Side dishes are the best part of Thanksgiving. Candied yams. Mashed potatoes. Stuffing. Yum. On Thanksgiving 2020, 88,000 Peloton subscribers had a side of cycling with their turkey. The company’s Turkey Burn workouts would have overflowed MetLife Stadium’s 82,500 seats. Peloton illustrates how business models, constraints, and opportunities are changing as economic activity shifts online.

Keeping Emma Busy

The internet enables scale that’s impossible to match offline. For example, Peloton has 36 fitness instructors. In the fourth quarter of 2020, it logged 98 million workouts. On average, each instructor led 30,000 athletes per day, enough to sell out Madison Square Garden and then some. Hosting 98 million workouts offline would require thousands of instructors, orders of magnitude more than what Peloton employs.

Modest headcount can serve massive online audiences. In September 2017, Peloton had 11 instructors and logged 2.5 million quarterly workouts. In the fourth quarter of 2020, Peloton logged 98 million workouts, a 3,800% increase. Over that period, instructors grew 227% to 36 from 11. Similarly, quarterly workouts per instructor grew 11x to 2.7 million from 227,000. Scaling like this only happens online.

To Infinity and Beyond

Moving online changes an industry’s constraints and economics. For example, space is a limitation offline. A studio can only hold so many yoga mats. Similarly, the number of seats in a spinning studio are fixed. A bike can only be used by one person at a time. If you book it, I can’t. Geography is another constraint. Your gym is probably located near your home or office. Similarly, time is a limitation. Offline classes run on set schedules. Looking for a 6:13am or a 9:48pm? You’re out of luck. Lastly, offline classes are single serving: held once, then gone forever.

Moving online removes constraints. Peloton’s 88,000 strong Turkey Burn shows that class size isn’t a limitation. Online classes are infinitely scalable (you’ll just need to buy a bike). Bandwidth is the new constraint, but this is ample and inexpensive. Thanks, AWS. Geography also ceases to be a constraint. You can live in Ames, Iowa or Anchorage, Alaska and stream a workout filmed in London. Similarly, schedules become flexible. Live workouts are time-bound, but past classes can be streamed whenever. There are thousands of 6:13am and 9:48pm classes. Lastly, workouts are all-you-can-eat. Content is produced once, but monetized forever.

Pump up the Volume

Digital goods have high fixed costs, but low marginal costs. It’s expensive to serve the first subscriber, but each additional customer adds little incremental expense. That’s because building a tech platform and content library requires a sizable upfront investment. To launch, Peloton needed to hire designers, engineers, fitness instructors, and producers. However, salaries don’t vary with workout volume or subscriber count. Similarly, content production costs are fixed whether a workout is streamed once or millions of times. As subscriptions grow, the fixed upfront investment is spread thin. For example, between the second quarter of 2019 and the fourth quarter of 2020, Peloton’s workouts grew 450% while instructor headcount, a proxy for payroll expense, grew 24%. The per workout cost fell dramatically.

Peloton has two revenue streams: selling hardware like bikes and treadmills and selling monthly streaming subscriptions. The subscription business benefits from the fixed cost dynamic described above. Roughly 50% of content development costs are fixed, according to Jill Woodworth, Peloton’s CFO. As workouts and subscriptions grow, these expenses stay flat. The remaining 50% of subscription costs, items like music royalties and streaming costs, are variable, growing in tandem with workouts.

Because revenue is unbounded but a chunk of expenses are fixed, subscription businesses can be very profitable. For example, Peloton invested heavily in studios in New York City and London. These studios can serve millions of new subscribers at little additional cost. After rent is covered, extra subscribers are all gravy. In contrast, serving millions of new customers offline requires new real estate. Additionally, the profitability of any one studio is capped by size and time constraints. Another factor enhancing profitability is that workouts are produced once, but can be streamed infinitely. As subscriptions increase, revenue can grow faster than expenses, yielding higher profits.

Sorry SoulCycle

The scale and fixed cost nature of digital businesses changes the investment calculus. An offline spinning studio must turn a profit from a limited number of bikes and classes. This constrains its ability to spend on instructors, studio space and other amenities. When classes are infinitely scalable and unconstrained by geography or time, businesses can spend more. Reach, class size and ability to invest are significantly higher for online businesses (it’s not all peachy, customer acquisition is more competitive too). In a New York Times profile, Robin Arzón, Peloton’s VP of fitness programming and an instructor, compared teaching at Peloton versus a fitness studio as:

The difference between standing with a megaphone in Union Square and getting on the soundstage at the ‘Today’ show

The online playbook is to spend heavily on content and customer acquisition with the hope of running heavy volume over fixed cost. This is why Netflix spends over ten billion dollars on content every year. Similarly, Peloton invested in TV-quality production studios and pays instructors six figures salaries along with stock options and perks like weekly physical therapy. Instructors are treated like professional athletes, according to Peloton instructor Jess Sims.

Digital markets congeal into a few scale players (Amazon, Google, Netflix) at one end, a long tail at the other and no man’s land in between. Due to fixed cost dynamics, scale begets scale. When things go well, more content attracts more subscribers and more subscribers enable investment in more content. The rich get richer. On the other end of the spectrum, niche and differentiated services like personal training sustain the long-tail. The middle gets squeezed as Peloton ups the ante for the value consumers should expect for $39 a month. Fewer constraints and more room to invest make for tough competition.

Peloton is the clear leader in connected fitness. How much fitness eventually shifts online is an ongoing debate. While Peloton experienced heady growth in 2020, it’s impossible to divorce this from Covid-19 lockdowns where home workouts were the only option. If fitness follows the trajectory of other digitized industries, there’s still plenty of room for boutique fitness and personal trainers. However, the prognosis for expensive mid-sized businesses like Barry’s Bootcamp, Equinox and SoulCycle isn’t rosy. Already kneecapped by Covid-19, they could suffer the same fate as the Thanksgiving turkey.

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Originally published at https://kjlabuz.substack.com.

Finance at Indeed. Previously finance at Etsy and internet equity research at Deutsche Bank. Find me @kjlabuz.

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