Peloton, Netflix, and When to Buy Broken Growth Stocks

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Everything went in Netflix's favor, and the trading multiples almost didn't matter because the momentum was positive, the enthusiasm was there, the brand was strong. Now that's basically been upended.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard is Tim Nolan. He's an analyst covering Netflix, which is down a lot from its high. Tim just downgraded the stock to sell. In a moment, we'll hear more about why, and we'll talk with another analyst who upgraded Peloton. The exercise bike company after an enormous stock decline there. Let's try to learn not just more about these particular companies, but also about a decision facing many investors now: how to tell whether a big drop for a growth stock is a buying opportunity or a time to cut losses and move on. Listening in is our audio producer, Jackson. Hi, Jackson.

Hey, Jack.

What do you use for exercise equipment these days?

I got an old bike. I just replaced the tires.

And what do you do? You hook up a screen to it? I mean, how do you get it to stay still while you do your virtual touring?

I go outdoors.

I guess that's one way you could do it. I think I might have broken the connected fitness movement. A year ago, we had the founder of NordicTrack on the podcast. We also talked about Peloton and Hydro and the popularity of exercise machines with big screens and interactive workouts. Then months later, I bought some machines, not because it made sense financially, but because I didn't ask for this pandemic, and if deploying some extra capital can help my family keep its sanity, it's worth it. And I haven't gotten any slimmer, by the way, which proves that you can't just spend your way to fitness. I mean, I'm sure at some level you could spend your way to fitness if you hired like a chef or a retired drill sergeant, but, uh, I'm not there.

I'll put something on Craigslist.

Peloton stock was selling for around $150 a share shortly before our episode a year ago, It has plunged since then, recently slipping below $25. Peloton attracted a flood of new customers during the pandemic, but now growth has sharply slowed. NordicTrack changed its name to iFit, the name of its software platform, and it was going to go public last fall, but it changed its mind, citing market conditions. More recently, high-price growth stocks in general have taken a beating. On the expectation that interest rates will rise over the coming year. We talked about that a couple of weeks ago, and it has accelerated since then. Before we hear the bull case for Peloton stock, let's hear a few words from a customer focus group, a fairly narrow focus group, more of a focus person, really. Okay, you say your name is Rebecca. What do you do for a living, Rebecca?

I work with you and Jackson on making this podcast.

Of course you do. That's our friend and Barron's colleague Rebecca Bisdale. She bought a Peloton the October before last because her wedding was a year away and she wanted to work out, but the gyms were closed. And because she had recently been outbid while trying to buy a house, she decided to put off home buying for now, which freed up some funds. She says she still likes her Peloton a lot.

I am a little bit obsessed with it. I have my favorite instructors, but then I also have like a tier above that where I'm convinced that they're my friends.

Jack, do you get the same way, or—

If you add together my wife's usage and my usage, you get my wife's usage. Rebecca says she's using her Peloton as much as ever. The handful of times I've used mine, I've done what are called scenic Scenic rides, where you take a simulated outdoor ride. I asked about that, and both Rebecca and Jackson laughed at me and strongly suggested that scenic rides aren't serious workouts and that I'm the only one who does them. Fair enough. Rebecca says it's the classes and interactive features that keep her coming back.

I'm pretty motivated by the streaks that they show, so that kind of keeps me on it a lot.

You're so social. You're such a social exerciser.

I am. I high-five people on the leaderboard every time that I'm like, not out of breath. I follow people. People follow me.

I asked if Rebecca is interested in adding another machine like a treadmill and if it would have to be the same brand to avoid paying multiple subscription fees. And she said yes to the same brand, but that she probably wouldn't get a treadmill because, well, she falls a lot when she runs. I mean, the details are not important to this discussion, but if you insist on hearing them.

In high school, I used to trip when I ran so often that by the time I got to junior year, I get into gym class and this guy Steven came up to me. He goes, oh, I'm so excited you're in my gym class. And I was like, oh, Thank you. And he goes, I love it when you fall. It's so funny.

