Peloton Interactive Inc

NASDAQ:PTON

Earnings Call Analysis

Peloton Reports Strong Q1 Results Amid Cost-Cutting and Leadership Transition

Peloton delivered first-quarter revenue of $586 million, exceeding guidance, driven by subscription growth. The company reported a gross margin of 51.8% and reduced operating expenses by 30% year-over-year, reflecting significant cost-saving efforts. Adjusted EBITDA reached $116 million, $56 million above expectations, while free cash flow was $11 million. For Q2, guidance projects revenue between $640 million and $660 million, with a decline in subscribers. Full-year revenue guidance remains at $2.4 to $2.5 billion, with adjusted EBITDA increasing to $240-$290 million. Leadership changes include Peter Stern as incoming CEO, effective January 2025, aiming for sustained profitability and growth.

A Robust Start to Fiscal 2025

Peloton achieved a promising start to its fiscal year 2025, exceeding its own expectations across key financial metrics. Total revenue for the first quarter was $586 million, surpassing guidance of $560 million to $580 million, primarily driven by a robust subscription revenue stream of $426 million, which grew by 3% year-over-year. The Connected Fitness product revenue, however, faced a year-over-year decline of 12%, totaling $160 million. Encouragingly, subscriptions accounted for a substantial 73% of total revenue, highlighting the increasing importance of the subscription model in Peloton's business strategy.

Impressive Profitability Metrics

The company reported an adjusted EBITDA of $116 million, which exceeded the high end of guidance by $56 million and marked a $107 million improvement year-over-year. This robust performance included approximately $15 million in timing-related savings within the fiscal year. Furthermore, Peloton generated $11 million in free cash flow, marking its third consecutive quarter in the black. The total gross profit of $304 million represented a 6% increase from the prior year, with an overall gross margin of 51.8%, exceeding guidance by 180 basis points. These figures reflect effective cost management and a shift in revenue mix favoring higher-margin subscriptions.

Cost Structure Optimization

Peloton's commitment to cost reduction initiatives is showing tangible results. Total operating expenses fell to $291 million, a reduction of 30% year-over-year. General and administrative expenses were down 21%, driven by lower payroll and professional fees. The reduction in sales and marketing spend was notable, with Q1 media spend down 57% compared to the prior year, aligning with the seasonal nature of hardware sales. Peloton remains on track to achieve over $200 million in run-rate savings by the end of fiscal 2025 as a result of their restructuring plan.

Subscriber Trends and Churn Rates

Peloton ended the first quarter with 2.9 million paid Connected Fitness subscribers, a net decrease of 81,000. This decline, while less than anticipated, reflects the company's strategy to focus on subscriber retention and quality over quantity. The average net monthly churn rate was reported at 1.9%, in line with expectations but slightly higher than last year's figure. Despite this, the company anticipates churn rates to improve slightly in Q2 fiscal 2025 due to a focus on improved member engagement through personalized offerings and enhanced content delivery.

Guidance and Future Outlook

Looking ahead, Peloton provided guidance for Q2 fiscal 2025 with expectations for total revenue between $640 million and $660 million, reflecting a sequential increase driven by anticipated seasonal hardware sales. For the fiscal year, the revenue outlook remains steady between $2.4 billion and $2.5 billion, with adjusted EBITDA guidance raised to a range of $240 million to $290 million, an increase of $40 million from prior estimates. The company also updated its free cash flow target to a minimum of $125 million, up from $75 million previously, signaling confidence in operational efficiencies and cash generation capabilities.

Leadership Changes and Strategic Focus

The announcement of Peter Stern as the new CEO effective January 1, 2025, adds a layer of optimism for Peloton. Stern's prior experience at Apple Fitness+ positions him well for driving innovation and strategic direction. Peloton’s core focus for fiscal 2025 will be aligning its cost structure, improving unit economics, and investing in product development to drive long-term sustainable growth. The company highlights the importance of engaging its existing members while attracting new ones through targeted marketing efforts, especially among demographics that have shown lower engagement.

International Growth and Market Strategy

Peloton noted an 8% increase in paid connected fitness subscribers in international markets during the first quarter, representing a promising avenue for future growth. The transition to third-party sales in Germany has proven effective, leading to above-expected sales performance, with plans to replicate this success in other international territories. The focus on improving user experience through innovations like personalized plans and community engagement features may bolster retention and subscription growth across all markets.

Earnings Call Transcript 2025-Q1

[Operator]

Good day, and welcome to Peloton's First Quarter Fiscal 2025 Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker, Mr. James Marsh, Senior Vice President of Investor Relations. Please go ahead.

[James Marsh, executive]

Thank you, operator. Good morning, and welcome to Peloton's First Quarter Fiscal 2025 Conference Call. Joining today's call are Peloton board members and interim co-CEOs, Karen Boone and Chris Bruzzo as well as Chief Financial Officer, Liz Coddington.

Our comments and responses to your questions reflect management's views as of today only and will include statements related to our business that are forward-looking statements under federal securities law. Actual results may differ materially from those contained in or implied by these forward-looking statements due to risks and uncertainties associated with our business. For a discussion of the material risks and other important factors that could impact our actual results, please refer to our SEC filings and to today's shareholder letter, both of which can be found on our Investor Relations website.

During this call, we will discuss GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP financial measures is provided in today's shareholder letter.

I'll now turn the call over to interim Co-CEO, Karen Boone.

[Karen Boone, executive]

Good morning, and thank you for joining us today. Before we dive into today's financial results, I want to share the exciting news regarding our CEO search. As you probably saw in our separate release this morning, on behalf of the entire Board, I'm thrilled to announce that after a comprehensive search, we have identified the next leader for Peloton. Peter Stern will assume the role of CEO and President on January 1, 2025. Peter is a seasoned leader and strategist with over 20 years of experience operating at the intersection of hardware, software, services and content at Ford, Apple and Time Warner Cable.

He has a strong track record of innovation, operational excellence and creating significant shareholder value. As the cofounder and driving force behind Apple Fitness+, Peter led its growth to millions of members and is responsible for successfully scaling over a dozen other subscription services, ranging from Ford Blue Crude to Apple iCloud to Time Warner Cable home security.

