Quick follow-up on Peloton
Hope everyone enjoyed a nice three day weekend.
I just wanted to follow-up on the discussion of Peloton’s unit economics with a link to an aptly timed interview with new Peloton CEO Barry McCarthy published in the NYT over the weekend.
McCarthy is the former CFO of Netflix and Spotify, so suffice to say he knows how to run a subscription business. One thing he said about the future direction of Peloton caught my attention and also pertains to last week’s discussion of unit economics:
How are you planning to change the pricing model to strike the right balance between revenue from subscriptions and products?
Selling subscriptions with a really low entry price. Playing around with the relationship between the monthly recurring revenue and the upfront cost to find some sweet spot in the consumer value proposition that gets people to buy into the user experience and affords you a really good margin.
So instead of selling a bike outright at more than $2,000 and then selling a subscription, you’re thinking of selling the whole thing as a subscription, say $150 or $200 a month — like a high-end gym membership?
It’s probably, instead of $39, it’s maybe $70 or $80. And then the upfront cost is dramatically lower.
Obviously, this would have huge implications for the unit economics of Peloton’s connected fitness subscription business. What McCarthy is talking about here is dramatically lowering the up-front cost to the consumer of owning a bike — functionally an increase in CAC — and a corresponding increase in LTV through a higher priced monthly subscription. I imagine current subscribers will be grandfathered in on the $39/month so we probably don’t need to assume a huge one-time surge in churn in connection with this pivot, but with a lower entry cost and higher month-to-month commitment we could probably expect an increase in churn levels under the proposed model beyond what the current business experiences.
Anyways, you can play around with the inputs in the model I shared last week to see how different pricing models might impact Peloton’s unit economics. In fact, that’s probably what Peloton excecs are doing right now. But, aside from unit a change in the unit economics this change in business model has one other big implication for the stock. Peloton is probably going to have to do another massively dilutive equity raise sooner rather than later.
With about $900mm cash on the balance sheet and the business projected to burn $1.3bn in 2022 before this change in business model, Peloton was probably going to need to tap the debt and/or equity markets for financing at some point this year anyways on the heels of selling $1bn worth of stock last November. With the change (again, only assumed based on the above interview at this point), the business is going to lose even more money in the short-term by subsidizing future subscription revenue and will need more external financing, faster.
Netflix of course has made significant use of debt to finance its growth so based on that it seems McCarthy might prefer that route, but I’m not sure how friendly the debt markets are going to be to Peloton before they prove out their new model. More likely IMO they will need to issue equity, probably below IPO price of $29/share, and that’s going to hang over the stock price until it gets done.
I’m in no rush to buy the stock until that clears, but looking ahead, the completion of another equity raise later in 2022 could mark an inflection point for the stock.
Lastly, I also wanted to share a podcast I just listened to because it includes a conversation that touches on a couple of the themes I’ve written about here so far (fast-forward to 26:00).
In the pod they talk about how it seems like the only thing that matters to the market right now is the “change in the derivative,” i.e. the trajectory of business fundamentals matters much more for valuation than the business fundamentals themselves. A made-up example to illustrate the point:
Say Company A and Company B were both earning $10 before COVID. Then, during COVID, Company A’s earnings doubled to $20 (covid winner) and Company B’s earnings halved to $5 (covid loser). Now as we head into 2022 and the world normalizes, company A is projected to earn $25 (25% growth on last year’s $20) and company B is projected to get back to earning $10 (100% growth on last year’s $5). The market right now is rewarding Company B because its earnings are rebounding off a depressed base and punishing Company A because its earnings growth is decelerating after a pandemic-fueled surge.
And to some extent this may be warranted, and higher (sustainable) growth rates should be rewarded accordingly. But between, say, a live events business and a telemedicine business, which one would you guess is trading 55% above their pre-covid highs and which one is 25% below? The one that had 18 months of business completely wiped out as concerts stopped or the one that increased paid users 46% to 54mm from 37mm and became the only way millions of patients were able to interact with their doctor?
In the pod the hosts muse over what the lessons are from the market we’ve experienced over the last year. They mention two things worth repeating here:
Flows are super important - more important than you think
CTAs and other momentum/trend-following strategies might be a much larger part of the market now than we realize and can push prices to extremes in both directions.
What this means practically is that these moves can go further than you think, and reverse faster than you think, which I think will be important to keep in mind as we emerge from what I think will prove to be peak rates fear.
For me, one takeaway is simply that maybe Mr. Market just trades what’s right in front of his face more than we want to acknowledge. You’ll remember our discussion of the second derivative of interest rates a couple weeks ago. I argued that markets were reacting to an increase in expectations of the future rate of interest rate hikes, despite the fact that we’ve yet to see one hike, the fed funds rate is still at 0 and long-term rates have barely moved.
We’ve all been taught the market is a discounting mechanism and prices things way out into the future, and I still want to believe that’s correct in the medium and long-term (although more professional investors are beholden to the short-term than you might think). But the short-term highs and lows on the path to get there certainly seem to be getting more extreme, and with volatility comes opportunity.
Disclaimer: nothing published in this newsletter is financial advice. The author may be long or short any of the securities or assets discussed at any time before or after publishing.