I’ve Joined the Peloton

Color Commentary

1. Peloton

One my best friends ordered a Peloton bike last week. The Peloton bike is a stationary bike for your home with a big screen built right on to it, through which users stream videos of spin classes. The classes on offer are both live (i.e. you have to show up at a certain time for the streaming video) and on demand (i.e. you just start the video class whenever you want).

It’s called the Peloton because a peloton is the French word for the main pack of cyclists in a race, all of whom clump together to try to slipstream behind the other riders. It’s a whole thing with a peloton about who’s in front taking the brunt of the wind and who’s in back taking it easy and they switch it up and all sorts of cycling strategy whatevers (I know virtually zero about cycling). So, this spin bike company uses the word peloton to indicate that even if you’re home alone on your bike, you’re part of the larger pack and connected to each other via their app. Cute, right?

Peloton the company went public in September 2019 – only about nine months ago – and still isn’t profitable, at least as of their most recent quarterly filing. I’ve not really followed Peloton as a company, beyond being aware that they went public. It has looked to me like an extremely (EXTREMELY) expensive piece of exercise equipment with no real moat and a lot of hot-on-their-heels competitors, both in-home and in-gym.

Well. Enter coronavirus and the shutdown. I don’t need to say that suddenly in-home exercise equipment got a lot more popular than it used to be.

So my friend ordered a Peloton bike so she can work out at home. She’s in the US and due to their delivery backlog, it won’t be delivered for at least another month, so she, in the meantime, has the Peloton app to use – it turns out they offer an app that is accessible on most devices and which streams their classes. So, you don’t actually NEED the bike to take their classes, though having the bike does give some important features like their live leaderboard and workout stats.

At the same time, I, in the past few weeks, have gotten into riding my road bike on a bike trainer indoors. I know nothing about cycling, and don’t really ride my bike except about once a year, but there it was sitting in my basement gathering dust and I needed a new activity for lockdown so onto a trainer it went. (Full credit where credit is due: my husband actually dragged my bike out from its dark corner of the basement and hooked it all up for me and then took it all down for me afterwards. He is a gentleman and a scholar.)

Riding a bike on a trainer is horribly boring, even with the TV on. It just is. So there we were, my friend and I, chatting away about our sudden cycling interests in these At Home Times and she was telling me about all the classes the Peloton app has for people even who do not have the Peloton bike. Running, strength, bootcamps, yoga, and you can take the spin classes even without their proprietary bike. There’s a 30-day free trial (I missed the 90-day free trial that was on until May) and presto chango, I got the app and we had an appointment to do the same ride together the next day. It was fantastic.

This is a perfect case of life turning into investing practice. Immediately the wheels in my head started turning and I started wondering: what’s the company behind this all about? What sort of prospects do they have? I had made a lot of assumptions about this company already, with their expensive product and unprofitable results. But now that I kind of liked their product, I wanted to examine the company. Is Peloton developing a moat, or are their competitors going to take the yellow jersey from them?

Yup, that’s a cycling reference. I do that now.

2. Details

First, the basics. Peloton offers two physical pieces of exercise equipment: a bike and a treadmill. There are rumors they will add a rowing machine, either natively or by buying Hydrow, which is basically the Peloton of rowing. In my research, I stumbled across this Bloomberg article from late last year, in which the first line really brings home how, until coronavirus, this company was not exactly the darling it has become, and it cracked me up: “Peloton Interactive Inc., the unprofitable fitness company whose stock has been skidding, plans to introduce two new pieces of workout equipment next year in a further expansion beyond cycling.” Yeah, well, it’s six months later and they haven’t introduced a thing.

To give Peloton the benefit of the doubt, maybe they were positioned to introduce new items and then had to divert resources to deal with the shutdown. However, they haven’t told their shareholders anything along those lines, so it’s all rumors. Peloton’s most recent quarterly report came on out May 6,

Their main products are incredibly expensive. The bike costs $2,245. The treadmill is almost double, at almost $4300. They get around that sticker shock, though, with a payment plan for the bike at $58/month for 39 months, which is less than what many of us pay for a gym membership. Restructuring the cost into a monthly gym membership in my mind really helps with the sting, BUT I can cancel a gym membership if something more interesting comes around in the next 3 years. I can’t cancel payments on that bike. Three years is a long time.

