Earnings Call Transcript - PTON Q2 2023

Operator, Operator

Good day, and thank you for standing by. Welcome to the Peloton Interactive Second Quarter 2023 Earnings Conference Call. At this time all participants are in a listen-only mode. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Peter Stabler, Head of Investor Relations. Please go ahead.

Peter Stabler, Head of Investor Relations

Good morning, and welcome to Peloton’s fiscal second quarter conference call. Joining today’s call are CEO, Barry McCarthy; and CFO, Liz Coddington. Our comments and responses to your questions reflect management’s views as of today only and will include statements related to our business that are forward-looking statements under federal securities laws. Actual results may differ materially from those contained in or implied by these forward-looking statements due to risks and uncertainties associated with our business. For a discussion of the material risks and other important factors that could impact our results, please refer to our SEC filings and today’s shareholder letter, both of which can be found on our Investor Relations website. During this call, we will discuss both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP financial measures is provided in today’s shareholder letter. I’ll now turn the call over to Barry.

Barry McCarthy, CEO

I want to do something a little bit out of the ordinary just to kick off today's call if you'll indulge me. A good friend of mine, Gail Tifford, once best summarized what's special about Peloton. I think when she described the brand as golden and the members' community as platinum. And what makes that possible is the incredible work done by our content team and by the instructors who give it life. And because of that, and in particular, I want to welcome back to the platform today one of our Instructors in London by the name of Leanne Hainsby, who after disclosing her recent battle with cancer, and her announcement that she's cancer free, is today, once again back on the platform and started her class just coincidentally, happens to coincide with the start of this earnings call. So welcome, Leanne. And thank you for all you do for us. And with that, let me turn the call back to the operator and take her first question.

Doug Anmuth, Analyst

Thanks for taking the questions. Barry, you wrote about how the new initiatives across rentals and retail partnerships and just changes in the overall go-to market drove 19% of CFU volume in the quarter. So, if you could talk more about how you think that will progress over the next 12 months? And which of these initiatives you expect to be most impactful to drive growth going forward? Thanks.

Barry McCarthy, CEO

Based on the last quarter performance and quarter to-date, I think perhaps the pre-owned business will be the most significant on a quarter-over-quarter basis. Last quarter to this quarter, our pass has doubled, as an example, and is continuing to grow rapidly this quarter. A large percentage, around 63%, I think with a 95% confidence, is incremental to the business. These customers tend to have slightly higher household incomes, but the fact that they don't have to make a tricycle commitment would not have come onto the platform. Now, regarding the third-party retail, it has less incrementality. We don't have enough data to be confident that we know how much of the revenue is incremental, meaning whether we would have sold it on our own platform but for the fact that we partnered with third parties. It did outperform our expectations in the quarter. But, of course, we had no history going into the quarter. So it's difficult for us to know how to forecast it, as with FaaS and CPO. We continue to be optimistic and are quite pleased with the performance during the quarter. We're uncertain about the incrementality, although we are invested in continuing to grow it, and we'll know more soon.

Doug Anmuth, Analyst

If I could just follow-up, you know Leslie joining as the new CMO. Do you feel like there's strong awareness of the new initiatives in the go-to-market strategy among potential consumers or is that going to be a big focus in your advertising and marketing efforts?

Barry McCarthy, CEO

Well, awareness is still low, but it's new. Are we going to make it a focus? Not particularly. I think the focus is going to be anyone, anytime, anywhere. It would be less about the bike; it will be about all of the occasions for use and inclusiveness.

Doug Anmuth, Analyst

Great. Thank you, Barry.

Operator, Operator

Thank you. Our next question comes from the line of Justin Post with Bank of America. Your line is now open.

Justin Post, Analyst

Great, thank you. Can you talk about hardware gross margins in the quarter? What were some of the puts and takes there? What it's going to take to get those to breakeven? And do you think the model is working now, as you think about your hardware sales producing subscribers? Thank you.

