Earnings Call Transcript - PTON Q3 2022

Operator, Operator

Good day, and welcome to the Peloton Interactive Third Quarter 2022 Earnings Conference Call. Please note this event is being recorded. I would now like to turn the conference over to Peter Stabler, Senior Vice President, Investor Relations. Please go ahead.

Peter Stabler, Senior Vice President, Investor Relations

Good morning, and welcome to Peloton's Third Quarter Fiscal 2022 Conference Call. Joining today's call are CEO and President, Barry McCarthy; and CFO, Jill Woodworth. 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 law. 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 actual 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. With that, I'll turn the call over to Barry.

Barry McCarthy, CEO

Morning, everyone, and thank you for joining today's call. Earlier this morning, we released the letter to shareholders, which discusses our strategy for growing Peloton's business and the Q3 performance. I'm not going to repeat what was said in the letter except to thank our employees for their hard work and our 7 million members for giving our work meaning and purpose. Before we begin today's Q&A, I'd like to acknowledge the contributions of William Lynch to the growth of Peloton. As part of the leadership transition at Peloton, William decided to resign from our Board to pursue other interests and we wish him continued success in his next endeavor. Operator, let's turn to our first question.

Operator, Operator

The first question comes from Doug Anmuth with JPMorgan. Please go ahead.

Doug Anmuth, Analyst

Thanks for taking the questions. Barry, trying to understand the recent hardware price reductions just in the context of your bigger plans. Are they just an effort to move inventory and perhaps drive a little bit more revenue near term to really envision fast becoming the primary or only business model over time besides the digital app? And what are you seeing in those early tests? And what could that service look like?

Barry McCarthy, CEO

Hey Doug. So the price increase was geared towards moving hardware and alleviating some of the stress we're seeing in inventory. We've also learned quite a bit about price elasticity and have seen a significant increase in total revenue as a result of the price decrease. So, I'm feeling pretty good about that and I'm looking to sustain it. The framework for thinking about unit economics begins and ends with LTV and then the CAC expense associated with the LTV. And today, we're operating – we operate in the range of, I would say, broadly 2:1 to 3:1 depending on seasonality, which I feel really good about. What was the third part of the question?

Doug Anmuth, Analyst

Just what the fast...

Barry McCarthy, CEO

Fast will be a complement to our business. So there are absolutely our members who want to own the bike outright, and we're delighted to sell it to them. And then there are others for whom the cost of entry poses a barrier. And roughly 53% of our customers year-to-date, by the way, have household incomes of less than $100,000. So Fast is an opportunity for us to continue to introduce consumers, mass market to our value proposition. I'm not sure what the mix will be over time. We need to test our way into an understanding of that as well as an economic model that enables us to earn an attractive return on investment. What we can say with certainty at the moment is that we're seeing faster growth than I had hoped we would see. So I'm enormously encouraged by early test results. But it's early. The total number of units that we placed is still relatively small on the order of 1,000. We're looking to aggressively expand the test on our e-commerce platform. I think we'll be fully live with A/B test by the end of June. We've got some engineering work to do to enable that. Maybe it will be a couple of weeks sooner, we'll have to see. So that’s complementary to the core business, not yet sure what that mix over time will be or what the ultimate pricing will be. But we need to test our way into figuring that out.

Doug Anmuth, Analyst

Thank you. Appreciate it.

Operator, Operator

The next question comes from Justin Post with Bank of America. Please, go ahead.

Justin Post, Analyst

Great. I have a couple of questions. Thanks. Can you help us understand the churn contemplated in your subscriber growth outlook for Q4? It looks like you have subscribers up 1% quarter-over-quarter. Just the dynamics of the quarter with the testing you're doing and then the churn. And then OpEx was up 19% year-over-year. Any update on your cost-cutting efforts and whether you're trending ahead or below your plan? Thank you.

