 16% that day because the offering quelled any liquidity concerns, but since then, shares have retreated about 30%. If you liked it at $46 before, you must love it at $40, right? Actually, no... Despite being a true believer in the long-term prospects of Peloton, I don't think that buying PTON shares in December 2021 offers a great risk-reward. Let me explain... Peloton bears think this is a fitness fad... another NordicTrack... P90X... or Thigh Master. They say that because engagement, as measured by monthly workouts per connected subscriber, has fallen. Take a look...  Source: Peloton Peloton bears think these bikes and treads are destined to become clothing racks. I strongly disagree and think that workout frequency is seeking equilibrium in a world where gyms are open, and many people are spending more time out of the home again, whether at work or elsewhere. The Peloton bike or tread is a great solution when you have just 30 or 45 minutes at an odd hour, with no time for travel. And with gym subscriptions costing more than $100 in many places – and boutique spin classes costing more than $30 – even if a subscriber uses the equipment only a few times per month, she is getting her money out of the subscription. The low 0.8% monthly subscriber churn and high 12-month retention rate of 92% are strong indicators that existing Peloton subscribers aren't going anywhere. You can see the base continuing to build here...  Source: Peloton A study of social media will also tell you that there is a core of highly engaged Peloton users. There are plenty of passionate brand evangelists out there sharing their stories about how this company is changing or improving their lives. I maintain this is a healthy brand. I've noticed none of the big bears on the stock that post about it on Twitter (TWTR) actually have a Peloton... and that the people who do have one find themselves defending the company and its product and service – but not its stock! The problem with buying the stock here is threefold: valuation, expectations, and management... Even with this fall, Peloton is still not a cheap stock. It's pretty clear that it is now pricing the equipment close to break-even – which, incidentally, I think is the right thing to do... I had actually suggested that it do this back [in the June 11, 2020, Empire Financial Daily]( in response to a reader letter... I think Peloton would be smart to reduce the price of its bikes and just grab market share, as the long-term opportunity is from selling subscriptions, not equipment. I'm guessing Peloton's bikes cost $1,400 to $1,500 to source, so it seems like the company has room to bring prices down from the current $2,250. I am going to award myself an A+ in sleuthing here because not only is the bike now $1,495, at the 7% product gross margin that the company is guiding to... the implied cost of a bike being $1,390. I sure was close! Since selling bikes and treads makes no money... the value in this company is in the subscriptions. At an estimated 3.4 million users, that's a run rate of subscription revenues at year-end 2022 of around $1.6 billion. At an enterprise value of $14 billion, it's almost 9 times year-end 2022 subscription sales. That's not a crazy valuation for a Software as a Service company ("SaaS"), but I think Peloton will settle out in the lower end of the range of the 70% to 85% gross margin you typically see at SaaS companies. Plus, the company has an overhead expense problem... and uncertainty about whether it can really add 900,000 more subs this fiscal year. If the valuation is too rich now at $40... How was it OK at $46, 18 months ago when it was a smaller company? My answer: It was a momentum company then... but it's not anymore. PTON shares have lost their momentum and must trade in relation to valuation now. I'll refer to my colleague Enrique Abeyta's tweet from over the weekend, which explains a lot...  Source: Twitter/@enriqueabeyta This broken momentum stock will likely go down until it becomes a valuation-supported stock... but we aren’t there yet. Finally, there is the issue of management. While I think they are doing the right thing with the price cuts... they are doing everything else wrong. They should have seen the hard landing coming... and proper planning and communication could have softened it a bit. I thought they were arrogant in [handling the treadmill recall]( and even more arrogant in acting like this business momentum would continue forever. They had their head in the sand about the coming slowdown. You can see it in the inventory build. And you can see it in their inexcusable error not to sell shares in the approximately two months that the stock spent hanging out over $140 in late 2020 and early 2021. There was clearly no end in sight for the cash burn. What were they thinking? Pair the flub on shoring up their balance sheet with the fact they had to lower guidance so materially just 10 weeks after giving it... and this is a management team that has lost control. I believe in Peloton's long-term prospects if it doesn't screw it up. This company needs new, competent leadership. One of three things needs to happen for me to get excited about buying PTON shares: drastic cuts to operating costs (that don't further slow growth), a reacceleration in product sales, or a new competent management team. Unless I see one of those things happening, I can't even think about it from a valuation standpoint until it is in the $20s. I would rather buy it at $50 with some things looking up than at $40 or $30 with everything going the wrong way and with a team that has let shareholders down. This was super long – but I hope it was of high interest, given how many people asked for it, so I'm skipping the mailbag, which will return later in the week... Are you an owner of equipment from Peloton, Tonal, Mirror, SoulCycle, NordicTrack, Echelon, Hydrow, or anyone else... if so, I want to hear from you! Are you using your equipment less or not at all? Do you still find value in it with the gym open? And if you don't own any home fitness equipment but you have thought about it, what is holding you back? Finally, does the on-screen death of a fictional character really dissuade anyone from buying a product... or is this all much ado about nothing? Share your thoughts in an e-mail by clicking [here](mailto:feedback@empirefinancialresearch.com?subject=Feedback%20for%20Berna). Regards, Berna Barshay December 13, 2021 If someone forwarded you this e-mail and you would like to be added to my e-mail list to receive e-mails like this every weekday, simply [sign up here](. © 2021 Empire Financial Research. All rights reserved. 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