2024-01-17 03:53:22 ET
Summary
- Toast is a cloud-based platform for the restaurant industry that underperformed the indices in 2023.
- The company has the potential to grow its market share and increase customer adoption with its robust product portfolio.
- Toast's management is prioritizing profitability and has shown improvement in revenue and earnings growth, allowing for upside in the stock.
Introduction and Investment Thesis
Toast ( TOST ) is an all-in-one cloud-based platform that powers the restaurant industry. Although the company operates in a large TAM with an innovative product portfolio, the company has seen its revenue growth slowdown in 2023. While the management has pointed to overall macroeconomic headwinds, the company has taken active measures to improve overall profitability.
While the stock has severely underperformed the S&P 500 and the Nasdaq 100 in 2023, I believe that if the company continues to capture a larger market share by acquiring new customers and driving deeper adoption into existing markets with a robust product portfolio, along with the management remaining committed to improving profitability, the stock can see at least a 32% upside from current levels over a 5-year investment horizon.
About Toast
Toast is a full-service, cloud-based technology platform that is built for the restaurant industry. As of Q3 FY23, the company has processed over $118 B of gross payment volume in the trailing twelve months across 99000 restaurant locations.
Approximately 83% of Toast’s revenue comes from processing transactions, thus representing a significant portion of the company’s overall revenue. Meanwhile, Toast is also gaining traction in selling its customers ancillary software modules, including digital ordering and delivery, marketing and loyalty, supply chain, and accounting, amongst others, through a subscription-based pricing model.
In my view, Toast’s subscription-based products could spearhead its growth story, as the company’s restaurant-only approach and focus on building an integrated platform will create a bigger moat by providing an end-to-end and superior customer experience over the long term.
Building the bull case for Toast
Toast is positioned to grow its market share as customer adoption rises.
As per its latest earnings report , there are approximately 860K restaurant locations in the US, contributing approximately 4% of US GDP from sales. Of the 860k restaurant locations, Toast had onboarded approximately 11.5% of restaurants. With an estimated TAM of $55B in the US, their projected revenue for FY23 of $3.85B will represent 7% of total market share. I believe that moving forward, Toast has an opportunity to grow its sales across both new and existing customers while also expanding internationally.
Toast is already seeing evidence of the “stickiness” of its solution, as 43% of its customers are now using six or more Toast products on the platform, versus 39% a year ago and 28% two years ago.
As per their latest earnings call , their new CEO, Aman Narang, said the following, which highlights the importance of upselling in driving business growth over the long term.
As we continue to broaden our products for our go-to-market team to serve a variety of customer types and pinpoints. Our upsell team becomes increasingly important to drive growth for the adoption of our platform across our customer base. As we approach 100,000 locations and beyond, our upsell teams can get bigger, and we continue to see this as a big opportunity for growth in our business over time.
When it comes to its product pipeline, the company also introduced Toast for Cafes & Bakeries, which is designed to help coffee shops and bakeries grow their businesses faster, while also launching a new Toast Now mobile app for restaurant operators that offers real-time insight into performance data in its latest earnings call.
In my opinion, the restaurant industry remains complex and fragmented at the same time as it undergoes fundamental changes in its businesses driven by inflation, labor shortages, and evolving customer preferences. To remain competitive, companies like Toast need to continually invest in technology to differentiate their products from competitors. I believe that this will enable them to optimize their operations, increase sales, and improve the guest experience. This is a secular force that should act as a tailwind for Toast to capture incremental market share as the total addressable market ((TAM)) grows and evolves.
The management has prioritized profitability.
Toast produced revenue and earnings growth in Q3 FY23 that missed expectations. Revenue grew 37% YoY to $1.032B. While overall revenue has been slowing down, subscription revenue grew 46% YoY, which has the highest gross margin out of all the revenue segments and therefore is a boost to overall profitability.
Meanwhile, adjusted EBITDA came in at $35M, representing a margin of 3.4%. This is a huge improvement from a year ago when adjusted EBITDA was -$19M with a margin of -2.5%. This was accomplished by streamlining total operating expenses, which grew at a much slower pace of 20% YoY compared to the overall revenue growth rate of 37% YoY. To me, this is indicative that the management has re-prioritized profitable growth given the overall macroeconomic environment of higher interest rates. At the same time, it is also reflecting the growing operating leverage of the company.
Shifting gears to FY23 guidance, Toast management is guiding for revenue of $3.83B–$3.86B and adjusted EBITDA of $38–$48M. This would represent a revenue growth rate of approximately 40% YoY, adjusted EBITDA growth of approximately 139% YoY, and an adjusted EBITDA margin of around 1.1%.