However, that’s not all. Add on bike shoes, a mat so the bike doesn’t slide around and so the sweat doesn’t land on the floor, a heart rate monitor, headphones, and weights for the arm workouts = $249.

But wait, we’re not done! There is a monthly subscription fee of $39/month ON TOP OF the bike itself. So really, that gym membership at $58/month is actually $97/month + a one-time fee of $249, and you’re locked in for more than three years. (Obviously, the treadmill costs even more.)

All in, if you’re someone who can afford that price for your workouts, it’s not insane. I get why people pay it. But how does Peloton get potential users to buy? How do they get people to commit?

Enter their app. Genius. Their app, in stark contrast to the above, is only $13/month. It streams all the same classes. It doesn’t have the same metrics nor some of the connectivity to the live classes that the Peloton bike has, but at one-third the monthly subscription and no bike to buy, do I care? I do not.

The class was great! And there are SO many of them. I’ve also done one of their yoga classes and some stretching classes. Of course, there are a lot of other fitness apps that offer great classes.

There’s more competition for in-home connected exercise equipment as well. Flywheel and Soulcycle are the two main in-person chain spin studios, and both of them have developed bikes for in the home (even though it could take business from their spin classes, but that’s their problem, I suppose). Flywheel’s bike is gone, as I’ll get into below. Soulcycle/Equinox has been making in-home bikes, though has not actually released them yet, and NordicTrack is trying to get in on the action, as well as a small company called Echelon.

How will Peloton protect its business going forward? Does Peloton have enough of a moat to resist these attacks?

3. Moats

I see two potential moats: a secrets moat and a network effects moat.

Secrets Moat: Peloton has actually patented their technology of live rider rankings on a leaderboard in both live classes and on-demand classes. It was money well spent on a good patent lawyer, because Peloton recently successfully pursued a lawsuit against Flywheel that the parties settled this January in Peloton’s favor. Here is Peloton’s press release about the settlement and, if you like to read source material like I do, the Notice of Settlement filing.

Here are the actual patent filings at issue:

I really enjoy reading the story of a patent, by the way; it’s the lawyer’s time to shine and show what’s gorgeous about this invention. Just read this first paragraph of the description of the first patent: “Humans are competitive by nature, striving to improve their performance both as compared to their own prior efforts and as compared to others. Humans are also drawn to games and other diversions, such that even tasks that a person may find difficult or annoying can become appealing if different gaming elements are introduced. Existing home and gym-based exercise systems and methods frequently lack key features that allow participants to compete with each other and that gamify exercise activities.” Tell me more!

It’s not often there’s a patent suit this successful. Not only did Flywheel settle, Flywheel admitted patent infringement and shut down their bike program entirely. Then, because the bikes they sold would no longer work (except as a “dumb” bike) they let Peloton email their users and offer them the option to trade in their bike for a Peloton bike. What?!! That’s a patent lawyer mic drop. That’s full dominance. It’s insane.

Here’s a long, but worth reading, investigation into the story behind the lawsuit and “Project Magnum”.

Peloton has now filed a lawsuit against NordicTrack along the same lines as its successful suit against Flywheel, and same thing against Echelon. No lawsuit against Soulcycle so far, perhaps because, it sounds like from this review, the Soulcycle bike does not include a leaderboard? Soulcycle’s in-person classes don’t have leaderboards. Peloton’s patents cover more far more than just a leaderboard, though.

This was a good read about their legal prospects, though note that it is an old article before the Flywheel settlement.

My conclusion is that Peloton does have a far stronger secrets moat than I originally expected, and putting Flywheel’s bike out of commission was a huge message to everyone else trying to get into their industry.

Network Effects Moat: There is a huge difference in stickiness between customers who have spent thousands on Peloton-specific equipment and customers who can sign off an app with a few clicks. Peloton’s recent 10-Q states “2.6 million Members as of March 31, 2020″ and defines as a “Member” anyone with a paid subscription of any kind. Of those Members, 886,100 are Connected Fitness Subscribers with a bike or treadmill. Which means roughly 1.7 million Digital Subscribers.

