Should You Be Sweating Peloton Stock?

Despite a solid quarter, Peloton (PTON -0.65%) has fought an uphill battle against mismanagement, treadmill recalls, and even data privacy leaks. In this episode of Industry Focus: Consumer Goods, join Motley Fool analysts Asit Sharma and Emily Flippen as they circle back around on Peloton and discuss just how critical Peloton's recent struggles are to its long-term thesis. 

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This video was recorded on May 11, 2021.

Emily Flippen: Welcome to Industry Focus. Today is Tuesday, May 11th, and I'm the host of this Consumer Goods episode, Emily Flippen. Today, I'm joined by Motley Fool analyst Asit Sharma, as we update our thoughts and our analysis on Peloton. Long overdue update here for one of the worst performers in our consumer goods basket. Asit, thanks so much for joining.

Asit Sharma: Emily, thank you for having me and I'm excited that I got the nerve to actually have this conversation. Just kidding. [laughs] I actually like it when you talk about a stock that you like and it falls, it gives you a chance to reassess your thesis. I'm not that scared, just kidding around.

Flippen: When I say it was one of the five companies that we picked for our Consumer Goods basket back at the beginning of 2021, I really mean me, since I think I was the one who brought it to the table. I think we owe our listeners and I really owe myself, an explanation for why Peloton and my position in Peloton is down nearly 50% in four months. It's truly been quite an overall wind business. I think we're going to end this episode by asking ourselves the question of, is this thesis dead? Like, is the Peloton thesis intact still, or should I be selling my shares at this point?

Sharma: Yeah. Emily, we shared the picks beforehand and I had every chance to say, what are you thinking, Peloton? But I didn't. I liked the idea despite some reservations that I have. Now I still like the idea as a long-term investment, but we need to figure out what's going on with the stocks since we discussed it, which at that point I think still seems promising, but it's had some adversity that it's had to deal with.

Flippen: It's had some adversity, although I will say a lot of it has been self-inflicted. Maybe let's not bury the lead here with the story that I think everybody has heard at this point, which is about the treadmill recalls after taking a really strong stance against recalling the Tread+ treadmills and reports that they were life-threatening to children and pets. Peloton then last week came out and said, actually, we were wrong, we're sorry, we're going to recall them. Not just the Tread+ but also the tread, treadmills. Those are two different types of treadmills from Peloton. The market clearly is not responding very positively to that news.

Sharma: The key word is sorry. This is a promising revenue stream for Peloton because it represents an expansion outside of the Peloton bike, so management definitely is behind us. Although, as you've pointed out, as we are prepping for this episode, Emily, treadmill, they only make up about 15% of recent revenue that Peloton is booked on as topline. They are going to take a hit with some refunds in the recall, and management, when they discuss this issue, said they expect about 10% of treadmill owners to participate in the recall. Revenue will take $165 million hit next quarter and adjusted EBITDA earnings before interest, taxes, depreciation, and amortization will decrease by about $60 million. I wanted to start out here before hearing your thoughts, just to say, OK, this is late. At least the keyword was stated, sorry, this wasn't put in a very passive voice as sometimes corporate apologies are. Mistakes happen, mistakes were made. [laughs] I am going to give the management team some points for finally coming out and saying, yeah, we're sorry about this. There is a back story though behind this that began in March which we'll get into. What are your thoughts in general before we hit the details?

Flippen: I'm torn. Taking this story in isolation, we'll talk about it a little bit more, but taking the recall story in isolation as it is right now, I tend to agree with you. I will say, I am in no position to be judging anybody for being wrong and I think having the ability to acknowledge your mistakes, openly apologize for those mistakes, and then move forward is an important quality to have. That being said, when something serious happens as you want to know that management is being thoughtful with how they manage situations, I can't help in my mind, but to compare it to the E. Coli situation that Chipotle went through a number of years ago. Arguably, more impactful, given how frequent and right spread the issue was. But there was an immediate and tangible impact on the business as consumers lost faith in the quality of Chipotle's product and that had an impact on the stock. But I think long-term investors were always able to see through that because of how aggressively Chipotle management handled it. They came out and they said, look, we're taking this seriously. They closed on dozens of stores, they reworked their entire supply chain. 

