Connected fitness specialist Peloton (NASDAQ:PTON) announced yesterday after the close that it is acquiring Precor for $420 million in cash. The news sent shares to record highs in extended trading. Peloton shares had already gained over 430% so far in 2020 as the company has inadvertently benefitted from gym closures related to the COVID-19 pandemic.

The proposed purchase is quite promising on a number of levels. Here's why investors are so excited about the transaction.

A couple taking turns using a Peloton Bike+ at home.

Bike+ is suffering from supply constraints. Image source: Peloton.

Addressing one of Peloton's biggest challenges

Peloton has had a good problem on its hands: Demand is consistently outstripping supply. The company has been scrambling to fulfill orders. While booming demand is certainly positive, struggling to meet it can still be problematic.

Long wait times -- new orders for Bike+ are currently quoted a delivery time of over 10 weeks -- have been a thorn in Peloton's side. Reports emerged last month that many customers were canceling their orders due to delays. Peloton had acquired one of its manufacturing partners, Tonic Fitness, back in November 2019 to take greater control over its supply chain. But Tonic is based in Taiwan. Heavy fitness equipment still takes a long time to ship halfway across the world.

"[W]e will likely be operating under Bike+ supply constraints for the foreseeable future, causing longer order-to-delivery time frames for Bike+ for a couple more quarters," CFO Jill Woodworth noted on the earnings call last month.

Precor is a leading manufacturer of commercial fitness equipment with an existing manufacturing base -- around 625,000 square feet of manufacturing capacity -- in the U.S. By bringing manufacturing closer to home, Peloton should be able to improve its ability to fulfill orders more quickly once the deal closes in early 2021. The consumer discretionary company plans to start manufacturing its connected fitness products in the U.S. before the end of 2021.

Expanding into the commercial market

Scooping up Precor will also augment Peloton's research and development capabilities by adding approximately 100 engineers. It will also expand the company's total addressable market. Thus far, Peloton has mostly focused on the home fitness market. That business has flourished as many retail gyms have gone bankrupt during the pandemic.

While many analysts expect the shift to home fitness to be a secular trend that persists even after the pandemic subsides, it's still a little too early to know for sure. While some gyms won't reopen their doors, the industry will eventually recover to some degree. Beyond gyms, the commercial market includes hotels, apartment complexes, and corporate campuses. Peloton will soon be a supplier to that massive segment of the market.

Peloton is effectively buying its way into the commercial market. It's also adding new product categories beyond its bike and treadmill since Precor also makes other types of equipment.

Cash is king

At $420 million in cash, the Precor acquisition is a steal when factoring in the transformative potential. Considering Peloton stock's meteoric rise this year, investors might wonder why the company isn't using its stock as currency. After all, structuring the acquisition as an all-stock transaction would have minimal dilution costs.

The answer may be that Precor is currently a subsidiary of Finnish company Amer Sports, which is in turn owned by a consortium of investors, many of which are based in China. It's possible that not all of those stakeholders want Peloton shares, particularly as geopolitical tensions between the U.S. and China remain high. Sometimes, cash is king.

Peloton had $2 billion in cash on the balance sheet at the end of last quarter, along with $250 million available through a revolver. The company generated $312 million in operating cash flow with modest capital expenditures of $49.2 million, translating into $262.9 million in free cash flow last quarter. Peloton can easily afford the acquisition, which will likely prove worth every penny.

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