Few companies can credit the COVID-19 pandemic for boosting their businesses quite like Peloton (NASDAQ:PTON) can. Shares of the high-end fitness equipment maker have more than tripled since its IPO 12 months ago, catapulting the company to a $25.9 billion valuation.
As consumers shifted behavior due to shelter-at-home orders and are still hesitant to visit their local gyms, the health crisis has created the perfect environment for Peloton to thrive. While sales and subscriptions grew at an impressive clip in the fiscal fourth quarter and remain the figures most investors pay attention to, I want to focus on one of the most important and often overlooked metrics -- unit economics.
The value of a Peloton subscriber
Dissecting the unit economics for Peloton means taking a look at the lifetime value of a customer compared to the cost of acquiring that customer, where a ratio higher than one is better. It might sound complex, but it's actually quite simple. Peloton's core customers in this instance are its Connected Fitness Subscribers -- those who purchased a piece of equipment and who pay the $39 monthly fee.
Based on a May 2020 investor presentation provided by the company, the lifetime value of a Connected Fitness Subscriber in fiscal 2019 was $3,593. This calculation estimates the length of a subscription by looking at monthly churn, which is cancellations net of reactivations. It then accounts for direct costs and the contribution of each subscription to arrive at the gross figure above.
The cost to acquire a Peloton subscriber
Customer acquisition cost looks at company-wide sales and marketing expenses and divides those by the number of new subscribers added during the corresponding period. The interesting thing about Peloton is that it sells its own equipment at a very high margin, which lets the company quickly recoup most of the sales and marketing costs. In fiscal 2019, the net cost to acquire a Connected Fitness Subscriber was approximately $5.
No, that is not a typo. The large disparity between long-term customer value and cost of acquisition illustrates how Peloton excels at driving value on a per unit basis. It is virtually impossible for a subscription-based business to be profitable if it has poor unit economics. If a company is not making money on each customer, it won't be long until it's out of business.
It's worth pointing out that these figures look even better for the recently ended fiscal year 2020, mainly because Peloton was able to add 580,000 Connected Fitness Subscribers while significantly reducing sales and marketing expense as a percentage of revenue. Expect customer acquisition costs to increase again as we move past the pandemic, and Peloton is forced to spend more on marketing.
The Apple of fitness?
The most common knock on Peloton is the cost of its stationary bikes and treadmills. Critics say it turns off potential customers who cannot afford the four-digit price tag of the hardware. However, as mentioned above, selling premium equipment is a genius move as it allows Peloton to capture a lot of customer value upfront.
Just look at Apple, which has built its empire with this strategy of selling software-differentiated hardware at a high margin. It works so well, because consumers want and need the services offered by the tech behemoth but can only do so (for the most part) on a device sold by the company.
Likewise, Peloton's impressive software and burgeoning workout and content catalog attract new users, but only if they purchase a bike or treadmill first. Peloton's value-accretive equipment sales increase customer retention and engagement, as users view the sunk cost like an investment and feel the need to get their money's worth by exercising more. At the same time, growing expertise in designing and manufacturing exceptional equipment creates a moat around Peloton's business, raising barriers to entry for new entrants that must invest heavily in hopes of recreating similar capabilities.
This is a high-quality business
The coronavirus pandemic highlighted just how exceptional Peloton's business is. The company's unit economics are extremely impressive, because it takes a page from Apple's playbook and sells high-margin fitness equipment differentiated by its own services. Investors should always seek out companies that not only disrupt a product or service but ones that also look for ways to capture a lot of the value it creates by innovating the business model as well.
As with most disruptive growth companies, the stock price reflects what the market already knows -- this is a business that can outperform the competition while attacking a large and lucrative opportunity. It's best to be patient and continue following Peloton until an attractive entry point presents itself.