After Peloton Interactive's (PTON +6.51%) share price recently sunk to a low of $22.81, the stock has rebounded sharply to the high 30s. While there have been reports that Amazon and Nike could be exploring an acquisition offer for the company, investors appear to have a lot of confidence in management's new plan to put Peloton on a more solid financial footing with regards to profitability.
These are good signs the stock has bottomed. Still, investors shouldn't get too excited just yet. Here's what to expect from the cost-reduction plan and why upside for the stock from these levels might be limited in the near term.
Image source: Peloton Interactive.
Bringing costs under control
Revenue grew just 6% year over year in the recent quarter, or an annualized rate of 56% compared to the same quarter two years ago. On a two-year compounded basis, that might look great, but management cited lower-than-expected demand and reduced traffic, which paints a negative outlook for the near-term direction of Peloton's revenue.
The slowing demand trends hav been a disaster for Peloton's bottom line. The company has continued to spend nearly a third of revenue on marketing to win new customers, and that contributed to an operating loss of $425 million in the quarter compared to a profit of $58 million in the same quarter last year.
With sales of bikes and treadmills not high enough to cover customer acquisition costs, Peloton unveiled a thorough cost-reduction plan to firm up profit margins. Peloton is basically reversing its manufacturing expansion plan it pursued a year ago with the acquisition of Precor.
By optimizing logistics and delivery costs, reducing warehouses, and improving the efficiency of its manufacturing, management is targeting $800 million in annual run-rate savings by fiscal 2024. Unfortunately, this does include a reduction in Peloton's workforce. On the flip side, management plans to continue investing to support its roster of studio content and instructors.
It will take time to build meaningful profitability
While $800 million in cost savings seems like a lot, it may not significantly boost Peloton's profitability, at least not anytime soon. In the first six months of fiscal 2022, Peloton has already logged an operating loss of $785 million. Management guided for full-year adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) loss to be between $675 million and $625 million.
When asked on the earnings call if it could provide a long-term operating margin target for connected fitness products, management wouldn't go there but emphasized that the goal for now is to bring net customer acquisition costs back to neutral.
However, the cost savings over the next few years is designed to position Peloton for long-term sustainable growth on both the top and bottom line, which is welcome news for investors. The plan should guide Peloton toward consistent free cash flow to self-fund the business without any help from external financing, such as issuing debt or new shares.
Keep expectations in check
The most important question right now is what is Peloton's business worth? With management not providing long-term margin guidance, it's difficult to appraise an unprofitable business. But Peloton is still a strong brand, and it has the benefit of generating roughly a third of its revenue from subscriptions that generate high margins.
The average profit margin of companies in the S&P 500 index has hovered around 10% over the last five years. If Peloton's long-term margin can average out at that level, its normalized profit would translate to $370 million based on management's guidance for full-year revenue of $3.7 billion to $3.8 billion. At a current market cap of $12.4 billion, that would put Peloton's price-to-earnings ratio at 33.
That would be a fair valuation for a leading brand operating in a growing market. The virtual fitness market is estimated to grow 33% per year through 2027, according to Allied Market Research. Peloton continues to bring in more connected fitness subscribers, up 66% year over year to 2.77 million in the last quarter.
Still, management doesn't expect the cost-reduction plan to be completed until at least fiscal 2024, so reaching a meaningful margin level will take time. Because of this, investors should keep their expectations in check and not expect the stock to rise much further in the near term.