Barry McCarthy, CEO

Liz and I will tag team this. Let me start with the high-level stuff, and she’ll backfill on the specifics. We manage the LTV to CAC. In making those calculations, we take a holistic view of the revenue stream and the expenses associated with both the hardware and the subscription. From my part, I don't particularly care about the hardware margin, or particularly about the subscription margin. I care about it on an aggregate basis, and I care about the relationship between the lifetime value of the customer relative to the cost of acquisition. That's the framework we use in deciding whether or not the model is working. In the recent model, I think we were operating at 1.4 to 1 LTV to CAC, which means that each time we add a new subscriber to the business, we increase the enterprise value because that customer will be net profitable over their life.

Liz Coddington, CFO

To just add a little bit more detail to what Barry mentioned, we did enrich our holiday promotion, and that of course has an impact on our hardware gross margin. We managed to our LTV to CAC ratio, so we may have spent more on promotion, but it balanced out and resulted in that 1.4 ratio of LTV to CAC. I also want to comment that our overall gross margin, when we outperform on connected fitness, means the lower margin of our hardware becomes a sort of higher penetration relative to subscription. That will depress the overall margin a bit, but we're happy with that because we get the subscribers and the subscription revenue over time that comes with them. The only thing worth noting on our gross margin is that this quarter, we did take a number of reserves; we had higher costs, and the costs of revenue were impacted by some excess and obsolescence reserves. After we got through the holiday period, we realized that we had more inventory than we needed and took a reserve against that. We also had some very specific returned inventory that we planned to refurbish and sell, and so we took a reserve for that. We continue to have some reserves associated with inventory from our tonic manufacturing facility. All of those had roughly about a $32 million impact on our connected fitness gross margin in the quarter. Regarding when our hardware connected fitness margin will turn gross margin positive, we are not giving guidance on that timing. However, as Barry said, we are continuing to focus on optimizing our LTV to CAC. Many levers that factor into that include promotions, financing strategies, and third-party channel strategies. All of those things create a drag on our gross margin.

Barry McCarthy, CEO

One additional comment is important to remind everyone that there are clear tradeoffs between the rate of growth of the business fueled by the pace of marketing and sales and marketing spending on one hand, and the impact that spending has on free cash flow. So, spending more on marketing could grow us faster, but it would come at the expense of free cash flow. Our overarching objective is to move the business to free cash flow on a sustained basis so we can control our own destiny. Thus, our first priority is to manage the business free cash flow, and then within that framework, manage for growth.

Justin Post, Analyst

Great, thank you.

Operator, Operator

Our next question comes from the line of Eric Sheridan with Goldman Sachs. Your line is now open.

Eric Sheridan, Analyst

Thanks so much. Maybe if I could ask a two-parter. Obviously, there was a lot of demand pull forward through the pandemic, and you went through this sort of normalization dynamic post-pandemic. Are we back on firm ground where you think you understand what the normalized end demand trends are in the category? And therefore, you're now in a mode of sort of executing on leaning in or leaning out with respect to promotion and marketing, and we could be back to some sort of normal seasonal cadence in the business? That's number one. And number two, maybe following up on Doug's question from earlier; just can you help us better understand how the mobile app strategy fits broadly into the Connected Fitness goals? Are you still viewing it as a potential feeder product for conversion and the subscriber funnel, or is there an increasing view that maybe this can operate as sort of a stand-alone strategy for folks who might never come around to the hardware? Thanks so much.

