As legendary investor Warren Buffett is known for saying, "Turnarounds seldom turn." Peloton Interactive (PTON +3.50%) has been dealing with this harsh reality for over a year now.
While the current CEO, Barry McCarthy, is doing everything in his power to right the ship at the company, it's alarming to see just how inaccurate his initial forecasts about the business's future have proven to be. This revelation, though, provides a key lesson for investors.
Let's take a closer look at how McCarthy overpromised and seriously underdelivered regarding a critical data point.
Managing expectations
A few months after taking over as CEO, McCarthy said during fiscal 2022's third quarter (ended March 31) earnings call that "the objective here is to get the business to positive free cash flow in FY '23, just full stop." McCarthy even went on to say that he was "very confident" that goal was possible, as the company has "plenty of capital to do that, regardless of what happens in the economy."
On that same earnings call, when discussing his outlook for the 2023 fiscal year, McCarthy said, "Positive cash flow trumps growth." Thus far, Peloton has achieved neither of those things.
First let's look at growth. Frankly, there is none. In each of the last three fiscal quarters, revenue declined by more than 20% on a year-over-year basis. And management thinks year-over-year sales will have fallen by 37% in the second quarter of FY 2023, which ended Dec. 31 and reports on Feb. 1. To be fair, revenue is expected to increase on a quarter-over-quarter basis. But management severely missed the mark when it reported sales in the most recent quarter, so investors should temper expectations.
Why the continued decline? You can blame the macro environment, with soaring inflation and higher interest rates discouraging consumers from spending, particularly on four-figure home exercise equipment. You can also point the finger at consumer behavior returning to normal following the pandemic. Maybe it's a combination of all these factors.
In terms of free cash flow, Peloton's financial situation is still in dire straits. In the subsequent two quarters after McCarthy's comments, the business posted a combined negative operating cash flow of $545 million. And although this metric showed a sequential improvement, the leadership team has completely taken back its prior target, now aiming to hit "near breakeven" FCF in the second half of fiscal 2023. This is the perfect example of overpromising and underdelivering. McCarthy should've been more cautious with his words, even though he says the company is beating its one-year turnaround timeline.
NASDAQ: PTON
Key Data Points
The macro picture matters
What really makes me scratch my head is the fact that McCarthy thought Peloton could reach positive FCF no matter the reality of the broader economic situation. What if the Federal Reserve's inflation hikes led to a severe recession in 2022, with spiking unemployment, low consumer spending, and plummeting real wages? Even the most successful and financially sound enterprises would be significantly hurt in that environment.
While McCarthy has been quick to point out that progress is being made on the cash flow front, he also mentioned in that same Q3 earnings call that Peloton's cash flow position was worse than he had first assumed. So, it's all the more puzzling for him to say that Peloton would hit positive FCF no matter the broader economic situation. When McCarthy took over Peloton, the company was in poor financial shape, raising debt, and not even generating profits. Fair enough that McCarthy would try to win over investors by painting a rosy picture of better days ahead, but this has proven to be an extremely poor job at managing expectations.
An essential lesson for investors
I'm not a Peloton shareholder right now, and I won't even begin to think about buying the stock unless there are major improvements in terms of growth and the company's financial position. For what it's worth, Peloton does have a powerful brand in the fitness industry, one known for making a fantastic product that has a fanatical user base. This definitely has to be worth something.
If investors learn any lesson from this situation, it's to take any management forecasts with a huge grain of salt, especially when it comes to businesses that are undergoing drastic restructuring efforts. While executives will no doubt want to please shareholders in the short term with their comforting comments, astute investors should keep their expectations a bit more tamed.