Oh, it's horrible.

Not a nice guy.

Didn't stop me from dating him anyway.

Thank you, Rebecca. Peloton customers pay up to $2,500 for their bikes, plus $39 a month in subscription fees. And they can buy those little shoes to clip in. They can buy some 3-pound weights. There's a mat that goes under the bike, all kinds of stuff. There are 2.8 million subscribers now, plus another 900,000 or so who pay a lower fee for an app-based subscription. Wall Street analysts have generally turned more bearish on Peloton as its share price has fallen, but one of them is going against the herd. Scott Devitt at Stifel, who was bullish on the stock through much of the pandemic and downgraded it to a hold recommendation in November, recently upgraded it to buy. He says that back before the pandemic, he had predicted how many subscribers Peloton would have by this coming June, the end of the company's fiscal 2022, and that it now looks likely to have 42% more subscribers than he had originally estimated. He also says that Peloton's share price has gotten so low that the company is attractive based mostly on the subscribers it has now without even factoring in much growth potential.

Just looking at the Connected Fitness subscribers, you know, those customers right now, they churn about 8% a year. The lifetime value of that individual customer is about $6,000 in revenue, about $4,500 in gross profit. So I started thinking, like, if all you did is refill the subscribers that churn out, you never even really grow the business again. The business is now being valued at about $3,000 in enterprise value per customer, and the customer generates $4,500 in gross profit. And that assumes no growth, no product expansion, no further global expansion.

You heard Scott mention churn, or the number of subscribers who leave. It's pretty low for Peloton, but does that mean that customers are still enthusiastic about their bikes like Rebecca? Scott says one clue is that customers are using their bikes a lot, going for around 16 rides per month on average.

It does seem like engagement's holding up, and that 16 is about 2x the average time that a consumer has a gym membership goes to a gym. So engagement relative to alternatives, it's still extremely high.

Scott acknowledges that Peloton has some warts. It didn't handle its manufacturing constraints particularly well. It lowered the price of its cheaper bike, but more recently it added hundreds of dollars in delivery and setup costs, creating some confusion. Also, Peloton insiders, including co-founder John Foley, sold a lot of stock at more than $100 a share before the big decline. That's a bad look, but Scott says it's also understandable because Management teams can end up with a large percentage of their net worth tied up in a single stock, so they sell to create liquidity. In my experience, Peloton bikes, NordicTrack treadmills, and Hydrow rowers are all high-quality machines with sleek software. NordicTrack is ahead for now on the number of different machines it offers. Scott says Peloton has an opportunity to become the Apple of the business. And he says that there are close to 100 million gym memberships in Peloton's markets, which makes the company's subscriber base of close to 3 million look like it has room for growth. That's even if he doesn't have to factor in much of that growth to like the stock.

They'll continue to grow into new markets over time as well. So I don't think that there's a long-term cap from here, but I also think that that matters less with the enterprise value, you know, approaching $8 billion now. So how much of that growth is factored in after the stock's come in so much is significantly less than approaching zero.

Thank you, Scott. Time for a look at Netflix. That's next after this short break.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, We analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.

Welcome back. I've never liked the saying buy low, sell high. It makes it sound like there's a universally agreed upon point when a stock's price has gotten low. If that were the case, there wouldn't be a market in the stock because no one would sell. The whole existence of a stock market is built on disagreement over whether prices are in fact too low or too high. If we're talking about the broad market, it's easy. Buy now and keep buying every so often and sell much, much later because there's no way to accurately predict short-term performance, but stocks tend to rise nicely over long time periods. But if we're talking about individual stocks, it's more difficult, especially in the case of fast-growing companies with dramatic price changes. Netflix stock briefly touched $700 a share in November and then got cut nearly in half to less than $360 a share at one point this past week. One high-profile hedge fund manager, Bill Ackman, made a big purchase of shares and they bounced on the news. But I noticed one analyst had become more bearish on Netflix shares as they were plunging, downgrading them from neutral to sell.

