Some of you may not be familiar with Unity Software, but you are likely a beneficiary of the content developed using their software. For example, in 2020, 71% of the top 1,000 mobile games were made with Unity and had 2.7 billion monthly active end users who consumed content, created, or operated with Unity.

My newsletter primarily focuses on identifying the competitive advantages that differentiate the company. Other terrific newsletters go into greater detail on Unity’s history, financials, management team, and other information.

Unity Software is a game engine, a technology platform for creating and operating interactive, real-time 2D and 3D content. Its platform’s software solutions help game developers, artists, automotive designers, filmmakers, and others, create, run and monetize interactive, real-time 2D and 3D content across multiple devices (mobile phones, tablets, PCs, consoles, AR/VR).

"Today, Fortune and Global 500 companies in industries such as architecture, engineering, construction, automotive, transportation, manufacturing, film, television, and retail are using Unity across many new use cases, including automobile and building design, online and augmented reality product configurators, autonomous driving simulation, and augmented reality workplace safety training. These new forms of content are emerging parts of our business and represent a significant opportunity for growth." - Unity

If you don’t have a gaming background or are unfamiliar with Unity, skip through parts of the video below to gain an understanding of Unity’s capabilities.

Unity surpassed 2 million active developers using their software, making it one of the largest developer communities. Unity monetizes its software through tiered paid subscription plans:

Unity also provides its customers the tools to grow their end-users, run and monetize their content, and increase the lifetime value of their end-users through optimizing customer acquisition costs. As a result, for this revenue segment, Unity profits on a usage basis and revenue share.

"Gaming engines succeed because game distribution has grown, and publishing is more commoditized; by being the next layer of the supply chain after a commodity, they end up with monopolistic economics and a growth tailwind." - The Generalist

The video game industry caught significant tailwinds from structural changes over the last couple of decades. As a result, video games are now a mainstream form of entertainment. Monumental industry changes:

In contrast with the old model:

"Publishers sold physical discs and cartridges through retailers to consumers who mostly played on consoles. Because of the persistent increase in development costs, this model ultimately became a strongly hit-driven one, resulting in a comparatively high degree of consolidation among participants, as only a handful of publishers, retailers, and platforms controlled the larger bulk of the market." - One Up

In this new era, these structural changes lower the barriers to entry into the video game market and broaden the addressable audience. This clearly bodes well for Unity as they continue to democratize 2D and 3D content creation and is taking advantage of the growing audience.

In the past, the video game market was mostly controlled by large corporations that had the capital to build their own game engines. However, Unity lowered the cost of game development as its engine is available to all types of creators at a relatively low cost.

Now smaller game studios are launching because of the turnkey game engine solution Unity provides. Before Unity and other game engines, video games were designed from the ground up and tailored to specific hardware, like the Atari 2600 console. If you are a new game studio, it’s an obvious decision to use one of the few prevalent game engines, like Unity, versus building your own solution. The equivalent to building your own game engine would be a start-up company wanting to spend a significant amount of capital building out their cloud infrastructure instead of using AWS, Azure, or Google Cloud.

Unity’s most significant competitor is Epic Game’s engine called Unreal Engine. However, they currently serve two different markets. Unreal mostly serves AAA games, which are higher fidelity, more code-intensive games. Unity mostly serves mobile games with coding complexity. Roblox is a game platform that allows users to program games with little to no code, of which 67% of users are under the age of 16.

The difference in coding complexity is not a software bug but rather a feature that allows them to capture their desired markets. That’s not to say that they can’t converge into each other’s markets over time.

Learning to build in Unity or other engines is like learning a new language. Developers need to dedicate roughly 6-9 months using Unity to have a foundational grasp of the software, and it takes years to become an expert.

Switching costs are high for both the developer and game studio:

Activision, EA, and other large game studios created and use their own game engines, which is a source of competitive advantage for them because it helps retain employees. EA, for example, uses a proprietary engine called Frostbite, and its developers are trained with that engine. Since the Frostbite engine is unique to EA, employees can’t easily quit and go to another competitor. Instead, the developer would need to relearn a new game engine language. The bottom line is whichever game engine a developer learns, they become stuck to that game engine, especially as their experience increases in using the game engine.