Barry McCarthy, CEO

I'll take the churn part, and Jill will take the cost-cutting part. So we're hedging our bets a little bit in guidance related to churn. We saw a very small increase in cancellations when we announced the price increase of the all-access service from $39 to $44. But the price change doesn't actually hit until June 1. And so, we're still a little uncertain about what the churn impact will be. I would say, it’s been quite small.

Jill Woodworth, CFO

And on the restructuring side, if you look at the OpEx and COGS savings in the second half of fiscal 2022, so what's already achieved, we expect about $165 million of OpEx savings in the second half. And we're certainly on track for $450 million in OpEx savings for fiscal 2023. In terms of COGS, we expect about $30 million to $35 million in savings in the second half, already baked in, and we're on track for about $100 million of COGS savings in fiscal 2023. So as we outlined last quarter, this is something we're incredibly committed to, and we've already made a lot of progress. I think, culturally, the organization understands what we have to do.

Justin Post, Analyst

Great. Thank you.

Operator, Operator

The next question comes from Youssef Squali with Truist Securities. Please go ahead.

Youssef Squali, Analyst

Thank you much. Barry, just in terms of supply chain issues, can you maybe just clarify a bit how Andy and Angel are improving the process? I think you had a nice mention of them in the letter. And just broadly speaking, your predecessor had followed the strategy of maybe owning a bunch of productive assets, including Precor. Is that still strategic to the direction of the company and how that fits in your overall solution? Thanks.

Barry McCarthy, CEO

About the supply chain, let me say that I don't think we had the visibility that maybe we would have wanted. We had a number of systems issues related to supply chain that we needed to address and we've taken steps to do both. I think we also haven't made quite as much progress in rightsizing the production as we needed to. We've been working as closely with our partners in the supply chain as we needed to related to the ordering of long lead-time parts. Andy and his team have taken important steps in addressing all of those issues. And in the process, we have much greater visibility into how the supply chain issues affect the business overall. So, it was an area where we had work to do. We're making a lot of progress. We'll make more, but I'm feeling pretty good about that piece of the business. I would characterize it as an urgent need when I stepped in and I'm proud of the progress we're making. With respect to Precor, there were a couple of things we were trying to accomplish with that acquisition, bolstering our go-to-market strategy in commercial, which along with corporate wellness, is an important area of growth for us in our core business. Beyond that, I haven't spent a lot of time yet thinking about the Precor business. For the moment, I just want to put a pin in it. I'm not signaling that it's not core, but I'm not signaling it is core either. There have been so many other issues to address. I just haven't gotten there yet.

Youssef Squali, Analyst

Great. Thank you.

Barry McCarthy, CEO

But the overarching strategy is, look, it's all about Connected Fitness. It's about the magic that happens in the tablet. We need to be good at hardware, but being good at hardware is not nearly sufficient. The thing that makes us special, that accounts for the low churn rate that drives the exceptionally high Net Promoter Scores is all the magic that Jen Cotter and her team and our instructors bring to the service, and we need to be absolutely great at that. And that calls for, I think, a shift in the investment priorities of the business at least as compared with where we spent money historically in order to double down on the things that have made us great.

Operator, Operator

The next question comes from Ron Josey with Citi. Please, go ahead.

Ron Josey, Analyst

Hey, thanks for taking the question. Maybe I want to talk a little bit more or help to understand gross margin assumptions and third-party delivery. I think in the note in the letter, we talked about lower gross margins for product in the range of $300 million. So maybe, Jill, help us understand where these savings are coming from. Is it greater efficiencies in manufacturing, third-party delivery? And Barry, you mentioned some issues in last mile. Maybe help us understand how those have been fixed or what's going on there? And then lastly, just Jill, I think in the letter, we talked about free cash flow timing changes and how that impacted free cash flow this quarter versus going forward. Any insights there would be helpful. Thank you.

