Optimistic Horizon: Reaffirming Faith In Peloton’s Future (NASDAQ:PTON)

Initial Bullish Stance on Peloton

Peloton’s (NASDAQ:PTON) stock has attracted a lot of bears recently because of its weak growth and losses. We published a buy rating on Peloton back in May 2023 because we were bullish on its strong brand and loyal customer base. Further, we like that it is the leader in the home fitness space. Even though Peloton only has 3 million connected fitness subscribers at the moment, we believe the home fitness market can become much larger than most people think over the long term. Peloton, in our opinion, is more than just a pandemic winner. Furthermore, we weren’t just optimistic because we believed Peloton could draw in younger customers. Instead, we envisioned that Peloton’s core customers could be people with chronic diseases, which according to the National Library of Medicine can make up as much as 33% of the worldwide population. Customers in this category typically value Peloton’s convenient and vibrant community more. This can assist the client in maintaining their workout routine and, eventually, help them get healthier. Compared to young people who frequent the gym primarily for exercise or socializing, this is a different need. Furthermore, Peloton ought to be able to expand over time since, unlike many of its competitors in the home fitness market, it has figured out how to monetize itself.

However, we haven’t updated our view on Peloton since our last coverage in May. This is because we noticed that the user base expansion had stopped and the company was having growth issues. That’s bad news for a high-growth stock like Peloton since it could lead to more selling.

The Recall’s Ripple Effect

We believe that several issues in their operations during the previous few years are the root cause of the growth problems. This covers the product recall that lasted from January 2018 to May 2023 because of flaws, the decline in demand following the conclusion of the COVID lockdowns, and inflationary pressures. We consider the recall to be the most hazardous of these.

The reason for the recall was the bike seat had a defect that made it potentially dangerous to fall off while riding and cause injury. Peloton’s recall of 2.2 million bikes was a tough but necessary call. The number of reported injuries was small – just 35 out of millions of users. But Peloton wanted to protect their brand reputation and play it safe.

The massive recall will be devastating in the short term for the relatively new company. But they’re betting that prioritizing safety and securing customer trust now will pay off in the long run, even if the next few quarters are financially painful.

We still believe Peloton’s bike recall was the right long-term strategic move for the company. But we definitely underestimated how much it would hurt their user growth in the short term. Turns out a lot of folks who rushed to buy Peloton cycles during the pandemic ended up returning them after the recall. That created way more pressure than we expected.

Peloton tried kickstarting some initiatives to get membership growth going again, like partnering with individual companies and colleges. But we didn’t think those strategies would move the needle much. Doing a bunch of one-off partnerships takes a ton of time and effort for not enough payoff. We doubted those deals could offset the recall impact.

Strategic Partnerships as a Turning Point

But the game changed when Peloton announced an exclusive partnership with fitness giant Lululemon (NYSE:LULU) in September 2023. Lululemon decided to ditch Mirror and go all in with Peloton instead – a huge win. This makes Peloton the sole provider of digital fitness content for Lululemon’s legions of fans. And Lululemon becomes Peloton’s primary athletic apparel partner.

Short term, this probably benefits Lululemon more since they’ll immediately get apparel sales. It also limits Peloton’s ability to partner with other athletic brands. But we believe teaming up with a fitness powerhouse like Lululemon can be a much more successful play to advance the Peloton brand versus one-off deals.

Additionally, Peloton just announced a partnership with TikTok to bring Peloton content to the platform. This includes live classes, instructor videos, creator collaborations, class clips, and celebrity tie-ins. That kind of massive exposure on a platform used by over a billion people could be game-changing.

So while the recall fallout was worse than expected, these new partnerships with Lululemon and TikTok make us bullish again on Peloton’s growth trajectory. Aligning with top brands seems a smarter path forward than the one-at-a-time partnership approach. If these deals gain traction as we expect, Peloton could emerge from the recall even stronger and bring their user growth roaring back.

At first glance, young people don’t seem like Peloton’s core market. But we think their new TikTok partnership could be a bigger deal than some realize. TikTok’s user base keeps expanding way beyond just the Gen Z crowd. As it becomes more mainstream, the marketing exposure on TikTok could end up being even more effective for Peloton than the Lululemon deal.

Market Reaction and Investors’ Opinions

The market seems to agree – Peloton’s stock jumped 30% in just 2 days after the TikTok announcement. Investors see the potential there.