Unity is winning in building a large competitive advantage by addressing the largest developer market in video games: mobile games. Unity’s less code-intensive product enabled a larger audience to build games using their software. And from what I mentioned above, it’s challenging to switch to engines. Therefore, Unity is in a position to retain a massive share of developers in the future.

Unity can further widen the funnel's mouth of acquiring developers by adding no/low code features and moving down the market into rudimentary game development (like Roblox). Unity also partners with universities to train students, which engrains them into the ecosystem early on. Also, there is 750 hours worth of learning content on Unity’s website and certifications that developers can earn, which gives most people the tools to learn their software.

As Unity’s technology improves and closes the gap between Unreal Engine, they can leverage their large, experienced developer community and move up the market into higher quality content development.

Developers skilled in Unity software are fungible across industries that use Unity to create content. Architecture, engineering, and construction firms will pull talent from game studios well-versed in Unity and vice versa. The lines are blurred between the industry developers work in, but one thing remains the same, Unity’s software to become the infrastructure to build content across multiple industries.

"Because it generally is too expensive to develop in-house tools (e.g., game engines), most studios rely on essentially the same technologies. Consequently, a studio’s greatest asset is its talent pool." - One Up

Unity exhibits a network effect moat within the context of the developer talent pool:

"Unity’s popularity is a highly defensible moat itself. It is the engine most students and professionals use to build interactive 3D content. As a result, it is preferred by companies because of the large talent pool to recruit from and there are a lot of young professionals trained in Unity who will see applications for it at non-gaming companies they work at." - Monetizing Media

37% of Unity’s revenue was generated by customers in EMEA; 35% of revenue was generated by customers in Asia-Pacific; and 28% of revenue was generated by customers in the Americas. Thus, their global audience is broad, and their talent pool is diverse.

Every detail seen in a game needs to be developed, from trees to car tires, to the characters' eyes. Depending on the level of granularity, this can be a daunting task to game studios that takes a lot of developer’s time. Therefore, all game studios reuse old code that can be transferred and integrated with new games, decreasing redundancy in coding and saving the studio time and money. However, reusing old code limits a game studio to only their team’s developments.

Unity has a marketplace called the Asset Store, where developers can buy and download code created by someone else and integrate the code into their own content. The types of assets include items, landscapes, visual effects, audio, game templates, and more. The image below shows examples of a house and various dogs for $89 and $100, respectively.

Source: Unity

Searching the asset store and purchasing a $100 asset could potentially save hours, weeks, or months of work for game studios. The idea of the asset store is to reduce the time spent recreating code and redirect developers’ time on more creative tasks to enhance the game.

There are always two sides to a marketplace, the supply and demand side. The supply side is developing code and contributing the asset to the store for others to buy. The demand side is developers who buy the asset and integrate the code into their content. As more developers use Unity and contribute to the Asset Store, the value of Unity’s software becomes greater because there will be more variety and higher quality code to buy from the store. The Unity Asset Store aggregates the supply and demand and creates a self-reinforcing cycle of growth built on network effects. As more developers contribute to the marketplace, customers will find that it provides a more efficient game development process.

The picture below illustrates the top publishers on the Asset Store. The top publishers are both professional and user-generated content. Which effectively demonstrates the value proposition of making money for contributing code assets.

Source: Unity

CD Projekt, a game studio, released a game last year called Cyberpunk 2077, which ended up flopping because of bugs related to performance. But they built an incredibly detailed world (see the picture below)! It cost $121 million in development cost for roughly 9 years and a team of 500 people to create an open world that takes place in a futuristic, cyberpunk city dominated by technology. The level of graphical detail pushed the video game industry limits (perhaps too far, hence why it flopped). However, imagine if CD Projekt sold the assets that were created in the game on a marketplace. For example, they could sell the code of buildings, cars, hands, guns, and numerous other assets.

Source: Cyberpunk 2077

The risk of creating a game is that you don’t know how gamers will respond until it’s published. But what if there were greater assurance that game studio’s return on investment could increase if they sell assets on a marketplace? Perhaps more game studios would undertake ambitious projects that take lots of time and money.

Pricing power is often an indication of a moat. Customers tend to be more price-sensitive when the product is undifferentiated, and the product does not add significant value.