Importantly, Peter has also been a passionate member of the Peloton community since 2016 and have a deep appreciation and reset for this business, this brand and the impact that we have on millions of people around the world every day. I truly cannot wait to officially welcome him to Peloton at the start of the calendar year.

Turning to our financial results. I'm extremely pleased to share that we are reiterating our fiscal 2025 financial goals today, which include: first, aligning our cost structure to the current size of our business by delivering over $200 million of run rate cost savings by the end of fiscal year '25 from our cost restructuring plan announced in May 2024. Second, improving our unit economics across all products and sales channels in pursuit of delivering sustainable, profitable growth and meaningful free cash flow generation. And third, continuing to make strategic investments in innovation to enable Peloton to return to top line growth in the long term. This includes product development in both software and hardware features, refining our marketing strategy to attract new audiences, as well as evolving our content offering to deliver more diversified, engaging fitness experiences. We believe these efforts will delight our current members and attract new ones to our strong and loyal community.

Our Q1 results were strong, exceeding our guidance on all key metrics, which Liz will discuss in greater detail. Progress on cost reduction efforts are reflected in our profitability metrics. We are proud to report Q1 results, which includes $13 million of GAAP operating income, $11 million of free cash flow and $116 million of adjusted EBITDA. Our results also highlight the continued strength of our category-leading connected fitness subscription business, which had over 6 million loyal members, 2.9 million connected fitness subscribers, 586,000 app subscribers and over $1.7 billion of annualized subscription revenue was 68% gross margin.

I am thrilled to see our cost reduction efforts materialize in our financial performance to date. And I must say the team has done an incredible job not only to deliver but to exceed our goals thus far in reducing costs. A key part of managing our business towards profitable growth involves ensuring all the subscribers we acquire are profitable and ensuring we have sustainable unit economics. We manage our business through a lens of LTV to CAC and have taken actions to improve the areas that are in our immediate control on both the LTV and the CAC side of the equation.

To enhance customer

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improving unit economics across all products and sales channels in pursuit of delivering sustainable, profitable growth and meaningful free cash flow generation and third, continuing to make strategic investment growth.

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Some of the pricing changes I mentioned were specific to our international business, where we raised the price for all of our bike products in all international markets in the first quarter to expand Connected Fitness product gross margin. This was especially important in Germany, where we transitioned our operations to an entirely third-party retail and distribution model. This means that while our first-party website will remain live to serve as a brand awareness and product education platform, we are now directing traffic to third-party retailers, namely Amazon and Fit Shop for sales and fulfillment.

Germany sales have outperformed our internal expectations following the third-party transition. We are optimistic that this channel strategy could provide a more capital-efficient model to explore expansion into additional international markets over time. Paid connected fitness subscribers in our international markets grew 8% in Q1. We remain bullish on international as a source for long-term growth based on the strong retention and engagement trends that mirror those in our North America business.

We continue to optimize our sales channel strategy for stronger unit economics in our North American business as well. In Q1, we continued our efforts to close underperforming first-party retail stores. Next month, we will test the reimagined smaller store concept in Nashville, Tennessee to evaluate a more cost-efficient retail model. We also expanded third-party and online retail capabilities ahead of the all-important holiday season. On our website, we launched an exciting partnership with True Med in early October, which makes it easier for qualified U.S.-based customers to use pretax, HSA or FSA dollars to purchase telecom products. We are also pleased to announce that for the first time, the Pelton bikes [indiscernible] will be available at Costco this holiday season with special pricing across 300 U.S. locations and at costco.com.

All of these changes position us well to capture the seasonally strong holiday demand with healthier unit economics, delivering stronger Connected Fitness gross margins and free cash flow. There is so much great work being done to optimize our channel and go-to-market strategies, improve our unit economics and gross margins and rearchitect our cost structure. All of this has made Peloton a more sustainable and profitable business. One that is better equipped to serve our members and grow our business over the long term.

I will now pass the call over to Chris, who will provide an update on our innovation efforts across marketing, products and content where we are making thoughtful investments to drive sustainable, profitable growth.

[Christopher Bruzzo, executive]

Thanks, Karen. As Karen mentioned, we're focused on improving the efficiency of our customer acquisition costs. And this requires us to be strategic with our marketing campaign that generate demand from target growth audiences and to be disciplined with our marketing spend. In that way, we reduced total sales and marketing expense by $64 million or 44% year-over-year in Q1, primarily driven by historically low media spend in the quarter.

In fact, our Q1 was the lowest quarter of media spend since fiscal 2020 over 4 years ago. We intentionally pulled back our media spend during Q1 because it is a seasonally low hardware sales period for us. As we look ahead to the holiday season, we are already ramping up media spend to support demand generation ahead of this important time for hardware sales and subscriber additions. Our go-to-market strategy continues to evolve with a balanced approach that creates demand among new growth audiences, coupled with improved efficiency in our short-term conversion tactics.

Today, 2/3 of our members are women. So we see an opportunity to attract more men to Peloton through targeting and messaging that highlights the robust value of a Peloton membership. Further, we see an opportunity to grow our Tread business, given our estimates that show the at-home treadmill market is more than twice the size of the at-home stationary bike market. Our goal is to build demand among core audiences and capture that demand during less frequent promotional moments. While we are still in early days, we're encouraged by the signal that suggests these marketing strategies are working. In Q1, we saw a 9% year-over-year mix shift in hardware sales towards men with the highest shift in our Tread portfolio.

All of these efforts will enable us to expand LTV to CAC year-over-year, while refining a marketing approach to better support sustainable and profitable demand growth in the long term. While our LTV CAC ratio improved significantly in Q1 to 1.9x, it was still slightly below our target of greater than 2x during the period with historically low media spend. As our media spend and promotional activity increased in Q2 to drive demand creation and conversion during the holiday shopping season, it's worth noting that many of the customers acquired during Q2 will not activate their subscription until Q3. As a result, there will be some quarterly swings in LTV CAC similar to what we've seen in prior years.

