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Did Peloton Ever Have a Moat?
Last week, Peloton announced that its co-founder and CEO would be stepping down to become Executive Chair, while also announcing significant layoffs.
This comes after an earlier article that discussed how the firm used the advice of McKinsey to restructure and cut high costs.
Peloton, which became the work-from-home and gym-lockdown poster child at the height of the pandemic, is now trading at a fraction of its maximum value (at $37.46, down from $162.72, to be precise).
While I am not going to litigate any mistakes the firm might have made, I will focus on one crucial question: Did Peloton ever create a moat?
This is an interesting question since it is clear that the company was growing very fast. Most firms try to accelerate their growth because they want to convert that growth into a competitive advantage, or in other words, into building a moat. And while this may seem obvious, the reality is that most firms grow without actually having the ability to create that moat.
So before we go deeper into Peloton, let's briefly discuss moats.
The term moat, or economic moat, which was popularized by Warren Buffett, refers to a venture's ability to maintain competitive advantages in order to protect its long-term profits; just like a moat protected those inside the castle from attackers, in medieval times.
The different types of moats are:
Intellectual Property (IP): owning the rights to a certain patent, copyright, or trademark (or know-how, even if not patented) that allows a firm to offer a better solution than the existing technology does (i.e., a faster search engine, a more effective drug). This is very common in pharmaceutical and telecommunications companies.
State Granted: the state grants the firm exclusivity to customers or assets. For example, the right to a specific spectrum of radio frequency or the right to mine a specific rare earth mineral, etc.
System Rigidity: otherwise referred to as switching cost. Customers are often reluctant to switch from one product or service to another because they don’t like discontinuity, or because they already exert relationship-specific costs. When the apps you use regularly exist only on your iPhone, for example, you are less likely to switch. If a firm has invested in training its salespeople on Salesforce, it’s likely to continue that way. Some of these decisions are economic-based, but most are behavioral. Note that this holds only for existing customers, and doesn’t translate into a competitive advantage for new clients.
Scale-Based Moats: when a firm, by virtue of its scale, is either reducing its cost (supply side) or increasing value to its customers (demand side). The latter happens in markets where there are significant network effects, such as social networks (Facebook), and two-sided markets (Airbnb). The former occurs primarily in more traditional manufacturing, cloud computing, or e-commerce, where significant investment is needed, but the marginal cost diminishes over time (Walmart, Amazon, TSMC).
Note that a firm may have multiple moats, and the more it has, the more it should scale to deepen the moat (i.e., its competitive advantage).
Does Peloton Have any Moats?
While I’m no branding expert, I know that Peloton has a very strong brand. But what I’m asking is: In the absence of a brand, is there a real competitive advantage that deepens over time?
So let’s start with the obvious, Peloton has no IP-based moat. The bike is very stylish and I am sure it’s not easy to build the software that delivers the real-time sessions, but neither is something a capable competitor cannot replicate.
The same is true for state-granted moats. The firm doesn’t have any, and I am not saying this in a negative way. It’s just a fact.
What about switching costs? Peloton was actually doing quite well with customer loyalty:
“In the last quarter, the churn rate was just 0.64% per month or 7.68% per year. The pandemic brought down the churn even more but it was never above 1% per month. The average gym has a yearly churn of about 30% and the more upscale clubs (like spinning classes) still about 20%.”
Of course, it’s being measured over a relatively short period of time, and the comparison should not necessarily be with gyms, but rather with home appliances and other fitness equipment (albeit comparing it to gyms is interesting given the Peloton subscription fee).
Nevertheless, with an annual churn rate of less than 8%, Peloton has a high customer stickiness, which indicates significant switching cost.
However, the problem with moats that are based on customer stickiness is that while they definitely help retain current customers, they don’t translate into a competitive advantage that can be used to attract new customers. In a world where you are expected to grow continuously (and your stock valuation is tied more to your growth rate rather than your profitability), the ability to build a competitive advantage that allows you to attract new customers is an absolute must.
The key question is: Is it possible to use the existing customer base to attract (and then retain) the next customer cohort.
The only way to achieve this is either by lowering your costs via scaling, which can be translated into lower prices, or by increasing the value of the product and service via a larger scale.
Supply and Demand Based Economies of Scale
Let’s divide the discussion into two:
Does Peloton exhibit (not only claim) any cost-based economies of scale?
Does Peloton exhibit (not only claim) any demand-side economies of scale?
We will view (1) through the lens of the cost of manufacturing or servicing the marginal customer, and (2) through the lens of network effects: has the CAC (customer acquisition cost) decreased, and has the ARPU (Average revenue per user) increased?
Neither of the above has a zero-marginal cost. Manufacturing bikes costs money, and while the subscription may be more incremental in cost, the more virtual workouts you join, the more music licensing you have to pay for.
