By David Trainer, Kyle Guske II and Sam McBride
Luxury fitness company Peloton Interactive is expected to IPO on Thursday. At a price range of $26-$29 per share, the company plans to sell up to $1.1 billion of shares with an expected market cap of around $7.6 billion. At the midpoint of the IPO price range, Peloton currently earns our Unattractive rating.
Peloton’s /zigman2/quotes/208035743/composite PTON -1.69% suspect accounting and outrageous claims about its total addressable market suggest a WeWork -like perception of reality. The business is moving farther away from profitability with no realistic path to achieve the cash flows implied by its valuation.
Mind the (non) GAAP
Peloton was founded in 2012 and launched its signature stationary bike in 2014. The company has sold 577,000 products (mostly its bike, but also the treadmill it launched in 2018) and has 511,000 subscribers to its streaming fitness classes.
Despite its rapid growth, the company has made no progress toward profitability. Its economic earnings , the true cash flows of the business, declined from -$54 million in 2018 to -$226 million in 2019 (Peloton’s fiscal year runs through June 30).
Peloton tries to mask the extent of its losses by highlighting adjusted Ebitda , every unprofitable company’s favorite metric. This metric excludes $90 million in stock-based compensation expense, $22 million in depreciation and amortization, $12 million in litigation expense, and $7 million in construction costs related to its new corporate headquarters. In total, Peloton’s adjusted Ebitda excludes $124 million (14% of revenue) in expenses, while also ignoring the company’s cost of capital.
More often than not, we’re seeing private companies and investors operate as if capital has no costs.
Figure 1 shows that Peloton’s adjusted Ebitda understates both the size and the increase of the company’s losses.
In addition to adjusted Ebitda, Peloton uses two other misleading non-GAAP metrics:
• Subscription contribution margin: Normally, contribution margin refers to the operating profits of a specific segment. In this case, however, Peloton’s subscription contribution margin refers to the gross profit of its subscription offering, excluding stock-based compensation and depreciation and amortization expense. As a result, the company shows its subscription contribution margin rising from 47.5% in 2018 to 50.8% in 2019. Without excluding those items, subscription gross margin declined from 43.3% to 42.7% over the same time.
• Average net monthly connected fitness churn: Instead of disclosing its churn rate on an annual basis, as most companies do, Peloton discloses it monthly. The company’s 0.65% monthly churn (which sounds very low), annualizes to about 8% churn, which is not nearly as impressive. In addition, 11% of its subscribers are on prepaid subscriptions, which means they have no option to cancel. Peloton’s true annual churn rate for subscribers that are eligible for cancellation is probably close to double digits.
Red flag from the auditors
Investors need to take Peloton’s GAAP numbers with a grain of salt. The company disclosed a material weakness in its internal control over financial reporting as a risk factor in its S-1 . This disclosure means Peloton didn’t have adequate technology and processes in place to ensure the accuracy of its financial statements and increases the odds that Peloton need to restate its financials in the future.
As an emerging growth company , Peloton is not required to have its auditor give an opinion on its internal controls. We applaud the company for disclosing this risk factor in its S-1, but investors should know that this disclosure is voluntary and could be eliminated in future filings even if the problem persists.
Lack of disclosure raises more red flags
Peloton omits certain details that are important for investors to understand the growth potential of the business. In particular, the company doesn’t break out sales numbers for its new treadmill, which it launched in 2018.
The two important facts Peloton discloses about the treadmill are:
1. It’s responsible for a decline in the company’s product gross margin from 44% in 2018 to 43% in 2019.
2. It caused the company’s inventory balance to increase from $25 million in 2018 to $137 million in 2019, a 440% increase.
The fact that Peloton apparently has around $100 million worth of treadmills in inventory, and that it’s earning inferior margins on those it does sell, suggests that the launch of its treadmill has not been successful. We can’t know for sure without more disclosure, but if Peloton was selling lots of treadmills it would probably be quick to tell us.