We consistently evaluate the overall picture of LTV CAC on a full year basis to inform decisions about quarterly media investments. Now beyond our marketing efforts, product development plays a key role in driving long-term growth as well. This includes both hardware and software innovation. Recently, we launched a number of software updates that are designed to drive higher engagement from our members by offering alternative workouts, a greater level of personalization and more social engagement on our platform. While we are encouraged by early results, all of these software updates are still in an early test phase, and we expect some of these software initiatives to be more effective than others. Our development approach prioritizes getting early versions to market sooner, so that we can test how customers respond and iterate accordingly. This allows us to be nimble, scaling investments up or down with the results we see.

Strength is the second most popular modality in our platform, and it continues to take share. In September, we launched a public beta test for a new app offering called Strengths in order to deliver strength training programs that are designed for use in a gym setting. These are non-class based workouts and customizable to address the member's specific goals. We have gathered more than 70,000 sign-ups to date of people who are interested in trying Tread+. We are getting productive feedback from our test population of 5,000 that is informing our product iterations.

Beyond extended strength offerings, our members have shown considerable interest in game inspired fitness experiences. In fact, over 10% of our active subscribers engaged with Lane break in Q1 and our first game inspire Fitness offering. So we are currently testing our second game inspired experience in a closed beta of 100 existing bips members. We're building this to deliver an immersive social and competitive workout experience. We also believe a greater level of personalization will enhance the value of Peloton to our members.

Among the small population of our existing members, we are testing a new software feature called personalized plans which provides a weekly workout plan both in our app and through our connected fitness hardware based on our member's individual fitness goals. Our goals for personalized plans include both improving retention for new members who may need help getting started on our platform, as well as driving higher engagement among our existing members to enhance the value Peloton brings to their workout routine.

Now we know that there is extensive social engagement among our members happening off of our Connected Fitness platform. So we're making changes to enable our members to engage with one another. We recently launched private teams, a new feature where existing members can share results and compete and challenges. Team creation and adoption is pacing well, and it's aligned with our expectations. Early results show members who joined teams are both increasing workouts taken and connecting other members via fine friends at a faster pace than prior to joining James, demonstrating healthy signals of a growing network effect.

Okay. So beyond our exciting software initiatives, we're proud to continue delighting our members with our best-in-class instructor-led fitness content, which delivered strong engagement results in Q1 that were relatively stable year-over-year and well above pre-COVID levels. Our annual all for one programming event included various popular musicians and a live performance from Keith Urban in Studio. These offer [indiscernible] classes generated over 26,000 live member workouts and over 900,000 workouts on demand in the first week available on the platform. We also rolled out a number of new offerings to serve our members' diverse interest, including strength for soccer and new programs across bar, palates, yoga and medication. We expanded our treadmill modalities by launching walking boot camps, which are excellent lower-impact workout options for members and the latest in a series of content options for walking and hiking. .

At the same time, we delivered more content for the Performance athlete segment, adding more 75, 90 and 120-minute classes in response to member interest in those options.

I'm incredibly proud of the Peloton team for continuing to innovate across marketing, product and content, while we significantly reduced cost in the business, that operational excellence that we're seeing from the team has made all of this possible.

And with that, I'd like to hand it over to Liz, who will take us through a review of our first quarter financial performance.

[Liz Coddington, executive]

Thank you, Chris. First, I'd like to provide an update for how we are tracking against the cost restructuring plan we announced in May. As of the end of Q1, we have actioned all payroll-related changes that were assumed in the restructuring plan, which will deliver over $100 million of annualized run rate savings. We continue to make progress and benefit from all other nonpayroll-related savings. Together with the payroll savings, we are still on track to deliver over $200 million of run rate cost savings by the end of fiscal 2025. And we are realizing some of these savings faster than we anticipated.

Also, we're delivering additional cost efficiency through reductions to media spend that were not included in our $200 million restructuring goals. Now I'll spend a few minutes on our Q1 results. We ended the quarter with 2.9 million paid connected fitness subscribers, reflecting a net decrease of 81,000 in the quarter. This exceeded the high end of our guidance range by 10,000 subscribers. The main driver of our subscriber outperformance was slightly favorable churn versus our expectations as a result of fewer subscription pauses. This favorability was partly offset by slightly softer gross additions than we expected.

Average net monthly paid connected fitness subscription churn was 1.9%, slightly favorable versus expectations and in line with the prior quarter and an increase of roughly 40 basis points year-over-year. As a reminder, our net churn performance from the year ago period included a onetime benefit as a result of elevated subscription on positive in the first quarter of fiscal 2024, following elevated pauses in the fourth quarter of fiscal year 2023 in response to our original bike seat post recall.

We ended the first quarter with 582,000 paid app subscriptions, reflecting a net decrease of 33,000 in the quarter. This result exceeded the high end of our guidance range by 12,000 from both higher additions and better-than-expected average monthly paid app subscription churn, which was 7.1% in the quarter. In the first quarter, we've continued to scale back the amount of media spend dedicated to support growth in paid app subscriptions to maximize media efficiency. As we continue evolving our app with software enhancements, such as personalized plans and private teams, and developing new app offerings like our Strength+ beta. We may elect to invest more in app Media if we see signals that suggest we can accelerate growth of app subscribers efficiently.

Total revenue was $586 million in the first quarter, comprising $160 million of Connected Fitness products revenue and $426 million of subscription revenue. Connected Fitness products revenue was down 12% year-over-year due to lower hardware demand as subscription revenue was up 3% year-over-year due to content licensing revenue from Lululemon and Google Fitbit.

Total revenue was above the high end of our $560 million to $580 million guidance range, primarily due to higher subscription revenue as a result of higher paid connected fitness and paid app subscribers than we expected as well as slightly higher Connected Fitness products revenue. As a reminder, Q1 is a seasonally lower period for hardware sales, which is reflected in the revenue mix of 27% Connected Fitness and 73% subscription for the quarter. Total gross profit was $304 million in the first quarter, an increase of $18 million or 6% year-over-year. Total gross margin was 51.8% and 180 basis points above guidance due to favorable Connected Fitness Product segment gross margin and revenue mix shift towards our subscription segment.

