Good companies do not always translate to good investment opportunities. Unfortunately, that disconnect often shows up often when new and exciting companies like the restaurant point-of-sale platform Toast (TOST -2.57%) go public.
There are reasons to be excited about Toast as a company, but here's why I'm passing on the company's recent IPO -- at least for now.
Toast's place in the point-of-sale space
Running a restaurant is no easy task; there are many aspects to keeping the operation running smoothly. Restaurants are often small businesses, and their founders might know more about food than business management and logistics.
Image source: Getty Images.
Toast is a cloud-based, point-of-sale (POS) and software service that helps manage all aspects of running a restaurant business, including order entry, menu management, analytics, online ordering, and much more.
The point-of-sale industry has many competitors, including Square, Lightspeed, Toast, Stripe, and others. These companies have all thrived, because the addressable market is so large: There are more than 31 million small businesses in the U.S. alone, and included in that number is roughly 860,000 restaurants. Toast was built for the restaurant industry from the ground up. This specialization has enabled it to carve out market share among the competition as Toast's platform serves more than 40,000 restaurants.
Looking at the numbers
Toast earns revenue in several ways and breaks its top line into:
- Subscription services
- Financial technology solutions
- Hardware
- Professional services
The company generated $703.7 million in revenue through the first six months of 2021, up 105% year over year. Such growth is impressive, but it's important to note the first half of 2020 included the onset of pandemic lockdowns when many restaurants temporarily closed their doors or reduced their service, making for an "easier" comparison in 2021. While investors should track how the company continues to grow with the pandemic coming under control, revenue in the first half of this year was still up 155% from the same period in 2019.
Toast's margins are a more pressing issue, in my opinion. The company's gross profit margin for the first half of 2021 was 22%, which is a bit low for a technology business. The culprit here is Toast's hardware sales and professional services, which cost more than they generate in revenue.
Investors should look for subscription revenue to grow as Toast expands its customer base over time. Subscriptions are the most profitable segment of Toast's business with a 66% gross margin, but they contributed just 10% of revenue year to date. Otherwise, the company is unprofitable when you factor in sales & marketing, research & development, and administrative expenses.
The hype machine on full power
As companies prepare to enter the public markets, the investment banks that underwrite the initial public offering (IPO) price the stock. A company's financials, comparisons to peers, overall story, and demand for shares can all impact the price at which a company goes public. As a result, "hype" can be a factor.
Toast got a lot of attention leading up to its IPO, and the initial offering price rose accordingly. The deal ended up exceeding its original range of $30 to $33 per share, pricing at $40. When Toast started trading on Sept. 22, its price climbed further with an opening trade of $65.26 per share, though it has since settled in the mid-$50 range.
Why I'm passing on Toast
Toast has generated $1.18 billion of revenue over the past four quarters. Its market cap of $28.4 billion as of this writing values the stock at a price-to-sales (P/S) ratio of 24. Despite referring to itself as an SaaS (software-as-a-service) company, Toast's low gross margin somewhat tarnishes that narrative and could make it difficult to justify the stock's high price tag.
Lightspeed, a similar business that focuses on the broader hospitality industry, trades at a P/S ratio of 35, but it carries a far higher gross profit margin at 54%. Meanwhile, analysts expect industry leader Square to grow at a similar rate to Toast this year (101% revenue growth for 2021), but Square sports a similar gross margin (23%) but trades at a P/S ratio of less than eight.
These comparisons aren't perfect -- smaller companies can often command a premium valuation because they have more room to grow over time. But considering where similar stocks are valued, it seems investor hype has pulled much of the near-term upside out of Toast, which is why I'm passing on the stock for now.
