To some investors, Peloton (NASDAQ:PTON) is another sign of a market gone mad. Peloton has a market capitalization near $12 billion — yet it remains unprofitable. And even as the economy has largely come to a halt over the past two months, PTON stock has rallied.
I don’t agree with that characterization. It’s true that Peloton isn’t profitable. But that doesn’t mean the stock is worthless — or even overvalued. As for the economy, we’re already starting to reopen. I still believe much better days are ahead.
That said, I do believe that, after such a steep rally, there are legitimate worries about valuation. A 9% decline on Tuesday suggest other investors agree with that take. More may follow.
Peloton is a wonderful business. It will provide a buying opportunity at some point. I’m just not convinced that point has arrived just yet.
Subscription Gross Margins
No, Peloton isn’t making money. But that is not, in and of itself, a bad thing.
Indeed, criticizing PTON stock simply because it’s unprofitable is a knee-jerk mistake. It’s an unfortunately common example of investors looking at valuation first and the business second. That thought process led investors to miss out on huge returns in supposedly “overvalued” names like Shopify (NYSE:SHOP), Tesla (NASDAQ:TSLA) and even Amazon (NASDAQ:AMZN).
It’s not unforgivable that Peloton is unprofitable. In fact, the company probably shouldn’t be. Peloton is establishing a base of well-heeled customers across the country. Those customers are paying monthly fees for programming that offers enormous margins. It’s a model that can drive growth for years.
And so it’s a model that Peloton, wisely, is investing behind. One key reason is that gross margins are enormously attractive.
An investor only need look at this month’s fiscal third-quarter report. In the equipment business, gross margins were a healthy 45.8%, up 3.5 points year-over-year. That’s more than enough to drive consistent profitability as the business scales and customer acquisition costs come down.
But what’s really interesting is the margins on the subscription business. In the year-prior quarter, subscription gross margins were under 26%. In Q3 FY2020, they neared 58%.
Why? Because extra subscribers don’t cost Peloton much at all. Production costs are fixed. The same is true of network infrastructure. Additional subscribers add some bandwidth expense and that’s about it.
Unprofitable PTON Stock
There are companies that would sell their product at a loss to drive subscription revenue like that. Roku (NASDAQ:ROKU), in fact, has that kind of model, albeit in a very different business.
Peloton, however, has an equipment business that should make solid profits. I’m skeptical that business supports a $12 billion market capitalization, or anything close. Fitness equipment manufacturer Nautilus (NYSE:NLS), for instance, is worth less than $200 million.
But the two businesses combined have real value. The only reason they’re not profitable right now is that Peloton is spending substantially on acquiring customers. Sales and marketing expense in Q3 was 30% of revenue. And that’s with the company canceling advertising spending in mid-March.
That level of spending is wise. It’s an investment. Customers acquired in 2020 are going to contribute high-margin recurring subscription revenue in 2022 and 2024 and even beyond.
Because Peloton subscribers tend to stick around. Monthly churn in Q3 was just 0.46% (that figure is net, so reactivations are counted against losses).
Peloton could slash that advertising spend, and show near-term profitability. But it’s doing what good companies — and good investors — do: it’s taking the long view.
A Return to Normalcy
Of course, good investors can take the short-term view, too. Entry points matter. And Tuesday’s decline, in particular, raises some near-term worries.
PTON was down 9% on a green day for the markets. And it wasn’t alone. A number of “pandemic plays” like Zoom Video Communications (NASDAQ:ZM) also fell.
Tuesday was a day for the normalcy trade. Investors are optimistic about life getting back to normal, or a “new normal”, and reacted accordingly.
And I don’t believe that’s necessarily going to change. Peloton did get a big tailwind from the crisis. It’s literally selling bikes as fast as it can manufacture them. (That’s why it canceled ad spend toward the end of the quarter.) But gyms are going to reopen, Americans are going to head back out, and that tailwind is going to fade.
To be clear, that doesn’t mean the rally in PTON stock made no sense. Again, Peloton customers are profitable over the long haul, and customers acquired over the past two-plus months will contribute to earnings going forward as well. Rather, investor attention may head elsewhere for a while.
If it does, and Peloton’s stock gives back some of these gains, there’s an opportunity for patient, long-term investors. This is a wonderful business. It has years of growth ahead. Near-term losses are going to lead to long-term profits.
At a current price of $41, PTON stock probably isn’t a terrible buy. But at a cheaper price, it’d be an even better buy. And I believe we’ll get that cheaper price at some point in 2020.
Matthew McCall left Wall Street to actually help investors — by getting them into the world’s biggest, most revolutionary trends BEFORE anyone else. The power of being “first” gave Matt’s readers the chance to bank +2,438% in Stamps.com (STMP), +1,523% in Ulta Beauty (ULTA) and +1,044% in Tesla (TSLA), just to name a few. Click here to see what Matt has up his sleeve now. Matt does not directly own the aforementioned securities.