Connected Fitness Product gross margin was 9.2%, ahead of internal expectations and up 600 basis points year-over-year, primarily driven by product mix shifts towards higher-margin precore and bike rental products reduced personnel-related expenses and lower warehousing costs, partly offset by higher expenses associated with our standard warranty reserves. Subscription gross margin was 67.8%, in line with internal expectations and up 40 basis points year-over-year. Total operating expenses, including restructuring and impairment expenses were $291 million in the first quarter, a $126 million or 30% reduction year-over-year, reflecting the progress we've made thus far towards rightsizing our cost structure.

We are tracking ahead of our cost savings targets across all expense buckets. General and administrative expenses were $120 million, a decrease of $32 million or 21% year-over-year, primarily driven by lower payroll, stock-based compensation and professional service fees. We are pleased with the progress we've made on reducing G&A expense thus far, but we recognize the need to reduce G&A as a percentage of revenue over time and see opportunities to do so. Sales and marketing expenses were $82 million, a decrease of $64 million or 44% year-over-year, primarily from lower spending on media, payroll and stock-based compensation.

As Chris mentioned, we intentionally reduced Q1 media spend 57% year-over-year. However, we have already begun ramping our media spending this quarter in preparation for the holiday season. And while we still expect media spend to be down year-over-year in Q2, we expect less of a reduction compared to Q1. Research and development expenses were $59 million, a decrease of $20 million or 26% year-over-year, primarily driven by reductions in payroll, stock-based compensation and product development costs.

This quarter, we recognized $8 million of impairment and restructuring expense, of which $5 million was noncash. The noncash charges were primarily related to asset write-downs in relation to retail showroom exit. The cash charges consisted of $3 million in exit and disposal costs and professional fees, offset by a $0.5 million net benefit from lower severance and other personnel costs. We also recognized $24 million of supplier settlements due to accruals in the first quarter related to settlement of a dispute with a third-party supplier. Adjusted EBITDA was $116 million in the first quarter, which was $56 million above the high end of our guidance range and a $107 million improvement year-over-year.

Our first quarter adjusted EBITDA outperformance included roughly $15 million of timing savings within the fiscal year. We generated $11 million of free cash flow in the quarter, outperforming internal expectations and delivering our third consecutive quarter of positive free cash flow. We ended the quarter with $722 million in unrestricted cash and cash equivalents. Overall, our first quarter performance reflects the progress we've made in rearchitecting our cost structure while maintaining our leadership position within the Connected Fitness category and the strength of our highly retentive, high gross margin subscription business.

Next, I'd like to provide context on our financial outlook for the second quarter and fiscal year 2025. Our guidance for Q2 FY '25 ending paid Connected Fitness subscriptions of $2.84 billion to $2.86 million reflects a sequential decrease of 50,000 subscribers at the midpoint. We expect our average net monthly paid connected fitness churn rate to slightly improve sequentially in Q2. Our Q2 FY '25 ending paid app subscription outlook of $560,000 to $580,000 reflects a sequential decrease of 12,000 subscribers at the midpoint, as a result of a decision to limit app media spend. Revenue guidance of $640 million to $660 million reflects a sequential increase of $64 million at the midpoint. As a result of these subscription trends, combined with an expected seasonal increase in hardware sales. Total gross margin guidance of 46.5% reflects an expected sequential decline in gross margin of 534 basis points as a result of a seasonal mix shift toward our Connected Fitness Product segment during the holiday sales period.

Our second quarter adjusted EBITDA guidance of $20 million to $30 million reflects a sequential decline of $91 million at the midpoint, mainly due to higher sales and marketing expenses as we increased media spend for the holiday season. Our full year FY '25 guidance reflects the expectation that hardware sales will decline year-over-year as well as an expectation that average net monthly paid connected fitness churn will continue to increase modestly year-over-year and follow our historical seasonal pattern. Our full year guidance range for paid Connected Fitness subscriptions of $2.68 million to $2.75 million remains unchanged and reflects a broad range of outcomes. We will continue to refine our strategy to improve unit economics over the course of FY '25, which may include additional changes in pricing, promotional strategy or other levers available to achieve our financial targets. Any changes in these areas may affect our growth additions for paid connected fitness subscription across the fiscal year.

Our full year guidance range for paid app subscriptions of $550,000 to $600,000, a $20,000 reduction versus our prior guidance reflects our decision to limit app media spend as we invest in product development to improve the member experience. Additionally, as we continue to improve our member experience, we see clear opportunities to improve engagement, which could result in favorability to churn for both Connected Fitness and app. While we are optimistic we can improve engagement through product and content innovation and evolving our marketing strategy, the timing of when we will start to see meaningful impact from these efforts is uncertain and, therefore, not reflected in our guidance.

Our primary focus for FY '25 is delivering our key financial results, which include total revenue, total gross margin and adjusted EBITDA. We are prioritizing these metrics, along with delivering free cash flow. Our FY '25 outlook for total revenue remains unchanged at $2.4 billion to $2.5 billion as well as our outlook for total gross margin, which remains unchanged at 49.0%. We are raising our FY '25 adjusted EBITDA guidance by $40 million to $240 million to $290 million, which reflects our continued improvement in profitability, largely due to gross margin expansion the operating cost savings we expect to achieve related to our previously announced cost restructuring plan and reduced media spend year-over-year.

We are also raising our free cash flow target to at least $125 million an increase of $50 million from our previous guidance, primarily from lower inventory production that we expect to create a greater working capital tailwind as well as continued operating expense efficiencies. Following our Q1 free cash flow result of $11 million, we do expect to achieve positive free cash flow in all 4 quarters of the fiscal year. We expect to make meaningful progress in deleveraging our balance sheet throughout FY '25 and beyond.

And now I'd like to turn it back to Chris for some closing remarks.

[Christopher Bruzzo, executive]

Thanks, Liz. I want to take a moment to recognize the remarkable progress the entire Peloton team has made since I took on the role of interim co-CEO with Karen in May. In a relatively short time, I've seen it get smarter in many ways. We've made meaningful progress toward our goals of rightsizing our cost structure, improving unit economics and innovating to drive long-term profitable growth. and we are just getting started. So with today's announcement that Peter Stern will start is Peloton's next CEO and President in January, I will be stepping down as Co-CEO effective tomorrow, November 1.

