Earnings Call Transcript - PTON Q1 2024

Operator, Operator

Good day, and thank you for standing by. Welcome to the Peloton Interactive 1Q 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ remarks, there will be a question-and-answer session. Please be advised 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.

Peter Stabler, Head of Investor Relations

Thank you, Ken. Good morning and welcome to Peloton's first quarter and fiscal 2024 conference call. Joining today's call are CEO, Barry McCarthy; and CFO, Liz Coddington; and Chief Marketing Officer, Leslie Berland. 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. I'll now turn the call over to Barry McCarthy.

Barry McCarthy, CEO

Morning, everyone. Thanks for joining us. In a break with tradition, I invited Leslie Berland to join us, knowing that growth is on everyone's mind. And this begins a process whereby in future calls, you can expect me to invite other operating executives so that you have an opportunity to gain exposure to them and they have an opportunity to gain exposure to you. You can hear firsthand from them about different aspects of how the business is being operated. And with that, we'll open the phones to questions, Josh.

Doug Anmuth, Analyst

Thanks for taking questions. I have two. First, the number of different growth initiatives going just as you think about your forecast for revenue growth and positive EBITDA and substantial free cash flow in the back half of the fiscal year. Can you just help us rank the two to three biggest drivers across these various initiatives? And then secondly, how do you think about the timing for the Lululemon partnership to benefit the business just given access to their large membership base? Thanks.

Barry McCarthy, CEO

Well, let's see. From my perspective, with respect to the drivers, a couple things. One is we're going to reintroduce the Tread+ this quarter and begin taking pre-orders. If we're successful, that will be a big driver of incremental cash flow and revenue for us. Remember, we have all of that inventory in the warehouse already, fully paid for, and sent before I walked in the door. So that would be the first point. The second is continued success in growing app-related subscribers. I'm sure we'll have more questions about how we're thinking about that opportunity going forward. Finally, we need to achieve continued success with the core all access membership. I think our growth projections are reasonably conservative in that regard. So that's how I'm thinking about the growth initiatives. In terms of Lululemon, that's live, and we are benefiting from it as we speak. So actually, there's nothing more to say about the economics of that on a going-forward basis.

Liz Coddington, CFO

Yes, the one thing I can add on Lululemon is that we just started having our content available for the Lululemon studio members who have a mirror that actually went live yesterday on November 1st. As far as receiving the revenue-sharing benefit from that agreement that we have with Lululemon, that started effective in November. We expect roughly about $10 million of revenue for Q2 coming from that subscription revenue for us.

Barry McCarthy, CEO

Yes. There is an apparel component to it. It started phenomenally strong. Then an initial launch in Chicago drove a tremendous amount of store traffic for them and a huge increase in apparel sales for us. We will be working on a more complete integration of that opportunity, although that will develop a little slower over time.

Doug Anmuth, Analyst

Thank you.

Operator, Operator

Thank you. One moment for questions. Our next question comes from Shweta Khajuria with Evercore ISI. You may proceed.

Shweta Khajuria, Analyst

Okay. Thank you for taking my questions. Could you please talk about the promotion environment this year versus last year and any change in your strategy in terms of running promotions this year? Length of time, the depth of promotions, any comments on that, please? And then the second is how should we think about your guidance for the quarter and for the full year? Puts and takes that are baked into or the assumptions that are baked into your guidance and any potential impact from these new partnerships that you are accounting for in your guidance for the full year? Thank you.

Barry McCarthy, CEO

Let me say just a brief intro. I'll turn it over to Leslie to discuss her thoughts about the promo environment for the current quarter. Liz will take the last part of the question. I believe that on a Q-over-Q basis for the completed quarter, we had a higher AST and were less promotional than we were a year ago. We were higher by approximately 3%, which reflected in the improvement in gross margin on a year-to-year basis, along with the 31% increase in gross profit that helped deliver in the quarter. Leslie, would you like to talk about the holiday?

Leslie Berland, CMO

Yes, absolutely. Happy to be on the call. I think we're very excited as we embark on holiday. We always bring exciting value to both our members and new customers as well. I think what's interesting to mention is how we bring these promotions to life. We've really learned over the past couple of months regarding digital and social media marketing, specifically creator and influencer marketing, which reframes and contextualizes both this value and the promotion. We're seeing really strong traction in all of our work in this space, and you will absolutely see this come to life during the holiday. The other part I will mention is what you read in the shareholder letter around our partnerships. Much of our partnership work is starting to take form at the exact same time and being in several markets as well. So there's a great sort of coming together of these initiatives in the next few months.