I can't help but feel like Peloton management did exactly the opposite. It felt like the least they could've done, it sounds bad, but kept their mouth shut about it until they had some sense about the scale of the issue. But in practice, they did the exact opposite. Came out with a really strong, almost condescending statement, talking about how wrong this consumer protection agency was about the safety of their treadmills, only two in a matter of days walk those exact same statements back. I worry about their ability to make solid judgments and that's a concerning thing. I hate owning a business, I hate owning a stock where I am concerned about management's decision-making capacity because in practice, owning a piece of the business is entrusting managers to make good decisions. They've already made one, I'm not sure I can forgive one more bad decision after this.

Sharma: That was a little hard to stomach. Let's rewind the tape back to March. This is when news emerged that a child had died after using the Tread+,, several other children were injured. I think the final counter is somewhere around 71 kids by being sucked under this treadmill, dragged under it. The first response, which was a letter from CEO John Foley, was to say that, hey, we were shocked and saddened by the death. However, we strongly urge consumers to understand how to use these treadmills safely, to follow the safety procedures, and to utilize the key removal process. So there is a key that you can take out if you're an adult after you use it, it's really like a laundry list of what consumers should be doing. It didn't quite get to the aspect of victim-blaming that you sometimes see corporations engaging, but it did seem very tone-deaf. This consumer protection agency has taken issue with the fact that the Tread+ is designed, and let's call it in an unusual manner for treadmill, and I'm quoting from the CPSC, from this agencies communications from the spring, it has an unusual belt design that uses individual rigid, rubberized slats or trends that are interlocked and ride on a rail. 

If you think about it, you've got this rail system that has interlocking slats and there's a lot of clearance. You think of the way a car has a clearance over a road. Now, just picture the treadmills you're used to seeing. Those have these long rubberized belts and most treadmills that consumers have been using for decades sit like an inch or two off the ground because this belt has very little clearance, so it's almost impossible for a child to get sucked or dragged underneath. The initial communications from the CPSC were very detailed and were talking about this design feature. Yet the response from management was tone-deaf, sort of lecturing users and saying that, yes, we're sorry, but come on people, [laughs] use this stuff the way it's meant to be used. There was actually a lack of eye-to-eye agreement on what was problematic here. I actually don't know if the course of action that Peloton is taking out, I believe, where they left it, that they are looking at software to make the treadmill be able to stop sort of instantly if it's not in use. If that's the correct solution and I don't know how they're going to be working with the agency to correct it, they are cooperating now. 

My take on all of this is that I agree with you, Emily, the economic consequences are probably just a blip in the long term for Peloton. But man, this is deemed my enthusiasm a little bit because it's really uncomfortable to have to wonder if the CEO or management team is thinking about their financial incentives or thinking about share price, when adversity hits. Is your first response, let's protect the business operations and let's protect share price and shareholders, or is your first thought, potentially we made a mistake and we really need to dig into this and tell everyone, OK, we're taking a timeout here, which is essentially what Chipotle did as you point out. If I remember correctly, Chipotle really took it on the chin and just projected out quarters and quarters of lost restaurant margin because they were going to have higher labor costs for the cleaning procedures. They were going to change the way that they tested the heat in the food to protect against the Norovirus. They had so many things that really impacted their margins, but they just very quickly took that hit, which promoted the sense of confidence in management, although ultimately the original founders worth that to, to keep running that business. For business reasons, not this reason for business reasons, they eventually transitioned out and a new CEO with experience in scaling these types of companies came in. That's all by the wayside. 

What's important to draw from the lesson Emily brings up is that there are two ways you can respond. One is to send a signal to shareholders that you take this seriously. The other is to project a denial and a desire for nothing to be harmed. I think wishful thinking is one of the worst corporate responses that you can have and defensive wishful thinking too, the defensive posture is even worse. We will talk in this episode about what the recent financials look like and the fact that probably this long-term bull case is intact. But I just hate the feeling of having to wonder about management and where their heart is, where their brains are, where their gut is, how they make decisions. It's one of the most uncomfortable things for me. So I am not quite as enthusiastic about this stock and I do agree with you, Emily, if anything else comes up, where we should say three because you're going to bring up strike number two in just a second. [laughs]

Flippen: I am.

