Bernstein Analyst Aneesha Sherman joins Yahoo Finance Live to discuss Peloton earnings, consumer demand, and the outlook for growth.

Video Transcript

- And everyone, switching gears, getting back to Peloton, are you still riding? Shares tanking after the company reported a wider than expected loss in the third quarter. Revenue declined 24% year over year as the company also slashed its fourth quarter revenue outlook, citing softer demand. For more on the future of Peloton, let's bring in Aneesha Sherman, who is the Bernstein senior analyst. Aneesha, first and foremost, we've got to get to your particular rating on the stock, how you look at Peloton even after this report.

ANEESHA SHERMAN: Yeah, I mean, this quarter was all about the problems with hardware. Hardware sales were half of what they were a year ago, and hardware inventory is double what it was a year ago. So there's just too much hardware sitting in warehouses that isn't selling, and it stems from the oversupply and the over ordering over the course of the pandemic.

And so this is the big challenge. Subscription revenues actually were up year over year, and user engagement on the app continues to be up sequentially. Those metrics are good.

The hardware is what's bogging it down. So I think it's a question of we need a few more quarters to work through that inventory of hardware to get back to a positive free cash flow position. But I guess the question is now, in an environment of growth, in an environment of excess inventory, with rates going up, with potentially spending coming down across the sector, is this going to be tolerated by investors?

So I think that's the big question related to the stock. I think on a 12 month basis, I'm still positive on the trajectory. We should see sequential improvement through the year as that hardware inventory base starts being wound down. But I think the question is to what extent are investors going to be able to wait that out rather than look for other opportunities in the short term.

- Oof, that's a tough question, Aneesha. I mean, you know, and to Brad's point, you still have an outperform on the stock because as you say, you are long term positive and confident that they'll be able to work out these issues. But it does seem like that they have some really hefty challenges above them. I mean, is your rating in part a vote of confidence in the new CEO that he'll be able to get his arms around all of this?

ANEESHA SHERMAN: To some extent, yeah. And as he said on the call, the analysts call this morning, he inherited this business kind of halfway through the quarter. So we weren't really able to see his work as much in Q3 as we will in Q4.

And so he talked about some of the challenges of inheriting the business and the problems with it and not being able to turn around the business within a month to which-- to the extent where we could see results coming out of this quarter because the quarter ended March 31 and sounded a lot more optimistic when we were talking about Q4 and certainly FY23. But you know, that's now talking about two more quarters that we need to wait to see that performance come through.

- Aneesha, are two words on the earnings release raised red flags to me, and that was by Barry McCarthy, the CEO of Peloton-- thinly capitalized at the very bottom of the release. Now you don't normally hear that from an accomplished executive like Barry in this type of tech tape. What do you think he meant by that, and do you think he is signaling some form of outside investment nearing, and what might that look like? Or are Peloton investors looking at getting diluted again?

ANEESHA SHERMAN: So he did say that he has no intention of diluting shareholders. They just raised $750 million of debt. They have a $500 million unused revolver.

I think it's about cash flow buffer in an environment where supply chain logistics, storage of these bikes is getting more and more expensive. And that cost is unpredictable. So I think it's back to the hardware. You know, when you have a bunch of unused hardware that's sitting in warehouses, that's difficult and expensive to store. And storage and freight costs are unpredictable.

And so you need enough of a cash buffer to get through until you're able to unwind that inventory and then benefit from cash flow. So again, it's weighting those couple of quarters before the hardware can sell through before they can end up with a much leaner inventory position. It's right now 20% of sales.

- When you have, though, a decline in connected fitness products revenue down, like we saw year over year, 42%, and more of the subscription revenue growth that you had seen, what does that do to the pipeline, the roadmap of customers who are going to convert from digital only into a connected fitness device, and how does that impact even the profitability for a company that has leaned into those connected fitness devices as well for the majority of its revenue pie?

ANEESHA SHERMAN: So that's one of the pivots that we're going to see. The new CEO is a subscription, a software guy, and his strategy is very much to focus on content and digital as opposed to focusing on the hardware. And I think that is the right strategy.

The hardware is not what differentiates Peloton. It's the content. It's the experience.

It's the platform. And for too long, it's been a hardware company. It's known as a bike company.

I was amazed to see in the release that there's only a 4% unaided awareness for the digital app in the US. Only 4% of people know it exists. So there's a lot of opportunity to increase the subs revenue stream, which is much higher margin, much lower incremental marginal cost, rather than focusing on the hardware. And the way they're doing that is lowering the price point of the hardware and raising the price point of the subs to gain more revenue from the subs and use subs as a way to get people into the ecosystem.

- I know it exists. Tried it, didn't like it. But maybe they're hoping that most people don't feel the same, Aneesha.

Speaking of the content, I don't believe the company discloses its agreements with its instructors, which, when we're talking content, that's what we're talking about. We're talking about their superstar instructors. That's why people consume Peloton's content. Is there any risk that as the company, you know, has these troubles that some of these people are going to jump ship, that they'll start their own thing, or they'll go work for an athletic apparel company, for example? Is that something investors need to keep an eye on?

ANEESHA SHERMAN: There is always that risk. The company has multi-year contracts with the inspectors. They are very well compensated.

They're given a lot of freedom to do other sponsorship, other unrelated non-competitive gigs. You know, you'll see them being spokespeople for other brands. They have their own social media following.

So they are not unhappy. They were not the target of the layoffs and the cuts to compensation that went across the company because the company recognizes that they are incredibly valuable. Now there's always a risk of that happening. I think what there isn't a risk of is some kind of wholesale walkout of instructors because they're being treated badly because that isn't what's happening.

- Aneesha, I believe you also cover Lululemon. And they, of course, at the top of the market, they bought Mirror and hasn't lived up to expectations. After this type of quarter for Peloton, is it a signal to Lululemon's team that they should close down Mirror?

ANEESHA SHERMAN: Yeah, honestly, I do think they should. I mean, they don't look like they're going to. They just hosted an investor day a few weeks ago where they talked about their plans for Mirror and essentially using Mirror as a customer acquisition tool to bring new users into the Lululemon ecosystem, where they will then purchase more apparel and become loyal customers.

And my argument is there are a lot better ways to spend customer acquisition dollars than on a $500 million connected fitness acquisition. But it looks like they are going to give it a go and integrate it into a Lululemon app rather than spin it off or shut it down. I don't think that's the best way to use the cash flow. The business is going to be money losing for the next few years. What they're hoping is to use it as a customer acquisition tool to broaden their loyalty to Lululemon overall.

- They need to reinvest in some more men's inventory of pants. I go to Lululemon on the weekends, and they just don't have my size anymore. I'm tired of it.

We'll leave it there. Aneesha Sherman, Bernstein senior analyst, always good to see you. We'll talk to you soon.