Karen has graciously agreed to continue as interim CEO of Peloton until Peter arrives. It has been a great experience working with Karen, Liz, the lead team and the many talented team members here at Peloton. I am very proud to be part of Peloton for the difference we make in millions of lives every day. and I look forward to staying very involved as a much smarter Board Director going forward.

Thank you for the time this morning. We can now open the line for Q&A.

[Operator]

[Operator Instructions] And our first question will come from the line of Simeon Siegel with BMO Capital Markets.

[Simeon Siegel, analyst]

Congrats on the ongoing progress and on the new CEO announcement. It's really great to see. So some really nice momentum here on the profitability trajectory. So Karen, recognizing I got to ask you something to speak on someone else's behalf. I guess I was hoping you could speak to how you think or expect Peter would approach the balance of growth and profitability. I'm wondering, do you expect any actions that you take will flow quickly once you start? Do you think you're going to have a taking stock period? It just it seems like you've all done a really collective nice job on diagnosing the problem that you're already successfully affecting that plan to improve the free cash flow. So I'm just curious if we can assume that, that continues or whether wait and see and then we'll watch of either 1 to approach the business a new.

[Karen Boone, executive]

Thanks, Simeon. It's absolutely on our mind. It's absolutely the right question, it's how we're going to balance profitability and growth, and it was, frankly, top of mind for the Board as we were looking for the next CEO. Peter is the right CEO for this chapter. He's a seasoned strategist. He's known for execution and he does have that strong track record of driving innovation and growth. I will pause and just say, do you think we've set the table for his rival job one was refinancing the debt in May, we did that, we stabilized the balance sheet and it's put us in a much better position to manage our maturities.

And Liz has talked a lot about the progress on executing the restructuring reducing inventory levels, focused on profitability to generate the cash flow to allow us to begin deleveraging. So we do feel like we now have that stable base upon which to grow. In the very near term, and I don't know how long this is going to last, but we have been managing an uncertain macro environment, an uncertain consumer backdrop. There's been weather and hurricanes. We have a very intense focus on election. So we've been focusing on what we can control. I don't expect that to change under Peter's leadership. We've been very clear that we're not going to chase unprofitable sub growth. And we've been much more disciplined with spend up and down the P&L. Our media and marketing investments have been much more thoughtful, and we're optimizing our unit economics by product and by channel. So those are the things that I do not expect to change or we're going to continue to monitor those and kind of see when it makes sense to turn back on some of the growth spending and more meaningful ways.

But I guess, make no mistake that, that's not kind of where the story ends. Innovation and growth are still very important to us. It's an and, it's both, we are making investments in content, in product development, both software and hardware and marketing growth is important for this very important holiday period where we are unlocking marketing dollars. And again, this is going to be a big part of Peter is going to be a big part of this equation. He has the relevant experience. He has the track record and a large portion of his compensation is going to be designed to balance those and drive both profitability and growth.

So his incentives are well aligned with those goals. I think, of course, he's going to have -- one of the things I love about them is he absolutely has a growth mindset. So of course, I think he's going to have a taking stock period. I think we want them to come in and learn what has worked, what has not worked before he just kind of fires before he aims and learns. So I do think there'll be a taking stock period. But I'm really excited about his arrival. He is I believe the guy who is going to come in and set the strategy that is going to return us to growth. He is very bullish. We all are very bullish on the health and wellness space, the share of wallet that is going to go to this category. So again, he's going to spend time learning. We will spend time aligning on where to go, how quickly to invest.

And again, I do believe he's the right leader to return us to growth. And I do believe strongly that under his leadership, our brand is well positioned to be a long-term player and the absolute leader in this category.

[Christopher Bruzzo, executive]

As you can tell from Karen's remarks there, she and I have been very involved in this process. And with Peter in particular. And so we're very excited. He's really aligned. All those conversations have been so positive. So we know we've got the right leader that's going to bring the right balance and focus on growth.

[Simeon Siegel, analyst]

Say the excitement is resonating. So that's great. And then if I could just follow up quickly on that, maybe for Liz. A quick one. It's not a lot, but I think this is the first quarter of sequential inventory growth in a long time. So any help on the composition of that inventory? Any way to frame what type of equipment is making up that increase? And I guess I'm asking not as much for the number. I'm just wondering if we should be reading into that as a signal that maybe you do see some uptick in demand ahead or maybe it's the build for the new distribution partners or which is why often it's a nonevent and it's just a function of maybe the lighter gross side as you mentioned. So any help on that inventory vis-a-vis the growth comment would be helpful.

[Liz Coddington, executive]

Sure. So the question, I believe, is around our sequential growth in inventory in for the first quarter. As we said during -- it's pretty modest, it's pretty modest, and it's really related to our seasonal buildup of inventory ahead of the holiday season, and we do expect a significant inventory tailwind on the full year. We've done some great work our supply chain team has done some excellent work in working with our manufacturing partners to reduce our production levels over the course of the year to enable us to be a lot more efficient with our inventory over time. and reduce our days of on-hand inventory, which is great. And that will create a cash tailwind for us over the course of the year.

In Q1, it's up very slightly, but that's in relation to just the seasonality of buying ahead of the holiday season, and we expect our inventory balances to come down over the course of the year. But we are just to be clear, producing inventory for all of our products, so -- because we do need that inventory over the course of the year. But we do see it as an overall tailwind for us on a full year basis.

[Operator]

And that will come from the line of Curt Nagle with Bank of America. .

[Unknown Analyst]

Congrats on the solid quarter. This is Camuto for Curt Nagle. This quarter churn came in line at a seasonally high period. What are the fact -- what are we factoring for the rest of the year? Would that be a stable rate compared to the last year for the remaining quarters?

[Liz Coddington, executive]

Sure. So first, let's take a step back. Our business continues to benefit from very strong subscriber retention and low churn overall. In Q1, our average net monthly churn was 1.9%, which was relatively in line with last quarter. It was up 40 basis points year-over-year. As we discussed during the last quarter earnings call, we expected Q1 net churn to be up year-over-year due to a few reasons, including the following: slightly worse overall retention from our 1P and 3P subscriber base, which we've talked about, mix shift towards secondary market subscribers, which do have a slightly lower retention than our first-party subscribers. .