Liz Coddington, CFO

Okay, so I'm going to take the question about guidance for Q2 and the full year. Our Q2 guidance reflects what I believe to be a balanced view based on the macroeconomic outlook and the fact that there is some uncertainty around the performance in the holiday season. But it reflects a few considerations. It reflects the seasonality of our hardware sales and the fact that Q2 is a heavier hardware sales quarter for us. This is linked to all the holiday promotional activity. It's also a quarter where we expect astonishingly an improvement in our connected fitness gross margin. Some reasons for that and our overall gross margin is coming down seasonally as expected. Connected fitness is actually anticipated to be up, in part due to fixed cost leverage from the higher connected fitness unit sales. We also expect a slight mix shift away from our bike rental relative to Q1, as we anticipate our rental take rates to be a little lower, driven by a high promotional activity in the quarter. In addition, while this is offset by some holiday promotional activity, net-net, we expect it to be slightly higher. Our adjusted EBITDA guidance reflects the fact that we will have seasonal marketing spend to support the holiday season. It's important to understand that this media spend actually supports growth in both Q2 and Q3, so the timing of that is reflected in our adjusted EBITDA guidance. Now you had asked about partnerships. The way we are thinking about these partnerships is that they are just getting started, so there's not really an explicit benefit baked into our guidance for subscribers directly as a result of many of these partnerships for Q2. The one thing I mentioned earlier about Lululemon would be the exception. As we build out these partnerships and the structures start to take shape, gaining more traction, we'll incorporate more of that into perhaps future quarters of guidance. For the full year, I want to highlight a couple of considerations. Our back half forecast reflects our expectations for revenue growth acceleration in Q2 and Q3. Additionally, our growth margin targeting for the full year reflects our Q3 and Q4 growth margins expected to be higher, largely driven by a mix shift between subscription and hardware sales. We also anticipate benefits from the reintroduction of Tread+, while acknowledging that this is a new launch for us and carries some uncertainty in our guidance regarding its performance in the back half of the year.

Shweta Khajuria, Analyst

Okay, thank you. Thank you, everyone.

Operator, Operator

Thank you. One moment for questions. Our next question comes from Ron Josey with Citi. You may proceed.

Ron Josey, Analyst

Great. Thanks for taking the question. I want to ask a bit more about engagement trends. As Barry mentioned in the letter, you talked about an increase in monthly subscription engagement in the quarter and members engaging with longer classes. Do you think that has more to do with a seasonal usage pattern or reflects the strategy of being anywhere and everywhere, with longer and more diverse types of classes coming out? I'm curious how you use this trend of greater engagement to improve overall brand perception. With Leslie here, could you help us a little more with brand perception and what we’re doing to enhance that over time? Thank you.

Barry McCarthy, CEO

The 6% increase in engagement among all access subscribers is year-over-year. So it's not a seasonal trend. And Liz, correct me if I’m wrong, I think it's 12% year-over-year for app engagement as well. I think it reflects some progress on personalization and how we've executed on that, with Jen Cotter and her content team, as well as the differences in the preferences of the members. So if we're programming our classes well, and if more people are taking longer classes, it's because they're choosing to and we're producing enough of them, enabling discovery on the platform to better serve their interests.

Liz Coddington, CFO

I do want to correct one thing really quick. The 6% includes both the connected and the app subscribers total for app engagement.

Operator, Operator

Thank you. One moment for questions. Our next question comes from Aneesha Sherman with Bernstein. You may proceed.

Aneesha Sherman, Analyst

Thank you. Two questions from me, please. The first one is on inventory. As you're continuing to clear inventory, what is the normalized level of hardware gross margins you think the business can get to? I know you've talked about double-digit underlying margins. Does that view change now with the growth of FAS in the mix? And then I have a quick question on POP. You took an impairment of $31 million. Can you give us an update on the work being done on that and what you're expecting as the outcome? Are you still expecting a sale? Thank you.

Liz Coddington, CFO

I can take the question on POP first. In the quarter, we took an impairment of only $15 million in this particular quarter. We are still looking to sell POP, talking to a variety of interested parties, and we hope to make a sale soon, but we are still working on that. Regarding inventory and normalized hardware gross margin, we do expect to move into a more normalized inventory position. We've been purchasing inventory as we prepare for the holiday season. I want to comment that in Q1, it was a use of cash, but from Q2 to Q4, we anticipate a bit of a tailwind on inventory. By the end of the year, we expect to be pretty normalized regarding inventory and the seasonal cash flow that the business historically has. We see some benefits as we transition to that more normalized inventory position, and we don’t expect any further write-offs of inventory. We're better managing our reserves, and on a unit economics basis excluding promotions, all our SKUs are generating double-digit gross margin positive aside from the guide.

Aneesha Sherman, Analyst

Okay. And can you talk about how the impact of FAS might change the normalized gross margins going forward?

Liz Coddington, CFO

Yes, so a little about FAS. In terms of the impact on gross margin in Q1, FAS was less than a 10 basis points impact on our overall gross margin. So relative to the size of FAS compared to the overall size of our business, it’s a bit of a drag, but not a huge drag on gross margins. The reason FAS impacts our gross margins is that when people join FAS, they pay a fee for the delivery, and our cost to deliver that hardware is more expensive than the delivery charge we charge the customer. So as we grow that part of the business, you will see that impact on gross margin in the first month of the FAS subscription.

