Highlights
We issue a Buy recommendation on Peloton Interactive, Inc. (PTON) based on a one-year target price of $13.43, selling at a 87.3% upside potential from its closing price of $7.17 on May 22, 2023. Our recommendation is primarily driven by:
Macroeconomic Outlook – Consumer spending in the US declined by 0.7% in March 2023, mainly due to inflationary concerns. Despite this, the economy remains healthy and robust, with solid consumer credit and unemployment rate remaining low at 3.4% in April 2023. Although the possibility of further rate hikes poses a threat to the economy, as long as unemployment remains low, consumer credit and spending are expected to remain firm. The US has thus far avoided a recession, and the labor market remains strong, with the unemployment rate at a historic low of 3.5% as of March 2023.
Growth Strategy – Peloton has emerged as one of the industry's fastest-growing companies, witnessing a remarkable 115% increase in revenues and a substantial 140% surge in subscriptions during 2021. With an estimated membership base of 7.25 million as of 2023, Peloton has solidified its position as one of the most popular fitness platforms. However, in 2022, the company faced significant challenges, with an exceedingly high operating expense (Opex) margin of 95% and a contraction in sales growth. As a result, Peloton incurred staggering operating losses amounting to -2800 million.
Valuation – Valuation methods currently indicate a positive intrinsic value of $13.43 per share, suggesting an upside potential of 87.3%. However, the DCF valuation paints a more conservative picture, estimating a value of $3.36 per share. This disparity can be attributed to the considerable debt Peloton has accumulated. Nonetheless, Peloton's positive trajectory is supported by its ability to retain a substantial number of active users, capitalize on its strong brand recognition, and offer competitive pricing for fitness activities.
Main Risk Factors – The fitness equipment market is fragmented, with global and regional players dominating the market. Many consumers are now opting for a hybrid approach to working out, and both the gym and home fitness equipment industries stand to benefit. Additionally, the industry is susceptible to seasonality, impacting its overall dynamics.
Business Description
Peloton Interactive, Inc. is a direct-to-consumer, multi-channel retail company that provides internet-connected stationary bikes, treadmills, cycling shoes, dumbbells, resistance bands, and fitness apparel. Peloton's business strategy incorporates two revenue models: subscription and production. It manufactures products such as the Peloton Bike or Tread and sells them directly through retail showrooms and on its website. In addition to the physical products that it sells, Peloton also provides connected fitness subscriptions for different household users, giving them access to its classes.
Peloton's key competitive advantages include: a loyal community of over 5.9 million members as of June 30, 2021; focus on vertical integration, first-mover advantage, and competitive dynamics; paying its fitness instructors much more than competitors, which attracts some of the best fitness instructors in the industry to exclusive deals.
Peloton's priority is growth to take advantage of and improve its leadership position and the scale economies and network effects that come with it. Peloton has adopted new strategies such as new pricing models, new content structure, and a new digital app strategy.
Industry Overview and Competitive Positioning
The home fitness equipment market size was valued at USD 13.7 billion in 2028, registering a CAGR of 2.75% from 2016 to 2027, pushing even further Peloton’s growth boundaries.
Peloton's competitive landscape includes other fitness equipment companies, such as NordicTrack, Echelon, and SoulCycle, as well as traditional gyms and fitness studios. Its new strategy under the leadership of Barry McCarthy includes new pricing models, a new content structure, and a new digital app strategy.
Peloton's primary source of profit up until now has been its membership subscription, and the company is focused on engaging and retaining consumers through an integrated experience that combines content, software, service, and community.
Peloton's average net monthly connected fitness churn rate has stayed impressively low, which is a testament to the company's ability to retain customers, additionally, Peloton's competitive position is strong due to its loyal community, focus on vertical integration, and ability to attract top fitness instructors.
Financial Analysis
Overview The financial condition chart above illustrates Peloton's future prospects, highlighting our assumptions (please refer to the Appendix for complete financial projections). Our analysis begins in 2020, coinciding with Peloton's late 2019 IPO that allowed the company to be publicly traded. As mentioned earlier, the fitness industry is fragmented, providing Peloton ample opportunities to expand its consumer network and capitalize on the platform's popularity. However, it is important to note that Peloton's remarkable revenue growth from 2017 to 2021, with an average year-on-year growth of 100%, has resulted in significant financial deficits that have remained uncontrolled in subsequent periods. This has led to increased operating costs, with Opex margins rising from 40% in 2021 to 95% in 2022, thereby significantly impacting EBITDA/EBIT margins.