Barry McCarthy, CEO

I'll jump in first, and then I'll hand it over to Liz. We outperformed in the quarter. The good news and the bad news is that we outperformed. The bad news is our accuracy in forecasting, especially given the many changes we made in the business model, is not as highly evolved yet as it will be. Is that because of the changes we made in the model or because consumer behavior is different than we have understood it historically? I think it may be a bit of both. The reason I say this is that we've continued to outperform even our updated forecasts in the quarter. So, I think the answer to your question is no, we're not back to normal yet; there's some new normal happening, and we don’t yet understand what it is. One minor point with respect to seasonality is that among the things we're seeing that we didn't expect is that FaaS has not exhibited seasonal characteristics of the rest of the business; it didn't spike at all during the holidays, it just continued its march as if the holidays didn't happen. Regarding the app, I think of it as its own endgame. We can see all access subscriptions through hardware, or maybe not – I don’t really mind. The end goal for that strategy is to expand the TAM by reaching a user base that historically we've not been able to access to do it with our core strength, which is all of the content and the user experience that our instructors give life to, and enabling consumers to use that content on competitive hardware, whether it is in their home, in the gym, or outside, whether it is strength, yoga, running, or rowing. Today, it’s a bike, tread, or row in your home; tomorrow, it could be all those other things. I think the path to the promised land is the app – at least that's how I conceptualize it, and that's the opportunity we're trying to pursue. Liz, do you want to add anything?

Liz Coddington, CFO

I think you explained it quite well, Barry. The only thing I will add is that from a modeling perspective, we still expect that our revenue for the year will resemble that of fiscal '22.

Barry McCarthy, CEO

Let me just drive home the point not to read too much into this call. But today, we have as many subs as we're forecasting we're going to have at the end of the quarter. We have seen plenty of churn historically, particularly at the end of the seasonal rush. We're forecasting that whatever incremental growth we have, we will get back in the form of churn. We're not forecasting a spike in the churn rate, just the math, to be clear; but it could be right, it could be wrong. We're going to find out.

Operator, Operator

Thank you. Our next question comes from the line of Shweta Khajuria with Evercore ISI. Your line is now open. Shweta, your line is open, please check your mute button.

Shweta Khajuria, Analyst

I'm sorry about that. I guess I have a quick question on free cash flow. You got to positive free cash flow this quarter, excluding some of the supply-related costs. How should we think about the magnitude of each of the key drivers of getting to positive free cash flow in fiscal year '24? Specifically, I'm talking about the cost cuts you've made that have had an impact, supplier contracts you've renegotiated that have had an impact, but also inventory drawdown has an offsetting impact. So could you help us in terms of what will be driving the trajectory of sustainable positive free cash flow? Thank you.

Liz Coddington, CFO

Sure. Shweta's question is really about what is going to drive sustainable free cash flow into fiscal '24. You mentioned inventory; inventory will continue to be a tailwind for us in fiscal '24. We must also be very conscious about our operating expenses to be as efficient as possible and doing our LTV to CAC analysis to make sure that we are acquiring subscribers efficiently. Lastly, growth is crucial; we have to find ways to grow the business so that we can cover our operating expenses over time. Since we've already bought most of the inventory and have much of it on hand, operating the business efficiently will help maintain positive free cash flow or break-even free cash flow ideally. Yes, the key is figuring out how to continue to grow the business. By the way, as we grow the app part of the business, it is a higher gross margin business that will benefit us over time as well.

Barry McCarthy, CEO

Let me jump in and add that let's discuss some of the changes in the year ahead compared to the past year in terms of savings. We saw a significant reduction in headcount in the past year and commensurate savings. However, I made it clear in a previous call that as far as I am concerned, we're done with headcount reductions. I want to reaffirm that to all of our employees who are listening to the call. We have significant opportunities for additional expense reduction in the business, and I expect that we will realize these in the next year or two. These savings are in middle mile, last mile, and operating systems, including ERP, warehouses, and order management systems, which are causing many manual processes. We still have a lot of inventory, and we incur significant storage costs. As we work down our inventory positions, we have additional savings to be realized. It is essential to note the trade-off between growth and cash flow and savings. If we lean back into international growth, for example, we're going to lose more money; we can grow faster, but we will only grow if the LTV to CAC shows net profit over time. Adding new subscribers means we lose money; this is true across the board with many subscription models like Netflix, Spotify, and Peloton. Ultimately, we have to find the right balance.

