Listen in to this episode of Industry Focus: Tech for a breakdown of how Toast (TOST 0.53%) has grown from a humble, point-of-sales solution into a robust offering aimed at making life easier for restaurateurs, staff, and customers.
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This video was recorded on September 17, 2021.
Dylan Lewis: It's Friday September 17th and we're talking about Toast. I'm your host Dylan Lewis, I'm joined by fool.com's tippity-top tea toddler of tremendous treasure troves, Brian Feroldi. Brian, how's it going?
Brian Feroldi: Dylan, tell me if you've heard this one before. We're going to dig through an S-1 today and it's a tech company.
Lewis: I know. Listeners at this point are like, "Are you guys ever going to talk about earnings?" We just hit so many of these perspectives, there have been so many interesting companies that have come public. This business we're going to be talking about today, Toast, soon to be public probably at some point later this month. I have to say Brian, before we get into the breakdown of the company, got to give a shout out to one of our listeners. We're talking about Toast today because Daniel Rodin said, "Be interested to hear about the Toast IPO, it sounds like a compelling industry with real growth potential. Love the show." I think just to kick things off, Brian, let's talk a little bit about who this company is and what they do.
Feroldi: I've never heard of Toast prior to me reading through the IPO, but apparently they are a big deal in the restaurant industry. First, a little background about the IPO itself. We still don't have all the details yet, so the day we're going off of is the most recent S-1A. The company is looking to come public somewhere between $30-33. Although as we've seen before, that price could move. If they hit $33, it looks like they'll raise about $800 million and the valuation of this company will be $15 billion. This is a big software company that I'd never heard of.
Lewis: Yeah, it's definitely in that category for me, I was shocked at the sticker price of the valuation that was being turnaround given prior to the email about this business hadn't followed it much. But super interesting because this is a company, Brian, that plays in a space similar to a stock that you and I really like, and that's Olo, we've talked about that on the show before. Very different business, very different financial makeup. But at core, this is a business that is bringing technology to restaurants. That has been a very compelling story, especially over the last two years.
Feroldi: What has happened to the restaurant industry over the last two years is nothing short of seismic. What the changes have gone in the restaurant industry have really been a huge tailwind for Toast. Let's start quickly with just the mission of the company. First off, they have a good mission and they promote it right upfront. Toast's mission is to empower the restaurant community, to delight their guests, do what they love and thrive. I love it.
Lewis: Yeah, it's straightforward. It tells you exactly what you need to know. If you watch any speeches given by their CEO, Chris Comparato. Very stakeholder-oriented in how he goes about explaining what Toast does. There is a multi-stakeholder approach here, where they are looking at the restaurateurs, they are looking at the employees, they are looking at the end customers. Really you need to check every single box, you need to tell everybody to find something that truly works in the industry.
Feroldi: We've talked about Olo before on the show. As you've thought, we are both shareholders. Olo is short for online ordering, and that gives you a sense of what that company is focused on. Toast really focuses on basically every other thing that a restaurant could possibly need. Quick background on the restaurant industry. Most people have been to a restaurant and they realize restaurants are complex organizations to run. There are custom food orders all the time, the menus are constantly changing. At the same time, food is perishable and the industry has high turnover and high failure rate mixed with low margins. When you combine COVID on top of that and the fact that consumers are demanding online ordering, mobile ordering, payment at the terminals and delivery is a huge task for these restaurants to keep up with the changing times.
Lewis: Brian, I think just to underscore that for a second, if you listen to the Tuesday show, the Consumer Goods show, they get into retail and restaurants. The businesses that have thrived over the last five years have been chains that have made heavy investments in mobile and customer rewards programs. The Chipotles of the world, the Starbucks' of the world. I think it's proven over the last couple years to be difficult even from very large organizations to nail that. Imagine being a smaller business, maybe a regional chain or a mom and pop shop. It's near impossible to do that on your own. You really need someone else to be bringing that stuff in for you.