Sharma: We should say three strikes. Boy, it's going to be hard to hold Peloton stock after this. Having set that up, what is the second strike that you wanted to talk about?

Flippen: It's a great segue because I did all of the initial research. The story of Peloton over the last couple of weeks has been the recall. There's the second story that really got almost swept under the rug, but points out a lot of the same issues that we had when dealing with the recall. That is to say the recall isn't the problem right now. It's going to have a temporary impact on the EBITDA margins, as you mentioned, some refunds, maybe a bit of an impact on brand image, but all of those things are surmountable. The big question is, what does this mean for management? If this was the only strike against management, I think I'd be able to overlook it in the way that we see so many visionaries for companies really mishandle bad situations. I think Elon Musk is probably the easiest one to pull out of my hat here because he's done an amazing job of making Tesla one of the biggest car companies in the world and a true pioneer for electric vehicles, while at the same time, he's almost notorious for mishandling PR situations in health and safety issues. You could say the same thing is true for Peloton. That is until you add additional concerns on top of it. 

The other story that was really overshadowed by the recall news is concerns over data privacy. If you go back to January, there are some initial almost comical concerns about the fact that President Biden was bringing his Peloton into the White House and people expressing concern about the risk for Peloton or outside actors to have security concerns over things like accessing the webcam or the microphone. It turns out those risks weren't entirely unsubstantiated. While they were not spying risks, there were no people tapping into your machine to take a look inside your home, they're actually having issues regarding leaking personal information on its users through Peloton's API, application programming interface. What's this inadvertently leaking the concern there? Again, is it the fact that some users or some outside actors were able to access things like workout statistics, location, gender or age, even when those profiles were set up to be private? 

The big issue was the way that management handled the situation. Peloton had apparently known about the data privacy issues for months and had tried to silently apply fixes for it but they were unsuccessful by the way, which makes the whole situation just that much more head-aching. But they never informed the users or Peloton's own vulnerability researchers about these concerns. It actually wasn't until journalists had caught wind of the problem that Peloton actually went public and fixed the issue. That to me just says everything you need to know about management. It says, and along with the way they handled the data privacy issue and the way they handled the recall issue, that they're really not doing a great job of acknowledging where they're weak and actively trying to improve upon it. They take a very defensive approach to their issues, sweeping them under the rug, trying to pretend like they don't exist until they can't pretend that they don't exist anymore. They did that same thing with the treadmill recalls. Until their backs were against the wall, it wasn't until then that they recalled the treadmills. Until journalists and publicity had gotten wind of the data privacy issue, they didn't get to the situation of fixing the problem. In my opinion, two big strikes against management here, poor management all around. Any one of these issues on their own, totally fine. Those two things together just make me a frustrated shareholder.

Sharma: Emily, it's all about management and the execution of management. The first is something that you can forgive them for, so management of technology, because it is a new world for many companies that are furthering fitness through connected subscriptions and even adding a social element into their platforms. Being able to originate these platforms and then make them more robust. You can forgive a few stumbles where a company doesn't realize that its API is leaking out information. But the second thing that you should apply to this situation is what about the brand management? What does it say about the sophistication and maturity of the management team? I want to go back, so let's use another example, we compared the first strike to how Chipotle reacted. 

I want to compare this to how Marriott reacted just a few years ago when it had the exposure of a lot of personal data and credit card information through its loyalty program which was hacked. The late Arne Sorenson, who to me is like a gold standard of brand managers, was very upfront and he had his team, when they found out that the loyalty program had been hacked, actually, if memory serves, they sat on it but it was a few days. [laughs] Maybe it was a week. Then they rolled that information out before they had all the details and told shareholders that, "Look, we don't know the extent of it. We don't think that anyone's secured data in terms of credit card numbers has been compromised, but this is what happened. We're still investigating and we'll keep you posted." The share price took a little bit of a hit, but it didn't take long for it to recover because when a shareholder sees this type of posture for management, you feel that you're being led into the information flow as they discover it. You have trust that they're going to level with you, good or bad. This is the way to promote confidence and any mature management team will do this out of just the learning process where you have a couple of small PR incidents and you get the rhythm that it's good not to hide things. 