Aneesha Sherman, Analyst

Really helpful. Thank you.

Operator, Operator

Thank you. One moment for questions. Our next question comes from Eric Sheridan with Goldman Sachs. You may proceed.

Eric Sheridan, Analyst

Thanks so much for taking the questions, maybe two if I could. In terms of FAS, has there been anything you've learned so far on the subscription side that we might see you extend out subscription options into other connected fitness hardware products over time? I'm thinking about relaunching Tread and coming back to market with that with maybe new messaging. That would be number one. Then I just want to ensure we understand the messages on the app strategy and what you're seeing. In terms of applying marketing dollars and ROI, how would you characterize the success you've had in terms of the free tier of the application layer versus the paid tier and elements of how the conversion funnel continues to evolve for the application strategy? Thanks so much.

Barry McCarthy, CEO

Let me jump in on FAS and I'll say a few words about the app strategy and then ask Leslie to join. I think it's unlikely that we will extend FAS at least to treads and treadmills because that installation is more complex than the bike. It’s possible that we might extend it to rowing, but it’s still quite early in the life cycle of that product, and I think we have more to learn before we would consider doing that. So overall, we have our hands full with the growth opportunity that FAS currently presents at a 90-plus percent year-over-year growth rate and having just opened up Germany, where it started off, with very small numbers, but going much faster than we were forecasting. There is plenty for us to focus on with FAS as it stands. Regarding the app strategy, the marketing team was tremendously successful in driving high volumes into the free tier. However, we were not effective at converting those free users into the paid funnel, which is why we shifted our focus back to the paid app in Q1, where we've achieved great success. We’re seeing higher price points than we initially forecasted with significantly higher take rates for the app plus subscription.

Leslie Berland, CMO

Yes, and I'll just jump in a bit to provide context on the strategy and some of the interesting data points that we observed. The goal, including the app, is to energize our core member base and attract new and under-penetrated demographics that have historically not represented our core member base. The app provides an amazing opportunity in terms of our free message, giving us a remarkable chance to rebrand and relaunch our brand. We initially anticipated massive volumes of downloads, and what's intriguing about that, tied to our objectives, is we brought in new demographics. We brought in people who represent our core member base, but we also saw considerable growth with free and paid demos including men, Gen Z plus, and others. These areas, along with our partnership efforts, represent where we will continue investing to drive relevance and engagement both with our current members who represent those demographics and also for new growth opportunities.

Nathan Sheldon, Analyst

Hey everyone, this is Nathan Sheldon on for Lauren. Can you provide an update on how rental churn has progressed? Are you seeing that decline as we anticipated a few months ago? Additionally, how should we think about the range of outcomes you're now considering for the steady state of churn going forward? Thank you.

Leslie Berland, CMO

I can answer the first part of your question, Nathan, but we missed kind of the last part of your question about something that is somewhat garbled, if you wouldn’t mind repeating that.

Nathan Sheldon, Analyst

Yes, just how can we think about the new range of outcomes to the steady state of churn rate over the long-term? Thank you.

Leslie Berland, CMO

In terms of churn for our rental subscription model for FAS, in Q4 we mentioned that we experienced an uptick in churn concerning the bike seat post, and we saw that for FAS as well, but we have seen it decline substantially from the peak in Q4, roughly by 100 basis points. However, it's still higher than our all access regular member churn. Your other question was about churn in general. We did see an uptick in churn due to increased pause numbers. We expect to see our churn rate come down in Q2 and Q3 as well.

Barry McCarthy, CEO

Let me spend a minute discussing the changing mix of the subscriber base and the growth in rental. As the mix changes over time, people need to understand.

Leslie Berland, CMO

Overall, we see different churn rates for these different types of Peloton subscribers. We have our regular all access members who purchase new hardware from us. Then we have the bike rental model for our rental subscribers. Finally, we have a third group, which is comprised of secondary market individuals who buy their hardware from someone else in a marketplace that we do not facilitate. For our regular all access member base, we see the lowest churn rate in general. It varies somewhat seasonally, but it’s typically lower, closer to 1%. I don't have the exact number in front of me for that group. This last quarter, it's probably around 1.4 or 1.5. Then we have the secondary market group, which has a higher churn rate, generally at around 2% to 2.5%. Finally, we have the bike rental group, which experiences churn rates of around 5% to 6%, influenced by seasonality.

Barry McCarthy, CEO

It’s worth spending a moment discussing the secondary market, which has seen significant growth. The source is usually a Peloton all access member who cancels, which shows up in our churn numbers. On average, within six months, a bike that was sold in the secondary market by a canceled member likely ends up being purchased by a new member, rejoining us as an all access member. While our core business continues to grow, the secondary market is expanding even faster. This means that the 1.4% churn rate on all access members is actually lower on a net basis, and it also implies that if the secondary market continues to grow faster than the new sales market, our reported average churn rate may gradually increase over time, even if the behavior of the individual cohorts remains consistent. If the cohorts start to deteriorate, we will inform you.