In Unity’s case, if you are a game studio or developer using their software, you are essentially stuck and will take most price increases. At the beginning of 2020, Unity raised its price for Unity Pro and Unity Plus subscriptions.

Unity Pro increased 20% or $25/month/user. This is a no-brainer for game studios to continue using Unity. An average salary for a game developer is $100k. In the eyes of a game studio, the Unity Pro subscription is 1.8% of a developer’s salary, and the price increase was 0.3% of their salary.

Unity’s switching cost moat is great enough to drive its prices and profits upward as long as the cost to the customer does not exceed the cost of switching to a competing provider. I could make the case that Unity’s software is vastly underpriced compared to the value that game studios receive. However, Unity is keeping prices low to gain market share from new game studios and new developers and is not focused on maximizing profits for their current customers.

Final thoughts: I mostly referenced the gaming industry because it is currently Unity’s largest market. However, everything I wrote about above applies to all the different industries that Unity serves.

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Spotify is a uniquely fascinating business to study competitive advantages. They were founded 15 years ago and their profit margins have struggled to break free of the industry's powerful grip. However, that is changing!

This newsletter takes you through the journey of Spotify's path to power.

Spotify is a household name and one of the most commonly used applications every day. Spotify is mixed into my daily activities: exercise, commute to work, tasks around the house, listening while working, hosting people, and more. I can switch from a podcast to a nostalgic playlist from the 2000s to a new music discovery playlist unique to my style. Few companies generate the daily usage equivalent to Spotify.

Most people know Spotify is special, but what about their business durability? The company was founded in 2006 and has yet to turn a profitable year. Why should we believe that that will change? Competitive advantages need to translate into sustainable profits. If they don’t, then it is likely not a competitive advantage. So is there a strategy for scaling without near-term profitability?

Spotify has two distinct product offerings, Spotify and Spotify Premium. Spotify Premium members pay a monthly subscription fee but don’t have to listen to advertisements and can access their playlists offline on multiple devices. Spotify offers a free version with advertisements as a customer acquisition tool. In fact, 60% of Spotify’s paying users first start out using the ad-supported freemium option.

It's no secret that Spotify is trying to become more than just a music streaming platform. In recent years, the company has spent almost $1 billion on podcast-related investments in an attempt to diversify its offering into all things audio, including music, podcasts, live conversations, audiobooks, and more.

The narrative around Spotify is becoming clearer to people as Spotify expands into podcasts and more audio than just streaming music. However, there are still misconceptions on what’s truly important to their long-term competitive advantage and where that value actually lies with these strategic moves.

To understand Spotify’s competitive advantages, you first need to understand the backdrop of the music industry.

The age of the internet and digitalization completely changed the music industry. Reference the chart below to see the timeline and effects of the monumental changes for revenue generated in the music industry. The music industry was at its peak revenue, with CD sales as the main pillar by the time the internet became popular. However, the industry didn’t adopt the internet fast enough. Napster then steps into the story and launches in 1999, giving access to people across the world to download free music. It was a free service of almost every song you could think of, even songs you didn’t know existed. It sounds a lot like Spotify now; however, Napster was illegal and infringed on copyrights. In 2001, Napster was sued and closed its peer-to-peer network, but the cat was out of the bag by that point. Millions of people were used to getting music for free.

iTunes launched in 2001 and became one of the premier marketplaces for music, but iTunes was just a compromise and not a long-term solution. Consumers were given a digital experience, and labels/artists could still make CD-like revenue per song or album, but only for people willing to pay. iTunes never solved consumer behavior for pirating music. Buying a single song for $.99 or an album for $9.99 was too expensive when you compare it to $0 (FREE!). Now Spotify comes into the picture with its revolutionary business model that changed and revitalized the music industry.

Source: RIAA, Moatology

"We founded Spotify to give consumers something they couldn’t get — music anytime, anywhere, and at the right price. Along the way, we broke the grip piracy had on our industry and restored the growth of global music through paid on-demand streaming." – Daniel Ek, CEO

Spotify was a large step function increase in value for both consumers and suppliers. Consumers could access millions of songs for free or cheap for the premium version, legally, and with a massive increase in convenience and consumer experience by having everything on one app. The value proposition was exponentially better than what iTunes offered and even better than pirating music. Spotify made a better version of free music – that’s hard to beat! Artists and labels were able to start monetizing the consumers that were otherwise downloading songs illegally. As you can see in the chart below, revenue increased as music piracy decreased.

