Here's Why Peloton's New CEO Is Saying 'No' to Growth

Peloton Interactive (PTON -0.98%) is expected to report results for the fourth quarter of its fiscal 2022 early next month. And management will likely communicate its expectations for the business in fiscal 2023 at that time. Considering that shares of Peloton are down by 95% from their all-time high, I'm sure investors will be watching this event with utmost interest.

However, investors need not wonder what new CEO Barry McCarthy's focus will be in the coming year for the connected-fitness company. On the fiscal Q3 2022 earnings call, McCarthy said five words that unequivocally set the tone for fiscal 2023: "Positive cash flow trumps growth."

Peloton says "no" to growth

Peloton sells home exercise equipment and monetizes its hardware with a subscription service offering exercise classes. Investors were initially attracted to Peloton because it was a high-growth stock. Consider its historical growth rates.

Source: Peloton Interactive's financial filings. Chart by author.

You'd be hard-pressed to find another business that sustained a compound annual growth rate of more than 100% for four years at this scale. It's commendable. But it's also over.

Through the first three quarters of its fiscal 2022, Peloton has generated $2.9 billion in revenue, and it's guiding for revenue in the $675 million to $700 million range in its Q4. Assuming the company achieves the high end of management's guidance, revenue for fiscal 2022 would be down about 10% year over year.

However, Peloton does have growth opportunities that it's choosing not to pursue. For example, McCarthy said revenue for its subscription business in international markets was up 92% year over year in Q3. Given this strength, one might think it would make sense to energetically push into these nascent markets.

But McCarthy disagrees. Through the first three quarters of fiscal 2022, just 9% of Peloton's total revenue came from international markets. Because these operations don't yet have the necessary scale, if the company were to pursue growth in them more aggressively, it would do so temporarily at the expense of free cash flow.

Therefore, Peloton is saying "no" to this international growth opportunity -- and to other growth opportunities as well -- for now.

Peloton says "yes" to cash flow

With Peloton stock down by 95% from its peak, you might think that the business is in its death throes. However, it does have a viable path back to positive free cash flow -- and McCarthy has a plan. In Q3, he said, "The objective here is to get the business to positive free cash flow in [fiscal year 2023], just full stop."

There are multiple facets to that strategy, but I believe the most significant part involves improving its inventory management. As of Dec. 31 -- the end of its fiscal Q2 2022 --  Peloton had more than $1.5 billion worth of inventory on its balance sheet, an increase of 64% year over year. That same quarter, its revenue from exercise hardware was down 8%. In other words, inventory was building up and demand was sliding.

For most other tech companies, hardware products have short shelf lives as new models make older ones obsolete, making inventory buildup a crushing scenario. Fortunately for Peloton, exercise bikes and treadmills don't go through rapid product iterations. Today's inventory can be sold next year and beyond while still maintaining relevance.

At the end of its Q3, Peloton's inventory was down to $1.4 billion. And management expects that metric to keep falling as its slows manufacturing. Considering that its market capitalization is only $3.1 billion now, selling this existing inventory could result in game-changing amounts of cash flow in fiscal 2023 and beyond.

One of the keys for Peloton, therefore, is whether its brand has enough power to keep attracting customers. On one hand, it seems to have lost a little luster. According to Comparably, Peloton's Net Promoter Score (a measure of consumer engagement) was 63 as of July. This is a significant drop from its score of 76 in August 2021. However, when it comes to these scores, anything above zero is positive, and 63 is still quite a good result. 

As another data point, the Prophet Brand Relevance Index recently ranked Peloton as the second-most relevant brand in the U.S. for the second year in a row -- behind only Apple. These data points suggest that Peloton still has the brand power to sustain strong equipment sales, even if its growth is slower (or nonexistent).

All Peloton needs is to maintain fiscal discipline while it converts its excess inventory into cash flow -- and that's what it appears to be doing. Therefore, this broken stock could start performing well from here.