Things Just Got Tougher for Peloton

In this podcast, Motley Fool senior analyst Jim Gillies discusses:

• How challenging Peloton Interactive's balance sheet is right now.
• Why Peloton will almost certainly have to raise money.
• The retail landscape.
• Why Costco Wholesale is his favorite retail stock, followed closely by Home Depot.

Some companies are pulling back on investments, but others aren't stopping. Motley Fool producer Ricky Mulvey and Motley Fool analyst Sanmeet Deo look at some businesses playing offense in a tough environment.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on August 15, 2022.

Chris Hill: It's a big week for retail, but before that, things just got tougher for Peloton. Motley Fool money starts now. I'm Chris Hill and I am joined by Motley Fool Senior Analyst, Jim Gillies. Happy Monday. Thanks for being here.

Jim Gillies: Thanks for inviting me, Chris.

Chris Hill: But let's start with Peloton, which is [laughs] cutting nearly 800 jobs, closing some amount of its locations. Along with these moves, Peloton is raising prices on some of its equipment. I'll just spot you up with the most illuminating comment from CEO Barry McCarthy, who said in a memo to employees, "We have to make our revenues stop shrinking and start growing again, cash is oxygen, oxygen is life." I don't disagree with that, Jim, but when you and I were chatting earlier today, I said to you, when I first saw this story, the immediate thought I had was this seems a panic move.

Jim Gillies: You're going to get me in trouble, Chris.

Chris Hill: It's one of those shows, good.

Jim Gillies: [laughs] Peloton. It's a panic move and yes, he's entirely correct of everything he said. Might've been nice if the founder, former management, who ran this truck into the dirt might've actually, I don't know, thought about that once or twice before, as I said, running this truck into the dirt. Where's my notes for this here? This is a company that has in the most recent balance sheet, I think, they're going to report their fourth-quarter fiscal earnings, I think they have a June fiscal year, so they're reporting late August if last year's anything to go on. Most recent balance sheet, $1.4 billion in inventory moldering on the balance sheet, $1.9 billion in cash burned in the first three quarters of the present fiscal year. Nice of the CEO to tell us that cash is oxygen after starving the business. Not his fault, but the term management suite starve the business.

This is a business where the CFO, I believe last November, the now former CFO on the conference call. No, we don't need to raise capital and I think eight days later they raise capital. It's the company with $880 million in cash on the balance sheet, roughly the same amount of the debt on their balance sheet. Now, fortunately for Peloton, the debt on the balance sheet is all convertible. Debt doesn't convert, I believe until 2026. The convert price is well over $100, there's no danger of this. When we get there, there's certainly no danger of this company needing to put shares. They'll have to pay that back. But hey, you know what? If the fire is not out by then it won't matter. I don't know what credit line avail of it. This is a company, that's probably going to have to raise capital again, frankly, in the next quarter or two because they're burning $600 million a quarter for the last three or four quarters in a row.

They have got negative product gross margin, which I guess makes sense why they're saying, hey, we're going to raise prices, might be nice to not lose money on every single bike and treadmill they put out the door. Product revenue was down 40% year over year, 25% quarter over quarter, Q2 to Q3. Put into perspective that $1.4 billion in inventory on the books, that's up from $937 million at the start of this fiscal year. It's up from $245 million at the end of fiscal 2020. This is a company that is inventory bloated themselves to frankly near death. I am reminded when I see what the CEO said. Again, it's not his fault, he came in from I believe Spotify and I think he's put Pandora before that, which of course was, I believe purchased by Spotify or maybe that was Sirius anyway, the man has some.

Chris Hill: He was at Netflix in one point.

Jim Gillies: I'm reading his bio here off Cap IQ. I think his most recent gig, no, I don't really know. You said Netflix as a CFO, I think from '99 to 2010, it says here, more recently he was at Spotify. He does have financial chops. That's good, because that's the guy who's going to understand, hey, we're in trouble. I am concerned he's come along a little too late and when something like this comes along, I'm reminded of as I'm often reminded in situations like this by, I quote from Warren Buffett or uncle Warren E. Buffett. The quote is, "When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." The economics for Peloton went over the cliff real fast. Like I said, in their most recent quarter, they burned over $700 million. They've got $800 million in cash. Do you really want to be raising? I mentioned that prior capital raise that the CFO apparently didn't even have a week's view into her business at the time, or eight days, sorry.