I compiled the data on their Connected Fitness Subscribers from the three quarterly reports we have and ran growth percentages.

Reporting DateNumber of Connected Fitness SubscribersPercentage Growth
Sept 30 2018276,957 
Dec 31 2018362,38831%
March 31 2019457,10026%
(missing May 2019 quarterly info)
Sept 30 2019562,77423%
Dec 31 2019712,00527%
March 31 2020886,10024%

They divide revenue into revenue from products (“Connected Fitness Products”), and then revenue from the app alone (“Subscription”). However, Peloton’s definition of Subscription includes both product owner subscriptions at $39/month and app subscribers like me, who only pay $13/month and can quit anytime for something better. Huge difference between them. and I’d like to see more distinction from the company between the two. The product owner subscriptions are extremely sticky because these people bought a bike or treadmill. They’re in for that monthly payment, unless they stop using the bike or treadmill altogether.

The network effects come in because Peloton has created a connected community. The app tells you if you have friends in the same class, and even sends you a “badge” for taking a class with a friend. You can see the names of other riders in the classes and send a virtual high five to the other riders. The instructors sometimes call out milestones in class, like someone’s birthday or 100th ride. There are requests by users for more friend-oriented connected features like creating private waiting rooms before a class into which friends can gather, and then start the class together at the same time. Users clearly enjoy the social aspect and want more. The network starts to turn into a moat as Peloton gains market share, and if my real-life friends all have Pelotons and I want to do classes with them, am I going to go get the Soulcycle app or bike? No, I’m going to get the Peloton also.

I’m not sure Peloton has reached that level of network yet, but they’re certainly miles ahead of their competitors, and that counts for a lot.

4. Issues

It looks to me like, without coronavirus, Peloton’s new user growth was going down. Between the six months of March to September 2019 the growth was only 23%, and then it popped up again for the holiday season, which is their biggest selling season. The March 2020 growth was driven by the March shutdown.

Even though Peloton seems like it would be perfectly positioned for our At Home Times, they have issues to deal with in the lockdown.

First, their live classes had to shut down. They have studios from which they broadcast the live classes and those were closed. They’ve been able to send out equipment to some of their instructors to broadcast “live from home” classes, but with nowhere near the same volume as before. This will go back to normal at some point.

Second, and a much larger issue, is that the bike and treadmill require in-home personal delivery because they’re huge and heavy. Not possible in quarantine for the delivery people to come in and assemble the equipment. The company was able to find a workaround for the bike, by assembling it outside. It’s called threshold delivery, which is quite a fancy term for making someone who just spent more than two grand drag their 150-pound bike inside and up the stairs themselves. However, they weren’t able to find a workaround for the treadmill, so one of their products is simply not available to be purchased during the ultimate time for them to sell. I don’t see how they could have foreseen that problem, but still, it’s a bummer. All those treadmills sitting in a warehouse somewhere costing money instead of making money. They are going to have to fix this delivery issue, and soon.

Third, Peloton burned $110 million on building studios in New York and London, showrooms, and their headquarters. Are those even going to be used now?

Finally, an issue to watch is music rights. They have to license the music they use in their classes, and the music is integral to offering a great class. Without music, no spin class would do very well. (There are apps that talk you through a ride while you listen to your own music, but the experience is much reduced.) In the risk factors listed in their 10-Q, there are several listed risks relating in various ways to music rights. It’s a major factor in their business.

But my real worry is an extended economic downturn. All of a sudden, when spending gets tight, throwing a few thousand dollars towards a bike starts to feel pretty optional.

LET’S GET PRACTICAL

13-F filings are out! That website I found a few weeks ago hasn’t updated its 13-F screener past Q3 2019, unfortunately. Too bad. I was excited about that one. I had intended to write about the 13-F results in this issue, but then I got too interested in Peloton. So, that will come next time. However, here’s a great example of 13-F filings being old news: Berkshire Hathaway shows airline ownership in their filing, when Mr. Buffett told us he sold them all in April. He didn’t have to tell us he sold them, but did anyway. It’s a good reminder to use the filings as idea-generating sources, but not to actually put too much emphasis on the filings.

Ownership Disclosure: Danielle Town does not own stock in companies mentioned herein

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