Shweta Khajuria, Analyst

Okay. Thank you, Barry, thank you, Liz.

Operator, Operator

Thank you. Our next question comes from the line of Ron Josey with Citi. Your line is now open.

Ron Josey, Analyst

Great. Thanks for taking the question. Maybe, Barry, I wanted to follow up on your comments on churn just now. I understood there's no real change and you have maybe a little bit higher churn on seasonality, just given the holiday. But do you think this 1.1% churn is, call it, the new normal for full members now that we're in three quarters into the price hike? Maybe any insights on the churn around FaaS subscribers. I think we added shoes and benefits to the program this quarter that might have brought churn down for these FaaS subscribers. Any insights there would be helpful regarding churn?.

Barry McCarthy, CEO

Let me discuss the overall churn number. Regarding FaaS, it has a higher churn rate than the typical all-access customer, which is running about 4.5% to 4.7%. That should not alarm you, and here’s why: The subscriber base is still young. Over time, if you were to look at individual cohorts, we must understand what the shape of the retention curve looks like. As the subscriber base ages, the average churn rate will come down. At what rate does it become asymptotic? Is it going to be 1% or 3%? Based on our current understanding of consumer behavior, we believe the payback for FaaS customers receiving a new bike is about 18 months, and for those receiving a used bike is 12 to 14 months. This is as good as we hoped - much better than the worst-case scenario of two years. Therefore, we are still learning how to operate the program, but at least based on the churn behavior we're observing with roughly 24,000 FaaS customers in total, I think there's reason to be optimistic. Although some cash flow negatives arise because you are not selling hardware upfront and recouping that investment as quickly, we're seeing faster growth as a consequence.

Liz Coddington, CFO

Yes, sure. I just want to add one point that for the quarter for Q2, we were actually closer to 28,000 FaaS subscribers at the end of Q2, which is about double the number from Q1; so great growth for FaaS.

Barry McCarthy, CEO

The CEO doesn't know the numbers. Sorry about that, folks.

Liz Coddington, CFO

Let's discuss churn. Our churn was flat quarter-over-quarter, and we're pleased with our Connected Fitness potential levels overall. FaaS has a minimal impact on overall churn at this point. Currently, we don't expect significant changes to our current churn levels, aside from small seasonal variations from quarter to quarter.

Ron Josey, Analyst

Thank you, Barry, thank you, Liz. Very helpful.

Operator, Operator

Thank you. Our next question comes from the line of Brian Nagel with Oppenheimer. Your line is now open.

Brian Nagel, Analyst

Hi, good morning. Thanks for taking my question. So maybe a couple of questions. Maybe unrelated, I'll shove them into one to just make it simple. First off, with regard to the now expanded distribution infrastructure with Amazon and Dick's. Any additional insights on how you may further develop that infrastructure? And then my second question is regarding FaaS; as you look at the initial growth there, are you allowing that growth to be dictated by the market, or are there governors in place right now that you could adjust over time to drive that growth one way or the other?

Barry McCarthy, CEO

If you mean drive the growth up or down? The answer is yes. Let's say that we are concerned about the cash flow drain; we could decide to slow it down. We would take specific orders for the day and halt sales, for example. Additionally, international expansion is another lever; we can decide how fast to go. A third lever is to adjust the value proposition and make it pricier, which has churn implications, lifetime value implications, and cost of acquisition implications. But it's undoubtedly one of the variables we factor into deciding how to modulate growth; we could lower prices, which would likely grow faster.

Liz Coddington, CFO

The only thing to add to the first part of the question is around insights on developing our infrastructure with Amazon and Dick's as third parties. It's still very new for us. We've only been roughly a quarter into our relationship with Dick's. We recently went through our first holiday season with our third parties. While our third-party sales, along with the rest of our sales, outperformed our expectations during the holidays, we're still learning about those partnerships and figuring out how we want to proceed to ensure a win-win for both our business and our partners.

