Peloton (NASDAQ:PTON) sells a high-end spin bike to get its members into a subscription for its live-class monthly subscription. Given this razor-and-blades business model, you might think that it's selling its equipment at cost to attract customers. But that's far from what's happening. Motley Fool analyst Tim Beyers and Fool contributor Brian Withers explain the cost structure and gross margins of the business on a Fool Live episode recorded on Feb. 8, and discuss why there's even more opportunity to improve margins over time.
Brian Withers: He [a viewer named Brendan] asked whether the Connected Fitness products are a loss leader. This is the costs, the product sale at 870 million and their cost of goods sold is 562 [million], so they are making a gross margin of 35 percent on the Connected Fitness products. To me, that's pretty impressive.
Tim Beyers: It's not just pretty impressive, Brian. That is Apple-like. [LAUGHTER] Let's be clear. I don't want to undersell that. That is an Apple-like gross margin, Brendan. That is a phenomenal gross margin on hardware. I mean, at the risk of overselling it, once you start getting either close to or into the 40s, and Peloton's been in the 40s before, they've deliberately brought that number down as they've lowered the price on the bike. They've actually lowered it deliberately down to 35 percent because they could. They have a bananas gross margin on their hardware. Thank you for showing that, Brian. Yes, that is exactly what I was talking about.
Brian Withers: Well, it could also be higher because they're spending all this time [and money] expediting too.
Tim Beyers: Right.
Brian Withers: The other thing that Precor, I'm getting my manufacturing and distribution background back up, [LAUGHTER] Precor is going to bring some design for manufacturing, design for reliability, design for long term stuff to Peloton that they may or may not have figured out yet. I saw Fitbit started as an early company and once they were a little ways in and they started to get to mass market, they brought in a Chief Operating Officer who understood warranty costs. You're familiar with circuit breakers?
Tim Beyers: Yeah.
Brian Withers: Similar in product design, a circuit breaker busts, and it's a cheap thing so that you don't ruin your TV, which is an expensive thing. So when you have a warranty thing, you want to break the cheap parts and you what the cheap parts to wear out, and you want them to be easy to ship and replace at a customer. I don't know the way the Peloton bike is set up, I've watched your last deep dive with, I was back in August.
Tim Beyers: Abby?
Brian Withers: Abby, yes. You said that Seth said they make cheap bikes [LAUGHTER] they're crap.
Tim Beyers: Yeah. But let's put that in context. Seth builds bikes. Seth is an expert. Seth knows more in his pinkie [LAUGHTER] about bikes than I will ever know about bikes in my entire life.
Like if he says that the quality on the build of a Peloton bike is not up to par, I believe him and I believe that for the audience that he is, that wants something that is very professional and to spend the amount of money he's spending. Like he wants the equipment to be top-notch. That is not how Peloton is thinking about premium pricing. Their premium price is not in the hardware of the bike even though they consider it decent. But I'm going to go with Seth on this one, the premium that they're putting into it is the community and the content. Like the content is the piece where Peloton is putting a lot of their money into it. I mean, they're putting money into a partnership with Beyoncé. That should tell you a lot.
Brian Withers: Yeah. Well, I think there's opportunity even with the bike though, when you talk about those gross margins, I look at Precor. Precor was founded in 1980, so they have 40 years of manufacturing stuff that gets beat to crap every day in a gym and I'm sure they have a refurb program and a warranty program, and the gym's calling these guys up going, "My thing broke," that's the last thing that they want. This partnership is so smart and I think they're going to make their bikes way better over time and bring in the manufacturing smarts of the heavy equipment [manufacturer matched] with the digital capabilities [of Peloton].
I think it's an exciting match.