Jill Woodworth, CFO

Sure. On Connected Fitness gross margin, what you have happening currently and what we saw in Q3 were a few sort of one-time items. You have an increase to tread, plus returns reserve. We also took additional inventory reserves around accessories, primarily driven by a strategy shift in the way we went to market with the Peloton Guide. We also had higher scrap reserves for bike, which essentially is not resalable inventory that has been returned to us and cannot be refurbished. Additionally, we will experience in Q3 and Q4, higher detention and demurrage and storage costs, due to our inventory position being higher than we expected, given the decline in our demand forecast. So a lot of these issues are one-time in nature or short term in Q3 and Q4. In terms of the overall restructuring efforts in COGS, there’s a lot behind that. Some of that was related to the shift to third-party logistics (3PL), which we did realize some savings going from a much larger in-house delivery fleet. Moving to 3PL helped us variabilize that expense, reducing some of the fixed cost overhead that was a challenge to leverage with lower demand volume. But there's more optimization we can do here. There’s more we can achieve with better warehouse management and better optimization of our labor structure. That's part of what I think we can see on the horizon for fiscal 2023. Next year, we’ve negotiated better freight rates, which we’ve talked about. I believe there is future opportunity in the longer term to improve procurement sourcing and better product margins as a result of reworking how we design and build our products and taking some costs out. Lastly, if we deliver products better and service products better, I think we can also bring down our cost of warranty. There’s a lot for us to do within that segment over the next year or two.

Barry McCarthy, CEO

As it relates to last mile, let me say, we have parts of the world, like Australia, where our partnerships with 3PL work seamlessly for us, and users have a good experience when we transitioned to 3PL. After the restructuring, we put in place systems integration that enables us to work and assume this way with those partners. As a consequence, our members who are being serviced by some of those partners had extremely frustrating experiences. To begin with, when we transitioned to 3PL, there were about 10,000 orders in our system that got transferred. That meant right out of the box, 10,000 people got rescheduled, and we did nothing to communicate to those people initially about the transition. Many of them had deliveries that were rescheduled and rescheduled. We had no ability in our customer service organization to see into the delivery schedules of our 3PL partners to help deal with delivery issues that our members were experiencing. These are just some examples of some of the implementation-related issues that have created membership-related issues that have affected our Net Promoter Score that we are looking to address on a go-forward basis.

Jill Woodworth, CFO

And just to summarize on free cash flow, as outlined in the letter, we're focused on achieving positive free cash flow in fiscal '23. There are really four drivers to this. The first is growing the business, which we've outlined in the shareholder letter with various strategies to grow our subscriber base. We have multiple levers in Connected Fitness margin improvement, which we've already detailed so I won't rehash them. We believe we are on track with restructuring savings. Next year, we expect significantly lower CapEx spend. We anticipate selling the land and facility we purchased for our Ohio manufacturing. Lastly, inventory is expected to turn from a source of cash to a use of cash in fiscal '23.

Barry McCarthy, CEO

Let me just jump in here and say regarding free cash flow, the objective here is to reach positive cash flow in FY '23, full stop. With the funds we raised in the term loan, I'm very confident we have ample capital to achieve that regardless of what happens in the economy. So, to the extent there are any concerns among investors about our ability to achieve that, I don't share them, and I want that to be clear.

Peter Stabler, Senior Vice President, Investor Relations

Next question, Tom.

Operator, Operator

The next question comes from Shweta Khajuria with Evercore. Please go ahead.

Shweta Khajuria, Analyst

Thank you very much. Let me try two, please. You mentioned several growth drivers. One of them was third-party retailer partnerships. Can you please provide a little more color on how the economics of those partnerships would work? I understand it may be very early, but how you're thinking about it perhaps? And then the second question is, another growth driver you mentioned was adding value through digital app subscriptions. So as that subscription base grows, where do you think churn rates could shake out over the next, call it, a couple of years with both growing digital app subscribers and Connected Fitness subscribers? Thank you.

