Description

Toast (NYSE: TOST)

Date: 11/30/2022

Recommendation: Long

I. Investment Summary

1. The restaurant industry significantly lags the broader economy in technological adoption, spending less than 3% of revenue on technology (vs. ~5% on average across other industries). Current workstreams at restaurants are filled with manual paper processes or legacy technology stacks that are difficult to use, riddled with errors, and frequently experience outages. Especially as Covid-19 catalyzed digital transformation, restaurants face increasing pressure to compete with technology-enabled products.

2. Toast’s ability to win new locations is highly under-rated by the Street. An EMV-induced point-of-sale upgrade cycle from 2015-2017 is lapping its end of product lifespan (~7-8 years), creating higher-than-expected demand for POS systems over the next three years. Additionally, given that Toast’s win-rate of new restaurant openings is much higher than conversions of existing restaurants, we expect significant upwards revisions to Street location estimates.

3. The subscription platform is under-monetized, with adoption rates of newer modules accelerating significantly. Today, Toast customers spend less than one-third of the potential subscription ARPU of the platform, and our channel checks and alternative data analysis indicate that attach rates of key modules (payroll, StratEx, Takeout) on new lands is high. Critically, we believe investors are mis-modeling subscription ARPU growth as these new modules become a larger share of subscription revenue.

4. Because of the lock-in of Toast’s software into mission-critical restaurant workstreams, Toast has effectively won the right to monetize its customers via payments & financial technology products. Contrary to Street beliefs, Toast should see expanding net take-rates as volume mixes towards card-not-present transactions and Toast overlays high incremental gross profit fintech solutions (Toast Capital, Toast Restaurant Card) on top of core payments solution.

5. We believe the setup is particularly asymmetric entering FY23: a recent pricing increase set to become live in December has not yet been factored into Street models, and the lapping of the EMV-induced POS upgrade cycle in 2023/2024 result in current consensus numbers that are far too low. Our base case assumes a 9x fwd. Gross Profit exit multiple and $2.7bn of Gross Profit in 2026, corresponding to a ~2.3x MOIC / 30% IRR over the next three years. 

II. Company Overview

Toast is a vertical software platform that provides a set of software and payments processing tools enabling key restaurant operational workflows ranging from online ordering and kitchen inventory management to payment processing and worker payroll. Restaurant owners often do not enter the food services industry due to their passion for business operations; the industry is structurally low-margin, hectic, and difficult to manage. Toast has simplified restaurant operations for owners significantly, and in doing so, it has become the market leader pioneering the digitization of the food services industry.

Toast integrates payments processing into its software solution, charging customers a monthly subscription fee for access to its core point-of-sale offering and additional recurring fees for add-on modules, as well as a take-rate on the payments volume that restaurants experience. The ability to monetize incremental payments revenue and upsell new subscription modules enables Toast to price their initial hardware solution more aggressively, taking on negative hardware gross margin and pricing out expensive legacy competitors. Additionally, this revenue model results in best-in-class sales efficiency (<15 month payback period) and aligns Toast’s growth with the success of their customers, enabling Toast to see high recurring revenue flow-through with zero incremental customer acquisition costs. 

Gross Profit Disaggregation: Because Toast recognizes payments revenue as the gross interchange (before card networks and issuing banks take their share), we show Toast’s segmentation on a gross profit basis instead. 

III. Under-estimated Location Growth Story

The restaurant industry is in its early innings of digitization, with Toast as the primary beneficiary.

The restaurant industry is sorely under-digitized, spending less than 3% of revenue on IT (versus an economy-wide average of ~5%). While horizontal payments and software solutions have grown rapidly over the last few years, the restaurant industry has been left behind. The complex nature of the industry has resulted in poor product-market fit between traditional horizontal POS players like Square, Clover, or Lightspeed. The list of complexities that restaurants uniquely face is long, including the need for menu SKU modifications, demand to provide food quickly, and ingredient-based inventory management. However, the combination of Covid and persistent labor shortage have demonstrated the mission-critical nature of a technology stack that can streamline key restaurant processes.

% of Revenue spent on IT

The TAM is still mostly greenfield or controlled by clear legacy share donors like MICROS and NCR Aloha.

Toast currently services 74k restaurant locations (42% YoY growth), but it is still the early innings of Toast’s penetration of the market. Our research reveals a TAM of ~860k restaurants in the U.S., of which we estimate ~650k locations are serviceable (excluding large enterprise chains). This yields a high-single digit penetration rate for Toast, which we expect to grow significantly over the next five years. Today, MICROS and NCR Aloha, two clunky, legacy on-premise POS systems, hold significant market share, north of ~50% of all locations. Former employees, industry experts, and customers unanimously place Toast’s steady-state market share at higher than the current combined share of MICROS and NCR Aloha, and our expectation is that Toast will control >50% of the market by the turn of the decade. In certain cities where Toast has a more developed sales force, former sales managers estimate that Toast has 55-60% market share, and we believe this is reflective of their long-term market power as they expand their go-to-market strategy. Our scrape of Toast’s mobile applications confirms significant penetration into the core geographies where the company has built out a sales motion, with swaths of the U.S. remaining largely greenfield. 

