Peloton, the premium Connected Fitness company that sells $2,000 stationary bikes and $4,000 treadmills, recently filed its S-1 for an IPO. One of the more interesting investor debates taking place is whether Peloton is a hardware company or a subscription service. Peloton bears argue that the company is selling overpriced commodity hardware, while the bulls argue that the company is selling a customer experience – premium connected fitness hardware differentiated by a subscription service. If that sounds familiar, that’s because it draws comparisons to the most successful hardware-differentiated-by-software business in the world – Apple. So, does Peloton have Apple qualities?
First, let’s consider the business model. Peloton sells premium fitness hardware (currently just stationary bikes and treadmills) at what many consumers would consider to be exorbitant prices, even compared to other premium fitness brands. The element that sets Peloton hardware apart, however, is its subscription service. Peloton owners can pay $39 a month to subscribe to unlimited live and on-demand fitness classes, track their workout metrics, and compare their performance to other Peloton users. Think of it as a Soul Cycle class in the comfort of your own living room, with a higher upfront fixed cost but lower ongoing monthly costs. For those interested in the classes but are unwilling or unable to pay the hefty upfront hardware cost, Peloton also offers a digital-only membership for $20 a month but lacks connectivity to workout metrics and other Peloton users.
There are some obvious similarities to Apple – both companies sell hardware at a premium and justify that premium through a differentiated experience – Apple through iOS, the App Store and increasingly its proprietary paid apps, and Peloton through its connected live and on-demand fitness classes. But that is where the similarities end. While both companies generate higher-than-typical hardware margins – over 30% for Apple and over 40% for Peloton – only Apple “makes money” from hardware as Peloton uses the gross profit from selling its fitness hardware to offset its substantial sales and marketing expenses to arrive at a net Customer Acquisition Cost (“CAC”) of approximately zero. It is possible that with sufficient scale, Peloton’s hardware margin could more than offset the investment in sales and marketing, but it is also possible that cheaper hardware alternatives drag down the price of Peloton’s bikes and treadmills while also pushing up sales and marketing expenses.
By netting sales and marketing expenses off against hardware gross profit, Peloton wants to draw investor attention to the high lifetime value (“LTV”) of each subscriber, which the company estimates to be almost $3,600 based on the $39 per month subscription price and less than 1% monthly churn. Compared to a “net” CAC of zero, this looks very attractive. Management is, in effect, trying to position Peloton as a subscription business.
Two issues arise here that investors need to consider. Firstly, a true subscription model is attractive because of zero marginal costs of distribution. In Peloton’s case, there is very much a marginal cost of distribution to the subscription business – the cost of the hardware. Whilst management would love investors to consider the two separately, it is impossible because subscription and hardware sales are intertwined. Subscriptions require a Peloton bike or treadmill, and although the digital-only membership has zero marginal cost, there are no hardware profits to offset sales and marketing costs. This is not to say Apple has zero marginal costs of distribution for its services business, as the iPhone still costs several hundred dollars to manufacture, but the App Store and the proprietary paid services are incremental benefits from owning an iPhone, rather than the other way around.
Secondly, a high LTV is only attractive if the total addressable market (“TAM”) opportunity is equally large. Peloton estimates the TAM for its fitness hardware (and by extension its subscription service) is 67 million households globally and 45 million in the U.S., with a serviceable addressable market (“SAM”, based on existing products and price points) of 14 million and 12 million globally and in the U.S., respectively. With 577,000 connected fitness products sold globally to-date, Peloton has 4% penetration of its SAM. But investors must remember that the $3,600 LTV comes with a $2,000 to $4,000 upfront entry fee for the customer, and to suggest that nearly 10% of U.S. households would be willing to pay that much for a piece of exercise equipment that costs a further $39 per month may be a stretch.
Additionally, each “subscription” comes with unlimited user profiles, which further shrinks the TAM at the household level. For example, the two Peloton bikes in the gym of my apartment building serve nearly 150 households for $78 a month, and even then, they are hardly used by the tenants. This results in worse dynamics than account sharing for other subscription services such as Netflix, as one Peloton in a gym can serve any number of users.
Peloton claims to be a “technology company that meshes the physical and digital worlds to create a completely new, immersive, and connected fitness experience”, but it is ultimately up to the investor to determine if these claims fit a company that sells expensive hardware with attached subscription services. Comparisons to Apple’s hardware-differentiated-by-software model during the iPhone’s heyday are not without merit, although the question of whether Peloton is a truly disruptive innovator remains open to debate.