Barry McCarthy, CEO

I don't have an answer to the second question at the moment. Until we understand the monthly revenue, gross margin, and acquisition cost, we won't have the context to consider churn effectively. From experience, building a successful subscription business involves managing the relationships between churn, gross margin, and not treating one factor in isolation. I know this might not be fully satisfying, but it’s the reality we face. We need to figure out how to expand the marketing funnel and leverage the digital app for that purpose. It could be through a bring-in model or a straightforward subscription model, but it's still uncertain. Our consumer mix currently stands at roughly 80% female and 20% male, and we aim to bring that closer to the Internet standard of about 50-50. The unaided brand awareness is only around 4%, making it the best app that few know about. We must address this. The app is quite lightweight, allowing for rapid growth across different regions, and expanding internationally is a key priority for us. Regarding the first part of your question about third-party retail, I won't discuss specifics today, but I can indicate a possible shift. We are in conversations with several potential retail partners at this stage. It’s still early to fully grasp the cost-benefit dynamics, but too early to share details publicly. I don't expect any deal we negotiate to differ from those made with other hardware distributors through third-party retailers.

Shweta Khajuria, Analyst

Okay. Thank you, Barry.

Operator, Operator

The next question comes from Arpine Kocharyan with UBS. Please go ahead.

Arpine Kocharyan, Analyst

Hi. Thank you for taking my question. I was wondering if you could walk through the hardware versus software margin outlook for Q4 and what contributes to the 31% guidance since it implies a meaningful improvement versus Q3. I'm just trying to understand how you get there.

Jill Woodworth, CFO

Yes. On the subscription margin, we expect versus Q3, a slight continued leveraging of fixed costs. We'll see a small benefit from the pricing increase from one month of that. Remember, most of our costs within subscription are variable. On the Connected Fitness side, we expect a negative margin. There are a few factors at play. We just reduced our prices significantly across the portfolio back in April to drive scale and growth. But we also have some items consistent with Q3 around managing our excess inventory. We're still going to see elevated detention and demurrage and storage costs. However, we believe those will largely abate as we move through fiscal 2023. So those are not permanent. The third factor in Connected Fitness margin will be around logistics. Again, with the lower demand forecast, we're not getting the fixed cost leverage we would have expected. Our new supply chain leadership has only been here for about six weeks, and this is certainly an area of focus for optimization.

Arpine Kocharyan, Analyst

That's helpful. And just a quick follow-up. Is there anything you could share on price elasticity of demand that you saw as a result of price cuts? Anything you could quantify? I understand commentary could be limited given the competitive nature of pricing in general, but anything else you could share in terms of demand change that you saw as a result of your pricing initiatives? Thank you.

Barry McCarthy, CEO

Well, we talked about the unit increase in the letter, right? That was in the range of 70% and the revenue increase was less of course, but it was also pretty dramatic, I think around 50% as compared with the baseline growth we were seeing before we made the price change. It's abundantly clear that the business was better served by the reduction. It still remains to be seen what the net impact is once the price increase kicks in in June. But early indicators are that the churn related to that will be slow, but we won't know until we know.

Arpine Kocharyan, Analyst

Thank you very much.

Peter Stabler, Senior Vice President, Investor Relations

Next question, Tom.

Operator, Operator

The next question comes from John Blackledge with Cowen. Please go ahead.

James Kopelman, Analyst

This is James on for John. In the letter, you mentioned rolling out additional international markets. What geography should we be thinking about next? Are you still focused on Latin America and European adjacent markets? Any color on timing would also be helpful. And then, as a follow-up, you mentioned the goal to reach 100 million members. Jill, could you provide any update on how you're thinking about it across the regions you're currently in? I think it's been a while since the last update, which I think was around 20 million global SAM back in 2020. Thank you.

Barry McCarthy, CEO

With respect to international, I'm not sure yet. We’re still in the middle of developing our final FY '23 plan. There are finite resources to spread across the business. The threshold question for us is how many of those resources to allocate to growth in international. If we look at subscription revenue growth in the current quarter in North America, it was 53%, but in international, it was 92%. International has potential to drive a lot of growth. However, the more growth international drives early in its development, the more money we lose. Since our overarching goal is sustained positive cash flow for the business in FY '23, positive cash flow trumps growth. There are opportunities we’re considering internationally that will make it more economical to launch new markets. For instance, thinking about last-mile delivery: currently, our bike and Tread must be installed. A simpler solution would be to design it so it could be delivered by a service like FedEx, meaning you wouldn't have to be home to receive it, lowering costs and logistical challenges in launching new international markets.