Well, we actually initially downgraded Netflix from a buy to a hold about 2 years ago when we saw the streaming wars really taking shape. And this was around the time that Disney+ launched. And it just felt like, you know, Netflix had a fantastic run for so many years, but it was getting more competitive.

That's Tim Nolan, an analyst at Macquarie Research. As he points out, streaming has gotten crowded. The comic Jim Gaffigan recently tweeted, "They should bundle all the streaming services together and call it cable." And he makes a good point. I have 8 streaming services, not counting the free ones. I have to get around to cutting some of them. I accumulated them during the pandemic. Netflix stock recently plunged more than 20% in a day following the company's latest quarterly report. Subscriber growth came in slightly below expectations, and the company's guidance for subscriber growth in the current quarter seemed exceptionally low. But Tim says it wasn't just the subscriber outlook that turned him so bearish on the stock.

What really got us actually to pull the trigger and put the downgrade to a sell rating on it was the outlook comment on operating margins. While people focus on subs very much for this company, and that certainly does matter to all of these types of streaming companies, Netflix had said they would expect a run rate operating margin increase of around 300 basis points per year, but they came out with a guidance of operating margins being down 100 to 200 basis points.

100 basis points is another way of saying 1 percentage point. So Tim's saying that instead of margins increasing by 3 points, they might fall by a point or two. And that's largely a function of spending on new shows and movies. But Tim says that in the past, when Netflix would ramp up spending, it would bring in so many new customers that margins would get a boost. Now it just looks like an industry spending war.

Look at the competition now, you know, WarnerMedia/HBO, especially when it gets together with Discovery, you know, Amazon is still very much there and everybody is like bragging about how much they're going to spend on content and it hurts everybody's margins, of course.

Netflix burned cash for many years. In 2020, its free cash flow turned solidly positive, but that was because studio production was shut down and subscriptions soared early in the pandemic. Free cash flow then turned negative again last year. Tim expects it to once again turn positive from this year on. That's an important milestone for any startup, but Netflix, of course, isn't a startup. It's a 25-year-old company that first got into streaming 15 years ago. Investors used to joke about Amazon.com that it was the world's largest nonprofit, but technically Amazon had generated positive free cash flow for many years before its earnings for accounting purposes turned positive. With Netflix, It's one thing for free cash flow to be modest or even negative while subscriptions are rocketing higher. But now it looks like growth is sharply slowing. Maybe that's just a hiccup. Growth has slowed and then accelerated in the past. I asked Tim, are there things Netflix can do to boost growth besides spending more on content?

Then it's back to the reducing price question, and that's what they've done in India. So produce more content, market it differently, better, more effectively if that's possible. And/or reduce price. Of course, in the US, Netflix has gone the other way and raised price, which I find quite surprising. In India, what they've done, which I don't find surprising, is cut price because India's SVOD market is extremely crowded, even more so than here. And most of those services are offered at, you know, a relative purchasing power parity price in India. So not $8 a month, but, you know, a fraction of that.

Tim mentioned India's SVOD market. That stands for subscription video on demand, which is the industry term for service like Netflix. Markets like India are relevant here because Tim says Netflix has more or less gained as many subscribers as it can in the US and Canada. How about offering a lower price subscription tier with advertising like some other services do? Those can generate the same or even higher revenue per user as higher-priced tiers. But Tim says that's unlikely in the near term for Netflix, and not only because the lack of advertising is part of its identity.

Netflix has never run an advertising business. I mean, you don't just start advertising. You have to get a whole staff on board. You have to, you know, establish relationships with all the agencies, with all of the— I mean, the demand-side platform ad tech companies that can be serving you the ads. It's not a simple undertaking.

Tim says there will be a price at which Netflix looks attractive again, but that investors should wait for now.

