The elements of a growth stock can vary, but a central feature is its ability to generate better-than-average revenue growth over a sustained period of time. That definition places restaurant technology specialist Toast (TOST -2.74%) in this category, considering it grew revenue 60% year over year in 2022 and it expects to increase revenue about 37% in 2023. Toast is a growth stock with market-beating potential.
Now, some might disagree given that the company isn't profitable -- not even on an adjusted basis. However, beneath the surface, the metrics are trending in the right direction. And one in particular suggests Toast is about to blow investors' expectations away.
How Toast could shock the market
Toast's products are made especially for restaurants. It sells hardware products, including handheld point-of-sale devices. It also has a variety of cloud-based software modules for ordering, customer loyalty, supply chain management, and more.
There are at least two general reasons to like the industry Toast is in. First, spending in the restaurant industry is surprisingly resilient. According to foodservice insight company Technomic, during the last six economic recessions, foodservice spending only fell twice -- and one of those times was during stay-at-home directives stemming from the COVID-19 pandemic. In other words, investors can reasonably expect consistency from restaurant-focused companies even during tough times.
Second, restaurants -- especially the small and medium-size businesses that Toast targets -- are generally in need of technological improvements, providing a large addressable market for Toast. According to the 24th Annual Technology Study from Hospitality Technology, restaurants spent less than 2% of sales on technology in 2021. For its part, Toast believes this could eventually increase to 5%, giving it an expanding market opportunity.
In short, Toast's market is recession-resistant and the adoption of technology within it is poised to increase.
Now, Toast's growth rate is superb. But investors have undoubtedly noticed it has slowed substantially, as shown below.
TOST Revenue (Quarterly YoY Growth) data by YCharts
The company's products are now used by 85,000 restaurant locations. And one would assume that the bigger the business gets, the more challenged its growth will become. However, the opposite might actually be true.
According to Toast's management, the more restaurants that use its technology, the faster (and easier) it grows. Once Toast hits a 20% market share in a particular area, management considers it a "flywheel market." In flywheel markets, leads start coming in more quickly and its win rate increases.
Therefore, it's possible that Toast could actually begin growing faster and more efficiently as it scales. And that would blow investors' preconceived expectations away.
How Toast can improve its bottom line
For what it's worth, there are signs that this is already happening. There are only a couple of quarters of data here, so take it with a grain of salt -- a couple of years would better establish a trend. However, revenue growth is starting to outpace growth in spending for sales and marketing, so perhaps the company is indeed getting more efficient as it scales, supporting the flywheel hypothesis.
TOST Sales and Marketing Expense (Quarterly YoY Growth) data by YCharts
Another dynamic of Toast's business model could allow patient, long-term investors to see better profitability. At the start of a business relationship between Toast and a restaurant, the revenue is low-quality. Hardware and professional services (which include installation services) are two revenue streams with negative gross profit margins for Toast.
Therefore, the cost is steep up front for new customers for Toast. But most of this low-quality revenue isn't recurring, it's one-time. From there, the company has the chance to generate higher-margin sales. Transaction-based revenue has a positive gross margin. But the star the show is subscription services, with a 66% gross margin in the first quarter of 2023.
Toast's revenue for subscription services was up 70% year over year in Q1. This growth was driven by new customers. But existing customers also increased the number of software modules they were paying for. In the first quarter, 42% of Toast's customers were using six of more modules, up from just 36% in the prior-year period.
As subscription services take off, Toast's overall gross margin has shown steady improvement over the past year.
TOST Gross Profit Margin (Quarterly) data by YCharts
Toast certainly needs to increase revenue substantially over the long haul from here. The company's gross margin will need to continue showing improvement. And management will need to keep operating expenses under control. None of this is certain. And failing at any of these things could derail the entire investment thesis for Toast stock.
However, I would say that these financial metrics are trending in the right direction for Toast. If it continues, I would expect the company to surprise investors and reach strong profitability, which would likely allow it to beat the market over the long term.