Moreover, Peloton's debt burden, as measured by Net Debt to EBITDA, has increased over the years, with a 2-year compound annual growth rate (CAGR) of 6.35%, resulting in a total Net Debt burden of almost $2.2 billion in 2022. In contrast, EBITDA has decreased significantly, with a 2-year CAGR of -3100%. The shift in macroeconomic conditions from a highly leveraged system with access to cheap capital, which prevailed until 2022, has led to increased refinancing costs, pushing Peloton’s WACC to 13,5%.
Pessimistic Outlook for Peloton Inc.
In an overall stagnant economy with negative consumer confidence and an uncertain inflationary environment where central bankers may once again raise interest rates, coupled with an enormous debt burden that becomes more burdensome with higher rates, Peloton will be compelled to shift its focus towards a subscription business model given its higher marginality. This strategic shift will likely lead to a reduction in the fitness product market and a decline in its market share impairing company’s ability to benefit from the increase in market size leaving the upper hand to ordinary gyms and competitors.
Optimstic Outlook for Peloton Inc.
With Peloton's restructuring plan already underway to stabilize its debt situation, a strong market position as a claimed leader in the home fitness equipment industry, an impressive customer retention rate of 90%, and one of the largest communities in the sector boasting 7.25 million members in 2023, coupled with a $13.7 billion market in the home fitness equipment industry projected to grow at a compound annual growth rate (CAGR) of 2.75% until 2027, we maintain an optimistic outlook for Peloton Inc. We believe that the company will successfully manage its outstanding debt, further reduce it, and enhance shareholder and company profitability. This will enable Peloton to fully leverage its prominent market position and popularity, thereby capitalizing on the industry's structural growth.
Valuation
A number of valuation methodologies were utilized in deriving a target price for Peloton Inc. (PTON), including a 5 year DCF and Multiple Valuation.
DCF Model
A Discounted Cash Flow Analysis was used to estimate the intrinsic Value of Peloton Inc. due to the predictability of cash flows in relation to growth and profitability. The base case for this model was formulated using guidance from historical performance, industry outlook, an assessment of PTON’s competitive positioning, and company guidance on revenue, and earnings growth.
This model is driven by Unlevered Free Cash Flow as this represents cash that is available for debt and equity holders and is calculated as EBIT minus taxes, plus D&A, minus CaPEx and change in Net Working Capital. The historical horizon is two years (2020 to 2022), given the recent IPO of Peloton in late 2019.
The model is forecasted five years, mainly because the industry of home fitness equipment is considered to be in its mature phase and longer horizon would require more stringent and comprehensive historical data.
We have assumed that product COGS margins will remain steady at 80%, taking into account the ongoing restructuring efforts of the company. Additionally, we have incorporated the company's estimates for a 17% growth in subscription revenues in 2023, factoring in the projected increase in subscribers. Furthermore, our assumptions include a terminal growth rate of 5% for total Peloton members and 7% for connected fitness and app subscriptions.
The DCF is most sensitive to the following factors, the derivations of which are explained below:
Weighted Average Cost of Capital (WACC)
As a common discount rate, we used the WACC as this metric represent best the equity and debt holder’s interest. To calculate Cost of Equity, we utilized the traditional CAPM relying on external analysis for market risk premium and beta.
Terminal Value
Using the Multiples Method, we have calculated a terminal value that exceeds the Enterprise value. When the terminal value surpasses the enterprise value for a particular year, it indicates the expectation that the company will continue to expand and generate cash flows beyond the projected period. Furthermore, it implies that the value of those future cash flows outweighs the value of the company's current operations. This can be a positive sign for investors, as it suggests that the company has strong growth potential and may be undervalued. However it’s important to conduct sensitivity analysis to test the robustness of the model and the impact of changing in assumptions.
The implied EV/EBITDA multiple calculated using the Multiple Method is currently -13.8x due to the negative EBITDA recorded in 2023, while EV/EBITDA using the DCF stands at -2.9x in 2023. However, as the net loss is gradually mitigated, the EV/EBITDA multiple is expected to appreciate to 8,5x, being more in line with those of peer companies.
Sensitivity Analysis
As we never rely on one number due to the fact that with DCF modelling lots of assumptions are involved, we conducted sensitivity analysis to get a range of potential values, at which change in exit multiple (industry multiple) as well as change in perp. Growth rate and WACC were most important.
Price Target and Range
The Price Target of $13.43 is primarily derived from two valuation methodologies: the 5-year DCF, which yielded a Target Price of $3.36, and the Relative Multiple Approach, which resulted in a Target Price of $23.51. It is important to note that these models involve various assumptions that can potentially impact their accuracy. To mitigate this, we have combined the two methodologies and assigned equal weights of 50% to each outcome.
Appendix A: 3-Statement Model - Drivers
Appendix B
Appendix C
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