They raise capital, I believe in the lower early 40s, dollar per share. Stock's in the low teens right now, the more you have to raise capital via equity means, the more you're going to dilute present shareholders. For those who have held through a 90% drop, and I'm sorry, I'm so dour out of the gate, you fed me the disaster going here, we'll be better in a bit. If they do have to raise capital and I hope they don't for shareholders who still own this thing, but I'm not seeing a lot of turnaround potential. Just to go back to one more point, when they said, that we need to raise prices, they are going to raise prices. They're raising prices on their bikes by 500 bucks a bike, and I think it's 800 bucks per unit by the treadmill. But remember how I mentioned they had negative gross margin, they're moving products just to get it at the door the last three quarters. It's already not selling and now you're raising the price, good luck. I don't have a lot sunnier disposition to say here. I'm afraid.

Chris Hill: Well, I didn't ask you to come on just for your sunny disposition. 

Jim Gillies: [laughs] Good.

Chris Hill: But before we move on to retail though, what would you ask McCarthy on the conference call? Assuming they come out with a report that does not indicate some radical reversal of fortune, what is the question you would ask? Would it be around a capital raise? Because when you just run the numbers, it's hard to imagine they don't get money somehow somewhere.

Jim Gillies: They have to get money somehow somewhere. I have a difficult time believing. Belief is always a terrible word to use with investing, because I can believe a great many things, but cash doesn't lie. This is a company that burned about $735 million in the most recent quarter, about $550 million in the quarter before that, about $645 million in the quarter before that. Like I said, they've got about $880 million cash on the books. Pretty much their value that, where is your cash coming from, Barry? Where is your next capital coming from? Because I think this is a business that you have to demonstrate you're going to survive the next year.

Then you can talk about growth and maybe adding to those subscriptions. The subscriptions are actually monetizing fairly well. People who loved their Pelotons, the number of fitness sessions after spiking during the pandemic with a reopening world, the degradation there has trailed off and they look they're doing fairly decently. It's a small sample set, so I don't want to draw any great conclusions there, but there's some optimism. To get to be optimistic in three years and have this turnaround and they talk very directly and which I like. On the most recent shareholder letter, the third-quarter shareholder letter, although that's a pet peeve of mine as well, that they talk about, hey, turnarounds are hard, we're in a turnaround now.

Chris Hill: Good, you seem to have a reasonable appreciation of where you are in the pecking order at this point, my questions would circle around, what is your fire suppression plan for the next year? Once the fire is out, then we can talk about your turnaround because how especially heading into a recession. Assuming we have a recession, I have some thoughts on that as well, but assuming that the popular opinion of we're heading into a recession is in fact true. Jacking a price on a souped-up treadmill that I have to pay 60 bucks a month for to get a subscription. It's probably not going to clear the books of that bloated inventory.

Chris Hill: Let's move on to retail then because it's a big week.

Jim Gillies: Now that I've just killed it.

Chris Hill: It's a big week for retail. We've got the earnings reports coming later in the week from Walmart, Target, Home Depot. I don't remember big retail being as weird as it is right now and when I say weird, I'm referring to the fact that in general, the major retailers tend to travel in a pack. The fortunes of one tend to reflect the fortunes of another. This is certainly the case for years now with Home Depot and Lowe's where they report earnings one right after the other and whatever. It's much more newsworthy if they don't have similar results than if they do. But at the moment, in part because of what we got three months prior from Walmart and Target with their inventory debacle, I don't have a great sense of the retail landscape, which is why I'm looking forward to this week because I feel like we're going to get some more clues into things like inventory controls, back-to-school shopping, and possibly even the earliest of indications around year-end holidays. When you step back and look at retail, does anything standout to you in particular?