Feroldi: Yeah, just think about all the functions that a restaurant owner needs to think of to service their customers and their employees. They're just taking the payments, collecting the orders, there's marketing, there's recruiting, there's payroll. Again, there's dealing with mobile orders. That's a lot going on. Historically, restaurants have taken care of each of those functions, either through manual processes or by buying a few different specific software packages. Toast got its start by providing restaurants with point of sale solutions, but they have now expanded significantly to offer basically any software tool that a restaurant could need. They offer point of sale, payment, payer processing, gift cards, loyalties. They can help with inventory, with kiosks, menu management, and online ordering. More recently they've got back-office processes, payroll, marketing, recruiting and even capital, so Toast platform really handles everything that a restaurant needs.
Lewis: I want to take that huge venue of features that you just laid out there and tie it to four figures that were thrown out there in a keynote that Toast CEO gave a few years ago. I think he does a very good job of painting a problem or the problem in the restaurant industry with a couple of numbers here. The first one is 5%, and that is the typical gross margin for a restaurant. We talked about a ton of businesses on the show, Brian. 5% is definitely on the lower end of gross margins for specialty for the tech show, but just generally that is not a lot of money left over to go around and either invest in your business, grow, or do whatever it is that you'd want to do. You're running on tight margins to begin with. 73%, the second number is the turnover in the industry on the staffing side. Three out of four employees leave within a year. Third number, 17%, failure rate for restaurants in the first year and then one in 12, the jobs in the U.S. that are in the restaurant industry. When you put all that together, you have brutal economics. You have a high turnover industry, both in the employees, but also in the restaurants themselves. The success rate, especially multiyear success rate is not particularly high and it is a very large part of the US economy that I think captures why tech-first solutions, especially things that improved the payment speed the employees might get the benefits that they might get, the access to capital for restaurateurs, anything that helps get at that is going to be super compelling for people in this industry.
Feroldi: Those numbers you just throughout are really important. As a reminder, those are numbers in good times. Those numbers get far worse when you throw in a pandemic on top of that. To say nothing of the labor shortages that we've seen essentially across the United States, restaurants are hurting right now and they've been hurting for two years. Companies like Toast are really needed to help these restaurants compete.
Lewis: Let's dive in a little bit to the Toast specific numbers here. Brian, we threw out a pretty gaudy potential valuation for this business. $15+ billion, I think $16.5 billion, maybe $17 billion, depending on where that IPO winds up pricing. I'm sure our listeners are wondering, "Okay. Well, how big is this thing?" What's the scale of this company that we're looking at here?
Feroldi: The headline numbers from the company look pretty good. The company as of the most recent quarter, so this is June 30th, 2021. The company reports basically half $1 billion in annualized recurring revenue. That figure was up 118% over the prior year. As for the customers themselves, this is the top dog and top dog in this space. They have 29,000 individual customers and their software is used in more than 48,000 locations. Some of the big customers that you might have heard of include Jamba Juice, Melting Pot, D'Angelo's and Papa Gino's. Now, this is a payments first solution, that's where the company really got its start and focused on. As of the last year, they've done $38 billion in gross payment volume. But they also offer a Software-as-a-Service business on top of that. Some numbers for that would be there net recurring revenue rate like the dollar-based net revenue retention rate that we know and love, that figure has consistently exceeded 110%. Some impressive numbers right out the gate.
Lewis: Brian, I always try to equate businesses that I'm not as similar with to other businesses, to just be able to get myself a little bit of understanding for how they've developed over time, what the roadmap has looked like. When I was looking at Toast, I couldn't help but think basically Square for restaurants with how they have released their products overtime and how they've expanded. It started as a point of sale. Basically, once you are there as the person who's facilitating payments, you have so much optionality in all of the other things that you're able to hop into. We've seen that in the timeline for what they have laid out for their customers with every additional year that they've been in business, over 10 years at this point.
Feroldi: I think that's a great comparison. In fact, Square is one of their major competitors. But yeah, like you said, the company did get its start in financial technology and payments. Even today, that is the lion's share of this company's revenue. As of the first six months of 2021, financial technology solutions, as they call it, have made up 78% of total sales and that figure grew 121%. Offsetting that is the fact that that is a pretty low-margin business for this company. Their second major source of revenue is subscription services, and that's their SaaS products, and that includes their point-of-sales, software, kitchen display systems, invoicing systems, digital ordering and delivery, marketing, loyalty, etc. That business is also growing pretty quickly, 52% as of the first half of 2021, but that is only 15% of sales. That matters because that is the highest margin product that this company offers. Two other revenue segments for this company include hardware, which is the point-of-sale systems themselves, terminals, tablets, handhelds, etc. That's about 6% of revenue and is also a professional services component for installation of these products, that is about 2% of revenue. Now that's important to know because while hardware professional services aren't that big of a revenue line, they carry negative gross margins. You can add all that together. This is a pretty low-margin business.
