Buying stocks relatively close to their initial public offering (IPO) can sometimes backfire, especially when the company is coming public with a lot of excitement from investors. Restaurant point-of-sale and operating software business Toast (TOST 4.70%) went public in mid-September 2021 at $40 a share, briefly traded near $70 a share not long after the IPO, but has since fallen roughly 71% from its 52-week high.
Such an implosion draws several questions from investors, like whether the stock can come back or if there's something wrong with the business itself. Let's dig a little deeper and see if we can determine whether the stock will rebound or if its investment prospects can better be described as what the company's named after.
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Toast has strong growth in a competitive field
Restaurants can be a challenging business model, which is why roughly 1-in-3 new restaurants don't survive their first year in operation. However, several digital tools have come out over the past decade that help restaurant owners, who sometimes know food better than they understand running a business.
Toast provides its clients with hardware payment terminals and a software ecosystem that lets restaurants do various tasks, including point-of-sale, loyalty programs, payment processing, digital ordering and delivery, operations management, and analytics. In other words, you can run a restaurant from a single integrated platform.
This particular sector is very competitive, with legitimate peers that go head-to-head against Toast, including Block, Lightspeed, and Shift4. However, Toast is designed for and focuses specifically on the restaurant business, which seems to be resonating with its customers. The company recently reported fourth-quarter 2021 earnings, picking up 17,000 new locations since Q4 2020 and growing revenue to $1.7 billion over the past 12 months, a 107% increase.
Toast currently operates in just over 40,000 restaurants and only in the U.S., but there are more than 600,000 restaurants in the U.S. and millions of restaurants worldwide. So Toast's total addressable market is expansive, even with competition present.
How profitable can Toast be?
Toast's downfall since its IPO may not be entirely its fault. The market has turned negative over the past year toward most growth and technology companies, thanks in part to concerns about higher inflation and geopolitical tensions. However, the company's inability to make money thus far could also be weighing the stock down.
The business is struggling to show a clear path to profitability despite more than doubling revenue over the past year. Its Q4 2021 free cash flow was negative $34 million. Additionally, its adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) in Q4 were negative $45 million.
Toast should be seeing operating leverage as it grows (when revenue grows faster than costs, increasing profits). It did $512 million in revenue in Q4 2021, but the resulting $117 million in gross profits means that its margin is just 23%. The lower margin may mean that it will take more time and revenue growth to be profitable. It's something that investors will see play out in future quarters, but the market doesn't seem to appreciate uncertainty these days, punishing unprofitable companies.
Does the valuation make sense today?
The charts below show how Toast trades with its competitors, using price-to-sales ratios to gauge their valuations. Toast remains the second-most-expensive stock in the group, even after its sharp decline. However, that valuation could be justifiable because of Toast's strong revenue growth, which was 107% over the past 12 months. The question for investors moving forward is whether Toast can continue growing at this pace, and only time will tell.
TOST PS Ratio data by YCharts
Investor takeaway
Toast's valuation needed to come back down to earth, and it did. Investors that feel comfortable waiting for Toast to grow into profitability could see strong returns over the years ahead. When growth stocks trade at attractive valuations, you don't need the valuation to increase to create returns, the real growth of the business itself should do most of the heavy lifting.