Barry McCarthy, CEO

No additional comments.

Operator, Operator

Our next question comes from the line of Youssef Squali with Truist. Your line is now open.

Youssef Squali, Analyst

Great. Thank you. Two questions for me. First, can you maybe speak to the level of promotional intensity in the quarter and your plans and expectations for the second half? In other words, what does the guide imply in terms of promotional activity? And two, maybe a clarification, Liz, on something you said earlier about the seasonality you're seeing this year being similar to 2022. In 2022, your fiscal Q4 was the lowest revenue quarter at about 19% of revenue. I assume that's what you're telegraphing, but what else would you like us to know about how Q4 may turn out? I know you're not guiding yet, so just directionally.

Liz Coddington, CFO

Regarding revenue for Q4, we're not providing guidance, so you can interpret my comment on revenue seasonality as you wish, but we're not providing specific guidance for the quarter. On promotional intensity, and Barry, feel free to add if I miss anything, but as we consider promotional levers, we return to the LTV to CAC and recognize promotion as one of the key levers. In this quarter, we'll make trade-offs between media spending, financing offers, and promotion. Noting that we currently have significant inventory, promotion is a lever for us. Although we don’t comment much on promotional strategy for competitive reasons, we are trying to manage inventory reductions while considering margin and cash flow. All aspects are crucial for promotional activity.

Barry McCarthy, CEO

Remember that using promotions is just a form of marketing spending, even if it appears differently in the P&L. It has proven to be enormously effective for us. However, more promotion erodes brand value. Thus, it should be used sparingly. In the years I've been here, we’ve had varying degrees of promotional activity each quarter; it’s up to Leslie to decide how aggressively or not she'll incorporate it into the marketing mix going forward.

Operator, Operator

Our next question comes from the line of Edward Yruma with Piper Sandler. Your line is now open.

Edward Yruma, Analyst

Good morning. Thanks for taking the question. Barry, in one of your earlier answers, you talked about the puts and takes on international growth and that faster growth would cost more money. I know you cited restoring international growth as a goal in year 2. What do you see as other than promotional levels that could help achieve that? And do you expect to enter new countries? Thank you.

Barry McCarthy, CEO

The long and short answer is that we’re still figuring it out. I would like to enter new countries, probably starting with Western Europe. However, I don’t know when or how much we would spend. I hope to have those answers in the next three months, but we don’t have them today. That covers the sentiment.

Operator, Operator

Our next question comes from the line of Aneesha Sherman with Bernstein. Your line is now open.

Aneesha Sherman, Analyst

Hi, good morning. So two questions, please. The first is with higher FaaS demand and faster deliveries at the end of the quarter. Does that suggest that there could have been some lagging subscribers in January? Is that already baked into your guidance of 3.08 to 3.09 for Q3? The second question is regarding marketing, which is down even as a percent of sales. I'm curious if you could give us color on how much of that is temporary, as you're holding back marketing on the digital app until you've relaunched it versus structural declines, such as a leaner team, lower field expenses, or maybe even structurally lower as we broaden our distribution footprint and need less marketing. Any color on that would be helpful. Thank you.

Barry McCarthy, CEO

The sales and marketing line item on the P&L is impacted by several factors. Some purely relate to marketing spend for the core business. Others are for the commercial and wellness business, as well as retail. We're in the process of dramatically shrinking losses associated with that component. All else being equal, as subscription revenue grows, sales and marketing expenses should decrease significantly as a percent of revenue. At the tutorial I provided during the Investor Day that Spotify hosted before its direct listing, for example, Netflix saw sales and marketing expenses decrease from roughly 24% to 14%, all while CAC remained relatively constant. This is due to how a subscription business operates; you only pay to acquire marginal new subscribers rather than for recurring revenue. Growth in subscription revenue effectively reduces overall sales and marketing expense as a percentage of total revenue. However, offsets like international expansion will elevate CAC in new countries since our brand awareness is low. We're balancing earnings and cash flow as we pursue growth while being mindful of the changes in CAC. If we can successfully raise word-of-mouth awareness and recurring subscriber growth, this will likely reduce overall sales and marketing expenses. In terms of the digital app, we need time to evaluate that opportunity.

