Peloton: SaaS Plus a Box or Boxed In?

The tides changed and Peloton was swimming naked. Or were they purposefully skinny-dipping? Let’s dive in and figure it out.

Connected Fitness Products

Sales dropped substantially, while costs rose substantially. Not a good combination.

Let’s talk about margins. Peloton bikes are crazy expensive, but apparently are also crazy expensive to make. Margins one year ago were 39%, but dropped to 12% in their latest quarter. That is a wild drop. So what’s driving it?

The recall reserve for the tread drove ~2% of the margin drop. Reduced pricing, increased logistic costs and rising component parts drives the rest of the increase. Next quarter GM% isn’t forecasted any better at 7% for next quarter. It turns out rising costs combined with lowering prices have a bad result on margin percentages. Guidance was more optimistic for the full year at 16%. The full-year guidance must assume significant efficiencies in their cost basis because price increases don’t seem like they are the path forward for management.

The connected fitness products aren’t the money makers though. They are the customer acquisition costs for the subscriptions. The margin for connected fitness should cover all the costs associated with acquiring customers (showrooms, ads, etc…). Right now that clearly isn’t happening and the massive drop in margin (plus rising costs) are a main driver in that.

Peloton at first glance should be raising rates, not lowering them. The subscription portion of their business model might be the answer to this puzzling decision.

Subscriptions

When I first learned about Peloton, I didn’t even think about their subscription business. I assumed the bikes/treads were so expensive, that was their business model. Like many others who have a cursory glance of Peloton, I was wrong. The subscriptions are the whole key to the business model.

Unlike Connected Fitness, the subscriptions portion of the P&L looks good. Revenue is up 94% YoY with margins not deteriorating. You don’t need to own a tread or bike to be part of Peloton’s subscription service, but you do need a subscription to make full use of any Peloton hardware. Even better yet, churn rate remains very low at 0.82% per month (92% retention on the year).

To learn more about the subscription business, I like to go back and read THIS piece from Tren Griffin. What strikes me the most here is the commentary around Roku.

Hardware may be a valuable way to distribute software/SaaS, but it makes for a much harder business model to execute on. The skills and business models necessary to get the product and service integration right are sometimes conflicting. Getting the hardware designed and manufactured correctly is non-trivially hard. Managing a global supply chain is tricky, as is customer service. The upfront cost of creating, manufacturing and the financing hardware for consumers can result in a higher customer acquisition cost, but the relationship can become quite sticky. But as anyone who has tried to sell hardware devices knows the amount cash required to do so successfully is huge. Up front expenses like non-recurring engineering and work in process make it hard to finance. Add upfront costs of SaaS customer acquisition to that and you are talking about significant cash requirements. In other words, the unit economics of a SaaS plus a box business model can require that the business raise a lot of cash before it flows enough cash to be self-supporting.

As an example of what I talked about above, The Street.com wrote this about how hardware impacts the unit economics of Roku:

“The Roku Player, however, is a true loss leader. Revenue was actually down 7% from a year ago while the cost of that revenue was only down 1%. The company acknowledges the Player as a loss leader, but the concerns become how quickly will it slow and how much will it drag the bottom line. Gross margins for the Roku Player dropped from 14.3% a year ago to 9.5% in the fourth quarter. Fortunately, the Platform gross margins are strong, at 74.6%, but those are also lower by almost 300 basis points from a year earlier.

SaaS plus a Box can work financially, but it is not an easy business model to get right.

https://25iq.com/2018/03/10/peloton-the-saas-plus-a-box-business-case/

Roku monetized in a different way than Peloton, but in many ways they are similar companies. Both leverage their hardware as CAC (customer acquisition cost). The major difference is Roku is selling $20 streaming devices while Peloton is selling $2k bikes.

If Peloton does view themselves as a subscription company and believes in their unit economics, their actions around lowering, instead of raising prices makes sense. You want to get your bikes and treads in front of as many customers sa possible.

Operating Expenses

So we went from bad (connected fitness) to good (subscriptions) and now we are at the terrible. This is the most disappointing part of the Peloton P&L. Sales grew 6% YoY, while operating expenses grew 140%.

Yeah, if that isn’t a red flag, I don’t know what is. As the COVID tail winds began to change, Peloton was caught swimming naked. Peloton was spending wildly to support their growth, but then in a matter of months that growth stopped. Peloton didn’t react quickly enough.

A Quick Note on the Fitness Industry

Some people believe the fitness industry is an investing wasteland. I think that is silly. Sex sells and for better or worse that really is what Peloton is. The fitness industry is the sex industry. Well close enough. A better way to describe this is dopamine. Peloton drives dopamine in many ways.

Some people strongly believe the fitness industry is inherently driven by fads. I don’t. I just don’t really think the right company has come along (at the right time). A historical problem with the fitness industry has always been scale. How do you scale an experience pre-internet? The window for a company like Peloton opened shortly before Peloton was created.

Bringing It All Together

We have some good here, some bad. When I look at the bad, it was largely driven by a complex situation and stupidity by management. Nothing is inherently wrong with the Peloton business model, it’s a pretty beautiful business model actually.

Peloton is drowning in risk and opportunity right now. Some of the financials are huge red flags. Yet Peloton has potential Lollapalooza effects working in its favor. It has a world class brand, a strong business model, driven by dopamine, has plenty of optionality and long-term industry tail winds behind it. I don’t think it is crazy to squint and see a $100B company. The problem is that it’s not crazy to see a bankrupt company either. I see asymmetric upside, but I’ll keep my position smaller because this ride is riddled with opportunities of wealth… and ruin.