Source: Statista

Brands, network effects, and other competitive advantages can take years, if not decades, for a company to build. But what about younger companies and companies that are still building moats? Counter-positioning is often the period of time the company is digging its moats to fend off competitors for the long term.

Counter-positioning is when a newcomer adopts a new superior business model, and the incumbent does not mimic due to avoiding the damage of their existing business. Counter-positioning was Spotify’s launchpad. At the time that Spotify launched, music revenues were dominated by CDs and iTunes. Spotify introduced a profoundly new business model superior to CDs, iTunes, and even pirating music for free. There are two reasons why counter-positioning contributed to Spotfiy’s success and pushed them to scale rapidly while other competitors in the industry sat back and watched.

You might have wondered why a powerhouse like Apple didn’t adapt their model quicker and squash Spotify. For Apple, the music streaming model was not compelling enough at the time compared to selling music on iTunes for $.99/song and $9.99/album. iTunes was making 30% of the revenue generated from selling songs and albums.

Spotify royalties are distributed from the revenue Spotify collects from ads and premium subscription fees. When Spotify pays artists and music labels, they tally the total number of streams for each artist's songs and distribute the revenue earned based on their share of streams out of the total number of streams. The diagram below illustrates how $1 of Spotify’s revenue is distributed to each party. The important difference from Apple’s model is that it requires subscription or ad revenue, which Apple did not have at the time, so they would’ve started from 0.

The decision Apple (and other incumbents) had to make was either to keep selling songs on iTunes for a profit or start over with a new business model that would initially be losing money. Apple would be starting with 0 subscribers; however, they have a large ecosystem to cross-sell. Of course, Apple decided to milk their profits from iTunes until it was absolutely necessary to switch to the newer, superior streaming model. This dynamic is what gave Spotify breathing room to grow.

Counter-positioning: From a competitor’s standpoint, the new business model had a lower net present value; therefore, they intentionally ignored Spotify to avoid destroying their current value.

Many people think Spotify is a broken business model because music is now a commodity; however, music becoming a commodity contributed to some of Spotify’s greatest powers because it led to higher demand and therefore scale! Spotify’s business model made music extremely accessible for anyone, anywhere, for an extremely low price; the result was commoditizing music distribution. Today, distributing music is not unique to any one company. I can listen to the same songs on Spotify, Apple Music, Amazon Music, or most other music platforms. From Apple’s perspective, they realized that the industry economics for Spotify’s model did not support a long-term competitive advantage because there would be no differentiation. Back to the point above, Apple milked iTunes profits as long as possible because they were in no hurry to join a commodity business. Apple, Amazon, and others eventually adopted the streaming model because it was accretive to bundle several other products to add value to their overall ecosystems.

By the time Spotify launched, the music industry’s revenue was nearly cut in half and the iTunes model was never going to revitalize the industry because it restricted demand. Discovering music on iTunes was limited because of the cost to purchase new songs. On the other hand, Spotify made music so cheap and so accessible, demand for music rose. Spotify allowed people to listen to music that they might not have paid $0.99 to buy. That turns out to be extremely valuable because the number of people listening to music and engagement rates have never been higher.

Microsoft used a similar strategy to sell their high margin software:

"Microsoft’s goal was to commoditize the PC market. Very soon the PC itself was basically a commodity, with ever decreasing prices, consistently increasing power, and fierce margins that make it extremely hard to make a profit. The low prices, of course, increase demand. Increased demand for PCs meant increased demand for their complement, MS-DOS. All else being equal, the greater the demand for a product, the more money it makes for you. Commoditize your complements." - Joel Spolsky

Microsoft successfully built demand for the PC market and pivoted to selling higher-margin software, a differentiated product that would yield a greater competitive advantage.

Music played an important role in propelling Spotify’s scale, but music is now just a complement to its overall strategy. Building competitive advantages is about competing to be unique, which may seem dreary for Spotify’s core business, music, because it lacks differentiation. However, increasing demand for Spotify’s music also means increased demand for their other audio content on their platform. Also, by rearranging commoditized content into personalized and popular playlists with continual updating, Spotify is in its own way creating a form of original content.