Lewis: I think it's super interesting because this company now probably looks a lot different in five years if everything goes the way that they want it to. I'm looking at fintech hardware and professional services and saying, that is the entryway for them to establish relationships with restaurants. The long-term thing to be super excited about is probably the subscription services side of their business, it's much higher margin. But it's really hard Brian to get any revenue on the subscription services side without first establishing himself with restaurants, the hardware has to be there for point of sale type purposes. Of course, the transactions need to be there. So you need fintech solutions. But just looking at what they've been able to do over the last 10 years, it wasn't until 2019 that they started rolling out payroll and team management, marketing, and capital services. Those are the things that make you, one, much stickier for the restaurants that you service, but two, also your financials are probably going to look a lot better because that starts to get more into the subscription services that we know are just going to be more beneficial for the company's bottom line.
Feroldi: Totally. That's just the nature of the way that this business came time-to-market. Again, they initially focused on the financial technology part, the point-of-sale systems. Like you said, once you get that that's the sphere that gets them in the door, and over time, they've gradually been able to build out a full suite of services. We've seen their gross margin increase over the last year and I think there's ample reason to believe that it continued to do so, especially as that subscription service continues to take up a larger and larger portion of the total. But it's still worth noting that right now this is a low-margin business.
Lewis: Yeah. Getting into the financials here for the full-year 2020, over $800 million in revenue up 23% year-over-year. We went into the sources there and gave the breakdown, gross margin when you put it all together, 17%, which was up double from fiscal year 2019. Of course, operating losses as we'd expect for a company in the stage, over $200 million and a net loss of about $250 million for the full year. What's fascinating, Brian, about this business is, I just laid out the full year 2020. If you look at the first half of 2021 for this business, radically different growth story and already dramatically improving financials.
Feroldi: That makes sense. The first half of 2020 got awful for the restaurant business. While this company was winning a huge amount of new business for itself and being installed everywhere, its customers were hurting, so it had to offer very flexible payment terms. There also wasn't a lot of payments flowing through its network. It makes sense that its one-year financials look a bit wonky, but the numbers for the first half of 2021 look much better. Revenue was up by more than double. Gross margin expanded to 22%. While they are spending very heavily on sales and marketing, on R&D, and on overhead costs, those costs are much more manageable now. They did report a net loss of $56 million. That does not excite me as an investor. But if you click into that more, the company actually produced positive free cash flow of $39 million over that same time period. This is a case study. There's going to be yet another case study of the difference between net income and free cash flow.
Lewis: Yeah. It's one of the eternal debates, right, Brian?
Feroldi: I'll take free cash flow every single time. So this company has a good one.
Lewis: Yeah. I think this is a classic business where the year-over-year numbers are just going to look weird. It's bound to happen and part of wanting to see a company come public and get a couple of quarters of results, especially one that operates in the restaurant industry, is just seeing how those things normalize over time. I think we'll probably in the second half of 2021 start to see them hitting more standard comps. I know at one point early on in the pandemic toast had to lay off, I think it was about half of their employees due to a lot of the headwinds in the restaurant industry and everything that was happening with the pandemic. One thing to keep in mind, just with this company is we have some sense of what the growth rates are. Don't expect them to be in the triple-digit year-over-year ballpark. I think they're going to be a little bit closer where they've been historically, although this is the type of business that can find accelerating growth. One thing I think that is super reassuring to me, Brian, is looking at the balance sheet. Plenty of coverage here with cash. As of year-end 2020, long-term debt of just about $170 million is over $580 million in cash on the balance sheet, and based on what we're seeing with the IPO, I think there's going to be even more cash there, whenever they go public.
Feroldi: They are expecting to have over one billion dollars in cash on their balance sheet after they go public, and there are some convertible notes on there and other things that are going to be wiped out. This company will have plenty of financial flexibility to afford losses if it wants to move forward. That's good to see.
