Home exercise company Peloton Interactive (PTON 5.78%) will sell equipment in Dick's Sporting Goods (DKS 1.27%) locations later this year, marking the company's first partnership with a brick-and-mortar retailer. This news comes about a month after Peloton similarly partnered with e-commerce giant Amazon, moving away from its direct-to-consumer (DTC) business model for the first time.
Growth investors may be excited by these announcements. Peloton is increasing its points of distribution, which could result in higher hardware sales. But as we'll see, there's a significant trade-off for those potentially higher sales.
The move away from DTC
Peloton stock is down 95% from its all-time high, but don't let the price per share fool you -- Peloton still has amazing brand power. According to Comparably, it ranks first among the top 100 global brands. And it has a stellar net promotor score (NPS) of 61. The company's NPS is admittedly down from a score of 74 last year. However, a NPS of 61 means that 77% of Peloton customers are actively promoting its brand to friends.
Peloton traditionally employed a DTC business model because of this brand power. As the company said in its filings to go public, "Our marketing is made more efficient by the significant word-of-mouth referrals from our loyal Members."
Peloton also sold exclusively DTC because it allowed it to control every aspect of the customer journey, starting with that very first touchpoint. The company is giving this up by partnering with Amazon and Dick's Sporting Goods. Of course, it points out that "Dick's teammates will be trained by Peloton to be fully knowledgeable about Peloton's suite of equipment." But it is giving up this customer touchpoint nonetheless.
Consumers can find Peloton products, minus its new rowing machine, in over 100 Dick's Sporting Goods locations this holiday season. And this could help reverse recent declines in hardware sales. In fiscal 2022 (which ended on June 30), Peloton's hardware revenue was down 30.5% from fiscal 2021. By exposing its products to more consumers through Dick's Sporting Goods and Amazon, Peloton hopes to sell more hardware in fiscal 2023.
What investors should know about Peloton
Reigniting hardware sales growth may be music to growth stock investors' ears. However, there's good reason to keep an optimistic yet cautious mindset when it comes to Peloton stock.
There's another crucial DTC benefit we haven't looked at yet. With no middle party selling its products, Peloton gets to keep all of the potential profit. By selling through Amazon and Dick's Sporting Goods, it's likely giving up some of this profit. I say "likely" only because Peloton didn't disclose how these partnerships were structured.
It's common for companies like Peloton to stock third-party retail stores and recognize revenue at that time. If that's how Peloton's new partnership works, it will first sell the hardware to Dick's Sporting Goods at lower prices and lower profit margins. Dick's will then make money when Peloton's hardware sells through to customers.
Peloton hardware has negative gross profit margins right now, which is a problem. In fiscal 2022, it spent $2.4 billion on its connected-fitness hardware but only generated $2.2 billion in revenue from these products. Granted, some of this was related to the (hopefully) one-time recall of its treadmill device. But Peloton's hardware margins were always thin even before. And they'll get slimmer by selling through third parties like Dick's Sporting Goods.
However, I don't think Peloton's new CEO Barry McCarthy cares. That might sound shocking but McCarthy is trying to deal with excess inventory and grow the company's subscription business. The chart below illustrates the problem. Peloton's management built up inventory in anticipation of ongoing growth precisely when its revenue growth rate was falling off of a cliff.
PTON Inventories (Quarterly) data by YCharts
If Peloton can simply move this inventory, it can convert it into cash flow. And that's a top-of-mind priority for management. McCarthy has said he wants the business at cash flow breakeven for the second half of fiscal 2023, which starts Jan. 1.
However, I believe McCarthy's greater purpose in partnering with retailers to sell hardware is to gain more subscribers. As he said on the fourth-quarter earnings call, "I think the primary growth opportunity for us is in exploiting our singularly unique competitive advantage, which is our content."
McCarthy comes to Peloton with experience in subscription services and is looking to drive people to that higher-margin, recurring revenue stream. Peloton's hardware is just a door -- one that McCarthy wants to open wide even if it lowers profitability for this segment.
Growth investors may be excited about Peloton's higher-revenue prospects. But they need to understand that recent moves can keep challenging the bottom line, at least in the near term. And this could lead to continued underperformance for the stock.