Liz Coddington, CFO

Regarding the lagging subscribers resulting from timeliness of FaaS demand, this is not unique to this year. Over the holidays, we typically sell many connected fitness units during Black Friday and Cyber Monday, which takes time to deliver. Thus, there are generally situations where customers order a Peloton product but do not activate their subscription until January. This trend happens every holiday quarter as we transition from Q2 to Q3.

Barry McCarthy, CEO

However, there is a bit of a backlog coming into this quarter relative to other quarters.

Liz Coddington, CFO

Yes, relative to other quarters. Yes, but it's included in our guidance and is not unique to this year compared to previous ones.

Barry McCarthy, CEO

By the way, let's give a shout-out to all of the folks at Peloton involved in delivering connected fitness units to consumers' homes. They significantly exceeded our expectations for the quarter, and we’re grateful for their efforts on behalf of the business.

Operator, Operator

Our next question comes from the line of Kaumil Gajrawala with Credit Suisse. Your line is now open.

Kaumil Gajrawala, Analyst

Good morning, everyone. Can you talk about the decisions regarding Precor and the Ohio facility? Is there any shift in strategy or impact from holding onto those assets longer in relation to the initiatives you've outlined?

Barry McCarthy, CEO

Liz will take Peloton Output Park, and I will address Precor. Let me start with Precor. When I think back to my first earnings call, I stated that our strategy is clear: our commitment is to Connected Fitness. If it’s not Connected Fitness, we’re not doing it. That brings us to the sale of Precor, which for all intents and purposes, is public knowledge as we’ve explored selling it. We started off well, but the price the buyer offered dropped significantly, and we chose to walk away. At some point, we had crossed a line where the deal was no longer viable. We own Precor but have not devoted resources or investments to it for our benefit. Instead, we have run it reasonably, even gleaning talent from it for our hardware business. We will adjust course. We understand how to add incremental value without incurring significant expenses, which should enhance the business’s value. Our overarching strategy is to run Precor for its own benefit and not to dilute those efforts for our operating business; instead, we will treat it as a standalone subsidiary. If we see success, there will be a dramatic increase in its market value. Only if we shift our strategy would we contemplate divestment.

Liz Coddington, CFO

As for the Peloton Output Park facility in Ohio, we had anticipated selling it by the end of calendar year '22. Unfortunately, that process was delayed. However, we are hopeful we will complete the sale by the end of the fiscal year, and we are confident about that; it's just taking longer than expected.

Operator, Operator

Our last question comes from the line of Lauren Schenk with Morgan Stanley. Your line is now open.

Unidentified Analyst, Analyst

This is Nathan Federer. I'm filling in for Lauren Schenk. Can you talk through how the initial demand for the rower has been, and what you think about production and distribution? Additionally, what portion of demand is coming from new versus existing subscribers? Lastly, what is causing the delay in selling POP, and how are you addressing that?

Liz Coddington, CFO

As for demand for the rower, similar to our other products, it outperformed our expectations over the holiday season. It’s newer for us, and awareness beyond our current member base is still evolving. Thus, during the holiday, a larger share of rower sales were made to existing members—roughly 65%. Since the holidays, this has aligned closer to about 40% as seen with existing subscribers purchasing our tread product. Regarding Peloton Output Park, it is a large facility in Ohio great for the right use case, but we need to find the right buyer. We're taking the time necessary for that.

Operator, Operator

Thank you. And I'm currently showing no further questions at this time. I would like to turn the call back over to Peter Stabler for closing remarks.

Peter Stabler, Head of Investor Relations

Thank you, everyone, for joining us today. We'll talk to you next quarter. Have a good day.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.