On July 12, Peloton Interactive (PTON 0.66%) announced it was done manufacturing exercise equipment in company-owned facilities. Rather, it's turning to partners to manufacture its popular stationary bikes and treadmills.
On one hand, this move was surprising because it was a complete reversal of Peloton's previous strategy. On the other hand, Peloton is under new management and it's determined to get back to positive cash flow. And it believes having partners manufacture its equipment will help it get there.
A history lesson in Peloton's supply
In October 2019, Peloton paid $47.4 million to acquire Tonic Fitness Technology, a Taiwanese company that had manufactured Peloton's bikes since 2014. At the time, management said it believed "that having greater control over our supply chain will enable us to strengthen and scale our production capabilities."
Five months later, COVID-19 was declared a global pandemic, forcing populations around the world to shelter in their homes to avoid the spread of the virus. Demand for Peloton's home exercise equipment consequently soared; revenue for fiscal 2020 (ended June 30 of that year) doubled to $1.8 billion.
At the same time, Peloton's management lamented an ongoing problem with procuring adequate supply. The company's backlog for exercise bikes at that time was a whopping $230 million, and customers were complaining about long wait times. Management's best efforts to control supply weren't enough.
Six months later, Peloton agreed to acquire Precor for $420 million. And here again, manufacturing capacity was the first reason management cited for the acquisition. But the purchase may have come at the worst possible time. As the chart below suggests, demand for Peloton's exercise equipment was plateauing. As a result, inventory skyrocketed:
PTON Inventories (Quarterly) data by YCharts.
As companies grow, it's logical for inventories to also increase. But Peloton's inventory growth greatly outpaced revenue growth. This means bikes and treadmills were getting made but not getting sold.
Peloton's path back to positive cash flow
Before 2021, Peloton was consistently close to breakeven or cash-flow positive. But as the chart shows, that dramatically changed in 2021, and has continued until now:
PTON Cash from Operations (Quarterly) data by YCharts.
Peloton absolutely has a path back to positive cash flow -- but it might not be by outsourcing its manufacturing. Here's why.
Peloton's spending on inventory increased more than 500% in fiscal 2021, reaching $587 million. And the company has spent $473 million through the first three quarters of fiscal 2022, up 30% from the comparable period of fiscal 2021. Building up inventory is clearly the primary culprit behind Peloton's negative cash flow. Therefore, the remedy is slowing production to sell more of the inventory it already has.
When new CEO Barry McCarthy took over in February, one of his first orders of business was to slow equipment production. Peloton's inventories peaked in the second quarter of fiscal 2022 and dropped sequentially in the third quarter, and it expects further improvements next quarter and beyond.
Peloton had $1.4 billion in inventory on the balance sheet as of the end of Q3. As those bikes and treadmills sell through to customers, they will be converted into cash flow. As long as management doesn't spend too much, this can indeed be a path back to positive cash flow.
The potential problem no one's talking about
Peloton's inventory is too big. But this has nothing to do with outsourcing or not outsourcing manufacturing. Peloton has too much inventory because management didn't accurately forecast demand.
Outsourcing manufacturing at this point could rob its chances of getting back in the black. Consider that Peloton is now outsourcing its delivery, whereas it had kept logistics in-house before. On the surface, this is a capital-light approach to business. However, the cost per delivery was up in Q3, hurting the company's gross margin.
When things are outsourced, Peloton loses some control over its cost structure. This is already happening with delivery logistics. And the same could potentially happen by outsourcing manufacturing.
As Peloton's cost of goods sold has increased, its gross margin has fallen. This has been exacerbated further by price cuts to move inventory. The result: In Q3, Peloton's gross margin for hardware products was negative 11%, whereas in the prior-year quarter its gross margin was a positive 28%.
Peloton is choosing to get leaner when it comes to physical products, and focus instead on its subscription service (not examined here). Slowing production will indeed be a catalyst to improved profitability, which is good for shareholders. However, by outsourcing parts of the business, management is giving up a degree of cost control. And that could become a new problem down the road.