Jim Gillies: We certainly got that negative surprise, negative reporting from Walmart and Target last go-round. Neither of those companies terribly excite me. They are certainly bellwethers and we should pay attention to them. It wasn't just Walmart and Target of course, even going down the quality chain to guys like Big Lots or whatever, it was pretty ugly across the spectrum. Because yeah, inflation seems to have caught them flat-footed so everybody had their inventory spike, inventory spiked because in part or I know a lot of their expenses also got quashed because the higher-cost inventory is now moving through your system. Like I said, as an investor, I'm not real interested in these large specialty, non-differentiated, names. The one I love to watch and love to follow is, which you didn't mention, maybe I'll hit that before we get over to the home improvement folks, is Costco. They have a bit of a different reporting schedule. I think they report third week of September because I believe they're on a June or September fiscal year. I think Costco is hitting on all cylinders. Every time I walk into Costco and walk out of Costco having dropped 250 bucks on an order that I plan to be under 50, I'm just like man, I don't own enough Costco.

The really interesting thing to me about Costco is for years, a lot of people would talk about how Costco passed on so much. Basically, you were buying most goods close to cost because they were making up all their profits essentially on selling memberships. For a time that was true, about 75% of operating profit over I was just looking at this last week. The first half of the last decade, about three-quarters of their operating profit was subscriptions, was memberships. Then it fell to 70%. And then it fell to 65% and in the most recent year, it was 57%. Costco is not only growing and doing well in operating profit, I think, is up 10 or 11% annualized over the past decade, perfectly acceptable. But they've also started to actually make a little bit more profit while keeping that hotdog at $1.50. My favorite retailer, both as an investment as well as just on a personal level, is absolutely Costco. A close second is another one you mentioned though, which is Home Depot and Home Depot and Lowe's. Yes, you're right, they walk lockstep.

I like Home Depot because well, first off, they decided about a decade ago that they were done breakneck expansion and they have gone to a couple of stores a year, opened a few retrofitted. But they've really turned that company into running it for cash and you just have to look at how the dividend has moved has skyrocketed up over the last few years, as well as the share repurchase. When they run that business for cash, all of a sudden they are returning it, all of it to people. I'm remembering the Bob Nardelli days back in the late 2000s. When he was just ruining that company because he wanted to apply GE earnings metrics or whatever and since his ouster, it's just done so much better and also too, I hold them as semi-Amazon proof because you're probably not buying a couple of thousand square feet of drywall from Amazon Prime and having it delivered, I imagine you're still going through the Home Depots.

Chris Hill: Am I wrong to assume that out of both Home Depot and Lowe's, we're going to get some color around presumably the benefit of commodity prices coming down?

Jim Gillies: Absolutely.

Chris Hill: That has to help them, all you have to do is look at the cost of lumber in 2022 and that's got to be accretive for them.

Jim Gillies: I think so. Now my question is going to be, I don't know the exact number, so I'm going to make them up.

Chris Hill: Fantastic.

Jim Gillies: Let's just say a little bit it, because it's it's more about presenting a point. Let's say lumber crisis have come down 50% has Home Depot past all that 50% to their buyers? Has Lowe's passed all that 50%, have they passed 30% back to, I'm reminded here, here in the Great White North, we just raised interest rates about a month ago, we went up a full percentage point. The Bank of Canada raised it by 100 basis points and that day I got an email from my local credit union talking about the higher interest rates they were paying on short-term deposits, certainly on three months to five years. Miraculously Chris, they went up between 10 and 40 basis points.

Chris Hill: Did they pass all those savings onto you?

Jim Gillies: Funny thing, isn't it? I'm wondering if Home Depot and Lowe's and I'm wondering if they've passed all those savings onto you. I'm willing to bet they haven't. Of course, Home Depot, we are emerging from pandemic closures. Those are further and further in the rearview. Thankfully. But people spend a lot of time on their houses because they had nothing else to do for almost two years. People spend a lot of time and money on their houses. I wonder what if that's going to carry over or people have gotten used to continued cocooning. How many companies have gone to a more hybrid work model so there's more people working from home on a regular basis. Someone like me has been doing it for 20 years. It's irrelevant, but for folks who have been doing it for maybe two years and now have the option to work from home three days a week or what have you maybe they want some more creature comforts than Home Depot and Lowe's can provide. I'm a lot more optimistic about those than I'm about the Walmart and the Target.

Chris Hill: Jim Gillies, it always great talking to you. Thanks for being here.

Jim Gillies: Thank you.