Counter-positioning: Incumbent competitors realized the new business model offered no support for differentiation because music distribution would be a commodity; therefore, they ignored Spotify.

Daniel Ek talked about the effects of globalization, automation, and digitization:

"You have to either play for being a niche, which could be incredibly profitable if you do it well, or you have to go for scale. And that scale has been completely redefined to a much larger scale than most people would have ever imagined was even possible." - Daniel Ek, CEO

Global-scale is quite clearly Spotify’s goal. Ek has mentioned their addressable market is 2-3 billion users, and they recently reported 356 million active users (158 million premium subscribers), implying a long runway of growth. Scale is the cornerstone on which Spotify is building its competitive advantages, so it is important to understand how they scaled and why.

Source: Spotify

Spotify achieved mass scale and continues to grow its user base because of a few reasons: 1) Most importantly, as I mentioned earlier, counter-positioning created space from competitors for Spotify to scale. 2) Music is a universal language that is listened to across borders allowing Spotify to reach a global audience. For instance, a Korean pop band like BTS can sell-out concerts in America. 3) Spotify’s user experience (UX) and user interface (UI) were superior to competitors.

I briefly touched on the economics of Spotify generating $1 of revenue, but here’s a refresher:

The problem, which has been widely discussed amongst investors, is that Spotify has a marginal cost problem. For every additional user Spotify attracts and additional revenue they make, they still payout 70% of their revenue to the labels and artists. As their revenues increase, their costs increase in a synchronized manner. This is why investors have balked when realizing Spotify has been growing for 15 years yet hasn’t turned a profit. At a smaller size, Spotify has no power to change its current profit structure.

There are two sides to a marketplace — the demand side and the supply side. When music or podcasts are posted to Spotify, it creates supply. When a person is looking for music or a podcast to listen to, it creates demand. Spotify needs to convince the supply side that it is worth it to post on Spotify because there needs to be an assurance that it will be met with a large demand of people wanting to listen. Spotify also needs to convince the demand side that they should sign up with Spotify because they supply users with high-quality content and has a greater variety.

As you can see, a two-sided marketplace has a chicken and the egg problem. It is a delicate process of deliberately scaling while balancing supply and demand to create a functional ecosystem. In the beginning, Spotify agreed to unfavorable terms with the music labels because they needed their large back catalog of music rights, which would bring the supply onto the platform. The labels agreed to terms because they were searching for ways to overcome the piracy issue. Spotify made the supply side of music labels’ distribution a commodity (cheap and available to everyone), which greatly increased demand. Thus, creating a symbiotic two-sided marketplace of supply and demand.

Now Spotify sits in the middle with control of two sides of the market and 356 million users. However, for Spotify to break away from the music industry’s grasp of its business margins, it needs a differentiated value proposition for its buyers and suppliers.

Within the last couple of years, Spotify allocated a lot of capital towards building its podcast ecosystem, especially focusing on exclusive podcasts only on their platform. They acquired companies that give people the tools to create podcasts and signed deals with podcast superstars, such as Joe Rogan. But why didn’t Spotify get into podcasts earlier?

For podcast creators to see the value in exclusively offering content to a platform like Spotify, the platform must have a large audience. This was the key to commoditizing music and building a large-scale audience. Spotify will offer other forms of audio, such as live audio, similar to Clubhouse. The dynamics of network effects will be present in all forms of user-generated audio content: podcasts, live audio, etc. With Spotify’s strategy of investing in new audio content, they gain unique and exclusive audio content that offers a differentiated value proposition to consumers. The more people on Spotify, the more valuable the platform becomes because it will attract more supply (audio content). The more supply on Spotify, the greater the demand (users), which creates a perpetual cycle of increased supply and demand.

Spotify sits in the middle, tasked with tearing down the friction between connecting the supply and demand. The easier Spotify makes it to search for new audio content and to experience the content, then it will add fuel to the virtuous marketplace cycle.

Continuing on the benefits of scale and the network effects of an online marketplace, advertisement dollars follow highly engaged and large markets. As Spotify’s users grow, the value proposition for placing ads on Spotify will increase.