But this reminds me of one of my kids when they were smaller, just to hide something small because they're too young to learn that, hey, it's just better to come out and say, "Oh dad, I broke that piece of electronic equipment that you love so much. I know I shouldn't have been playing on it while I was also standing on your desk, but I'm sorry." This thing one wonders when you see it in a management team that is handling sensitive information, that is trying to project itself as this global force in the fitness industry. That was disappointing on that front. Just not even that management was hiding it, but just that it didn't occur to them that it would be much better to just put out a press release and keep dealing with it.

Flippen: You reminded me of a funny story that my parents like to tell, which I think applies in this situation. When I was a kid, I woke up one morning, wandered out into my living room. Parents were at the dining table and they turned to me, looked at each other and said, "Emily, did you eat chocolate last night? Did you get the chocolate?" I said, "No. No way, did not eat the chocolate." "Are you sure you had no chocolate last night?" I said, "No. No chocolate." They said, "Go look in the bathroom mirror," and I go and I look in the bathroom mirror and there's chocolate all over my face from when I had woken up presumably in the middle of the night and eaten all the chocolate. This is Peloton coming out. They have a lot of chocolate on their face right now. It doesn't mean they can't wipe it up. I redeemed myself after that incident. But next time, you get a punishment, next time they're getting grounded.

Sharma: Grounding will potentially have some impact when shareholders like Emily Flippen are no longer eager to buy more shares or maybe even want to sell shares that they own. Now, I think we have to balance all this out with some brighter parts of the picture, right? Emily, you called this a weird silver lining to the whole situation?

Flippen: Yeah, I have to admit. Prepping for this episode, we were preparing this before we had heard about Peloton's earnings, just dealing with all the news around Peloton. As you can probably tell from the last 20 minutes or so ranting about Peloton's management, I was all rallied up before the earnings report, ready to have a field day, talking about how much I was irritated by this business. But their earnings report really was just totally weird, unexpected silver lining to the whole situation. Their earnings report taken in isolation was actually so impressive. I mean, the revenue grew 141%. Their operating losses, earnings-per-share losses, and net loss all contracted as a percentage of revenue really meaningfully, and their churn fell from 0.6% to 0.3%, which is the lowest the company has posted in six years. There were so many numbers here. They got me really excited. I think the one that blew my mind the most and that makes me the most enthusiastic about the prospect of Peloton was actually the workouts per month, per Connected Fitness subscriber, which rose to 26 workouts a month. I just want to know that's up from 18 by the way, last year. Who are these crazy people who are working out almost every single day on average?

Sharma: Well, I know I am not one, although I should say if all of you are listening on the podcast, if you could just see my biceps, they're so big from opening and closing my fridge repeatedly during the pandemic. I don't know who these people are. But this is even crazier. Emily, this is even crazier. After that 18 workouts per month number that you referred to in Q3 of last year, that was the quarter that ended March 31st of 2020. Workout search the next quarter like you'd expect, because that was the peak of the pandemic, to 24 workouts per month. So this was June of 2020. Then it trailed back down over the next two quarters to 21 workouts per month. I can see that because we have been a long year and people, I think, were over the worst part of the pandemic and we're dealing with it psychologically. But then the numbers started to grow again and they've leaped to this peak of 26 workouts per month. What in the world is going on? Things are opening up back here in the U.S., so I get that. I have heard people predict that Peloton is going to lose its subscriber momentum and it's going to lose the usage momentum once everything returns to normal, but it seems like the opposite is happening. Maybe next quarter when we compare it to last year's peak, the numbers will trail off a bit. I wonder how sticky this platform is. Now we see there's a clear sight to getting back out. People are vaccinated, yet people just are fond of their workouts and want to even up them even though the world looks like it's returning to normalcy.