But first, let’s take a look at Peloton’s business model. Peloton makes its money by selling fitness products like cardio bikes and treadmills, as well as workout accessories and apparel. In fact, $1.46 billion (79.8%) of Peloton’s total revenue of $1.83 billion, came from selling fitness products in 2020.
Let’s start with the Bike.
There are limited economies of scale here, primarily because most of the costs lie with manufacturing, suppliers, shipping, etc. Peloton’s cost-of-goods-sold margin averaged 59.8% over the last 5 years, and fluctuated between 66.2% (2017) and 54.2% (2020).
So we see some economies of scale, but not enough to create a competitive advantage, given the lack of consistent improvement in this metric. The firm really never competed on cost, so this is hardly surprising, but it didn’t excel in cutting its costs either.
Now let’s take a look at the Subscriptions.
In 2021, Peloton counted 2.49 million connected fitness subscribers, an increase of 87% YoY, while its entire member base totaled 6.2 million. Connected fitness subscribers are people who own a Peloton product and also pay a monthly fee to access all digital workout content.
But in order to give these numbers a monetary dimension, here is the Peloton subscription cost:
Digital Membership for $12.99 per month
All-Access Membership for $39 per month
So if more people are convinced to pay a membership fee, and the churn is very low, then even with a very high cost of acquisition (approx. $1,000 according to various estimates), the firm will still make money on every customer.
But again, I am asking a slightly different question: Is the firm creating a competitive advantage in a way that the cost of providing these workouts is decreasing as more customers join?
For those who don’t own a Peloton, it’s important to note that the bike can be used just as any other stationary bike, but if you have a subscription, you can access live workouts. Although the number of people joining these workouts is not very reliable, it’s clear that the marginal cost of providing such a workout for one more participant is almost zero.
The average cost per workout though, is not. The instructors are paid (mainly based on their popularity, with some making more than 500K a year), the studios are expensive to maintain, and music streaming is not cheap (according to some estimates, it’s almost $1 per customer).
Overall, the marginal cost of providing virtual workouts is not all that high, but again, this is primarily a competitive advantage concerning existing customers, and it implies that the firm can reduce the cost (and with it the price) of subscriptions, if it chose to.
But the question remains: Does the firm have any network effect (demand-side economies of scale) that allows it to increase its value to both existing and prospective customers?
Counter to statements by others, I would argue that it doesn’t.
Peloton and Network Effects
One can analyze Peloton’s network effects in two ways: among bike owners (cyclists) and among cyclists and instructors.
Network effects among cyclists: If I own a Peloton bike, and a friend of mine gets one too, am I better off? We could join the same live sessions (along with another 23,000 people), or we could track each other's progress (just like on Strava). But unlike Peloton’s former CEO who “saw everything except the community,” I still fail to see the real value of this network and how it enables connection among people. I am not saying there is no word of mouth and virality. But real value? I don't see it.
In fact, over time, Peloton had to decrease the price of its subscription, which of course can be part of a growth strategy (and it is), but it’s clearly not a demonstration of excess and increasing value.
Network effects among instructors and cyclists: Instructors are paid by the hour (with a bonus for popularity), but Peloton is hardly a platform. If more instructors join, am I, as a cyclist, better off? Maybe marginally since I have slightly more options, but since popularity is a factor, I’m probably going to want to stick to the instructors I am happy with. If more customers join, are the instructors better off? Maybe, in a limited way, through the company’s decision to pay them more, but not by enabling them to connect with more people. And again, we don’t see a strong indication of this in the data.
What Triggered the Discussion
We like firms that grow. And we should. But growth also hides significant pitfalls.
Everything looks great as long as you are growing. Then, the music stops and the lack of a real competitive advantage is exposed.
The big fall in Peloton’s shares came after announcing that:
“Sales of connected fitness products, including its Bikes and Treads, fell 17% to $501 million. Subscription revenue grew 94% to $304.1 million. Connected fitness sales accounted for 62% of Peloton’s business in the quarter.”
And it seems that a cost-based moat is necessary because:
“In August, Peloton slashed the price of its original Bike by 20% to $1,495. On Thursday, Chief Financial Officer Jill Woodworth said that while Bike sales accelerated after the change, the results haven’t entirely met Peloton’s expectations.”
And this is the core issue: with every product, you exhaust the current market. You need to go deeper and build a true competitive advantage if you want to stay ahead of all those who will start copying you and convince the unconvinced.
Peloton seems to be struggling with this.
Their current consumer base, which also seems a little less excited about using its Peloton now that it can go outside or back to the gym, was not used in order to create a real advantage, sufficient enough to attract new users.
Peloton will most likely be acquired by a firm that will use it to deepen its own moat. But the model, as a standalone, seems to have run its course.
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