And then we also had the impact of a onetime benefit in Q1 of fiscal '24 related to higher subscription on pauses following elevated pauses in Q4 of fiscal '23 related to our original

[Audio Gap]

and we did not repeat that benefit this year. As we move forward and look at Q2, we do expect our churn to improve seasonally compared to Q1 and we do expect that improvement would likely be a bit muted though compared to the quarter-over-quarter improvement that we saw in fiscal '24, again, because of those 2 headwinds that I mentioned about the slightly worse retention in our overall subscriber base and that mix shift into secondary subscriptions, which do have that higher term profile. So overall, for the remainder of the fiscal year, we expect our churn to continue to be higher year-over-year because of the mix of subscribers from the secondary market continuing to grow but we do expect churn to remain below 2% for the whole of fiscal 2025. I do want to point out though, and we've mentioned this before, that our guidance doesn't assume any potential upside to subscriber retention as a result of the software innovation initiatives that Chris talked about earlier, which we believe could positively impact member engagement and ultimately, retention over time. And the reason we haven't incorporated those is because the magnitude and timing of those benefits is uncertain at this point.

[Operator]

And that will come from the line of Brian Nagel with Oppenheimer.

[Brian Nagel, analyst]

I too would like to add my congratulations on the business and your CEO announcement. My question -- so first question, I've got to I'll ask them in the quarter. For just on the balance sheet, you talked in the prepared comments about '25 being a deleverage year. So I guess the question I have there is maybe if you can go in a little more detail. Clearly, the business now from the P&L standpoint is much more stable. You're generating cash flow. But are there any specific steps you can identify here to address the balance sheet, in particular, the debt that remains on the balance sheet?

[Liz Coddington, executive]

Yes. This is Bill. I'll take -- I'll start that one and folks -- so first of all, Ken mentioned earlier that we derisked our balance sheet with the refinancing in May, and that allows us to now be very focused on deleveraging over time. And we're also very excited to be talking about the positive free cash flow and also raising our minimum free cash flow target. We are being disciplined with the level of investments that we're making, and that's the goal there is to set us up for future growth that is sustainable and profitable. .

And so as a result of generating that meaningful free cash flow, we do see the opportunity to meaningfully deleverage going forward that we're going to continue to improve our adjusted EBITDA and then continue to generate that positive free cash flow. And when we do that, we will naturally deleverage. We also see, over the course of time, real interest cost savings with rate step-downs when our leverage ratio falls between -- below 5. And then eventually, there is also the potential conversion of our 2029 5.5% convertible notes. So our balance sheet is in a much better position than it's been in the past. We've lowered risks. We've positioned ourselves well for sustainable and profitable growth. And we also see the ability to strategically reduce our growth debt over time, and we will be strategic about that. But we don't have anything to share regarding a definitive capital allocation framework for how we're going to execute that at this time.

[Brian Nagel, analyst]

That's very helpful.

[Christopher Bruzzo, executive]

Go ahead did you have a follow-up question?

[Andrew Boone, analyst]

I did. And my follow-up question is unrelated, but I guess somewhat bigger picture to and maybe a little -- it's probably a better question as your new management team takes place. But if you look at the -- I mean, I guess, I'm looking at the business, one of the positives has been the ability of Peloton to really maintain that core base, and you talked just a few minutes ago about a moment ago about your the still very low churn.

But as you're watching the business, and if you stabilize the business, are you finding -- is there anything you can help us with this, like where you're finding those incremental pockets of new demand, those new customers that could come into the Peloton system.

[Christopher Bruzzo, executive]

Yes, this is Chris. That's a great question. And I think it goes straight to the kind of discipline that we've been talking about in marketing. A key part of that is who are you reaching? And what's the opportunity and what's the message and how are you doing that efficiently. And I think we've had some really great success just recently in focusing on men. In the prepared remarks, you're we talk about 2/3 of our current members are women. And so now we're targeting the male demographic in our advertising. We've done some more adviser in NFL games. We featured the Watt brothers. But more importantly, the campaign and the work that we're doing is expanding our reach, and we're seeing in the data that there's a shift toward men and new hardware purchases and with the greatest shift within that in the Tread and Treads products.

So we feel really good about that. And it's just an indicator of the way we're thinking about the marketplace now, which is targeting, as you said, targeting those discrete pockets and then being efficient and effective in the way that we're reaching them. I should point out that here in November, we're going to be holding a lot of member gratitude events and messages, and that's another core part -- core part of this, activating that incredibly loyal base to refer and engage their friends and family to bring them into the Peloton experience, you can see us do a lot more of that.

[Operator]

And that will come from the line of Nathan Feather with Morgan Stanley. .

[Nathaniel Feather, analyst]

Really encouraging to see the progress on profitability. As you think about how to drive sustainable profitable growth Interested to hear how you're thinking about where physical retail fits in as a component of your go-to-market and especially given the Costco launch. Do you see some portion of the customer base who are more willing to convert in person than online and then reflecting on the owned stores, just where you see the potential to improve performance in the prior format.

[Karen Boone, executive]

Sure. This is Karen. So on retail in general, I'd say we are still on the path to close some of the underperforming retail stores. That said, we will have them this holiday season. So the team has put together some really thoughtful activations in a subset of those stores to bring instructors and magic and excitement to them to make sure they're not -- they're still representing the brand well and engage with our members and new customers and have some excitement around these spaces. We are testing to the point on how we might imagine it, we're testing a smaller micro store concept in Nashville.

So it's a way to do it in a lower capital, lower payroll, lower square footage but still have a physical presence. It's also the reason why we are exploring additional 3P locations like Costco. We're hoping that reaches an incremental audience. We have we're still excited about a lot of people shop on Amazon. We're happy to be there and trust Amazon with the -- that's part of their day routine. And then we still have the [indiscernible] Sporting Goods internationally, 3 Ps important, too, and it's a much more capital-efficient way for us to roll out. So retail, I would say, is in the reimagined process. It's not going anywhere. It's just we're going to kind of optimize the mix between 3P and 1P and make sure that it makes economic sense and reaches as many new incremental buyers as possible.

