Is Peloton's economic moat defensible?

Some people argue that Peloton is Apple (HW), Tesla (DTC), and Netflix (Content) combined into one company. While it doesn't match the scale of any of these iconic brands, it is certainly matching them in their early growth rates. Peloton recently released its Quarterly numbers, and as expected, the demand for its bikes and subscription service exploded in the Corona economy. I will split this write-up into 3 parts: Signals, Analysis, and Predictions.

• For Q3, 2020, Sales were up 66%, $524.6 million in sales exceeding estimates of $485.4 million.
• Added 176K subscribers to the app without the hardware, total subscribers to 886K, nearly doubling from last year
• 23K people joined a single class. Yes, that's probably the largest fitness class ever.
• 44M workouts in the last quarter, 490K workouts per day on average, which is up 80%.
• For the full 2020 fiscal year, estimated revenue to reach between $1.72 billion and $1.74 billion, a year-over-year increase of 89%, vs. previously estimated $1.53 billion to $1.55 billion.
• A leading indicator of future growth: deliveries of Peloton have gone from 2-3 days to 8-10 weeks, indicating that demand is exceeding supply. This should sustain at least until the world gets back to some normalcy.
• As of last Monday, the company’s stock is up more than 61% over the last 12 months. Peloton now has a market cap of about $12.1 billion - i.e. currently valued at more than 7x MACYS, which is a 161-year-old iconic brand. Let that sync in.

But the key question is does this accelerated growth represent a pull-forward of demand or an expansion of the addressable market?

Let's look at the size of the market as estimated by Peloton. As per the data below (Source: Peloton Investor Presentation), the total addressable market in the US is about 62M users, who collectively spend $30B a year on gym memberships and fees. This is an average annual spend of $500 per user.

However, since Peloton plays in the more premium category and charges ~ $1,200 year (including the cost of the connected equipment at $57 per month + subscription fee of $39 per month), it's SAM (Serviceable Available Market) is much smaller at 14M users and ~$17B. It is estimated to do $1.7B in the fiscal year 2020, thus reach 10% penetration.

So back to the key question, has COVID-19 expanded this "connected fitness" market or just accelerated growth for Peloton? The real answer is still unknown, but we have some clues and assumptions. Given what we know, it will be 18 to 24 months before people feel fully comfortable going back to the gyms. I'm betting that people's behavior will be significantly altered and there will be more innovations in the "at-home" fitness space such as the Mirror and Tonal, resulting in more than 25% of the gym-goers to convert. And there are clear benefits from a cost and convenience perspective.

According to Peloton, the cost per user is significantly cheaper compared to the in-studio experiences, even after factoring in the cost of the equipment. Most of these comparisons are with the higher end of the market and combined with the current situation make Peloton and the likes extremely attractive for these users.

However, for the market to expand, new products at lower price points ($40-$60 per month, $500-$700 a year) will be introduced either by Peloton or new entrances that will try to take a bite of this market.

Let's talk about the economic moat - defined as structural features that allow a firm to sustain excess profits over a long period of time. Based on my years of experience in running DTC digital businesses, for any such business to be viable in the long run, two things must happen:

a. The acquisition cost must go down and remain low over time: for this to happen the business needs to maintain a low churn rate (the rate at which you lose customers) and increasingly acquire customers through organic channels such as word of mouth.

b. Customer life value must stay steady or even better, go up: this can happen through recurring revenues from your consumers and through an increase in average revenue per user (ARPU) with adjacent products and services (i.e. higher share of wallet).

A combination of a and b translate into sustainable and attractive unit economics (defined in terms of unit customers), thus creating a profitable business for the long term. Here's a simple equation to understand the strength of the moat in terms of attractive unit economics.

Where CLTR is the total lifetime revenue; Margins are the Contribution Margins for such revenue; CAC is the avg. customer acquisition cost.

So Peloton shared an analysis, where it showed that it almost breaks even in the first year of customer acquisition. Considering it has a ~3 years financing program, let's assume a customer stays with them for at least 3 years. This takes the CLTV to the CAC ratio to 3:1. My prediction is that this ratio will get even better over time, as it introduces new products and upgrades programs.

Here's what makes Peloton's moat defensible.

1. Vertically integrated platform [translation: higher margins]:

Like Apple, Tesla, and now Netflix, Peloton is vertically integrated. This means it controls the entire value chain of the business including Hardware, Original Content, and Proprietary Software (including UI/UX). Not only does this allow it to deliver a tightly integrated, premium experience, but also gives it extremely healthy margins of ~45%.

2. Brand Sex-Appeal, Social Quotient and Customer Loyalty [translation: Network effects]

Peloton's aspirational positioning makes it the iPhone of at-home fitness. The elegant design, high touch brand experience with luxurious 96 global showrooms, and elevated experience through various digital and physical touchpoints, makes it an extremely attractive product offering.

As a result, it has a cult-like following, and power-users act like brand evangelists. As per Peloton, 43% of first-time buyers heard about the brand through WOM. I can vouch for this personally since a friend who uses Peloton was so passionate that she converted me into a buyer while doing research on this story. Voila! New customer, zero CAC.

The element of social engagement - we ride together, compete with each other, facetime while riding to push each other, give high-fives, and earn awards, makes this an immersive and socially rich experience, all from the comfort of your home.

3. Recurring revenue bundle of HW and SW (Rundle) [Translation: higher switching costs for consumers]

The combination of a hardware and software subscription model is an extremely attractive proposition both for consumers and the business. Recurring revenue ensures the stability of cash flows and enables the business to retain its customers through cycles of upgrades.

4. Efficient Scale and Cost Advantage

Given the number of paid users are now close to 1M, and likely to double over the next 12-24 months, Peloton will have a cost advantage that will be hard to match. Especially, when it comes to content production cost, which will get amortized across users, and continues to decline at a unit level as the base of consumers grows. Think Netflix vs. a new streaming service, the economies of scale that Netflix have are extremely hard to match for any new streaming service.

1. Peloton's market cap doubles, from $12B to $24B+ over the next 24-36 months as it introduces new sub-$1000 fitness equipment for stay-at-home workouts. Just as Tesla did, Peloton started with high-end and will expand downwards to the middle to gain a significantly larger share of this rapidly growing market.

2. Peloton and Spotify strike a partnership for music curation, and probably offer a combined subscription model for its users.

3. Peloton expands its eco-system and launches a wearable device (such as a Fitbit) that enables the user to track calories, sleep and intensity while using the equipment.

While it's guaranteed that this "connected fitness-at-home" market is about to get extremely crowded, Peloton has built a strong lead, a robust platform, and a loyal customer base to catapult itself to become the market leader with 50%+ market-share of this $30B market. Thus, potentially growing 15 times from the current run rate of $1B and a market cap of $120B (8xRevenue). Happy days ahead!

Amit Rawal is a Sloan Fellow at Stanford's Graduate School of Business. He has spent the last decade in building and scaling e-commerce ventures for 40%+ of the world's population. At Stanford, he is focused on bringing together tech, design, and data to create joyful shopping experiences. He is a data geek and loves tracking all kinds of health and wellness metrics. He can be reached at [email protected].

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