James Kopelman, Analyst

And then for Jill, just to follow up on if you could share any color on the SAM. I think it was 20 million when last provided.

Jill Woodworth, CFO

Sure. That analysis hasn't been updated for the most recent price change, which I suspect will significantly expand TAM since that's the primary barrier. The 100 million goal is a long way from where we sit today. We have looked at the number of people that belong to a gym globally as an interesting data point to understand the number of folks interested in fitness, and that number is 180 million. We believe tech-enabled fitness has a massive opportunity to expand the market. We think software will drive a transformative experience, but we need to evolve our strategy significantly to reach that 100 million. This could include SaaS, further expansion, scaling the app, and much more international growth.

Barry McCarthy, CEO

We can’t get there without making the digital app a big success. It’s clear that people outside the United States also care about fitness, and we have the opportunity to capitalize on that. We’ll know how big the TAM is when we finish evaluating it. I know of digital apps that already have more than 100 million users focused on fitness, and I can’t understand why, given our early success in the category, we wouldn’t be one of those digital apps. So stay tuned.

Operator, Operator

The next question comes from Eric Sheridan with Goldman Sachs. Please go ahead.

Eric Sheridan, Analyst

Thanks so much for taking the questions. Barry, great to reconnect. Maybe, Barry, I'd love to take a step back for a minute and just get your perspective having been inside the business now over the last couple of months. What did you find that surprised you to the upside from some of your outside perspective? Where are you finding that you need to spend more of your time, or do you think there's a bit of a more effort that has to be applied to sort of get the business to workovers over the medium term? Just sort of a broader question on your perceptions and how that's resulted in how you spend your time and realigning assets. Thanks.

Barry McCarthy, CEO

Let me make sure I understand the question. What have I found internally that makes me optimistic about the success of the business?

Jill Woodworth, CFO

Surprise.

Barry McCarthy, CEO

The nature of turnarounds is they're full of surprises. I would say the biggest surprise in the quarter was the cash flow and related to that, the biggest surprise was our ability to quickly address it without diluting existing shareholders and adequately capitalizing the business. So, I'm really pleased with how the team executed to address that issue. I've found more talent in the building than I expected, which is incredibly important for execution. We were weaker on everything supply chain than I expected, but we're fortunate to get Andy, and he's moved quickly to build his team. I'm cautiously optimistic about our ability to address that. Lastly, when I first introduced the concept of fitness as a service, I found out the business had thought about it two years ago but never executed due to COVID, yet had already done thinking about it and so we were able to move on it faster than if they hadn't already considered it. Lastly, I’m encouraged by the growth. I was hoping for a 70% uplift, which I thought would be spectacular, but we're pushing north of 90% at the moment. It remains to be seen whether this value proposition will drive the kind of ROI we’d like to see to justify the investment. It has the potential to dramatically change our P&L if we roll it out. There’s no hardware gross margin in this business; we own it. There’s no transfer of title, we amortize the hardware over the expected useful life of the bike. The frame has a longer shelf life than the console. I expect the gross margins in this business to push high 70s to low 80s, with attractive customer acquisition costs. So far, nothing I've seen gives me pause related to it, though I know it won't be a straight path, and we may need to do some engineering.

Peter Stabler, Senior Vice President, Investor Relations

Next question, Tom.

Operator, Operator

The next question comes from Aneesha Sherman with Bernstein. Please go ahead.

Aneesha Sherman, Analyst

Hi, thank you for taking my question. Your point around digital being the tip of the spear and leading the way towards getting to 100 million, how does that fit with your point of international? Would you consider digital-only or digital-first expansion internationally to avoid some of the drag on margins you talked about earlier in the call? And related to that, last quarter you discussed going dark on marketing to understand the baseline. Has that plan changed now that you're thinking about top of the funnel and improving brand awareness? Thank you.