Flippen: A lot of that is because Peloton has been putting so much time, energy, and money into their content generation, partnering with celebrities, partnering with music agencies, creating really unique and proprietary content to really engage people even if they don't own a treadmill. As a reminder, there's a lot of digital subscribers who are not Connected Fitness subscribers, so these are people who just pay for the Peloton app without actually having a bike. They can use it just when they want to go running outside when they want to do a Peloton. Listen to their headphones, do a Peloton run as they're running outside. People who exercise at a gym or people who use some other sort of fitness bike, all these digital subscribers were up over 400% in the last quarter, year-over-year and they are closing in on one million digital subscribers alone, which is extremely impressive. When I think about what the future for Peloton looks like, certainly, there's a lot of emphasis on the bikes, on reformatted, hopefully, treadmills, all those optionalities, that's great. The hardware is important, but increasingly the software and the platform aspect of Peloton, I think, can be really engaging. There's competition in this space. There is no doubt about it, but I think Peloton is eating everybody else's lunch right now in terms of the quality of content they have on that platform.

Sharma: Yeah, I think content is driving subscriptions and this, in turn, you mentioned the margins are improving. Their subscription contribution, that is, the contribution of subscriptions to revenue is growing. So that was 68.4% of revenue this quarter. That's up 5% from the same time last year. We see subscriptions becoming a more integral part of the total top-line, which means if you project forward, if Peloton keeps growing at this rate, it means great things for margins. It means that they don't have to be quite as reliant on equipment because they have such a growing stable of content and they are investing in music, as you've mentioned. You see this picture of a company which simply has to keep adding to its user base, this great mix between equipment and disconnected digital subscriptions and they can just grow at a really nice clip. All they have to do is keep adding members, especially as they expand geographically, which we'll talk about in a moment. 

What this looks to me when I look at these financials is a company that can pull this off, can really be not just the first mover in this space but can be the dominant player in Connected Fitness if it won't shoot itself in the foot. So a couple of things, looking at their balance sheets this quarter, they have cash of about two billion bucks. They have marketable securities on their books. So this is like cash, but it's just invested in securities to maybe earn a little bit more on funds. Funds aren't completely static and losing to inflation. Total current assets, Emily, are $3.5 billion versus current liabilities of $1.3 billion. I always look at these two numbers. Current assets, subtract out current liabilities to get what working capital is. About $3.3 billion in working capital is really healthy. I'm looking down on their balance sheet. They've got about $822 million in debt. A fortress balance sheet, a lot of optionality here, money for them to grow to invest in new businesses. We know that they completed the acquisition of Precor, which is a manufacturer of bikes, treadmills, and other fitness equipment. After the quarter ended, that deal was about $420 million in cash. Emily, you can take that working capital from $3.2 billion down to $2.7 billion in change. That is still a lot of working capital on the books with just $800 million-odd of debt existing. 

I can see a very powerful company in terms of how it can invest in the future and just manipulate or extract out of this equation further growth. What I'm curious about though is if what you've seen of management this year overrides all the advantages. The fact that if we didn't have that, we probably would be sitting here today having a conversation that went somewhat like this. Well, Peloton hasn't really zipped past the market yet, but it's looking really, really vigorous. It's got great potential. The stock is doing well. We're having an unexpected conversation today after recent events. "Where do you land on this," I should ask, "at the end of the day when you take the financial picture, the potential together with what we've seen?"

Flippen: I loved that dichotomy because when we picked this company or when I bought this company back in January, I believe it was mid-January when I purchased it. I thought to myself, "I think this is a great business long term." I wonder what 2021 is going to look like for them because I will not be surprised if things like workout decreases, people go back to life as normal. If churn increases as gyms reopen, I was expecting all of these business-level things to shift a little bit, maybe have a rotation out of the stock, but for Peloton to still be here five years from now and to still be a really big force in the fitness industry. That was a thesis for buying and I very much still think that thesis is intact. When I look at the business performance, we already mentioned all of these numbers, but workout churn, engagement fees are higher or minus charges, which is much lower, but they are all moving in the right direction in a way that I did not expect back in January. I genuinely thought those numbers would at best hold steady. 

