Is It Time To Place An Order On Toast?

If you think about it, it is kind of amazing how much the restaurant experience has changed, even in just the past 5 years.

Spurred by COVID, even the smallest "mom-and-pop" food establishments now offer contactless payments and online ordering. It has become an expectation of consumers nowadays. In an industry as fiercely competitive as food service, everyone has to keep up to compete.

The Green Screen stock we’re looking at today is a key enabler of these trends: Toast (TOST).

Toast is doing for restaurants what Square did for small retailers. Better yet, it is one of the very few growth-oriented stocks I’ve looked at recently that trades at an attractive price. Let’s dig a little deeper into this one!

How Toast Makes Money

Toast’s primary value proposition is providing an "instant" point-of-sale platform to pretty much any food establishment, from a large, fancy sit-down restaurant to a single person food truck. Instead of requiring cash, or going through the headache of setting up a merchant processing account at your bank, the proprietor can simply purchase a Toast system and get everything needed to accept almost any kind of electronic payment.

Payments acceptance is a key feature, but the platform offers a lot more than that. If you want to setup an online ordering website, or integrate with a provider like DoorDash, Toast can sell you a solution to do it. Need a system where waiters can digitally enter orders and have them sent to the kitchen automatically? Toast can do it. Want to manage your restaurant’s payroll, inventory, scheduling, and marketing? Toast has a solution for that. Want to create a loyalty program? You can do it through Toast.

Almost anything you want to digitize in your food service-based business, Toast has a solution for.

All of this is in the cloud, so there is minimal computing equipment or IT knowledge needed to get started. Toast leases the hardware at less than cost and will come set everything up for you. An investment in Toast pays for itself in less than 14 months.

The firm makes money in 2 ways. First, it charges monthly or annual subscription fees for continued use of the platform. These are about 13% of revenue but have a profit margin of 67%, accounting for about 35% of the company’s profits.

Second, it takes a small cut of every dollar processed through their system. This payment processing revenue accounts for 83% of total sales, but at a lower 21.5% profit margin. Interest earned on loans through Toast Capital also contribute a little to this segment.

Growth Potential and Recurring Revenue

Nearly 100% of Toast’s revenue is recurring, through repeating subscription fees and payment processing, which is a classic "toll booth" model.

The growth story is pretty intriguing. The firm has a spicy 67.5% 3-year compound annual sales growth rate, and just ended 2023 with a +42% growth figure - not bad.

There are plenty of opportunities to continue growing both "wide" (adding more locations) and "deep" (selling existing clients more solutions).

Toast currently services 106,000 locations. But there are over 860,000 potential clients in the U.S. alone, and over 22 million worldwide! That’s a lot of potential business. Toast grew locations by 34% in 2023, and there’s no reason to think it can’t growth them by 20% or more annually for the next several years.

Going "deep", we see the company sporting a 117% net revenue retention rate. This means that, not only does it not lose many clients, but those clients tend to spend 17% more year-to-year. Much of this is from clients adding additional modules. To wit, in 2021, only 32% of customers used 6 or more Toast applications. In 2023, that grew to 43%. I think there is potential for it to expand further.

All told, Toast sees an immediate addressable market of $15 billion, vs. its current annual recurring revenue of $1.2 billion. Longer term, addressable market could be several multiples of that. Put simply, there is PLENTY of growth potential here for the next decade and beyond.

Is There A Moat?

Toast has a narrow SWITCHING COSTS moat, that gets deeper with each additional module a client adds. It would be a headache - but far from impossible - for a client to switch from Toast to a competitor like Olo or Clover. Toast’s challenge is to make sure that it stays ahead technologically, and continues to price in a way where it won’t lose business. Many of its clients are quite small, and the friction in switching providers isn’t that great.

So far, it looks like the company is doing a good job here. We mentioned its 117% net revenue retention, a good indication that current clients are quite happy with their Toast integrations.

Management and Financials

Toast’s management is a bit of an interesting story. The company was founded by 3 guys that worked at Endeca, which was purchased by Oracle in 2011. However, they hired Chris Comparato in 2015 to scale the company, and he sat as CEO up until the beginning of this year, when he was replaced with co-founder (and former COO) Aman Narang.

It is unclear why Comparato was replaced (he still is on the board and controls 7% of the shares), but a few things may have contributed. Last summer, there was outrage over a $0.99 fee he proposed to add for tickets over $10 - it was quickly drawn back. This may have been the last straw after Toast’s stock had performed very poorly after a $40 IPO at the end of 2021.

In any case, today we have a co-founder as CEO. Narang has a lot of executive experience here, and owns a substantial stake in the company (over 11%). He is joined by fellow co-founders Steve Fredette (president, 13% ownership) and Jon Grimm (CTO, 12% ownership).

On balance, we are left with a heavily founder-led and invested team, which we always prefer.

Financially, Toast is turning the corner. 2023 was its first year of positive cash flow. The balance sheet is debt-free with over a billion in cash. Gross margins have steadily risen from 9% in 2019 to 22% in 2023. Cash ROI is close to 27% even at less-than-mature margins. This is an efficient business. I like what I see, and hopefully the upward trends in profitability will continue.

Risks

Toast falls into the "medium-high" risk category.

Software-as-a-service and payment processing are great, but they truly shine in switching costs when applied to large, bureaucratic businesses where changing vendors is a multi-year process. That’s not the case for Toast, which services mostly smaller clients. It is relatively simple and quick for them to switch vendors if they so desired, which limits the moat here.

Restaurants are notoriously difficult businesses. Only about 20% survive for 5 or more years. Toast will have to spend regularly on marketing and fight with competitors to replace clients that don’t make it.

Food service is also quite economically sensitive. In recessionary times, when folks lose jobs and nest eggs shrink with the stock market, people are naturally less willing to spend money going out to eat. This brings payment volume down, directly hitting Toast’s top line. Expect some elevated down-side volatility in this stock during the bad times.

Finally, we’re assuming things in our price modeling that are not yet true. Toast will need to continue its profitability and growth trajectories for our fair value price to make sense. If growth slows, or reasonable profitability never materializes, this will be a loser.

Conclusion

Toast is a solid business all around, with all the characteristics we look for in a "Green Dot" stock. It makes it into the Watch List.

So now the question becomes, what is a fair value for the stock? Based off of CFO commentary in past earnings calls, I think Toast can eventually reach an 11.5% free cash margin. Looking for 5 year average revenue growth of just over 20% a year, a 4% dilution rate, and using a higher-than-average discount of 11.5%, I think Toast is worth $29.50 per share. With the stock currently at $23 and change, it trades right around a 20% margin of safety. Toast is very close to a BUY right now, but we will wait and see if we can get a slightly better price before diving in.