Toast: Toasting To Success, Premium Valuation Justified (NYSE:TOST)

Investment Thesis

Toast (NYSE:TOST) is a cloud-based POS platform that serves small to midsize restaurants. As of FY23, Toast continued to report consistent and strong growth as the total number of merchants continued to grow rapidly, boosting its annual recurring revenue (ARR) as well as revenue from FinTech (payment solution business). Losses have also been improving over the past few quarters through strong operating leverage. Moreover, the company has a strong balance sheet with no debt. In my view, Toast’s premium valuation is justified given its much stronger fundamentals.

Financial Analysis

1) Subscription Revenue:

In FY23, its higher-margin subscription revenue generated from its cloud-based POS platform grew 54% YoY to $500 million. Most of these revenues were driven by the onboarding of new merchants and the expansion of revenue from existing merchants. Out of Toast’s total number of merchants, 43% are adopting more than 6 products in FY23, an increase from 32% in FY21.

In the prevailing economic landscape marked by escalating costs and tightened budgets, Toast has been aggressively growing its merchant base, with both new and existing customers are not only onboard but also investing in additional products. This underscores the compelling value proposition that Toast offers, aiding restaurant operators in enhancing operational efficiency and driving revenue growth. This is strongly evident as of 2023, they are now available across 106,000 locations — adding 7,000 new locations, versus 6,000 new locations added in 2022, partly driven by international expansion.

Toast has captured 12.3% of the total 860,000 restaurant locations in the U.S. underscoring its dominance in the restaurant technology sector. Although this figure is likely to be lower due to its presence in international markets and enterprise segments, this still indicates that Toast is a preferred choice for restaurant operators, reflecting its strong brand reputation, robust product offerings, and effective S&M strategies.

Furthermore, Lightspeed (LSPD) which serves in similar market as Toast, reported last year that:

“Excluding Customer Locations attributable to the Ecwid eCommerce standalone product, our approximately 168,000 Customer Locations as at March 31, 2023 are located approximately 51% in North America and 49% across the rest of the world and the split of these Customer Locations between retail and hospitality represents approximately 62% and 38% of our total Customer Locations, respectively”

As restaurants are part of the hospitality sector, using a rough approximation, we can compute that Lightspeed has roughly over 33,000 locations (168000 * 51% * 38% ) in the hospitality sector in North America. Considering that North America does not only consist of the U.S. and hospitality expands beyond restaurants, this implies that the number of locations in the U.S. is likely lower. This suggests Lightspeed holds under 3% market share (33000/880000), which is much lower compared to Toast.

With a large customer base already using the Toast platform, it can leverage network effects to attract more merchants, as restaurants are more likely to adopt a system that is widely used within the industry. This creates a barrier to entry for competitors and reinforces Toast’s position as a market leader.

2) FinTech Revenue

The lower-margin FinTech revenue, which makes up the largest component of its total revenue, grew 41% YoY to $3.2 billion in 2023. This remarkable growth was primarily propelled by the escalating adoption of Toast POS platforms, resulting in a substantial increase in gross payment value (GPV). Notably, GPV soared by 38% YoY to $126 billion in FY23, up from $91.7 billion the previous year.

This is the segment of Toast where revenues are primarily transaction-based fees paid by customers to facilitate their payment transactions, generally calculated as a % of the total transaction amount processed plus a per-transaction fee. Toast Capital, which makes up a smaller portion of FinTech solution revenue, provides restaurants with access to funding through loans issued by Toast’s bank partner. In return, Toast Capital receives a fee from facilitating the transaction. Every day, a portion of a merchant’s credit card transactions will go towards repaying the loan until it’s fully paid off. This is to allow merchants to manage their cash flow without hefty upfront costs.

Although my previous article highlighted concerns regarding Toast’s higher payment processing fees compared to competitors, when compared to the overall value that Toast provides, the issue of higher processing fees may seem minuscule.

