Peloton's "Epic Comeback" Comes With Major Caveats

Nine months ago, connected fitness company Peloton (PTON -0.98%) was burning through cash at an alarming rate. In the third quarter of fiscal 2022, Peloton reported a free-cash-flow loss of nearly $750 million. For perspective, total revenue during that quarter was around $964 million.

The situation has improved since then, but investors should be careful to take the pronouncements of CEO Barry McCarthy at face value. "If you've been wondering whether or not Peloton can make an epic comeback, this quarter's results show the changes we're making are working," McCarthy said in the most recent letter to shareholders earlier this month.

Not exactly epic

Let's be clear: Peloton is still in serious trouble. Sales of connected fitness products have rebounded from their lows, but they were still down 52% year over year in the most recent quarter, and subscription revenue appears to have stalled out on a sequential basis. Peloton reported a generally accepted accounting principles (GAAP) net loss of $335 million on $793 million of revenue in the second quarter of fiscal 2023, not exactly an inspiring result.

Free cash flow was a loss of $94 million, but McCarthy pointed out that if you backed out one-time costs, such as payments to settle supplier obligations, free cash flow would have been slightly positive. That sounds like some real progress.

But free cash flow in any single quarter doesn't tell you all that much. There are a lot of inputs and outputs, and timing can greatly impact the headline number. Despite massive layoffs over the past year, stock-based compensation expenses have also ramped up.

For whatever reason, Peloton didn't provide a full cash-flow statement for the quarter in either its shareholder letter or its 10-Q but instead included statements for the past six months and the past nine months. So let's look at the past six months.

In the final six months of calendar year 2022, Peloton reported a free-cash-flow loss of $341 million. Two notable items get added back into the calculation of this metric. First, there's stock-based compensation. Peloton recorded $263.7 million of stock-based compensation charges in this six-month period. If you add those back in, free cash flow would be a loss of $605 million.

Stock-based compensation is not a cash expense, but it is a real expense. A company that can only report positive free cash flow by adding stock-based compensation charges back in isn't really free cash flow-positive, in my book.

The second item is changes in working capital. Generally speaking, a company that's growing will also be growing its working capital. This will create a drag on free cash flow since capital will be tied up in growing inventories and other short-term assets.

The opposite is true when a company is frantically shedding inventories and otherwise downsizing. Working capital can become a source of free cash flow, at least temporarily. This can't go on forever, but it can help in the short term.

In the six-month period we're considering, working capital contributed about $28 million of free cash flow for Peloton. That's not a huge number, but it is a massive shift from the prior-year period. In the same six months of 2021, working capital represented a drag of nearly $490 million. As Peloton attempts to start up its growth engine again, this benefit will disappear and turn back into a drag.

A terrible time for a turnaround

Ultimately, Peloton's turnaround depends on the company once again growing sales of its pricey exercise equipment. Two things will get in its way.

First, this is not an economy where expensive, discretionary products will sell well. Persistently high inflation is pressuring household budgets, and interest rates for everything -- from mortgages to car loans -- are substantially higher today than in 2021. Even Apple is starting to have trouble. The iPhone giant reported its first revenue decline since 2019 in its most recent quarter.

Second, going to the gym is making a big comeback. Monthly visits to gyms from March 2022 through August 2022 were up 18% compared to the same period in 2019, according to data from Placer.ai and as reported by The New York Times. People needed home exercise equipment in 2020 and much of 2021. That's just not the case anymore.

While Peloton may yet succeed in stabilizing its business and returning to growth, the company is still valued at roughly $5.6 billion. Given the headwinds, that makes little sense to me.