Up 166% since its IPO last September, Peloton Interactive's (NASDAQ:PTON) stock has been on an impressive run. Given the increased focus on finding ways to stay fit and work out at home as the coronavirus continues to spread, this is not surprising.
Currently trading at a price-to-sales ratio of 13.4, the company is priced to perfection. Sales in the third quarter of 2020 (ended March 31st) were up 66% from the prior-year period, reaching $524.6 million. Connected Fitness Subscribers (those who purchased the company's bike or treadmill) soared 94%.
It's clear that the market has validated Peloton's product offering and has rewarded investors nicely, but does the company deserve such a lofty valuation usually only found in the tech sector? Here's why I believe it does.
The definition of a tech company
A true technology company is characterized by the role that software plays in its business model. Some of the biggest stock market winners in recent years and the largest companies of today share this in common. If we spend some time understanding why this is, it'll all make sense intuitively.
The centrality of software allows a business to have zero marginal costs, improve its product or service over time, and have infinite leverage. This explains why companies like Facebook, Alphabet, and Netflix have been so successful and continue to grow.
Compared to the capital-intensive companies that dominated the economy in previous generations, all three possess business models that scale extremely well. Once a critical mass of users is achieved, free cash flow generation skyrockets as reinvestment requirements diminish. The end result is what matters most to investors -- shareholder value creation.
How does this apply to Peloton?
Now that we know what a technology company looks like, what does this mean for Peloton? Astute readers may have picked up on one main difference between Peloton and the three companies I mentioned earlier -- Peloton's main business is selling a physical product. Just like Apple, Peloton sells hardware that is differentiated by software.
Peloton's bikes and treadmills had a gross margin of 45.3% in the fiscal third quarter, which was higher than Apple's products segment in the same period. Selling high-margin products with its own software alone doesn't make Peloton a technology company. The key is the same reason why Apple can be considered a technology company -- disruption.
Previously, it was impossible to take cycling classes when and where you wanted. Peloton has now made this possible, while significantly driving down the price per class. If the avid cycler takes 20 classes per month, it'll cost him or her $640 through SoulCycle. One Peloton bike costs $2,245 plus $39 per month for the cost of subscription. After about four months the Peloton bike has paid for itself, not to mention the fact that the number of classes one can take is unlimited.
Get used to the high valuation
Investors who were lucky and smart enough to get in on the IPO could not be happier. Peloton sells a product its consumers absolutely love, and it has proven to be a clear winner during the coronavirus pandemic. The company's ability to make something feasible that previously wasn't by allowing fitness enthusiasts to take classes cheaply whenever and wherever they want to makes it a technology company.
With a scalable business model and growing network effects, investors should not be surprised if Peloton's stock keeps sprinting higher.