Like every other industry, the restaurant space is modernizing in multiple ways. One of the companies leading this change is Toast (TOST -2.46%). With its point of sale (POS) solution, management software, and delivery products, Toast's product suite is designed for restaurants looking to step up their game.
While the company's products are great, the stock hasn't had a good run as a public company. Since its IPO in the fall of 2021, Toast's stock has practically marched straight down, and is now just under 70% from its high. So is this a buying opportunity for this company? Or is there a reason it had a bad run?
Toast's POS system is just a gateway product
The base of any restaurant is the POS system. It's what places orders and processes payments. But that is just the beginning of what Toast can do.
Giant restaurant chains have the power and resources to offer pickup or delivery. However, it's a little more challenging when a mom-and-pop restaurant wants to do it. With Toast, a simple add-on to the base POS system gives these restaurants the ability to list their restaurants on third-party delivery apps or offer takeout with accurate readiness estimates.
Toast also has products that allow owners to better manage their employees, with payroll and team management software often done by hand in smaller operations. It can also help manage the most complex part of a restaurant -- food management. For example, with xtraCHEF, Toast uses powerful analytics to help restaurants control their costs and see how ingredient prices are trending.
Expansion drives revenue growth
As you can see, it's easy for a restaurant to start with a simple POS solution, then quickly expand to other more powerful tools.
This expansion is what makes Toast an excellent potential investment. As more restaurants grow with Toast, they utilize more products, further increasing Toast's revenue. The graph below shows that most restaurants use four or more products beyond the base POS system.
Image source: Toast. Note: The base POS system and payment processing solutions are not considered "elective" products.
This expansion helped drive Toast's revenue growth in the second quarter to $675 million, up 58% YOY (year-over-year). However, that overall revenue number doesn't tell the whole story behind Toast's business.
| Segment | Q2 Revenue | YOY Growth | Cost of Revenue | Gross Margin |
|---|---|---|---|---|
| Subscription Solutions | $76 million | 100% | $27 million | 65% |
| Financial Technology Solutions | $562 million | 59% | $448 million | 20% |
| Hardware | $30 million | 3% | $61 million | (103%) |
| Professional Services | $5 million | 40% | $25 million | (257%) |
Source: Toast.
All right, that's a long table, but the information contained within it is crucial for understanding Toast's business model. First, Toast loses money on both hardware and professional services. So the fancy Toast tablet you may notice at restaurants is sold at a significant discount to its cost, leading to a negative gross margin.
Toast offers professional services to customers to get them up and running, which is a high cost to the company. But these services are necessary -- otherwise customers would likely be lost in the complexity of the product ecosystem.
Moving to the money makers, payment processing makes up most of Toast's revenue. This revenue comes from a slice of each transaction processed through its payment ecosystem. It isn't a high margin, but it is still profitable.
Finally, there's a reason why Toast's subscription offerings are so crucial to the company: That's where it makes the most money. Each add-on a customer purchase is a massive win for Toast, which is why it will always push customers to add products and continue innovating to expand its offerings. Without that, Toast's business will never break even.
In Q2, Toast's net loss was $54 million, which isn't that far from breaking even. Additionally, Toast isn't following in the footsteps of many of its fast-growing tech brethren -- stock-based compensation and taxes were only $59 million, so shareholders shouldn't worry about being diluted.
It seems like business is right on track, but how about the stock?
Is Toast stock a buy?
Because of its lower gross margins, Toast's valuation is relatively low.
TOST PS Ratio data by YCharts
I think this was part of the stock's problem when it went public -- investors wanted a software company but realized it was a payment processing company with a subscription service on the side. While subscription services won't overtake payment processing in total revenue, as the company gains more customers and increase their usage, Toast's margins will improve, driving the valuation higher.
With customers using more services and locations rising 40% YOY to 68,000, the Toast investment thesis is on track.
I think investors can take a position here, as Toast's impressive product and growing subscription service are just beginning to take hold. However, restaurants are vulnerable to recessions, and many restaurants may close their doors with the U.S. economy struggling. This could be a potential headwind for investors, and needs to be considered a risk.
