Ever since seasoned subscription business veteran Barry McCarthy took over as CEO of connected-fitness company Peloton Interactive (PTON 4.29%), the company has been on a mission to reach 100 million members. For perspective, it had 6.5 million members as of its fiscal fourth quarter of 2023, the most recent quarter, which ended in June.
To assist with its membership goal, Peloton just partnered with athletic apparel company Lululemon (LULU 1.31%). For its part, Lululemon is abandoning connected-fitness hardware and content, relying on Peloton to provide those things for its customer base. Likewise, Peloton is moving away from its nascent apparel business, allowing Lululemon to provide that.
By partnering with Lululemon, Peloton's fitness content gets greater exposure to a large demographic, which could drive new subscribers. McCarthy is undoubtedly excited because that's the big-picture goal. Moreover, Peloton's subscription business is high-margin.
However, there's one aggravating detail that could keep Peloton's plan from paying off right away.
The hidden cost of doing business
In McCarthy's first letter to Peloton shareholders, he talked about two very common business metrics: customer acquisition costs (CAC) and lifetime value (LTV) of the customer. McCarthy admitted that it costs more to acquire a new member than what Peloton initially makes from them. But the idea is that the company will make up for it over the lifetime of the customer.
Subscription streaming companies commonly think about business in this way. Losing money upfront is seen as acceptable if a loyal customer is gained. Therefore, it's all about customer retention for these subscription businesses.
The fallacy, however, is that customer retention is free. I assure you, it's not. There are not only customer acquisition costs but also customer retention costs. And this pesky detail contributes to the large number of cash-burning subscription services out there.
Consider Peloton's partnership with Lululemon as an example. It's not a bad deal -- in fact, many see it as a win-win. But some investors believe it's simply selling its existing fitness content library to new subscribers, which would make the deal all upside for Peloton. And that's not the case.
The official press release says, "Peloton content will be updated on a weekly basis on the Studio device and companion app, with new Studio content produced by Lululemon through Spring of next year."
In other words, Peloton will need to regularly produce new content for Lululemon. Refreshing the library with new content is a constant reality for this kind of business, and it comes at a cost.
The challenges of scaling
Peloton is known as a stationary exercise bike company. And video content was geared exclusively to this initially.
Reaching Peloton's goal of 100 million subscribers with only bikers, however, is unrealistic. That's why the company has branched out into other exercise disciplines. But branching out complicates the scaling of its business.
Consider the following table. Peloton improved its subscription revenue gross margin by 1,450 basis points (the difference between 42.7% and 57.2%) in just one year by adding only about 600,000 net new subscriptions. But from fiscal 2020 through fiscal 2023, it only improved by 1,000 basis points by adding two million more subscribers. And more recently, its gross margin appears to have plateaued completely.
| Fiscal year | 2019 | 2020 | 2021 | 2022 | 2023 |
|---|---|---|---|---|---|
| Subscriptions | 0.5 million | 1.1 million | 2.3 million | 3.0 million | 3.1 million |
| Subscription gross margin | 42.7% | 57.2% | 62.1% | 67.7% | 67.2% |
Source: Peloton's financial filings.
The slowdown in margin improvement for Peloton coincides with branching out into other disciplines. Now, instead of just biking content, it makes content for running, rowing, floor-based exercises, and more. And in partnering with Lululemon, it will need to put a greater emphasis on yoga content as well.
Think of it in terms of Netflix. The company has a massive content-creation budget, spending over $6 billion on content in just the first half of 2023. If it specialized in just one particular content genre -- say just documentaries -- its regular, ongoing content spend would be astronomically lower. But then it wouldn't have nearly 240 million paid memberships either.
To attract a higher membership base, Netflix must spend to produce content that appeals to a large membership base. The same is true of Peloton if it expects to get to 100 million members.
Right now, Peloton appears to be experiencing an in-between stage. It's too big to ignore other fitness categories if it wants to grow. But it's still too small to further gain operating leverage in its subscription business because it's branching out so much.
It could eventually pay off for Peloton's shareholders. But for now, the company is still burning cash, so it may be best for investors to watch from the sidelines instead of viewing its partnership with Lululemon as a catalyst for the business and a buying opportunity for the stock.