Chris Hill: Shopify is one company tied to retail that's tapping the brakes on its growth. But some companies are hitting the gas pedal. Ricky Mulvey and Sanmeet Deo look at a few businesses playing offense in a tough environment.

Ricky Mulvey: You're in a recession, we're not in a recession. Today we're looking at some of the companies playing offense in a challenging environment. Joining us now is Motley Fool Senior Analyst, Sanmeet Deo. Good to see you, Sanmeet.

Sanmeet Deo: Good to see you, Ricky.

Ricky Mulvey: Playing offense is a lot easier when the market is raging upward. That's what Shopify did during COVID and now, some of those companies are feeling a little bit of a hangover.

Sanmeet Deo: Tobi Lütke wrote in a companywide memo to Shopify, "We bet that the channel mix, the share of dollars that traveled through e-commerce rather than physical retail would permanently leap ahead by five or even 10 years. We couldn't know for sure at the time, but we knew that if there was a chance that this was true, we would have to expand the company to match." It's now clear that bet didn't pay off."

Ricky Mulvey: It's this idea that you can go on offense when your stock price is soaring, upward, interest rates are low, but then it becomes a lot more difficult when you're in a more challenging market environment and then Tobi was very open in saying that we made these assumptions about the e-commerce market and adoption in that just didn't play out. Is that fundamentally what changed for Shopify?

Sanmeet Deo: It's interesting because they made this big strategic bet, like he said, and one of their biggest mistake and one of the mistakes a lot of companies have made during the pandemic that was at its industry growth to the extent for a long period of time and possibly even be a permanent shift and so they grew their headcount expenses a scale up to kind of anticipate that growth. Of course, they didn't take into consideration the effects on e-commerce, Shopify here, from a reopening of the economy and shifting consumer shopping habits once that occurs. This ultimately lead to a rapid ascent expense growth followed by slowing revenue and decline in margins. Now the company has got to play defense, laying off staff, cutting operating expenses to meet those lower revenue levels. While investors should be happy, Shopify is acknowledging this mistake and rightsizing. Big problem I see is a company may need to be more aggressive with implementing strategies to grow revenues and gross profits. But because of what's happened they're playing defense and catching back up.

Ricky Mulvey: In your view, are they playing smart defense?

Sanmeet Deo: It's interesting because I read an interesting take about how their take rates are much lower than the competitors of Amazon, eBay. It's almost like when I read this analysis, they're almost under earning and maybe it's time to close that gap and earn more and take more offense because you can only cut expenses for so long until you really need to ramp that revenue growth.

Ricky Mulvey: Let's talk about some of the companies going on offense right now. That's not just an idea, that's a good idea in and of itself. But when liquidity dries up, the market's down relative to all-time highs. That's when some companies are really able to grab market share. Any companies you follow that you see going on offense right now.

Sanmeet Deo: One company comes to mind is Axon. They make Tasers and body cameras. CEO Rick Smith, recently told The Wall Street Journal "right now I smell opportunity," he said, "yes, winter's coming now let's embrace it." He's buckling down on expenses for business travel and company swag, but he's also encouraging an aggressive mindset in terms of playing offense in their business.

Ricky Mulvey: There's a good Wall Street Journal article about it and he's got a swag czar and he lamented to the reporter that not every single event needs a T-shirt. While the labor market is hot, you're still seeing a lot of these tech companies implement layoffs and Axon is very much, in some ways, welcoming that, saying, "Cool. More computer engineers, that's good for us. Let's go find some talented ones for a company."

Sanmeet Deo: There's a lot of shifts happening in the marketplace with companies, maybe people, employees leaving companies or things happening. Now is the time when you can take advantage of those opportunities.

Ricky Mulvey: Trade Desk also had a blockbuster quarter recently. That's another company that seems to be going on offense in a challenging environment.

Sanmeet Deo: Trade Desk is, they had great earnings report recently, raised guidance in this environment, which is very, very impressive raising guidance when some companies are pulling back or not giving guidance. Many adtech companies, ad companies like [Meta's] Facebook and ad platform companies are feeling the pinch from advertisers pulling back on spend and some of those advertisers will pull back on the low-hanging fruit, stuff that they don't really need to do, with things like [Alphabet's] Google advertising is a much more prominent and impactful for them. But with companies pulling ad spend, Apple IDFA privacy changes continue to ripple through the industry, Trade Desk is playing the offense and they have been for a while with their new UID2 ad platform, which is gaining tractions, gaining partnerships and integrations with companies like Disney and AWS. It's showing the results and they're very bullish on connected TV advertising and where they play in the market and how they can capture share.

