When it comes to all-out growth, restaurant industry "tech operating system" Toast (TOST 3.42%) has continued to deliver since its 2021 IPO. But investors are demanding financial metrics that differ greatly from when this small financial technologist made its market debut. These days, investors are far more concerned about profitable growth.
By certain measures, Toast is making progress in getting itself in better financial shape. If the progress continues into 2024, perhaps Toast is a wonderful long-term value. But after reviewing the company a handful of times since the IPO and ultimately passing on making a purchase, I'm not so sure the stock is such a great deal right now. Here's why.
Is growth about to stall out?
Toast recently reported its third-quarter 2023 earnings, and investors were pleased with further strong growth in revenue (up 37% year over year to $1.03 billion) and annualized recurring revenue (or ARR) up 40% to $1.22 billion.
Toast is constantly expanding its offerings for the U.S. restaurant industry, a highly competitive space where thin profit margins necessitate that a technology partner not take too much of a cut from its customers. Software subscription services (everything from online ordering and delivery integrations to payroll to marketing) are a standout here. Q3 subscription revenue was up nearly 46% to $131 million.
However, Toast is primarily a digital payments processor. The "financial technology solutions" revenue segment was $856 million in Q3 (83% of the total), but gross profit on this segment was just $182 million, a meager gross margin of 21%. Gross margin for a fintech like this often subtracts things like payment network fees and is a more accurate metric to use for a company like Toast.
To make matters a bit worse, Toast is forecasting that growth is beginning to sputter. Revenue is expected to be as high as $1.03 billion in the fourth quarter, flat with Q3, but up 34% from last year's busy holiday season (year-over-year growth was 50% in Q4 last year). Surely a U.S. consumer pressured by higher interest rates is having an effect, but Toast also reports having about 10% market share of the U.S. restaurant industry digital payments space.
10% market share sounds like Toast could have ample room to expand. But I'm not so sure. Just as the restaurant industry is highly competitive and fragmented, so are digital payments. Toast competes against big heavyweights like Block (SQ 2.32%) and Clover (now owned by Fiserv (FI 1.70%)), as well as smaller peers like Shift4 Payments (FOUR 0.22%) and many other small competitors.
A proposed online order fee of $0.99 was also met with significant backlash from Toast's customers earlier this year, and the company later backtracked on it. This hiccup might be overstated for Toast at this point. Nevertheless, competitors like Shift4 have called out the controversial move as benefiting their own customer acquisition in the second half of this year.
Not the best relative value investment
Toast's fee increase snafu seems to illustrate the company's underlying financial position right now. As big as Toast has gotten, it still operates at a GAAP loss ($31 million net loss in Q3) and generates little in free cash flow (or FCF, which was positive $37 million).
And while I don't like to nitpick employee stock-based compensation (SBC) too much, it is definitely worth calling out here. SBC was $206 million in the first nine months of 2023, up 23% from the same period in 2022, and dialing in at a whopping 34% of Toast's gross profit (remember the importance of backing out payment network fees from a fintech's revenue). This is surely having an effect on Toast's ability to ratchet up its profit margins more robustly.
If growth is indeed beginning to stall out, it's high time to start hacking down costs as soon as possible.
All said, I don't think Toast is all that great a relative value right now as we head into 2024. Toast still has much to prove, and peers (including Shift4, a much smaller company that trades for just 18 times trailing 12-month FCF) are already profitable on all counts, and forecasting more robust growth to boot. Of course, imperfections can turn into tailwinds for the stock if management is able to fix them. But with too many financial questions pending an answer, I'm passing on Toast stock right now.