[Nathaniel Feather, analyst]

Great. That's helpful. And then given the more flexible international model you talked about in Germany and Austria, Interested to hear how you're thinking about potential further international expansion? And is distribution the primary constraint to growth? Or is it more on the localized content side?

[Karen Boone, executive]

Sure. So international is still another important part of the long-term growth strategy for us, it's just a matter of prioritization and sequencing. I do think we've made some very important steps. Germany is the example where we are entirely 3 now. So in order to do that and do that profitably and effectively, we had to make some pricing changes. We need to make sure there's sufficient margin for that third party to have the margin, and it still makes economic sense for us to do so. So now we have in a couple of different models, and we can test and see which ones. We're still learning what makes sense and how much to invest as we roll it out. But it's not -- there's not one limiting factor. It's just how do we want to sequence and prioritize the various investments. But I would say we're really excited about the way the international model has taken shape, again, both with the way we've taken some of the investments on the people side and centralize those. And then also with the pricing, it's just a better go-to-market strategy. So we will expand over time. We have no new plans to talk about markets right now. So that's something that Peter has onboarded will evaluate additional investments in current markets and/or new markets we want to go into over time. But it's still a very important part of the long-term strategy.

[Christopher Bruzzo, executive]

And it's really about -- it's not so much about barriers as it is about as we're thoughtful about our priorities, we have to be thoughtful about making an experience that meets the bar. And so the content does have to be relevant and localized. And so you're going to see us be thoughtful about that. And if we're expanding international markets, we're going to do it in a way that we're proud of.

[Operator]

And that will come from the line of Shweta Khajuria with Wolfe Research.

[Shweta Khajuria, analyst]

Hello. Could you hear me?

[Christopher Bruzzo, executive]

Yes. we can hear you.

[Shweta Khajuria, analyst]

Okay. I guess, could you please talk about how you came to the decision with Peter as the CEO, it seems like he has phenomenal experience, especially as it relates to Apple Plus or fitness experience with Apple, which is translatable. But as you were going through different candidates, what specifically about Peter, do you think we'll jump out as he comes on board.

[Karen Boone, executive]

Sure. Well, I couldn't be more excited. This is a fun one to talk about. Peter just really hits and checks a lot of the boxes that we were looking for. as you mentioned, his experience, not just the Apple Fitness+, but really, he has a ton of breadth of experience across hardware, software and content businesses across services, but he's also had a lot of experience driving growth through innovation, and that's where we are in our journey. As we've kind of talked about. We have the stable base. We now need to return to growth. And I also just really believe he's highly aligned with Peloton for values. He has been a member for 8 years. He loves what we're doing. He loves health and wellness. It's part of his own routine and is owned regimen. So I think he believes in the product. He believes in the space. He has a perfect skill set and experience that, and I just think he's going to be a great fit. So we're just really, really excited to get him started.

[Christopher Bruzzo, executive]

It's hard to add anything to that. I would just say on a personal level, he's thoughtful, considerate. He's going to definitely bring an approach to learning, which I think is excellent. And he deeply appreciates what Peloton has done, and he's excited about helping to lead the next chapter. .

[Operator]

Our next question, and that will come from the line of Andrew Boone with JMP Securities.

[Andrew Boone, analyst]

I wanted to double click on the reduction in marketing this quarter. Can you guys talk about the learnings as you guys did pull back there? And what may be incremental and then as we think about that 2 to 3x kind of LTV to CAC target, can you guys talk about the path back into that framework? And then for my second question is I'd love to double-click in terms of Connected Fitness gross profit margins you guys have seen steady improvement there. Is that kind of the ceiling? Or do you guys feel like there's more progress to go? How does that move into a step function and maybe in the double digits? .

[Christopher Bruzzo, executive]

Yes. I mean I'll start and then Liz, you can chime in. I think -- I would say the word at the top are as it relates to marketing is discipline. And I talked about it in the third remarks that I talked about it earlier in the Q&A, but effective audience targeting, being effective in the way that we're optimizing our investments the way that we're focused on the entire picture marketing picture, including the retention and engagement of our existing members. These are kind of the key hallmarks of what Lauren Weinberg, our CMO, has brought in this last year. to Peloton. We've gone from being promotion heavy to one that -- to a place where we're now balancing demand creation and desire with those moments where we can capture demand through conversion events. And and promotions and seasonal opportunities like we have coming up in the holiday and then you see the numbers. We've significantly reduced our customer acquisition costs. We've become much more disciplined in our media spending and a lot more focused on where are those qualified growth audiences.

So all of these areas, I'm really impressed with what Lauren and her team have done and the way they, I think, set up Peloton as part of this broader effort at the company to create a solid foundation of sustainable and profitable growth. So you can expect that to continue.

[Liz Coddington, executive]

So on the question around the LTV to CAC and the path back to getting to that 2x to 3x. So our goal is to get to that 2 to 3x range, ideally closer to 3, and we do have some work to get there. We're not quite there yet. And we have these near-term levers that we are focused on that are under our control. And then as Chris was talking a lot about investing in future growth. So the pricing changes that we've made and the reduced promotional activity that you saw in Q1 are way for us to improve our gross margins.

So we made progress on those in Q1 and as we go into Q2, we will still have promotions over the holidays, but we will continue to make progress on our LTV by improving our gross margins over time. And ultimately, our goal is to get to where we have significant positive gross margins across all products, all channels and all markets. The other piece is around our CAC, which Chris was talking about, that's really about the discipline, not overspending to acquire unprofitable customers. and then also evolving our messaging to target those audiences in order to drive that efficiency.

And then we also have in addition to kind of the working media dollars that we invest in marketing. We're also focused on those nonmedia costs that do hit our sales and marketing and impact our CAC, and that includes things like exiting retail shows, which Karen talked a little bit about earlier, optimizing our brand and creative spend and also optimizing our headcount. So we've been focused on all of those things. Now I think the last part of your question was around Connected Fitness gross margin and do we have ability to make more progress?