Meanwhile, a lot of analysts on Seeking Alpha remain pretty bearish on Peloton. Many still just view it as a pandemic fad. But let’s not forget Peloton booked $2.7 billion in sales over the past year. With their sticky subscription model, they’re poised to scale up and expand profit margins over the long haul.

Valuation

Base Case

Peloton’s stock is trading at a P/S ratio of just 0.78x, much lower than many of its sports category peers.

This is because the company’s user base is still not growing due to the recall and macro issues. That also severely impacted their profitability and market confidence.

Its fitness product gross margin has dragged down its overall performance in the last couple of quarters. Peloton was clearing inventory and took a hit from deleveraging when they decided to outsource manufacturing. But the good news is their fitness product gross margin has been improving quarter-over-quarter in 2023, turning positive again in Q1 FY24. Meanwhile, their subscription gross margin remains strong at 67.4% and expanding – much higher than peers. This shows strong long-term profitability potential.

Therefore, we believe that Peloton’s growth could be revitalized by cooperation with Lululemon. It offers successful brand promotion. Another significant move that could directly increase its product sales is the alliance with TikTok.

Peloton projects that their gross margin would rise to 44% in FY24, up 1102 basis points from FY23. That is about on pace with NIKE (NYSE:NKE), which is good.

So there are signs Peloton can turn things around despite the user growth challenges.

Ultra bullish case

In the short term, we think the valuation upside will come from multiple expansions to levels similar to peers. However, we were bullish because of the huge long-term potential that Peloton can serve customers with chronic health conditions.

In a previous article, we laid out a long-term target price of $14 billion – 438% upside from current levels. Here was our thinking:

If Peloton captured just 1% of people with chronic diseases globally (that’s only 0.33% of the total population), and we assume 3% long-term growth, 18% cost of capital, and 15% free cash flow margin, Peloton’s equity value works out to $14 billion based on a discounted cash flow model. That’s 178% above the current price.

Peloton said about 10% of sales are international right now. So if 90% of subscribers are in the US, Peloton already has about 0.8% market share of the chronic disease group here. Capturing 1% globally seems very doable.

So in my view, the huge unmet need among chronic disease patients gives Peloton a massive upside, even from today’s depressed levels. This is a long-term opportunity most investors are overlooking.

Assuming Peloton only captures 1% of the chronic condition client market (0.33% of total world population). 3% terminal growth rate, 18% WACC, and a free cash flow margin of 15% are assumed. Through Discount Cash Flow analysis, we get at a 14 billion equity value, which has a potential 178% return on the present price.

In its 10-K, Peloton stated that around 10% of their sales originated from the international market. Therefore, if we estimate that 90% of subscribers are in the US, we arrive with a market share of about 0.8% in the US. Our estimate of 1% of the global population with chronic conditions (0.33% of total global population) looks conservative. Investors should only consider the valuation to be expensive if the free cash flow margin falls below 5%, according to the following sensitivity analysis of the free cash flow margin and WACC.

Risk

Peloton’s user base is still declining, so if these new partnerships don’t restart growth in the next couple of quarters, there’s a chance the stock could pull back.

Also, with only $748 million in cash and about $80 million in free cash outflow last quarter, there’s some risk the market could start pricing this as a distressed asset valued only for its cash. That could severely drop the valuation from around $2 billion now.

If you’re just betting on multiple expansions to peer levels like in our base case, we don’t think the risk/reward is very compelling here. But if you buy into my ultra-bullish 438% upside scenario of Peloton capturing the chronic disease market, then the risk/reward profile makes sense.

It’s a matter of whether you think Peloton can turn around the user growth decline. If not, this could quickly become a melting ice cube. But if the partnerships start driving subscriber growth again, then the huge unmet need in the chronic disease market makes this an asymmetric upside opportunity, in our view.

Conclusion

In closing, we are sticking with our long-term bullish view on Peloton, even though we recognize the challenges they currently face. A strong brand that takes care of customers should find a way forward eventually, and we think the Lululemon and TikTok partnerships are steps in the right direction.

Despite the financials not yet supporting our ultra-bullish thesis, we believe the current valuation justifies the long-term upside potential we see. Peloton still has a solid core subscription business and a huge untapped market in chronic disease patients.

So while the bears are writing this off as just a pandemic winner, we rate Peloton stock a Buy. The risk/reward is compelling if you share my long-term vision for the connected fitness space and see the growth potential in digital health.

Current financials are rough but don’t tell the full story here. With the right partnerships and execution, Peloton can come back stronger. We are willing to look past the near-term challenges and bet on the long-term upside.