When Peloton Interactive (PTON 0.77%) went public last year, it was easy to question the company's future. Making and selling hardware is hard, and pairing high-margin software with hardware has a spotty history (just ask once high-flying GoPro). 

But 2020 has been a perfect storm for the home fitness business, and few companies have capitalized the way Peloton has. Does that make this growth stock a buy right now? The price is steep, but this may be a company that turned an important corner in 2020. 

Man biking on Peloton bike in bedroom.

Image source: Peloton.

Peloton's home fitness thesis

If Peloton is going to be successful financially, it's not going to be because it sells bikes. Hardware is a tough business and there are a lot of companies that do, or could, make similar quality home fitness bikes and treadmills. 

What Peloton wants to do is use hardware sales to sell content subscriptions that are high-margin recurring revenue. In the fiscal fourth quarter of 2020, subscription gross margin was 56.8%, up from 42.7% for full-year fiscal 2019, and given enough scale it's possible subscription margins could be in excess of 70%. 

The business is likely to be highly profitable if Peloton can get a big enough installed base, but that's always the problem for hardware companies. And that's where 2020 becomes a massive tailwind. 

A pandemic-driven boom

Peloton's growth during the pandemic has been nothing short of astounding. In the quarter ended June 30, 2020, the number of connected fitness subscribers jumped from 511,000 a year ago to 1.09 million. And quarterly workouts were 76.8 million, up from 17.8 million a year ago. 

Remember above that the key to Peloton's success is getting the installed base of bikes and treadmills up and getting people to use the subscriptions that are high margin for Peloton. The pandemic has supercharged the installed base and usage, which could be very sticky for the company long-term

Leveraging the base to grow new markets

Now that the number of subscriptions is increasing and hardware out in the world is going up, it's time to increase the value of subscriptions to make sure people stay engaged. That's what Peloton is doing by adding bootcamp, strength, yoga, and cardio to the cycling and running classes. Adding these services without raising prices is something only a digital content model could do because the marginal cost of adding classes is very low. And these new classes make the service more valuable for customers, which makes them more likely to continue subscribing. 

As the installed base grows, Peloton will likely continue to add digital services and also hardware offerings. And that'll steadily expand the company's reach into more homes. Given the traction Peloton already has, I can't imagine its subscriber base doing anything but growing for years to come. 

Is Peloton a buy? 

There's no question that Peloton's stock is expensive by traditional measures. It's not profitable long-term, so price-to-earnings ratios are useless and shares trade at a lofty 13 times sales. But this is a business that could live up to those expectations. 

Peloton has already built a large enough installed base of hardware to generate a profit (which it did last quarter), and it's adding both subscribers and class offerings at an astounding clip. That should keep people engaged and paying their monthly subscription dues. And given the high margins digital subscriptions bring to the business, I think this is a stock investors should buy and hold long-term.