Short answer, yes. For this investor. There is some nuance to that conclusion provided below and a lot more discussion provided in the attachement.
Investment Thesis
Current price of 68 cents for Peloton’s $1b senior zero-coupon convertible bonds (“ZCCB”) maturing on February 15, 2026 (CUSIP 70614WAB6) implies a return of 10.3% to an investor who buys and holds the bonds until maturity. Peloton have the right to redeem the bonds early from February 20, 2024.
Upside of 22.5% return exists if Peloton exercise their early redemption right.
Peloton is a fair business with some notable weaknesses including the one way correlation between the connected fitness products (lower margin) and subscriptions (higher margin) as well as the niche market of home gyms. The current price of the ZCCB is not a win-win scenario in the context of all the stakeholders. ZCCB holders have an inferior position without the returns to justify the position.
I recommend a target price of 40 cents (23% return in 2026, 51% return in case of early redemption) and not investing at the current price level.
Executive Summary
· Investors in the ZCCB are subordinated, unsecured and have a contracted return which is currently priced too close to the senior secured syndicated lenders to justify a downside risk which is asymmetric with that of the secured lenders (SOFR+650 and an OID of 95 – 96 cents and enforcement rights which give them access to any upside related to a restructuring of their debt into equity and subsequent sale).
· ZCCB investors do not have an opportunity to take an activist role. Peloton management are as incentivized to take direction from the ZCCB holders as they to take marriage advice from the senior secured lenders. Ideally, a credit investment in a mid-market company should have covenants which instill structure and disciple in the business as it develops as well as means for the investors to protect themselves and limit their downside. The ZCCB appears devoid of those types of mechanisms. It isn’t clear, from public data, if the ZCCB holders had to approve the senior secured loan but one would have to wonder why they didn’t ask for “a second lien” or similar consideration was not sought in exchange for waiving that covenant if it existed.
· Managing inventories and the associated costs has been a key topic in the last three earnings calls but results have not shown significant reduction of either. I agree with Barry McCarthy’s, CEO, statement, “Turnarounds are hard work.”. Mr. McCarthy arrived in February 2022. He hired a head of supply chain in March, a new CFO in May, and raised $750m of secured debt capital in between. I interpret those new recruitments and banks lending money as good signs but not indications that the turn around is complete (or anywhere near there).
· Burn rate of Peloton’s current business structure (combination of sales, costs & inventory levels) is $400m per year; $200m capex, $185m overspend on COGS + SG&A + R&D and interest expenses. Peloton has sufficient cash to continue to operate through the maturity of the zero-coupon convertible bond due in part to the overspend on costs being paid in share-based compensation. Pull to par on the ZCCB either through early redemption (from 2024), repayment in 2026 or market movements in the security price looks probable with the current business model assuming employees continue to accept stock-based comp en lieu of cash. Employees opting for cash results in the company being unable to repay the ZCCB in my base case analysis.
· At $10.51 per share down from >$160 per share at the peak, a question of how long the employees, management and shareholders will continue to support c.$350m p.a. of share-based comp arises. As noted above, ZCCB holders are holding the weakest hand at a table with senior syndicated secured lenders and investors. ZCCB holders can only hope that senior secured lenders will force management to keep the beneficial non-cash item of share-based comp on the balance sheet if current issues with costs and inventory aren’t rectified. After that, all three parties at the table are going to be hoping the employees don’t revolt.
· >$200/share Covert price is not within reach of the intrinsic value of the current business model. I don’t have a crystal ball to predict market sentiments and the price they may pay for the equity in the future, but the probability of a conversion upside looks remote.
· Intrinsic value of Peloton is negative (<$0) in the Base Case. Future gross margins of c. 26%, in line with the average gross margin realized since Q3 2021 (Mar 2021), are too low and result in negative operating income and negative free cash flow to service debt.
· I recommend against purchasing the zero-coupon convertible bonds. Combination of current ZCCB market price implying a base case return of 10.3%, ZCCB investors having zero control over the direction of the company and are exposure to 100% downside is not a compelling picture.
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