Barry McCarthy, CEO

Yes, going dark on marketing was not my plan. I've focused on what makes sense for driving business growth. The frame of reference I bring to that decision-making is LTV to CAC. Regarding international growth and the digital app, the answer is yes, but it remains to be seen what our value proposition for consumers will be, what's going to be in the app, and how we position it relative to all access. Historically, the approach has been all access first, digital later, which I think we need to change.

Operator, Operator

The next question comes from Rohit Kulkarni with MKM Partners. This will be our last question. Please, go ahead.

Rohit Kulkarni, Analyst

Great. Thanks for squeezing me in. A couple of questions for you, Barry. Can you talk about the obvious gaps in talent that you're trying to fill at Peloton? You talk about tech debt. Also, any examples of what improvements in processes or execution timeline can be made if you’re able to resolve the tech debt? And then finally, regarding the $800 million annual run rate savings by fiscal year 2024, why does it take so long to achieve these savings rather than just achieving them by next fiscal year if you're trying to get to cash flow breakeven? Is there a scenario where you could achieve these run-rate savings a lot sooner?

Jill Woodworth, CFO

Do you want me to take that restructuring question first?

Barry McCarthy, CEO

Sure.

Jill Woodworth, CFO

When considering cost per unit improvements through better design and procurement, you have to sell through your existing inventory first. We'll broadcast our inventory position at this juncture. But it will take us through fiscal 2023 to sell down. That’s one main reason for the longer time frame on achieving better cost per unit and realizing a lot of the COGS savings, which I think we stated amounts to $300 million by the end of fiscal 2024. As for OpEx, we’re moving as quickly as possible. Certain things will take more time as we transition out of certain real estate we occupy from a corporate perspective. We’re accelerating efforts but of the $500 million, we expect $450 million within fiscal 2023. We aimed to reach that $500 million run rate by the end of fiscal 2023, but COGS will take more time.

Barry McCarthy, CEO

Some of those savings are run rate-related. For instance, taking out $200 million from marketing partly stems from taking a different structural approach to how we market. The product savings are realized over time. This same reasoning applies to projected savings in G&A. The first part of the question was regarding gaps or what?

Jill Woodworth, CFO

Any talent you want to discuss?

Barry McCarthy, CEO

None that I want to highlight on this call. People at Peloton are getting tired of me saying talent density is job one. If there will be additional positions filled, you'll hear about them after the fact, but you should expect that there may be more talent in the building than you would have expected. Concerning tech, the business was outsourced, and a lot of software created issues. The business started to see some success, and like all tech companies I’ve been associated with, the resources were then focused primarily on engineering and product to accelerate growth. When COVID hit, the business exploded from 700,000 subs to 3 million subs, yet all those issues remained. The order management system is still using the original hacked code from when the business was first organized. Very much of that needs to be rewritten, and many downstream issues exist because of the way the order management system was structured, affecting systems related to accounting as well. For instance, there are 13 or 16 different screens customer service reps look at to see complete customer history. We’re bringing in a new Head of Customer Service, and we will address these issues so that when customers call us, our service representatives are able to be more helpful by organizing all that information on one screen. Examples of challenges also include pushing code in our engineering team, with a drop in productivity of engineers. Spotify effectively handled this issue in previous years, and we need to resolve it here. Consequently, it slows down our speed of updating the e-commerce platform or A/B testing. We should have to wait until the end of June to conduct website testing. That would take about 1.5 days at Netflix early on. It is what it is, and we’ll work through it. We understand the issues and will acquire the expertise needed to resolve them.

Operator, Operator

This concludes our question-and-answer session and I will turn the conference back over to management for any closing remarks.

Barry McCarthy, CEO

Okay. I'm sorry that we sort of ended on that downer note, because notwithstanding the stock price, I’m feeling pretty optimistic about the path ahead and the number of levers we have to turn to improve the operating performance of the business. I don't mean to sound overly positive, but I’m hopeful we'll look back on this call as an important turning point in the business. I look forward to checking in with you next quarter on our progress.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.