A Brief Analysis of Toast’s IPO

Last month Toast, the restaurant-tech company, went public and surged 56% in its NYSE debut. It raised about $870M in its IPO, selling shares at $40 each. The stock closed at $62.51, boosting Toast’s market cap to over $31B. That’s 288% higher than the $8B valuation the company held in a secondary share sale in Nov 2020. In other words, Toast nearly quadrupled its value in less than a year. Eye-popping wealth accretion like that is often worth double clicking on.

An Intro to Toast

First let’s clarify what Toast does. Taken from their S-1:

“Toast is a cloud-based, end-to-end technology platform purpose-built for the entire restaurant community. Our platform provides a comprehensive suite of software as a service, or SaaS, products, financial technology solutions including integrated payment processing, restaurant-grade hardware, and a broad ecosystem of third-party partners. We serve as the restaurant operating system, connecting front of house and back of house operations across dine-in, takeout, and delivery channels. Our mission is to empower the restaurant community to delight their guests, do what they love, and thrive.”

Fairly straight forward — Toast is a restaurant POS/Software company and they drive revenue through four main income streams: subscription services, financial technology solutions, hardware, and professional services. They’ve demonstrated an impressive growth journey since their founding in 2011 and currently serve about 48,000 restaurants across the US. A large number, but only ~5% of an approximated 860,000 restaurant locations across the US.

At the surface, this is a fairly exciting story of a company helping integrate tech solutions into a relatively laggard industry to streamline restaurant operations for the modern world. While I don’t doubt the company’s mission, I’m skeptical of their valuation — let’s dig into the numbers.

Financials

Toast’s top-line revenue and revenue growth is perhaps its most impressive attribute.

• Revenue grew 24% year-over-year from $665 million in the year ended December 31, 2019 to $823 million in the year ended December 31, 2020. It grew 105% period-over-period from $344 million in the six months ended June 30, 2020 to $704 million in the six months ended June 30, 2021.
• Dec 2020 to Dec 2021 growth is likely to hit 80%+; maybe even 100%. However, this spike is because of how the pandemic affected the business. Growth is likely to drop back to a more reasonable ~35% for 2022.
• From June 2020 to June 2021, the company generated $1.18B in revenue and will almost certainly close December 2021 well above $1B in revenue.
• Assuming similar performance to the first half of the year, 2021 annual revenue will likely close ~$1.5B. Given we’re at the end of October, let’s approximate revenue to date is ~$1.2B.

On the day of Toast’s IPO, the company held a market cap of ~$30B. Today, it sits closer to $25B. For its time on the public markets, the company has traded at about a 20–30x multiple. That kind of premium multiple puts the company squarely between other high-growth SaaS companies.

Creating a $1B business is a hard feat in technology, especially one selling software — there just aren’t that many of them that make it to that scale, let alone to do it in just 10 years. The challenge, however, is that Toast is hardly a software company.

“Financial technology solutions” (integrated payment processing) makes up about 80% of the revenue and unfortunately, the margins of this business are notably lower than traditional SaaS businesses. In fact this service yields only a ~20% profit margin compared to the ~70–80% margins expected of SaaS businesses. As far as some comparisons go, Shopify also profits from integrated payment processing on top of a software platform, but their margin for this service sits closer to 40%. Square, a direct competitor, holds a similar 40% margin too.

The SaaS part of Toast’s business is notably higher margin at 60%, but is still remarkably lower than Shopify’s 80% or that of most other SaaS companies. Also, Shopify’s subscription revenue makes up about 1/3 of the company’s revenue. Toast’s subscription revenue was only $100M in 2020, or ~12% of revenue.

Their other main revenue stream comes from hardware sales. Toast loses 25% on their Hardware revenue. $65M in revenue to $85M in COGS in 2020. This is obviously the lowest margin part of their business but taking a net loss here actually makes strategic sense as they maneuver market penetration and customer acquisition. This is very similar to Square’s approach to GTM expansion too.

Given how the company actually makes money, and its subsequently depressed profit margins which through June 2021 were 21.5%, it’s far-fetched to consider this a SaaS business. Even amongst integrated payment processing software providers, their comparably lower margins are relatively unsurprising. With low-margin customers (restaurants), it’s understandable that Toast also yields lower margins.

Despite a lower gross margin, it’s worth noting that Toast’s EBITDA of -$131M is actually comparable to other SaaS companies of similar scale, growth trajectories, and multiples. This is best shown in the chart below and primarily because they spend comparatively less on Sales. The theoretical long-term upside profitability however is still lower.

Valuation

I’ve attached some SaaS benchmarks for comparison below. Generally, you can see gross margins float between 60% and 80%, top line growth typically eclipses 30%, and EV/rev multiples tend to trade between 15x and 30x, often highly dependent on margin and growth levels. By comparable analysis, even a 20x multiple seems steep for a ~20% margin business that will likely grow at ~30% Y/Y over the next 3 years.

A closer comparison to Toast is Square, which generates ~$16B in revenue and trades at a $116B market cap. It’s TEV/Rev ratio is 7.4x. Its topline LTM growth has superseded 100% and its gross margin pre-2019 floated around 40%; in Dec 2020 margins fell to 28.9%. The question of course, is can Toast get there too…

Toast likely has a significant top-line growth opportunity ahead of them. Perfecting the product and leveraging a product led growth strategy will be integral to scaling with such a wide customer base, but they’ve clearly established strong product market fit and have successful accrued ~50,000 customers (still only 5% of restaurants in the US). Additionally, the revenues generated from payment processing have the chance to exponentially grow if their customers succeed. They are likely going to try and take every page out of Square’s book moving forward. It took Square 10 years to turn in their first profitable quarter, but they’re currently valued above $115B — not too bad…

The takeaway from all this — Toast is a good business, but trades at a very high premium by comparative analysis. Despite a hefty price tag, there is some chance that Toast grows to say a $60B market cap without ever really “correcting” in valuation, but markets are impossible to predict, and we’ll have to wait and see. Other concerns I’d highlight for the business include:

• On a macro level, wage pressures are rising for the restaurant industry, making restaurants a harder business to operate. Anything that hurts their customer base will inevitably hurt them.
• Toast does not benefit from the same e-commerce tailwinds that a Shopify has with their integrated payments bus model.
• Square has certainly taken notice and is the clear leader in innovative POS systems. Though not exclusively focused on restaurants and their acquisition of Afterpay suggests a different strategic direction and slightly different focus, the two will undoubtedly continue to go head to head in the restaurant space. They have formidable competition.