Stocks That Could Hit $0 as Fed Hikes Rates: Peloton
Time is running out for cash-burning businesses that are kept afloat with easy/cheap access to capital. These “zombie” companies risk going bankrupt if they cannot raise more debt or equity, which is no longer as easy as it used to be.
As the Fed raises interest rates and ends quantitative easing, access to cheap capital is rapidly drying up. At the same time, many companies are faced with shrinking margins and may be forced to pay no interest without the possibility of refinancing. As these zombie companies run out of cash to stay afloat, risk premiums will rise in the market, which could further reduce liquidity and create a growing series of corporate defaults.
This report features Peloton (PTON), a zombie company with a high risk of seeing its stock drop to $0/share.
Zombie businesses with little money are risky
Companies that consume a lot of cash and have little cash are risky in today’s market. Being forced to raise capital in this environment, even if the company ultimately succeeds, is not good for existing shareholders.
Figure 1 shows the zombie companies most likely to run out of cash first, based on last twelve months free cash flow (FCF) burn and cash on balance sheet (TTM). Each company in Figure 1 has:
- Negative interest coverage ratio (EBIT/Interest expense)
- Negative FCF on the TTM
- Less than 24 months before needing more capital to subsidize FCF TTM burnout rate
- Been a danger zone choice
Unsurprisingly, the companies most at risk of seeing their stock price fall to $0 are those with a poor underlying business model, which was overlooked by investors during the 2020-2021 stock market frenzy. Companies such as Carvana, Freshpet
Figure 1: Inventories in the danger zone with less than two years of cash in hand: as of 1Q22
To calculate the “months before bankruptcy”, I divided the TTM FCF consumption by 12, which is equivalent to a monthly consumption of cash. I then divide cash and balance sheet equivalents through 1Q22 by monthly cash burn.
And overvalued zombie stocks are the riskiest
Stock market valuations that incorporate high expectations for future earnings growth add more risk to owning stocks of zombie companies with only a few months of cash left. For the riskiest zombie companies, not only does the stock price not reflect short term distress facing the company, but it also reflects unrealistic optimistic assumptions about the long term company profitability. With these stocks, the risk of overvaluation is added to the risk of short-term cash flow.
Below, I’ll take a closer look at Peloton and detail the company’s cash burn and how much further its share price could fall.
Interactive Platoon (PTON)
I put Peloton (PTON) in the danger zone in September 2019, before its IPO and have reiterated my negative view of the stock several times since. Since my initial report, the stock has outperformed the S&P 500 as a 91% short. Even after falling 92% from its 52-week high, 73% since the start of the year and 74% since my last report in February 2022, I think the stock has a lot more downside .
Peloton’s troubles are well telegraphed – given the stock’s decline over the past year – but investors may not realize that the company only has a few months of cash to fund its operations.
Despite rapid revenue growth, particularly in 2020 and 2021, Peloton’s free cash flow (FCF) has been negative every year since fiscal 2019. Since then, Peloton has spent $3.7 billion in FCF, according to Figure 2.
Peloton spent $3.3 billion in FCF during the TTM ended 3Q22. With just $879 million in cash and cash equivalents on the balance sheet at the end of fiscal 3Q22, Peloton’s cash balance could keep the company afloat for just over three months from the end of its fiscal 3Q22. .
Similar to the situations above, Peloton raised $750 million in a five-year term loan in May 2022 to help shore up its balance sheet. Debt is extremely favorable to creditors, as it carries an interest rate of 6.5 percentage points above the guaranteed overnight funding rate (currently equal to 1.45%) and will increase by 50 percentage points basis if Peloton chooses not to have the debt rated by one of the major credit rating agencies. Additionally, the debt is structured to make repayment more costly for Peloton in the first two years. This new cash can keep the business afloat for three months, based on TTM cash burn rates.
If I assume the average consumption of FCF over the last two years and include the additional capital raised a month ago, Peloton only has 11 months of cash left before it needs to raise more capital or cease his activities.
Figure 2: Peloton Cumulative Free Cash Flow
Yearly dates represent the fiscal year. Peloton’s fiscal year ends on June 30 of each calendar year.
Reverse DCF math: Peloton priced to triple sales despite weakening demand
Below, I use my inverse discounted cash flow (DCF) model to analyze future cash flow expectations embedded in Peloton’s stock price. I also offer an additional scenario to highlight the downside potential for stocks if Peloton’s earnings grow at more reasonable rates.
If I assume Peloton:
- The NOPAT margin immediately improves to 1.7% (Peloton’s best margin, compared to -30% on the TTM) and
- revenues increase by 16% per year until 2028, then
the stock would be worth $11/share today, equivalent to the stock’s current price.
In this scenario, Peloton would generate $12.1 billion in revenue in fiscal year 2028, more than 3 times its TTM revenue and 7 times its revenue in fiscal year 2020. At $12.4 billion, Peloton’s revenues would represent a 17% share of its total addressable market (TAM) in calendar 2027, which I consider to be the online/virtual and home fitness equipment markets combined. For reference, Peloton’s share of its TAM in calendar 2020, or before the major pandemic boost, was just 13%. Among competitors with publicly available sales data, iFit Health, owner of NordicTrack and ProForm, Beachbody (BODY) and Nautilus (NLS) had 9%, 6% and 4% of the TAM, respectively, in 2020.
I think it’s overly optimistic to assume that Peloton will significantly increase its market share given the current market landscape, supply chain issues, and significant price and subscription changes, while achieving its lowest margins. highest ever recorded. In a more realistic scenario, detailed below, the stock presents significant downside risk.
PTON has 45%+ downside if the consensus is good
I run a second DCF scenario to highlight the downside risk of owning Peloton if it were to grow based on consensus revenue estimates. If I assume Peloton:
- NOPAT margin improves to 1.7%,
- revenue grows at consensus rates in 2022, 2023, and 2024, and
- revenue grows by 14% per year in 2025-2028 (continuation of consensus from 2024), then
the stock would be worth just $6/share today, a 45% drop from the current price. This scenario still implies that Peloton’s revenues reach $7.2 billion in fiscal 2028, which would imply a 10% share of its total addressable market in 2028.
If Peloton fails to achieve the revenue growth or margin improvement that I assume for this scenario, the stock’s downside risk would be even higher, which would expose the stock to downside risk to $0 per stock.
Figure 3 compares Peloton’s historical revenue to the revenue implied by each of the DCF scenarios above.
Figure 3: Peloton Historical and Implicit Revenues: DCF Valuation Scenarios
Dates represent Peloton’s fiscal year, which runs through June of each year
Each of the above scenarios also assumes that Peloton increases revenue, NOPAT, and FCF without increasing working capital or fixed assets. This assumption is highly unlikely, but allows me to create best-case scenarios that demonstrate the expectations built into the current valuation. For reference, Peloton’s invested capital in TTM is five times its level in FY2018. Assuming that Peloton’s invested capital grows at a similar historical rate in the DCF 2 scenarios above, the risk of drop is even greater.
Disclosure: David Trainer, Kyle Guske II, and Matt Shuler receive no compensation for writing about a specific stock, style, or theme.