Maybe it already looks attractive now, but the way these stocks tend to trade when they're broken like this is that tends to take them a while to get back into investors' favor. I would suspect we'll at least need to see a decent Q1 subscriber number from Netflix to get the stock moving again. If they miss that, it'll stay down. And even if they beat that number substantially, I don't know if that's enough yet to really get the stock moving.

Jackson, do we have time for a quick listener question?

Yeah, we got Zeke from Zurich.

Zeke from Zurich. It's a good thing we weren't going alphabetically. We'd have to go through Aaron from Addis Ababa and Beverly from Barcelona.

Charlie from Chernobyl.

I hear he moved to Chattanooga, actually. Friend of the show. Hi, Charlie. Let's hear it.

Hey, Jack and Meta, on the last show you talked about increasing interest rates and also the discount rate that's going to ultimately decrease the market cap or share price of a lot of growth stocks out there right now. As someone in mid-30s starting to save for retirement and trying to do all the right things like dollar cost averaging into ETFs every week, how would you tactically change behavior For example, I keep putting all my money in an S&P ETF.

Thank you, Zeke. Jackson, Zeke called you Meta, who of course is our colleague who's out on maternity leave, and he's got a great idea actually. I should have been calling you Meta all along for continuity, and now I've gotten used to Jackson, so it's too late. Zeke's question is about something we talked about in this podcast a couple of weeks ago now. How the prospect of rising interest rates was becoming a headwind for growth stocks and a tailwind for value stocks. And that process has continued or even accelerated since then. Declines for some growth stocks are now large enough to raise the question of whether it's a buying opportunity. Let me answer your question in two ways, Zeke. First, if you're worried about the S&P 500 index in particular being too concentrated in giant growthy tech stocks, it's still pretty concentrated. The index's 5 largest companies— Apple, Microsoft, Alphabet, Amazon, and Tesla— were recently valued at a collective $9 trillion, which puts them at close to one quarter of the index. Some of those are down by double-digit percentages this year. Value-priced parts of the index have done better, but even so, the overall index was recently down by a high single-digit percentage year to date. So I suppose that if you're loaded up on an S&P 500 index fund, you're still pretty heavily weighted in growth stocks. You might want to offset that with a modest position in an index fund that tracks value stocks, but I don't think you should worry if you already have a broadly diversified portfolio. European markets, for example, aren't nearly as concentrated in growth stocks as the US market. The second answer is based on you saying that you're in your mid-30s and starting to save for retirement. Take some comfort in knowing that early on in your savings, the amount you set aside is much more important than whether you get your asset allocation exactly right, and the opposite will be true a few decades from now. It's a matter of math. Let's say you have $50,000 in an S&P 500 fund now, and you're putting away $10,000 a year. Is there a way you could manage to increase your savings to $15,000 a year? Because the difference works out to 10% of your portfolio in year 1. On Wall Street, money managers build careers on outperforming by 1% or 2% a year over time. There's nothing I can tell you that will boost your returns by a guaranteed 10 percentage points this year., but you might be able to boost your wealth accumulation by that much if you can figure out how to save more. Now stick with these same numbers and assume you gradually earn more money and can put aside a little more in savings each year. Let you do that for 30 years and you earn a healthy but not astonishing return, say 6% a year. You could easily end up with millions of dollars, and as you get close to that point, your wealth accumulation will be dominated by your portfolio returns, not the amount you set aside each year. So by then, feel free to splurge a little, and getting the asset allocation right and reducing losses during downturns will be particularly important. But Zeke, I'm guessing that you know all of this already and that you're thinking about portfolio construction because you enjoy it, in which case you're in the right place, and keep doing what you're doing. Thank you, Zeke from Zurich and Tim and Scott, and of course Rebecca, but not Steven from high school. And thank all of you for listening. Please keep the questions coming. Just tape on your phone, use the voice memo app, and send it to jack.hough@barons.com. Jackson Cantrell is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, Please write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @JackHough, H-O-U-G-H. See you next week.

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