From a revenue standpoint, while this marks a slowdown in growth from prior levels, I believe that as the company continues to drive product innovation that allows it to gain more market share by acquiring new customers and driving deeper adoption amongst existing ones, it should be able to grow its revenue in the mid-20’s range over the next 5 years. At the same time, with management that is focused on cost discipline, I expect the company to continue streamlining its expenses, which should also result in improving margins moving forward.
This is how CFO Elena Gomez positions Toast’s 2024 plans for growth and profitability:
So as we think about the next year, if I was to give some color on that, we're growing healthy. We've got a great operating leverage story. So as we enter into 2024, we're going to go in with the same discipline, focused on growth and -- as well on cost discipline. And we've delivered healthy growth alongside driving this operating leverage over $160M in a year. So we're really proud of that. So despite the macro, of course, we're paying attention to it, but that doesn't change the sentiment of this management team about the opportunity ahead of us. I think the one thing I'll say is we're going to continue to invest, obviously, in the core business, but we've got some investments in some of our emerging businesses as well, which will help us really position us for long-term growth.
Building the bear case for Toast
Macroeconomic uncertainties may dampen Toast’s growth plans.
Despite higher inflation and interest rates, US consumers continued to spend on eating out at restaurants, with spending in restaurants up 7.2% YoY, as per the US Census Bureau Monthly Retail Trade. While part of it could be explained by the pent-up demand from the pandemic, the trend may be about to reverse. With the labor market showing early signs of weakness and wages growing slower than before, consumers have racked up a record amount of credit card debt at $1.08T. The longer interest rates remain high, the more consumers will be squeezed by higher interest payments, which will eventually weigh down on spending.
Meanwhile, the Federal Reserve has also laid out its projections , where it believes that the overall US economy will be growing at 1.4% in 2024, slower than before, and since consumer spending makes up 70% of overall GDP, as per the Bureau of Economic Analysis , we should be expecting to see spending levels slow down from current levels in 2024. The Federal Reserve has also laid forth in its projections that it expects the unemployment level to rise from current levels of 3.7% to 4.1% in 2024.
This will negatively affect consumer discretionary spending at restaurants. Toast management is aware of this risk and, as a result, projects its gross payment volume per processing location to decline YoY in Q4.
Should the US economy see a broader slowdown or even a minor recession, I believe that it may have adverse effects on restaurants, as they mostly fall under the SMB target market, which is often prone to business failures as they have limited resources. In that event, I expect restaurants will start to cut back on spending on their technology stack in order to protect margins, which would significantly dampen Toast’s growth plans.
Tying it together: Toast stands to gain 32% from its current levels.
Toast was up 1.28% in 2023, severely underperforming the S&P 500 and the Nasdaq 100. The company is trading at a forward price-to-sales ratio of 1.57, based on its FY23 revenue. While adjusted EBITDA is expected to grow by 139%, the company has yet to turn a profit on a non-GAAP basis. At the same time, the management has not provided a long-term operating model with guidelines.
As a result, I will utilize Seeking Alpha’s average analyst estimates, which project earnings per share will grow to $1 by FY27, which is in line with my estimates. Assuming that Toast is able to reach $1 in earnings per share by FY27, that would equate to a present value of earnings per share of $0.6 when discounted at 9.5%. In that case, the current share price of Toast is priced at a price-to-earnings multiple of 28 in FY27.
Assuming that the company is able to grow its revenue in the mid-20s region on average over the next 4 years, coupled with management that is committed to improving overall profitability, earnings should grow at or slightly faster than revenue growth. In that case, I believe that the price-to-earnings ratio of Toast in FY27 should be at least 2.5–3x of the S&P 500. Taking the S&P 500 as a proxy, where it has grown its earnings by 8% on average over the last 10 years, as per FactSet , with a price-to-earnings multiple in the range of 15–18, I believe that Toast should then be trading at a forward price-to-earnings multiple of at least 38 in FY27, which would translate to an upside of at least 32% over a 5-year investment horizon and beyond.
Conclusions
Despite the uncertainties that persist in consumer spending and the overall macroeconomic environment, Toast looks well-positioned to capture incremental market share in the restaurant industry. In addition, the management has demonstrated financial restraint in pulling together their cost profile, setting them on the path toward profitable growth. I rate Toast as a Buy with 32% upside from current levels.
For further details see:
Toast: Growing Customer Adoption And Expanding Margins Will Likely Drive Impressive Returns