Lewis: Yeah. While you and I were not as familiar with this company prior to doing the show, I think it seems to be the leader in the space. I think people in the restaurant industry, especially folks that are tech forward in this industry, have followed this company for a while. I know it's part of the very blossoming tech scene in Boston. Is it fair to say top dog, like best-in-class for the industry, Brian?
Feroldi: Yeah, I would say that that is a fair assessment to make despite the number of restaurants that they have, the number of individual restaurant customers that they have, and then they get great reviews from not only their customers but also from third-parties, saying that they are the fastest-growing done, the biggest suite. So, I think it's completely fair to say that their industry is top dog.
Lewis: We see a lot of other encouraging signs. I think we want to know that especially in a more nascent space that we're investing in some of the best-in-class businesses. We have pretty good social proof of that between what we're getting in terms of customer reviews, what we're seeing in terms of the relationships they have, and also just the scale of the integrations with that, Brian.
Feroldi: Yeah, this is a company that has over 70 restaurant integrations built right into it that makes its product even more appealing to potential customers. Some of the ones you've probably heard of, they've integrations directly with DoorDash, with GrubHub, with Olo, and with OpenTable. It really seems like this is a full suite platform. Once you get started on it, you're going to stick with it for a long time.
Lewis: Of course, if we're getting into anything in the subscription space, one of the easiest things we can look at and say, our people delighted is that annual net retention number 110% recently, which is solid, and we've seen that track over time trending down a little bit, something to keep an eye on.
Feroldi: Yeah, it's an OK number. I would say, but I think that's just the nature of the business that this company is in. Keep in mind, they are serving restaurants in the step prior to COVID, was that about, what was it? 19% of restaurants fail in any given year. The company does not specifically call out its churn rate, but I think it's fair to say that investors are going to have to expect a fairly high churn rate, again, just given the nature of the business. That net revenue retention rate of 110%, 115%, I would say that that's pretty good given the customers at this server and what investors can expect moving forward.
Lewis: Yes, that's a great point. They could delight their customers, be fantastic partners. If the company goes out of business, it's still going to reflect as a lost account on their financials and there's not a lot you can do about that in a high churn industry like a restaurant thing.
Feroldi: Yeah. Reminds me about HubSpot, you just have to think about the customers that it served. HubSpot has never had a dollar-based net revenue retention rate over 100% or hovers right around there. In absolute terms, that sounds terrible, but when you think that they serve a lot of customers that go out of business in that context, it's pretty good.
Lewis: Yeah. I think this is a classic no shortage of opportunity here, type business. Brian, we mentioned it's a best-in-class and leader in the industry. One in 12 jobs in the U.S. economy being restaurant jobs. There is a lot to like here in terms of the potential and really the big greenfield in front of this business.
Feroldi: The company calls out that in the U.S. alone, there are more than 860,000 restaurants locations individually. That gives the company roughly a 6% market share. If you look on a dollar basis though, the company believes that it's annualized recurring revenue potential in the U.S. is about $15 billion, and it believes that it has about 3% of the market share there. But this company is not just a US story, or at least it hopes to be not just a U.S. story moving forward. They do call out that they do plan on entering international markets. If they could do so successfully, the numbers just explode. The company said that there are 22 million restaurant allocations globally and that they generate more than $2.6 trillion in annualized sales. I would say their opportunity in the U.S. is big but the real opportunity of this business is international expansion.
Lewis: Yeah. If you're trying to think of how to make sense of that in terms of how to appropriately discount that as an investor, I would say that's killer optionality. I'm not baking it into what this company becomes in the next three years. It's nice to know that that's there for them, but it's not going to be the core reason why I'd be a buyer of this business if I am a buyer of this business.
Feroldi: Yeah. I agree with that. If the company already had sales in international markets and that was already like, say, 5% or 10% of the total, and we saw clear signs that they were succeeding in international markets. That's one thing, but we don't see any of that thus far. That is a nice-to-have could expand the pie down the road, but like you, I'm not giving them any credit for that today.
Lewis: I mentioned CEO Chris Comparato before. He is not the founder, but he has been with the company for just about half of its operating history at this point. Looking at management culture, Brian, there's a decent amount of inside ownership here. This is a management team where if you are going to become a shareholder, you're basically giving them the power to do what they want to do with that business. That's the way the voting structure is set up.
