Connected-fitness company Peloton Interactive (PTON 4.10%) is being booted from the Nasdaq 100 index, a collection of some of the stock market's largest growth companies. The Jan. 13 announcement of that change was just the latest development in the stock's precipitous fall from glory.
For those unaware, Peloton stock rose by around 500% from late 2019 through the end of 2020, as investors cheered its success. However, slowing growth has caused the stock to drop more than 80% from the all-time high it reached one year ago -- and right back to the neighborhood it was in as of December 2019.
You'd be hard-pressed to find a noisier stock than Peloton -- many popular arguments against the company miss the mark, in my opinion. In this article, I'll show you the real problem the company is facing. But I'll also remind you of where Peloton excels.
Image source: Peloton Interactive.
Why buy Peloton stock?
If you own a piece of Peloton exercise equipment (a stationary bike, treadmill, or its new strength training product) and pay for a subscription, you're considered a connected-fitness subscriber. As of the first quarter of its fiscal 2022 (which ended Sept. 30, 2021), Peloton had 2.49 million connected-fitness subscribers, up 87% year over year. And revenue for this segment was up 94%. That's a stellar growth rate, but investors are worried about a slowdown in monthly workouts.
Peloton's subscribers pay the same monthly fee regardless of how many times they use their equipment. Therefore, investors should be more focused on customer retention than average workouts, because that's how the financials work.
In fiscal Q1, Peloton's connected-fitness subscribers exercised 16.6 times per month on average. This was down from an all-time high two quarters ago of 26 workouts per month. Because of this sharp drop-off in usage, Peloton skeptics say users are abandoning the devices to become "expensive clothes hangers."
This bearish argument is absurd. The average piece of Peloton equipment was used on 54% of the days in the quarter. When, exactly, did their owners leave them untouched long enough to let their wardrobes accumulate on the gear?
Find things in your house that are used 54% of the time and I'll bet you still consider them relevant. And this product relevance has led to impressive retention rates for Peloton. Its 12-month subscriber retention rate is currently 92%, which is also its historical retention rate.
Based on what we've seen, Peloton's subscription business is fast-growing and sticky. And it's also high margin -- in fiscal Q1 2022, its subscription gross margin was almost 67%, compared to just 62% for fiscal 2021.
Therefore, if Peloton can continue growing its subscription business, it can be a good investment. And with plenty of untapped opportunities, I believe the company can indeed do that.
Image source: Getty Images.
Why you might not want to buy Peloton stock right now
Peloton's primary problem right now is that its expenses are out of control. In fiscal 2021, total revenue (hardware and subscription) rose 120%. But gross margin fell from 46% to 36%, and operating expenses grew 79%.
This first quarter of fiscal 2022 painted an even more dire picture. Gross margin fell from 43% in the prior-year period to 33%, while operating expenses grew by 140%. Even more problematic, total revenue was only up 6%. The end result was a massive $367 million net loss for the quarter.
Peloton management also seems to be making erratic financial decisions. We've already noted the gross-margin improvement for the subscription business. The erosion in overall gross profit, therefore, is entirely related to hardware. But this is by design. Late in 2021, the company implemented price cuts to generate more sales. And in theory, if customers remain loyal subscribers, that strategy could make sense over the long term.
However, management just announced new delivery charges for the Peloton Bike and Peloton Tread -- a move that seems to run directly counter to the recent decision to cut prices.
It's also fair to wonder whether management has a strong grip on Peloton's financial situation. The company ended its fiscal Q1 with $924 million in cash and marketable securities, and it had access to $285 million in credit. On the earnings call, CFO Jill Woodworth said, "We don't see the need for any additional capital raise based on our current outlook."
Twelve days later, Peloton announced it was raising $1 billion in a secondary stock offering, diluting shareholders. Either management wasn't being transparent with investors on the conference call, or the outlook changed by $1 billion in under two weeks. Either way, it's a problem.
If management can get a handle on the company's operating expenses, I'll buy more Peloton stock in a heartbeat. I love the subscription business and I think the stock's valuation is attractive here, assuming the company can stop burning cash at its current rate.
Great companies can be bad investments depending on how management handles their finances. That's why I'm waiting to add to my small Peloton position for now.