The fact that they've improved so dramatically is interesting and while I will admit that the third quarter is a seasonably strong quarter for them. So we might see some rotation out of that next quarter, and a slowdown in the next quarter. The results were still really impressive. I did not think to myself that the thesis would be so impacted by management, and I think it's an area of my analysis where I really lacked due diligence on my side and was diving into management more. It was something that I genuinely didn't see as impactful to the long-term success of the business as we've proven it will be and will continue to be over the last four months. So on my side, A for effort, F for results in terms of management analysis. 

To answer your question, I'm a shareholder of Peloton. No, I'm not selling my shares at this point because I think that at the business level, things are moving in the right direction. I think the biggest risk for Peloton right now is execution risk and that comes down to how the management team handles situations like this in the future. You can get away with it once, you do, Chipotle proved that. You get away with it once. But if you continue to spread E. coli across the United States, if you continue to kill people's pets and children with your treadmills, if you continue to spread their data without their knowledge or approval, then you're going to have serious issues and I think that is probably where I still hold the most concern.

Sharma: Yeah. One thing that you can't see when a company is a relatively recent IPO, which this still is, you can't see the track record of management executing. I don't know if you can give yourself too many demerits for that in your due diligence when you look back, and same here. But on the other hand, I think that over time this certainly plays out. You can do some [laughs] due intelligence in real-time with how management reacts to adversity. We should say, in execution though, the company is doing a lot that's working out. They have four strength classes. They recently expanded into Australia. The company is having theme-based comments. They had million-member workouts just between black history month and women's history month together. In finding themes to grow out great content, they're doing a great job there. Pulling in people that are edgier in the music industry, hiring more instructors, rolling out more classes, all of this, I think they've been pretty impressive in the last, I would say two, three quarters. For me, I think I feel that this management team still has a lot to prove. I will say that out of our basket, I think Peloton is the only stock that I didn't buy just out of having spoken about it a few times on live, a couple of times I am going to buy it. I'll have to go back and check my holdings. I'm committed to it, so I definitely will buy the shares. 

This episode reminded me, I needed to go back and check out of the basket. If this is the one that I didn't buy, I could own it. I know that sounds odd to those of you who are hearing me for the first time. But I have about 60 stocks spread across three different broad investing themes. It's not unusual for me to scratch my head, and try to remember if I actually bought the stock or not. I will get my skin in the game, either way. I am a believer in the mechanics of the business, and I think it can still turn around from that management level. Maybe they will learn, the same way that Emily Flippen learned that the next time she goes and raids the chocolate in her house, she'll go to the bathroom, and carefully clean her face, and then go to sleep. Now I'm kidding. Management shouldn't do that. Management shouldn't cover up bad deals. The real lesson they should learn is the lesson that Emily learned. To be transparent with our parents. To ask permission, to do things when it was the right time to do them. That's more what we want them to get out of this, isn't it?

Flippen: Hopefully. I think we're all still going to be eating chocolate at the end of the day. But yeah, the more transparent we can be with the amount of chocolate we're eating, and where we're spreading that chocolates, all the much better for shareholders. You're making me chuckle with your holdings comment. What I will say is, if anybody who is listening to this yourself included, choose to go and buy Peloton or bought Peloton recently, they can all rest assured that their cost basis is almost 50% lower than Emily Flippen. So even if it doesn't work out at the end of the day, you can still claim victory over me. 

Sharma: Maybe this is the time to buy.

Flippen: Asit, as always, thank you so much for joining and providing your insights.

Sharma: Thanks so much, Emily, it was a joy as always.

Flippen: Listeners, that does it for this episode of Industry Focus. If you have any questions or just want to reach out to say "Hi," shoot us an email at [email protected] or tweet us @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against any stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for his work behind the screen today. For Asit Sharma, I'm Emily Flippen. Thanks for listening and Fool on!