Ricky Mulvey: Speaking of companies playing offense. I think one frame to use is you look at a growing industry, take a little bit of a macro view, and then you look at the specific companies that are poised to take market share. A few months ago we looked at a company called Xponential Fitness. You see, a lot of fitness companies that are able to use COVID as an excuse or you see some companies kind of shrinking their footprint. This is one that has CEO Anthony Geisler has really never leaned on COVID as an excuse and he's also very much leaning into an international expansion for Xponential.

Sanmeet Deo: When COVID hit, he was very aggressive and thought very hard for his franchisees when it came to rent abatements, fighting the government to get COVID relief and pausing royalties for his franchisees and launching online platforms and digital platform for his franchise, he did a very good job of, instead of blaming COVID, going on the offense. That's continued especially now with them signing more international agreements, master franchise agreements in Japan and all across the world. One interesting story that recently came out that was very impressive to me was, on July 26th of 2022, it's competitor, F45 Holdings, came out with some rough news announcing a departure of CEO, reduction in global workforce, sharp cut in its full-year guidance for revenue and earnings and removal of financing facility for its franchisees, stock pulling over 60 percent in a day and usually this would be a not such a great read through for the boutique fitness industry. The next day in the morning, Xponential announced, "We expects to deliver strong results for the second quarter of 2022, has continued to reinforce his position as a leading provider boutique fitness globally, additionally, 'is on track to meet or exceed guidance metrics for the year.'" So in that press release as well they announced her preliminary Second-quarter results, strong member growth, store visits, sales, AUVs, your average unit volume growth for the stores. Very offensive move after F45's disaster, reassuring investors that were OK. I'm an investor in it myself and I was very pleased by it as well.

Ricky Mulvey: I earn shares as well. The only way you can play offense in a tough environment is if you have the balance sheet to back it up. Some of the companies we've talked about, Axon, Xponential, Trade Desk, any balance sheets there, stand out to you as for companies that could continue to play offense in a tough environment.

Sanmeet Deo: Yeah, absolutely. Trade Desk, which we were talking about earlier offline about how you and think like tech companies or some of these kinds of companies might have super strong balance sheets, but they have 1.2 billion of cash on their balance sheet and no debt so they're well positioned to continue to play offense like they've been doing. Axon as well, no debt on their balance sheet, $377 million in cash. Again, strong balance sheets that put them in a position to take the offensive maneuvers. Xponential's balance sheet has some debt and it's OK, but the main advantage for Xponential is, is a franchisor, so launching in international markets, growing their stores. As a franchisor, those costs are typically on the franchisees to open up stores so they can grow and expand in an environment without taking on too much heavy costs in this kind of environment.

Ricky Mulvey: We've talked about some of the companies with strong balance sheets playing offense. Which companies would you like to see off play offense? But maybe their balance sheet is holding them back. They don't have the ability now to go out and make smart acquisitions or really expand into new territories.

Sanmeet Deo: The first thing that came to mind is Netflix. They're in a very competitive space, they're looking to find their next leg of growth. They've done very well on stream, but now there's a lot of competitors out there. You saw Disney recently reported that they have in combination more streaming subscribers that Netflix, they have plenty of cash on their balance sheet, but they have about $14 billion of debt and they have a large content spend annually of about $17 billion. That's been management recently said that that's kind of where they're going to tap out at and they're not going to continue to go higher. But I feel like the obligations that they have is going to keep them from making any big splash on the acquisition front to build as ad platform or growths gaming business. They're working with Microsoft for their advertising platform and that's probably going to be good. In fact, Trade Desk actually mentioned that that would be a good move for them. But the gaming business, they've made some small acquisitions, but to make a bigger acquisition, to really drive home their position in that industry. They might be held back a little bit and they'd have to grow it more organically than otherwise.

Ricky Mulvey: Sanmeet Deo, thank you for your time.

Sanmeet Deo: Thank you, Ricky!

Chris Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.