Feroldi: While they only control insiders. First half, let's talk about the company. The CEO, Chris Comparato, as you talked about, joined the company in 2015. About the three co-founders of this business are all still involved. They currently occupy the roles of President, COO, and CTO, and they have a dual-class share structure, which we've seen many times. While insiders as a group, only own about 15% of the business. On a voting basis, they own 99% of the voting power. What they say goes.
Lewis: Altogether, I think it's not always a bad thing to see co-founders acknowledging that someone else maybe should have taken the help of this business. I don't know how you process that as an investor, Brian. There are a lot of great stories of founder-led businesses that have become wonderful compounders. There are also great stories of businesses and management teams that have identified, it's actually time for someone else to run the show here.
Feroldi: Yeah, I'm perfectly fine with that. There are people out there that are really good at starting businesses and are really good at running them when they're less than 50 or 100 employees. But once you get to a certain size of scale, an entirely different set of skill-sets is needed to take a company to the next level. I really like it when the founders start a company and then continue to be there because it's their soul in the game. They are the ones that really want to think long-term. I'm fine with this. I like the introspection of the founders of the company saying, we can't take this company where it needs to be, let's go and hire somebody.
Lewis: We have talked about a couple of different businesses and even just discussing this company, Brian, Square was the easiest way for us to provide a parallel for people and help them wrap their head around this business. We also mentioned Olo, a company that we're both shareholders in. I think the competition here is generally going to be these more full suite solutions that take an entire look at the business rather than a specific element of the restaurant industry, which is what all it does.
Feroldi: Yeah, that's going to be the No. 1 risk I think for investors here, is just the huge amount of competition. In the payment space, we talked about Square. There's also other companies like TouchBistro, Clover Health, Lightspeed, POS, etc. On the back-office side they are competing against companies like Oracle Micros, NCR, PAR Technologies. There's also Heartland Payment System, Shift4, Fiserv, etc. There is a huge amount of competition in the space. So far the company has been able to transcend that, win market share, and it's doing so because it seems to have the biggest suite of product offerings, but make no mistake. Those are some well-heeled competitors in the space and that's going to be something for investors to watch.
Lewis: I think putting this all together, I really like the way that they have gone to market and the way that they've expanded their offerings overtime. It creates a solution that's very obvious to people that are in the restaurant industry just based on the scale of what they're able to do. There are some industries where, Brian, it makes sense to go with something that's slightly more specialized and tailored to what you do rather than a square that can do that. But does it for retail in general. I think there's something really good there. I am a watcher of this stock as it comes public. I will say, I think there is something compelling here and worth paying attention to. Particularly if we see the subscription side of this business grow because it's going to have a dramatic effect on what the company financials look like.
Feroldi: Yeah. I say, I'm right there with you. When I was running for this, there's nothing that jumped out of me like, I want to own this on day one. But they clearly built a solid business here. It's growing fast. The platform is very sticky out of the top dog and the space. The founders are still involved. It's mission-driven, free cash flow positive. It's balance sheet will be pretty good and its customers really seem to like it. Offsetting those positives is the fact that it's a low-margin business. I really don't know what normalized growth levels for this company look like because the numbers we're seeing have COVID all over them. I don't know what the long-term dilution rate is. My gut feel is it's going to be pretty high, and while there is a big opportunity in the U.S, they've actually already captured a pretty sizable portion of it. It's not like this company can triple its revenue and still be 1% of the current market opportunity. That means that the international story is really going to have to pay off for investors here, and we have gotten no signs so far that this concept translates internationally, so that's a big risk for investors to watch.
Lewis: I think you nailed it, Brian. I don't know that I can sum it up any better than you just did. We have I think successfully gone through an entire episode without making up, and so I will end with one here. I toast you for your incredible analysis and the fun that you bring to the show, every single week.
Feroldi: Toast to you, Dylan, for a wonderful weekend.
Lewis: Brian, thanks so much for joining me.
Feroldi: Anytime, Dylan.
Lewis: That's going to do it for this episode of Industry Focus. If you have any questions or you want to reach out and say "Hey," shoot us an email at industryfocus.fool.com, or tweet us, @MFIndustryFocus. Looking for more of our stuff, subscribe on iTunes, Spotify, or wherever you get your podcasts. As always, people on the program may own companies discussed on the show and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Tim Sparks for his work behind the glass today, and thank you for listening. Until next time, Fool on.
