The restaurant industry is brutal. Most restaurants eventually fail, and the lack of technology has been cited as a reason. Software company Toast (TOST 3.42%) could be a potential solution.
Toast went public in the summer of 2021, a great time for companies to have an initial public offering (IPO) because of the bullish sentiment in the market. Today, the stock trades down more than 75% from all-time highs after rising interest rates dampened the prospects for various hot growth stocks.
In this case, the stock sale punishment might have gone too far. Here is why investors should consider Toast stock today.
A wild and fragmented industry highlights Toast's value
Food service could be one of humankind's oldest business models. It's a part of cultures worldwide and a popular idea that comes to mind for most entrepreneurs. There are nearly 750,000 restaurants in the United States alone.
But the restaurant business is competitive and far more complex than most realize. Entrepreneurs must manage perishable supplies and their finances, create a good product and an inviting atmosphere, and do everything as inexpensively as possible. This juggling act helps explain why poor technology can lead to restaurant failures.
Toast is an ecosystem of hardware and software designed specifically for the restaurant business. It helps restaurants process payments, do payroll, manage inventory, market to customers, and more. It adds technology to virtually every aspect of running a restaurant, a one-tool-for-all solution.
Today, Toast serves nearly 100,000 total locations. About 75% of new Toast locations originate from inbound inquiries, and 20% come directly from customer referrals. That speaks to the satisfaction customers have with the product. Word of mouth is powerful.
Toast is seeing improving financials
The company's financials could be better despite doing nearly $3.5 billion in annual revenue. The culprit is a meager 21% gross margin. Toast sells its hardware at a loss to acquire customers, relying on recurring, more profitable revenue from subscriptions and payment processing fees.
The good news is that Toast is becoming large enough to begin turning its financials in the right direction. Its free cash flow was $38 million last quarter and nearly positive over the past year. Look for free cash flow to grow faster as Toast grows.
Eventually, its earnings should turn positive under generally accepted accounting principles (GAAP). The company also still has $1 billion in cash and short-term investments against zero debt.
TOST free cash flow data by YCharts; TTM = trailing 12 months.
Competition is always a threat, but the restaurant business is so big that it might matter less. Toast's management estimates the global market opportunity is worth over $110 billion, so there is so much opportunity. And the company is unique compared to competitors Block (parent of Square) and Lightspeed Commerce because it's built for restaurants from the ground up.
Execution is never guaranteed, but there is no obvious roadblock to Toast continuing to grow its top and bottom lines for years to come.
Is the stock overly punished?
The timing of Toast's IPO shows up in the valuation, which once exceeded a price-to-sales ratio (P/S) of 24, a staggering price tag for a company with such low gross margins. But it's far more reasonable today, even too low at just over 2.
How do I know? Because the company's improving financials could completely change the picture a few years from now. Analysts agree; current estimates have Toast's earnings per share (EPS) turning positive and growing to $0.50 by the end of 2025, roughly two years from now.
The stock's price-to-earnings ratio on those estimates is currently about 30. Earnings could grow between 20% to 30% annually beyond 2025, which seems reasonable considering the market opportunity, its current growth rate (roughly 40% in revenue), and its billion dollars in cash. That's a price/earnings-to-growth ratio between 1 and 1.5, a great deal.
It's impossible to know precisely what Toast will do in the future, but long-term investors could eventually be glad they bought the stock at these levels.