Back in 2019, Spotify tried to play their hand in owning music rights to improve their margins, but Spotify's role was to increase the supply-sides value proposition and realized it is better to become great partners for the labels and artists. They also needed the music labels because of their valuable back catalog of songs. The labels supply is what feeds the machine of the two-sided marketplace.

Spotify released Marquee, which the labels can use to promote songs and albums. Even though Spotify still pays out 70% because of music royalties, they effectively increase their profit share because labels will funnel more money into advertising their music catalog.

Finally, after 15 years, Spotify will start to break away from the industry's stranglehold on their margins because ads sold on Spotify will be a higher contribution margin than music streaming.

Spotify’s two-sided marketplace is a moat because it’s hard to disrupt. A competitor needs a greater value proposition for both the supply-side and the demand-side. Scaling has and will continue to strengthen Spotify’s position of power.

Pricing power is often an indication of a moat. Customers tend to be more price-sensitive when the product is undifferentiated. That is why up until now, the price for customers has not increased and most of the economics go to the music suppliers.

If a company has a moat, then it’ll be able to sustain a lower cost structure or command a higher price. A company can sustain a premium price only if it offers something that is both unique and valuable to its customers. Spotify’s customers are its consumers and suppliers.

Pricing power - consumers:

Spotify increased the price of many of its subscriptions across the UK and parts of Europe, with the US only seeing a hike to its family plans. However, pricing power isn’t just when a company raises prices. Raising prices can often mean that the company realizes they’re capped out in terms of its addressable market. The reason Spotify has pricing power is because Spotify’s plan is to reach 2-3 billion people and they are currently at 356 million. They are at a fraction of their goal, yet they are still raising prices. Scale, as I talked about throughout this newsletter, is the name of the game for Spotify. They would not jeopardize that strategy for the sake of increasing prices unless they are confident they can still sustain their growth.

Pricing power - suppliers:

Marquee, their advertisement product for music labels, demonstrates pricing power because it effectively lowers Spotify’s cost structure.

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Customers that purchase a Peloton bike or treadmill make a significant upfront investment ranging from $1,895 to $4,295. After purchasing Peloton equipment, the value proposition must be meaningfully better for a customer to switch because the sunk costs are so high. Imagine consumers had to pay $1,000 for a TV in which Netflix is the exclusive streaming service for an additional $13 a month. The initial sunk cost would be a deterrent from customers switching to a TV exclusively providing Disney. I'm comparing apples to oranges, and the analogy is far from perfect; still, it illustrates how the initial cost is large enough to dissuade customers from leaving for a competitor later. However, Peloton can't rely on high switching costs to retain customers for the long-term; they need to improve its hardware and software consistently.

For most, sticking to a workout routine is hard! When January comes around, lofty goals are made, but studies show that most goals are abandoned by January 19th. You would expect a business in the fitness industry to have a hard time retaining customers; however, Peloton has averaged a 0.65% net monthly customer churn since 2017. In other words, 99.35% of customers keep using Peloton every month, and 90% keep their membership after 12 months, which is closer to 60% for traditional gyms. Peloton is retaining an insane amount of its customers!

Considering this retention level, when customers purchase Peloton equipment, it essentially locks them into a multi-year subscription revenue agreement ($39/month). Let me breakdown the implications of the high customer retention. First, the gross profit from selling a bike or treadmill (Revenue – Cost to make the bike) is greater than the amount they spend on marketing to acquire customers. Therefore, Peloton immediately earns back the amount they spend on marketing to acquire customers by selling their equipment. After acquiring their customers, the future implied value of the customer from subscription revenues is incredible.

Referencing the diagram below, the critical metric to takeaway is the estimated lifetime value (LTV) per customer is $3,593, which is the future value of subscription revenues. To summarize the value of a customer, Peloton earns back the marketing expense from the hardware they sell, and then expects to gain an additional $3,593 per customer over the next several years.

Source: Peloton (FY 2019)

High switching costs undoubtedly play a role in the high retention because the consumer paid a large sum. Yet, everyone also knows a few people that made an investment in other exercise equipment in their basement that's now collecting dust. So how is Peloton becoming the leader in fitness and retaining most of its customers? A majority of the value-add of being a Peloton user is NOT from the bike or treadmill itself. Don't get me wrong, Peloton sells great equipment, but that is now the bare minimum required in this industry and a fraction of the value of what Peloton has to offer.