For GAAP profitability in 2023, losses have further reduced by 25% YoY to -$287 million. In terms of EBIT margin, it is now at -7.47%, a massive improvement from -14% a year ago, and most of these improvements were driven by Toast’s strong operating leverage.

To further drive profitability, Toast has also recently announced that they will be cutting down headcounts by 10% which are primarily non-customer-facing roles. Additionally, management stated that they are expected to hit GAAP profitability by 2H25. Especially in the stock market today where companies are rewarded for achieving profitability,

Focus On Shareholders’ Value

There were particularly 2 points that were notable during the recent 4Q23 earnings call.

1) Managing Stock-Based Compensation Expense more closely

During the call, Toast management talks about managing SBC expenses more closely:

“Stock-based compensation is an area we’re managing with the same rigor and discipline as other expenses…our goal is for stock-based comp to decline from 27% in 2023 to low double-digits as a percentage of our recurring gross profit streams over the medium term. Managing our equity program will also improve dilution. We are committed to maintaining net share dilution on our total fully diluted share count, which includes all stock awards, to below 2% annually.”

During the low-interest rate environment characterized by rapid hiring, companies incurred excessive SBC expenses. These SBC dilute existing shareholders through the issuance of additional shares. In addition, it is a real cost to investors.

2) Share buyback

Management also talked about how they intend to return capital to shareholders:

“Additionally, as we start to scale free cash flow, our capital allocation approach will evolve. This includes prioritizing organic investments in areas we have signal and conviction that we can grow, looking at M&A if we see the right opportunities, and returning capital to our shareholders. To support this, our Board has approved a $250 million share repurchase authorization, which we will leverage opportunistically based on market conditions..”

Management’s decision to authorize a $250 million share buyback not only demonstrates their confidence in the company’s prospects but also signals their belief that the stock is currently undervalued. By opportunistically leveraging share buybacks based on market conditions, management seeks to capitalize on opportunities to acquire shares at attractive prices. By deploying capital for share repurchases, management aims to reduce the number of outstanding shares, thereby boosting EPS. By prioritizing organic investments, pursuing strategic M&A opportunities, and returning capital to shareholders, management is proactively managing the company’s capital allocation to drive long-term growth and enhance shareholder returns.

Growth Going Forward & Valuation

Based on EV/Sales, it’s evident that Toast commands a premium above its peers. However, this premium is justified by its exceptional growth trajectory, boasting a remarkable 3-year revenue growth rate of 67.50%, surpassing peers who have achieved growth rates below 30%+ and 40%+ over the same period. Additionally, Toast enjoys a significantly higher gross margin, coupled with anticipated profitability by the 2H25. Consequently, the market may have factored in Toast’s potential to achieve superior margins compared to its peers, further supporting its premium valuation.

The consensus estimate for Toast revenue is $4.8 billion in FY24 (+24.8% YoY) and $5.97 billion (+21% YoY) in FY25. This estimate also implies that Toast will maintain a similar revenue increment as FY23. Given Toast’s dominant market share in the small to medium restaurant sector, ongoing strong sales momentum, and expansion outside of its core markets, this will continue to support Toast’s growth, which makes these estimates achievable. This puts its forward EV sales at 2.53x in FY24 and 2.05x in FY25.

Conclusion

Toast is a cloud-based POS platform catering to small to midsize restaurants. The company has demonstrated consistent and robust growth, evidenced by the rapid expansion of its merchant base. Its aggressive approach to growth and operational efficiency has positioned it as a dominant player in the restaurant technology sector, capturing a significant market share in the U.S.

Moreover, management’s focus on managing SBC expenses and implementing a share buyback program underscores its commitment to enhancing shareholder value. By prioritizing prudent capital allocation strategies and returning capital to shareholders, Toast aims to optimize its financial position and drive long-term growth.

All in all, Toast shows promising improvements in reducing losses and a clear path to profitability, justifying its premium valuation.

However, at the same time, investors should closely assess the company’s ability to sustain its growth trajectory and achieve targeted profitability by the 2H25, as outlined by management.