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The time is running out for cash-burning companies buoyed by easy/cheap access to capital. These “zombie” companies run the risk of going bankrupt if they can’t raise more debt or equity, which isn’t as easy as it used to be be.
As the Fed hikes rates and ends quantitative easing, access to cheap capital is rapidly drying up. At the same time, many companies are facing declining margins and may be forced to default on interest payments with no possibility of refinancing. If these zombie companies run out of the cash they need to stay afloat, risk premia will rise across the market, which could further pressure liquidity and trigger an escalating series of corporate defaults.
This report includes Peloton Interactive, Inc. (NASDAQ: PTON), a zombie company with a high risk of its shares falling to $0/share.
Low-money zombie businesses are risky
Companies with high cash consumption and little cash are risky in today’s market. Being forced to raise capital in this environment, even if the company ultimately succeeds, isn’t good for existing shareholders.
Figure 1 shows the zombie companies most likely to run out of cash first, based on free cash flow (FCF) consumption and total back-to-back cash (TTM) on the balance sheet. Each company in Figure 1 has:
- Negative interest coverage ratio (EBIT/interest expenses)
- Negative FCF over the TTM
- Less than 24 months before more capital is needed to subsidize the TTM FCF burn rate
- Was a choice for the danger zone
Unsurprisingly, the companies most at risk of seeing their stock price plummet to $0 are those with a bad underlying business model that investors are overlooking during the meme stock-driven 2020-2021 market craze became. Companies like Carvana, Freshpet and Peloton have less than six months of cash on their balance sheets based on their FCF consumption over the last 12 months. These stocks have a real risk of going to zero.
Exhibit 1: Holdings in risk zones with less than two years worth of cash: from 1Q22
Sources: New Constructs, LLC and company records. To calculate the “months before bankruptcy” we divided the TTM FCF burn by 12, which equals the monthly cash burn. We then divide the cash and equivalents on the balance sheet through 1Q22 by the monthly cash burn.
And overvalued zombie stocks are the riskiest
Stock valuations that include high expectations of future earnings growth increase the risk of owning stocks in zombie companies when there are only months of cash left. For the riskiest zombie companies, the stock price not only fails to reflect the company’s short-term plight, but also reflects unrealistically optimistic assumptions about the company’s long-term profitability. For these stocks, overvaluation risk comes on top of short-term cash flow risk.
Below, we take a closer look at Peloton, detailing the company’s cash burn and how far its stock price could fall.
We put Peloton in danger ahead of its IPO in September 2019, and have reiterated our negative view of the stock many times since. Since our original report, the stock has outperformed the S&P 500 by 91% when short. Even after falling 92% from its 52-week high, 73% YTD and 74% since our last report in February 2022, we believe the stock has much more downside potential.
Peloton’s issuance is well known — given the stock’s decline over the past year — but investors may not realize that the company has just a few months of cash left to fund its operations.
Despite rapid revenue growth, particularly in 2020 and 2021, Peloton’s free cash flow has been negative every year since fiscal 2019. Since then, Peloton has burned $3.7 billion in FCF, as shown in Figure 2.
Peloton burned $3.3 billion in FCF in TTM-ending FY3Q22. With just $879 million in cash and cash equivalents on the balance sheet at the end of 3Q22, Peloton’s treasury could keep the company afloat for a little over three months after the end of 3Q22.
Similar to the situations above, Peloton took out a $750 million five-year loan in May 2022 to shore up its balance sheet. The debt is extremely creditor-friendly, bearing interest at a rate 6.5 percentage points above secured overnight funding (currently 1.45%) and rising 50 basis points if Peloton chooses not to take out the debt from one of the lending institutions to be rated by major rating agencies. Additionally, the debt is structured in a way that makes it more expensive for Peloton to repay it in the first two years. This new money can keep the company afloat for three months based on TTM cash burn rates.
If we take average FCF consumption over the past two years and factor in the additional capital raised a month ago, Peloton has just 11 months of cash left before it has to raise more capital or go out of business.
Exhibit 2: Peloton’s FY3Q22 cumulative free cash flow
Sources: New Constructs, LLC and company records. Annual data represents the fiscal year. Peloton’s fiscal year ends on June 30 of each calendar year.
Reverse DCF math: Peloton to triple sales despite flagging demand
Below, we use our reverse discounted cash flow model to analyze the future cash flow expectations that feed into Peloton’s stock price. We also provide an additional scenario to highlight the downside potential of stocks if Peloton’s sales grow at more reasonable rates.
If we assume Peloton:
- NOPAT margin immediately improves to 1.7% (Pelotons best margin ever compared to -30% over TTM) and
- Revenue will then grow 16% annually through 2028
the stock would be worth $11/share today – that’s the current stock price.
In this scenario, Peloton would generate $12.1 billion in revenue in fiscal 2028, more than triple its TTM revenue and seven times its revenue in fiscal 2020. At $12.4 billion, Peloton’s calendar year 2027 revenue would represent a 17% share of its total addressable market (“TAM”), which we consider to be the combined online/virtual fitness and home fitness equipment markets. For reference, Peloton’s share of its TAM in calendar year 2020, or before the big pandemic surge, was just 13%. Of competitors with publicly available sales data, iFit Health, owner of NordicTrack and ProForm, Beachbody (BODY), and Nautilus (NLS) held 9%, 6%, and 4% of the TAM in 2020, respectively.
We 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 pricing and subscription changes, while still achieving its highest margins ever. In a more realistic scenario, detailed below, the stock has a large downside risk.
PTON has 45%+ disadvantages when consensus is correct
We run a second DCF scenario to highlight the downside risk to holding Peloton should it grow with consensus earnings estimates. If we assume Peloton:
- NOPAT margin improves to 1.7%,
- Revenue growing at consensus rates in 2022, 2023 and 2024
- sales growing at 14% annually in 2025-2028 (continuation of consensus from 2024), then
The stock would be worth just $6/share today — down 45% from the current price. This scenario still implies that Peloton’s revenue will grow to $7.2 billion in fiscal 2028, which would represent a 10% share of the total addressable market in 2028.
If Peloton fails to achieve the revenue growth or margin improvement that we assume for this scenario, the stock’s downside risk would be even greater, putting the stock at risk of falling to $0 per share.
Figure 3 compares Peloton’s historical earnings to the earnings implied by each of the above DCF scenarios.
Figure 3: Peloton Historical and Implied Earnings: DCF Valuation Scenarios
Sources: New Constructs, LLC and company records. The data represents 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 us to construct best-case scenarios that demonstrate the expectations embedded in the current valuation. For reference, Peloton’s invested capital in TTM is five times higher than in fiscal 2018. If we assume that Peloton’s invested capital increases at a similar historical rate in the DCF scenarios 2 above, the downside risk is even greater .
This article was originally published on June 23, 2022.
Disclosure: David Trainer, Kyle Guske II and Matt Shuler do not receive compensation to write about specific stocks, styles or topics.