A commonly used phrase in 2020 among investors was "Covid-19 accelerated the trends that were already taking place before the pandemic." One exception was boutique fitness studios like Soul Cycle, CorePower Yoga, Barry's Bootcamp, Orange Theory, CrossFit, etc. Before Covid-19, the fitness industry's fastest-growing segment was boutique fitness studios, but that nearly came to a halt and is now slowly recovering. Consumers were paying a premium for high-quality classes because they were hungry for great instruction, experience, and COMMUNITY.

It's tempting to think that the value of joining Peloton is wildly mispriced when comparing it to cheaper alternatives. Prices for memberships to fitness classes seem baffling: SoulCycle ($500 for 20 classes), CorePower Yoga ($149/month), and Peloton ($1,895 + $49/month). However, that grossly undervalues the value of the community aspect. Why don't people want to find yoga YouTube videos for free and save hundreds of dollars a month or buy a cheap stationary bike (Amazon as low as $336)? Because working out alone sucks!

Numerous research studies conclude the benefits of exercising with other people. Here are some of the benefits:

It's more fun!

“In psychology, we have what we call mental blocks, which are certain thoughts and feelings that get in the way of us being able to push ourselves. It might be tiredness or insecurities. When somebody else is involved, it helps us to overcome our mental blocks because we are in it together with someone else.” - Sports Psychologist

Peloton's platform re-creates the community aspect by encouraging peer-to-peer interactions. Also, instructors are trained to talk as if they are talking directly to each user, making a strong connection to the personable instructors and welcoming users in the "Peloton family." Users take pride and ownership over the Peloton community and claim the instructors as their own. Peloton users experience the benefits of group workouts, but in the convenience of their home, which made the company wildly successful during the pandemic when social interactions were limited.

Here are some of the Peloton features that support social interaction and community:

Peloton's community created a strong competitive advantage benefiting from social network effects. Network effects occur when a product or service's value increases as more people use it, which creates a perpetual effect on growth. Peloton dominates in this aspect because when people consider their connected, at-home fitness options and understand the power of group workouts, there is a forceful gravitation pull towards Peloton's community. I chose to buy a Peloton because I had friends, family, and colleagues who were members and could share in the experience. If I bought another brand, the value I would've received would be limited to the quality of equipment and content.

Let me further illustrate this point because it is crucial to Peloton's long-term competitive position. As of December 31st, 2020, Peloton has 4.4 million members and is the world's largest fitness platform. Most people know at least one person that is a Peloton member. Imagine Peloton with 10, 20, 50, and potentially 100 million members, which is their goal for the next 10 to 20 years. If they achieve this growth level, the number of Peloton members you will know will go up by 2x, 3x, 10x, 20x, and so on, making it more enticing each step of the way. When the decision comes for a consumer to decide which fitness equipment to buy, the value of Peloton's vast member base is made known over competing brands. As more users join the community and social interactions deepen, so does Peloton's strategic moat.

E-commerce brands have succeeded by cutting out the middle man and controlling their customers' experience. However, there is a unique value that is hard to digitally replicate that comes from having a physical footprint. Peloton is planning to open in-person studios that will feature live classes, food, and drinks, as pictured below. The company understands the importance of community as their strategy because the value proposition for Peloton is shifting from at-home connected fitness to social network.

Source: Peloton

Increased engagement per user is a strong signal that Peloton benefits from the network effects mentioned above. The monthly workouts per user increased from 7.2 in 2017 to 21.8 at the end of 2020, pictured below in the graph. If members work out close to 22 times a month, that sounds like an addiction, forcing competitors to break members' habits. Peloton's quality of content, software, and user experience creates a desire equal to streaming services or social media, yet Peloton enforces a healthy lifestyle. Television is an easier avenue to hook customers because of the addicting nature; however, for Peloton to replicate that sensation for exercising is an incredible accomplishment.

Full disclosure: my wife and I are victims of the Peloton experience and are now completely addicted.

Source: Peloton

Although the social network effect contributed to increased workouts, Peloton's creative and expansive content library was the main driver. Over the last few years, Peloton expanded the variety of fitness classes, which increased user engagement by completing a full suite of exercising needs. Peloton is now a one-stop-shop for health and wellness with cardio, strength, and meditation classes.

