The restaurant industry has seen major changes over the past decade, especially since the onset of the COVID-19 pandemic. Small businesses now need to serve multiple delivery companies while also offering a seamless online ordering process across different mobile devices in order to compete with the fast-food giants like McDonald's.

This type of service is something a small business cannot build on its own and is why restaurants typically outsource their technology needs. Toast (TOST 1.05%) is one company that offers these services to individual restaurants, and its stock just went public through an initial public offering (IPO) in late September. Let's take a look at this restaurant technology company and see if it can be a good long-term investment. 

A toaster with two pieces of toast on top.

Image source: Getty Images.

Technology for restaurants

Unlike some of its point-of-sale (POS) and fintech competition, Toast is solely focused on serving the restaurant industry with its technology offerings. Its goal is to have the most comprehensive product suite for a restaurant owner to choose from. This includes both software applications and payment solutions. Toast's software solutions include POS, restaurant operations, kitchen dashboards, online ordering and delivery, and marketing. Restaurants pay a monthly fee to access these products to help them manage their business.

In 2020, Toast reported total revenue of $823 million. The company's subscription revenue was $101 million, growing 62% year over year, with $61 million in gross profit from the segment. With only $140 million in total gross profit in 2020, growth in subscription services is going to be vital for Toast in the coming years.

Toast's payment solutions include POS processing, working capital financing, and payment processing for suppliers and employees. Like most other POS products, Toast takes a small fee -- called a take rate -- on each order that it processes. Last year, Toast's payment segment generated $644 million in revenue, which would make you think the segment is way more important than subscription services. However, since it has to pay part of its fee to the credit card companies and payment networks like Visa and Mastercard, it is likely to have only brought in $135 million in payments/financial gross profit last year.

The company also has hardware and professional services divisions, but those both have negative gross margins and will not really matter to the overall business in the long run. 

It has lots of growth ahead

At the time of its pre-IPO filing, Toast's products were in 48,000 restaurant locations, which is up from 33,000 and 20,000 in 2020 and 2019, respectively. Currently, it only operates in the United States. Clearly, Toast's offerings are resonating with restaurant owners right now. But with over 860,000 restaurants in the U.S., there's plenty of room for this business to grow.

It isn't realistic to expect it will serve every restaurant, and it is competing against market leaders like Square. But if you believe every restaurant needs services like Toast in order to survive and thrive in the 21st century, then it is likely Toast has a ton of room left for expansion. And this is just in the United States. There are an estimated 22 million restaurants globally, which over the coming decades will all need technology solutions to improve their offerings to customers. 

Lastly, Toast has historically gotten consistent growth from existing locations. Its net revenue retention, which measures revenue growth from existing customers, has been above 110% every year since 2015. This means that customers who have been with Toast for more than a year have grown their spending by 10% or more year over year for the past six years.

But Toast's stock is not cheap

While a lot of Toast's business and financials look great, the stock is trading at an extremely high valuation after the IPO. With a market cap of $25.6 billion and only $254 million in gross profit over the 12 months ending June 30, the stock has a price-to-gross-profit ratio of 101. This means that even if the company eventually converts 100% of its gross profits into earnings (which it won't), the stock would trade at a price-to-earnings ratio of 100.

Even Square, the Toast competitor that is one of the most expensive stocks on the market, trades at a P/GP of approximately 30. A P/GP of 100 is much higher than the market average of 6-8 and indicates that investors are expecting Toast's gross profit to grow at a high rate for many years.

Can the company achieve these expectations? Maybe. But even though this business looks solid, there are not many (if any) stocks that deserve to trade at a P/GP of 101. Unless the stock price drops significantly, I'm staying far away from Toast stock.