Peloton

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Peloton sells premium exercise bikes and more recently, has started selling treadmills. $2,245 for the former and $4,295 for the latter.

The company has a certain caché to it. For instance, check out this funny Twitter thread that went viral last year. It gives some insight into Peloton’s marketing materials and its target market.

Peloton is the Ferrari of exercise. When the company started, it sold its bikes for around $1,200. Sales were solid but not explosive. Only after John Foley, the founder/CEO, decided to raise the price by over $1,000 did the company really take off. But the price alone wasn’t the sole ingredient in Peloton’s success.

The company sells a “Connected Fitness Subscription” which gives customers a library of work-out content. For $39/month, riders have access to high-intensity spin classes led by a professional instructor. Included is a virtual leaderboard to increase engagement.

FINANCING AND CHURN

Peloton also realized that the steep outlay doesn’t fit everyone’s budget. So instead of paying $2,245, customers can buy the bike for 39 monthly payments of $58 at 0% APR. In fact, 50% of people choose this option. Interestingly, the company’s fastest-growing demographic is younger than 35 years old with a household income under $75,000.

Since the financing plan is for 39 months, there is a high chance that consumers will pay the extra $39/month for the content library to unlock the full value of the equipment. While this proportion is likely high from customers that didn’t use the financing as well, the increased odds of lower churn seem to offset the generous 0% APR.

Further, Peloton also has a digital app. Until just a few months ago, the digital app cost $19.49 and allowed users access to the content library on their own devices. But now, the company lowered the price to $12.99 to widen its potential customer base. Connected Fitness Subscribers with the “Peloton Membership” have the digital app included in their $39 monthly fee. However, “Digital Members” can’t utilize the big screen on the bike since they only have access on their own device.

Another interesting aspect of Peloton’s business is churn. Historically, the company has reported about a 0.6-0.7% monthly churn, which translates into about a 91-93% annual retention. This is great, implying more than a 10-year lifetime value. However, 39-month financing doesn’t make much sense in light of this. So either the churn numbers are calculated in a slightly misleading fashion or the financing’s main purpose isn’t really churn but rather just a widening of the funnel.

To find out which one it is, here is the official definition of Peloton’s monthly churn:

We define Average Net Monthly Connected Fitness Churn as Connected Fitness Subscriber cancellations, net of reactivations, in the quarter, divided by the average number of beginning Connected Fitness Subscribers in each month, divided by three months

What’s tricky about this is just how fast Peloton is growing its subscribers. At the beginning of fiscal 2018, the company had just over 123,000 subs and now in the second quarter of fiscal 2020, it has over 712,000. Since cancellations are based on the quarter and the denominator (total subs) is based on an average of the 3 months, it likely makes churn appear a little bit better.

For instance, let’s use 2018 to 2019. At the beginning of fiscal 2019 (aka the end of 2018), the company had nearly 246,000 subs and grew to 511,000 a year later.

Judging by the reported average .6% monthly churn, we can gather that annual retention was 92.8% (100-(.6*12)). Using the company’s churn definition, we can roughly average out how many subscribers were added each month, which is around 22,000 (511k-246k)/12)). If we extrapolate that for 12 months, the average is 367,371 subscribers. So 7.2% (.6 * 12) annual churn on that number is 26,452 cancellations whereas, on the starting number of 246,000, it’s 17,688.

This is the difference between .6% monthly churn and .9% (50% higher). To recap, since subscribers are growing so quickly, Peloton’s churn stats likely reveal a lower number than how churn would traditionally be calculated. But it doesn’t drastically change the financing calculus. Even if our calculations are correct, a 9-year lifetime value (100/(.9 *12)) is much higher than 39 months of 0% APR runway. So this backs up the hypothesis that the financing is for accessibility rather than churn. The difference in retention between 89.2% and 92.8% doesn’t seem like much but it definitely affects the lifetime value of a customer. As a side-note, the company recently rolled out a home trial period which should inflate churn a little bit. I don’t mean to criticize the company for the way it presents churn; it makes sense based on how fast they are growing. I just don’t think it’s 100% accurate based on the way churn is typically calculated. With all of that said, 89% retention for a consumer product is great.

COMPETITIVE ADVANTAGE?

The interesting thing about Peloton is that its business takes a piece from different great companies. For instance, its content library is reminiscent of Netflix where the company can spend more because it can spread the costs across more subscribers. Also, the integration of hardware and software is similar to Apple. The problem is that it’s not a platform (even though its S-1 will tell you differently). App developers don’t have an incentive to build on top of Peloton’s Connected Fitness Subscription. It would be interesting if Peloton created a VR experience where it opened the ecosystem to developers. Imagine paying $5 for the ability to ride through the Tuscan hills!

Hardware has been shown to have a short shelf-life. And Peloton is no exception. NordicTrack, Echelon, and Schwinn already have similar offerings. It’s clear that the real differentiator is the integrated experience of quality hardware and well-crafted software. If Peloton can continue to grow its subscribers, it will be able to create more and more content for people.

Another interesting aspect is thinking of Peloton as a low-cost option compared to the gym or a spin class. For example, the average cost of a SoulCycle class in New York is $34. Based on the average number of monthly work-outs for Peloton (12), that comes out to $8/work-out if you do the financing option with the Connected Fitness Subscription (58 + 39)/12). Even if you buy the bike up-front, your payback period compared to SoulCycle would be 6 months of working out 3/week.

Now, obviously there are cheaper options; buying a solid $500 work-out bike and attaching your iPad with the $13/month Peloton digital app would be a good start. But again, Peloton is the Ferrari of exercise. If we extend this analogy, I guess SoulCycle would be like taking a limo everywhere you go (a bit excessive but fun once in a while). The point is, Peloton’s target market isn’t necessarily looking for a killer deal. It’s all about the caché and the brand. Notice that in all of the company’s marketing materials, you never see the bike in the garage. It’s always in the living room or something. That way you can casually bypass your Peloton bike when people are over. There’s a reason luxury brands are nearly always in product categories that are outward-facing. However, the simple fact is that Peloton’s go inside of people’s homes. The virality isn’t created through an in-person experience (besides guests asking about that exercise bike in the center of the living room) but rather through carefully-crafted marketing messages. There is also a community aspect where you can compete with other Peloton users but I’m not sure that constitutes a high switching cost.

At its core, Peloton is really a marketing machine masquerading as an exercise bike company. In 2019, it spent 6x more on sales and marketing than on research and development ($324 million vs. $55 million). Besides the economies of scale for the high-margin Connected Fitness Subscription, the brand is obviously of incredible importance to the investment thesis here. At the end of the day, assessing the long-term viability of a brand in today’s day and age is not an easy task. The main question here is how sticky is the content side of this business. It seems like there will be serious economies of scale but is there a diminishing return to each Peloton user? In other words, is engagement directly correlated to the size of the content library?

It strikes me as much different than Netflix or Spotify because of the novelty between a movie/song and a work-out. There are only so many variations of riding on a bike. While Peloton will never be an Apple or Netflix, there are some strong characteristics of its business. Relatively low churn (even considering the differences in calculations), a notable brand, and economies of scale in content just to name a few.

I’m not quite convinced that there aren’t diminishing returns to the content business which accounts for the real stickiness and lifetime value (apologies for the double negative). However, I am impressed by Peloton. As gyms shut down because of the virus, Peloton is also likely to have a decent tailwind.


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