A category of COVID stocks emerged after the 2020 lockdowns: companies that benefited from providing digital products and services to people who spent more time than usual in their homes. Some of these stocks soared to sky-high share prices and have come back down to Earth in the market correction over the past few months.
Digital fitness company Peloton Interactive (PTON -2.24%) might be among the most volatile of this group, dropping more than 80% over just the past year. Trying to buy the dip on this stock may have left some investors quite frustrated.
There are good reasons why the stock has struggled so much. However, there's sometimes opportunity in setbacks. There are two reasons why Peloton could be a big winner from this point by the end of 2022.
Image source: Getty Images.
Poor planning and execution
Peloton's business surged during the 2020 lockdowns; quarterly year-over-year revenue growth accelerated from 80% to 100% before COVID to almost 240% at its peak in 2020. Management responded to this uptick in business by spending heavily to increase its manufacturing output, buying fitness manufacturer Precor for $420 million in cash and hiring aggressively.
What management didn't anticipate is that demand for Peloton's products would fall as lockdowns ended. As you can see in the chart, the company's revenue growth fell off of a cliff.
PTON Revenue (Quarterly YoY Growth) data by YCharts
A factory requires money to operate. It spreads costs (like employees, utilities, and other expenses) across all of the products it makes, and this helps make the facility profitable. But when it runs at less than full speed, a factory can't spread those expenses out as effectively, and profitability goes down.
This chart shows how these increased costs hurt Peloton's financials when there wasn't enough demand to keep the factories at full pace. Peloton has drained cash from its balance sheet, and the business went from generating free cash flow to burning a lot of money.
PTON Free Cash Flow data by YCharts
Management's credibility has weakened
Execution mistakes are one thing, but Peloton's management has made things worse by reversing certain decisions and undermining its credibility with investors. The company's CFO, Jill Woodworth, said on its 2022 Q1 earnings call that it wouldn't need to raise any more capital; however, just a couple of weeks later the company raised $1 billion in a share offering.
The company cut the price of its products several months ago to make its pricing more competitive amid competition. Then it reversed course by raising its prices again and charging a separate delivery fee when it had always been free of charge.
Then there have been media reports that the company is pausing production. CEO John Foley issued a statement in response, saying only that the company is "resetting our production levels for sustainable growth." Meanwhile, a number of high-level executives are reported to have sold large amounts of stock.
Investors need to trust management because when volatility hits a stock, you can lean on leadership to continue executing and reinforcing an investor's conviction in the business.
The digital subscription business is thriving
But it's not all doom and gloom. Peloton still has some excellent traits that could turn the stock around over time. The company's long-term goal is to grow its digital subscription business, becoming the Netflix of fitness with users subscribing to its monthly subscription for access to its work-out content.
The company's preliminary Q2 2022 results indicated that subscriptions should come in at 2.77 million users, only slightly missing the original guidance of 2.8 million to 2.85 million. At the same time, the subscription service still shows low churn, just 0.79%, meaning less than 1% of subscribers leave the service each month. The company emphasizes keeping churn low, and so far it continues to succeed.
The subscription business is crucial because it's much more profitable than the bikes and treadmills. Fitness equipment contributed 62% of total revenue in the latest quarter, but subscriptions made up 77% of the company's total $263 million in gross profit. The equipment business gets all the headlines, but investors might want to pay more attention to the subscription business.
The bad news could be priced in
The stock's fall from grace has taken its valuation down with it; the stock is the cheapest it's ever been with a forward price-to-sales (P/S) ratio of just 2. The company's fundamentals have deteriorated, so it certainly deserves a lower valuation. However, at some point, there could be so much negativity priced into the stock that it becomes a potential opportunity.
PTON PS Ratio (Forward) data by YCharts
Peloton's market cap is down to $8.5 billion. If the subscription business were its own company, it would have done $1.02 billion in revenue over the past four quarters. A P/S ratio of 8 on that alone gives you Peloton's current market cap, meaning you're getting the equipment business for free.
The company's struggling financials are detracting from the subscription business's value right now. If Peloton can get its costs back under control over the next few quarters and see revenue growth at least stabilize, investors could begin to come back around on the stock, thinking that the worst is behind it. Peloton seems to be a much riskier investment these days, but that can sometimes mean there is more potential reward.