We certainly have the ability to make more progress over time. Again, we're really focused on the things that we can control, and you're seeing some of the progress there manifest. And then we will do the right thing in terms of LTV to CAC and if it does make sense to invest a bit more in the LTV side of the equation relative to the [indiscernible] taxable equation. We will continue to make those trade-offs as we go. But our goal is to continue to drive improvement in gross margin because that helps us fund our CAC and create a lot of that efficiency that we're looking for. Our holidays are an example, seasonally higher demand, we will be spending on media in that quarter, and that will drive growth into the future quarters, and we will also be spending on promotions in that quarter.

One other thing I want to mention is that [indiscernible] does sit within our Connected Fitness segment, and it's accretive to our Connected Fitness gross margin overall. So as the precore business grows, that will also drive higher connected fitness margins over time.

[Christopher Bruzzo, executive]

And the Connected Fitness margin.

[Operator]

And that will come from the line of Douglas Anmuth with JPMorgan.

[Bryan Smilek, analyst]

It's Brian Smilek on for Doug. I guess just as you enter the holiday season, can you just talk about which go-to-market channels and initiatives are key to just driving improving seasonality and higher hardware sales and then I know we've talked about it in the past, too, but can you just provide an update where the connected business industry is and the overall cadence of return to growth and rate of decline?

[Christopher Bruzzo, executive]

I'll take the holiday question unless [indiscernible]. Yes, thanks for the question. I mean we're entering the holiday season with cautious optimism. I think we talked about macroeconomic factors that are out of our control, but we're focused on things that are within our control. And I'm just going to be a broken record, and you can expect us to spend this in a disciplined way. We'll spend less on media this year. It will be less promotional than we were in our holiday season last year. And we will continue to manage our LTV to CAC ratios in the right way. But we're excited about, as I mentioned, ways of getting existing members engaged and involved through referrals. The way we're targeting pockets of growth and about new third-party relationships like the 1 we just discussed today related to Costco. So when we can do things like have our bikes available with special bundled pricing and extended warranty like we have like we're doing at Costco, that's another great opportunity. So we have a strong plan. We're prepared in I think we're going to focus well this holiday season.

[Liz Coddington, executive]

So I think the last question was a bit about the connected fitness industry overall. So we do track with third-party data the market share data around connected fitness and market share trends. Our data suggests that the overall fitness market declined around 2% year-over-year in Q1. We're seeing that gyms are settling into a new normal growing around 3% to 4% year-over-year in the last couple of quarters compared to 8% to 9% year-over-year growth that they were experiencing in Q1 and Q2 of fiscal '24. For the connected fitness hardware sales piece, sales overall are continuing to decline year-over-year. So Jim is still taking a bit of share. However, we are such a large part of the connected fitness market, that's the decisions that we are making to prioritize profitability are certainly impacting this trend. Some of the other things that we're seeing are, there are macroeconomic loss like the impact of inflation, interest rates, and uncertainty around the upcoming presidential elections that could be playing into overall Connected Fitness hardware sales in general. And then so just for us, we're focused on the things that we can control, which is really focusing on sustainable and profitable growth and then ensuring that we create the best possible experience for new and existing numbers that are joining our call time community.

[Operator]

And that will come from the line of Eric Sheridan with Goldman Sachs.

[Eric Sheridan, analyst]

Maybe just one question on content. As you continue to sort of build learnings around the business and think about where the strategy is going to go over the medium to longer term as Peter joins, how do you think about the right levels of investment in content duration around content and the role that content can play in continuing to drive sort of end demand on the user side and engagement and sort of conversion metrics over the medium to long term. .

[Christopher Bruzzo, executive]

Yes. Thanks. Well, I mean, is absolutely at the very center of our experience and our instructor-led content is -- it's a hallmark of what makes for a great Peloton experience. So there's -- that's -- we're going to continue to invest there and to innovate. We've done some really interesting things just in the last quarter around bringing new hiking and walking experiences to the treadmill, walking boot camps. We're doing some programs around taking walks after meals, which will be relevant as we approach the Thanksgiving holiday. So there's lots still happening in that space. We talked about all for 1 and the music partnerships that we did there. It has been and will continue to be an area that's incredibly important to us. And yes, I think that will continue.

[Liz Coddington, executive]

I can add one more thing. We are also investing in non-class based content, too. So in our entertainment offerings, in our gaming and fire fitness experiences, which we're leaning into. And so we're seeing the opportunity to expand beyond our core, our incredible instructor-led workout, which we have all these modalities and Chris was talking about some of the new ones that we've added that we really think are going to be value-added but also those non-platform that we are seeing gain some interest and traction, and we think we'll be able to drive engagement over time, which, again, as our subscribers are engaged, then they stick with us, and we've seen that time and time again, and we want that to continue. .

[Operator]

Thank you. I would now like to turn the call back to Ms. Karen Boone for any closing remarks.

[Karen Boone, executive]

Thank you, operator. Before we end the call, I just wanted to thank Chris for all the leadership he has brought to the business over the last 6 months, driving our teams towards innovation and reinforcing our member's first mindset during this period, there has been a lot of transition and a lot of change. I've been really lucky to have as my partner over the last 6 months in our interim co-CEO role, and we're very lucky to have the return to the Board and benefit from his experience and insights going forward. I will continue the role of Inter through the end of the calendar year before handing the baton back to Peter in January. And Chris and I will both be actively involved in ensuring a smooth and successful transition. I really can't -- couldn't be more excited to get Peter on board. In addition to the depth of experience he brings. He really has such a great respect for the many passionate team members who work to bring amazing experiences to our members every single day. And I know he brings a growth mindset and curiosity to learn all about the business. He's going to bring a fresh perspective as we continue on our path to deliver sustainable and profitable growth. And lastly, I am so proud of the Peloton leadership team, the many passionate and purpose-driven team members who are devoted to Peloton's success. All the hard work and progress has really set us up to continue to deliver on our goals as we enter the next phase of Peloton's journey under Peter's leadership, and we truly can't wait to welcome him to the team.

Thank you, and happy holiday.

[Operator]

This concludes today's program. Thank you all for participating. You may now disconnect.