Peloton reported positive sales and profit results in its Q3 2019 earnings last week, but another announcement in its SEC filing was much more interesting: the company acquired Tonic Fitness Technology, Inc., one of its long-time bike manufacturing partners based in Taiwan, for $47.4 million in cash. The filing said it acquired Tonic because “having greater control over our supply chain will enable us to strengthen and scale production, increase innovation, and allow us to continue to deliver the highest quality connected fitness products in the market.” 

There are three reasons why this move makes sense—trade war diversification, increased margin, and cheaper products—and each is crucial for Peloton’s future.  

Trade war diversification 

CEO John Foley said that the acquisition would give the company greater control amid the ongoing trade war. While Peloton has not leaned heavily on China in the past, focusing on other Asian countries such as Taiwan will give the company “more optionality if we find ourselves in the position of considering stateside manufacturing,” according to Foley. It’s hard to imagine that Peloton could maintain its already-expensive pricing if it had to manufacture its product in America, but there might be a way—if it comes to this—to make some parts or assemble the bike locally to avoid tariffs while sourcing most of the components from abroad. While there have been recent signs of trade war progress between China and the United States, Peloton’s acquisition is proof that the business community has little faith that the rocky waters ahead will calm down anytime soon. 

Increased margins

Peloton is vertically integrated in a number of ways: on the media since it produces and distributes its own content; on the logistics side since it manages its own delivery and installation in some markets. But when it comes to manufacturing, as noted above, the company relies on third parties to bring its products to life. Peloton gives up margin as a result but trades shifting the full burden of running its own manufacturing to a third party. With the Tonic acquisition that changes and offers Peloton increased margins and more complexity.   

Peloton reported a 45.8% gross margin in 2018 on its connected fitness products (bike and treadmill), which is very good. But in 2019 that number dropped to 43%, which it attributed to increased deliveries of its treadmill, which has a lower margin, in addition to rising delivery costs across its business. Tonic is a bike manufacturer as of now, which makes the purchase a bit more questionable because the treadmill is really where Peloton needs margin and therefore manufacturing help; there are also many complaints from angry customers on Peloton’s forums about the questionable quality of the Tread. Sure, better margins on the bike never hurt, but it will be important to watch if Tonic can start manufacturing the treadmill as well to help the company increase its margins and its product reliability. 

Cheaper products

Peloton’s products are not cheap. It’s bike costs $2,245 and the Tread costs $4,295. While the company offers financing through Affirm, which allows shoppers to pay for the bike in installments with Peloton covering the interest payments, it’s nonetheless a significant purchase. Peloton has over 562,000 subscribers across its platform as of the most recent quarter, but it needs to get much bigger to deliver on its promises to investors. 

Cheaper products will be key to this and news leaked this week that the company is working on a cheaper Tread that will cost below $4,000, in addition to a rowing machine, which could be less expensive than both of its existing products. The company’s purchase of Tonic, again assuming it can manufacture all of these products, will be key to this effort to decrease prices and increase purchases. 

Peloton’s pricing arc might follow that of Tesla’s, beginning on the luxury end of the market and slowly working its way down to the premium end. Peloton by definition won’t be for everyone, especially not its hardware products. But the market for its multi-thousand dollar bike and Tread is akin to Tesla’s limited market for the Roadster, Model S and Model X. If Peloton can come up with its version of the Model 3, it might actually be able to break away from the pack.