Thanks to excellent marketing, Peloton Interactive (NASDAQ:PTON) is one of the hottest brands in fitness right now. The company that wants to sell sweatholics a $2,245 exercise bike (or $4,000+ treadmill) currently has fewer than 600,000 subscribers, but the brand is already known by more than 50 million people who have expressed interest in learning more about its products. 

Peloton expects to sell millions of these things, and it probably will, given that sales have been doubling year over year. But one issue many have with the stock is that Peloton is bleeding cash. Its net loss has widened from $71 million to almost $200 million over the last two years. Throw on top of that a rich market cap of more than $8 billion, and it's understandable for some investors to be skeptical about the value in the stock right now. 

However, when we dig deeper into the company's numbers, there is potentially a very profitable business hidden underneath Peloton's cost structure. Because of that, the stock could have plenty of upside from current price levels. 

A Peloton exercise bike sitting in a living room of a house.

Image source: Peloton Interactive.

Flexing those marketing muscles

Airing commercials on prime-time TV is expensive. Peloton spent $324 million on marketing, or 35% of sales, in fiscal 2019 (which ended in June). That is really high. The idea is to introduce the brand to as many people as possible, grow subscribers, and rely on word-of-mouth referrals for long-term growth. 

Peloton reports its revenue across three categories -- connected fitness products (bikes and treadmills), subscriptions, and other (apparel and accessories). The largest sales category is fitness products, which made up more than three-quarters of revenue in fiscal 2019.

The company is clearly getting a good return on its marketing investment given the explosive growth in revenue and subscribers, as you can see in the following table. 

Metric Fiscal Q1 2020 Fiscal Q1 2019
Revenue $228 million $112.1 million
Connected fitness subscribers 563,000 277,000

Data source: Peloton Interactive.

Management's strategy is to reinvest virtually all the gross profit that Peloton earns from selling bikes and treadmills into sales and marketing in order to bring in new subscribers. In this table you can see that's exactly what management has been doing. 

Metric Fiscal 2019 Fiscal 2018 Fiscal 2017
Connected fitness product gross profit $308 million $154 million $70 million
Sales and marketing expense $324 million $151 million $86 million

Data source: Peloton Interactive.

Sales and marketing expense is the main reason Peloton is unprofitable. However, Peloton won't continue to spend 35% of its annual sales on marketing every year -- few companies do. At some point, brand awareness should kick in and allow management to lower marketing expense as a percentage of sales. If Peloton spent only 10% of sales on marketing, which is closer to the average of what other companies spend, the company would save enough money to report a small profit based on current sales levels. 

Peloton is also spending a lot of money on content creation, including instructors for fitness classes and studios for its digital subscription platform. This cost is included in subscription costs, which totaled $104 million in fiscal 2019. That left a gross margin on subscription revenue of 43%. Management believes the gross margin on subscriptions will increase over time, since a small number of studios and fitness classes can support a growing base of subscribers who engage with the classes online through the display attached to the bike or the Peloton app. 

This means that the profits from subscriptions could be the real driver on the bottom line over time. This reinforces the idea that Peloton Interactive is just what its name implies: not just a maker of pricey exercise bikes, but also an interactive fitness subscription service.

A screen attached to a Peloton bike displaying workout statistics.

Image source: Peloton Interactive.

It's clear that management is spending money now to get people aware of what Peloton has to offer. The aggressive spending on marketing is about getting the business to a tipping point where there are enough subscribers and brand awareness that management can pull back on marketing expense. Peloton shouldn't have to keep spending 35% of sales every year to market the product to the same people watching television every night. The company says that word-of-mouth referrals are one of its largest sales channels. 

Peloton spent nearly half of its sales in fiscal 2019 on marketing and content creation, not to mention $207 million on general and administrative expense, including Peloton's new headquarters in New York. All told, the company has plenty of money to play with in its operating costs to guide the business toward profitability in the long run.

A long-term profit margin of around 10% or more is very possible. If Peloton had spent $265 million on marketing and overhead combined last year, that would have left a $70 million profit on the bottom line, or a 7.7% profit margin. Of course, Peloton can't cut that much expense in marketing now, because it needs to grow its subscriber base. But this gives us an idea of how management is thinking about the long-term economics of the business.

Underestimated profit potential

Wall Street analysts are likely doing a similar calculation, because many of them have buy ratings on the stock. An analyst with Goldman Sachs thinks Peloton can achieve an adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) margin of at least 20% over the long term. The analyst expects Peloton to break even by fiscal 2024. Management is playing the long game, and investors thinking about buying shares need to do the same.

A 10% profit margin on Peloton's trailing-12-month sales would have translated to about $100 million in net profit. At a current market value of $8.1 billion, that would be a price-to-earnings multiple of 81. That still looks high, but not when sales are doubling year over year.

Peloton can likely keep posting stellar growth rates for a while. Company projections and analyst estimates put the range of potential subscribers from 10 million to 14 million over the long term. That is many times the company's current subscriber base of 563,000. 

If Peloton can successfully expand beyond the U.S. to international markets, the stock should be that much more attractive to investors looking for growth.