Source: Peloton

As the digital fitness industry grows and matures, the core business model truly becomes a content company. Price being equal, content quality is one of the most important deciding factors.

We're a software company. The entire leadership team comes from consumer Internet… what differentiates us is the software, which includes the streaming and the gamification and the network. We're also a media company on top of that, because we're streaming 12 hours of live TV content each day and have another 4,000 classes on-demand. - Peloton CEO John Foley

A main ingredient in Peloton's secret sauce is music. Music is an essential component of the exceptional content. The tempo of the music plays a role in determining the cadence of your pedaling. Upbeat music is often matched with high cadence performance output, and low-impact rides are matched with slower tempo music. Instructors will also weave the lyrics of a song into an encouraging message or story. Empowering messages in songs might boost your mood, and high-tempo beats can help exercisers get through a challenging workout.

Peloton's first music partnership was with Beyoncé, who signed a multi-year deal to create a series of themed workout classes. Beyoncé has been a Peloton member for several years and brings a large fan base with her to the platform. They also released remixes of three Elvis hits to be used exclusively across a variety of its classes. It marks the first time that artists created exclusive music for Peloton. This is just the beginning of their exclusive content and partnerships with artists.

Peloton has internal tools providing feedback on which music performs better, which music drives higher engagement, what music you're listening to when you set your personal records. They have an enormous amount of data that connects fitness, music, and personal data. Peloton has a unique data advantage with music interacting with fitness.

Peloton’s production of high-quality content in high quantity, in addition to their large customer base, gives them a wide moat. Producing original content becomes a fixed cost that shrinks in proportion to revenue as Peloton continues to scale. I’m going to use fictional, whole numbers to illustrate the point (they are in the ballpark to the actual numbers). Let’s assume Peloton paid $100 million to create all its content in 2020 and had 3 million subscribers, then the cost per customer would be $33. A competitor with only 1 million subscribers that wanted to create an equal amount of content at the same quality, would have to ante up $100 per customer vs. $33 for Peloton. As Peloton continues to grow its user base, its costs per user for content creation will decrease but smaller competitors will get crushed by the cost of trying to keep up. For a competitor to reach Peloton’s scale, they would likely have to lower their prices, but that shrinks their profit margins, which puts them at a disadvantage.

Hamilton Helmer, the author of 7 Powers, wrote this about Netflix, one of the most successful content companies:

If competition offers the same deliverable as Netflix, similar amounts of content for the same price, their P&L will suffer. If they try to remediate this by offering less content or raising prices, customers will abandon their services and they will lose market share. This creates a very difficult position for Netflix’s smaller-scale streaming competitors.

Scale also enhances data, consequently enhancing business decisions. If Peloton uses its existing wealth of user data to build a deeper competitive advantage, the company will be uniquely positioned to win in the future of exercise. They will have the ability to personalize recommendations for users that suggests rides, instructors, type of music, etc. Leveraging their wealth of data and improving the experience will attract more consumers, which will add to the amount of data. Peloton has reached a significant scale to experience the growth momentum from their data asset. As their member-base grows, Peloton will continue to collect data that will help inform future investments.

Peloton's brand is the culmination of everything it does. Their brand is built starting with the delivery experience, quality of equipment and content, apparel, instructor personality, company messaging, and anything they do that interacts with the world. Net Promoter Score (NPS) is a great measurement for a company's brand and customer loyalty. NPS is based on a one-question survey that asks customers to rate how likely they are to recommend the business or product, generating a score from -100 to 100. Peloton has an astounding 94 NPS! A high NPS score means customers love Peloton, and the company is generating a lot of positive word-of-mouth from their referrals.

Brand loyalty has a direct and positive impact on pricing power. The more loyal a customer is, the more accepting they'll be of maintaining a high price or a price increase. It is nearly impossible to find used Peloton bikes online and if you do, most of them are selling at the same price as a new bike. The robust resale market for Peloton gives them a distinct competitive advantage in pricing power.

Positive brand building:

Honorable mention moat:

Mistaken Moats:

Technology has changed the way we interact with each other, but the need for community has stayed constant throughout history. Peloton is at the forefront of developing exceptional hardware & software with community at the center.