Locations of Toast are shown in blue, and sales representative hires are in red

Investors are mis-modeling Toast’s net add opportunity set, resulting in Street estimates that are too low.

The pace at which Toast will grow locations is under-rated. In any given year, ~50-60k new restaurants are opened due to turnover and natural churn (replacing closing restaurants). Moreover, because the life cycle of a POS system is ~7-8 years, nearly 10-15% of existing restaurants look to replace their POS system in any given year. In sum, we estimate that over ~150k addressable restaurants (>20% of BoP addressable restaurants) will replace their POS every year. We believe most investors are misunderstanding this dynamic; because the restaurant industry has higher natural churn, Toast can grab market share at a faster pace than other vertical SaaS players in other verticals. When Toast is at the table during the RFP process, Toast has strong win-rates against peer solutions. Former Toast sales reps estimate that in 30% of opportunities, there was no competitor whatsoever, and Toast would win against Square and Clover in the majority of the remaining 70% of opportunities. These win-rates are especially strong in mid-market and full-service restaurants, where Toast dominates. 

An EMV-induced POS upgrade cycle in 2015 will result in higher-than-expected demand over the next two years.

The requirement for payment processors to accommodate the EMV payment method in 2015 resulted in a larger-than-normal share of restaurants upgrading their point-of-sale system from 2015 through 2017. Because the life cycle of a point-of-sale system is typically ~6-8 years, all the purchasers of POS solutions from 2015-2017 will look to replace their POS over the next ~2-3 years.

% Adoption of EMV-Enabled POS System

By our estimates, on top of the normal ~20% of addressable locations purchasing a new POS in a given year, we estimate that an additional ~3-5% of restaurants will be purchasers of POS systems in the next ~2-3 years due to the lapping of the EMV-induced upgrade cycle. Thus, by the end of 2023, we believe Toast will nearly double location count to ~111k (vs. 101k sell-side consensus) from ~57k at the end of 2021.

IV. Subscription Platform Upsell Potential

Toast has strong potential to drive higher subscription ARR per Location with new modules.

Toast has strong potential to upsell new modules to clients. Particularly, the acquisition of StratEx (now Toast’s payroll module) in 2019 can drive significant ARPU uplift as attach rates increase. Our primary work indicates that StratEx is priced at $10-15/month/employee, and StratEx can expand ARR of a given location by ~$2-3k alone. We estimate current penetration of the payroll module to be ~5% of customers, but feedback from customers indicate that this penetration can expand to >30% through our projection period. Note that 30-40% of Toast’s net adds are restaurants that newly opened, and the mission critical nature of payroll results in significantly higher attach rate (up to 50% in some markets per former sales reps) among these new adds. In total, Toast highlighted during the Q1 ’22 earnings call that payroll was attached to ~30% of new bookings, up from ~15% in Q1 ‘21. As the customer base mix shifts towards adopting payroll, Toast will see significant subscription ARPU upsell.

Above, we show the estimated attach rate and pricing for each of the modules in Toast’s portfolio. Observe that we do not include our discounting assumptions, so the ARR per Location does not precisely tie to the list prices above. These attach rates are based on conversations with former sales representatives at Toast as well as our own alternative scraping of Toast’s mobile app, where the queries reveal if a particular customer of Toast has toggled on certain modules.

The payroll solution is just one of many modules that provide subscription ARR upsell. Across its portfolio, Toast has expanded the percentage of locations using 4+ modules from 27% in Q1 ’19 to 61% in Q2 ‘22. In particular, we believe that delivery and takeout are still under-rated by investors. Our scrape of Toast’s mobile app reveals that just over ~33k restaurants have enabled the delivery and takeout, but former sales representatives have indicated that the attach rate on these products is nearly 100% across new adds. This should blend upwards as more customers are acquired by Toast.

Subscription ARR Per Location over Time (Projected)

Overall, we estimate, guided by customer feedback and assumptions on attach rates of various modules, that Toast can significantly expand subscription ARR per location to ~$8.1k by 2026 (from ~$5.4k today). This assumption is likely conservative, as it does not incorporate new products being launched or pricing increases for a player with significant pricing power. Historically, Toast has often increased prices for key modules, and customers are in sync that pricing could go ~20% higher before they would even consider churning. We expect this pricing power to flow through directly to earnings given zero incremental costs. Based on the attach rate math highlighted above, we believe Toast will deliver higher-than-expected subscription ARR per location than consensus estimates, and we are +4% vs. 2024 consensus subscription ARR per location. Note that management disclosed that new adds in Q2 ’22 had an ARR per new customer of ~$6k, so our assumptions are likely conservative.

Our belief is that investors are hesitant to extrapolate recent strength in subscription ARR per location growth over the past due to sequential ARR per location decline in Q4 ’21 and Q1 ’22 relative to Q3 ’21. As a result, despite the strong Q2 ’22 print, the Street is underwriting a sequential slowdown in ARR per location growth coming into Q4 ’22 / Q1 ’23 in-line with the results in 2021. Our understanding is that this extrapolation of historical seasonality is a mistake. Conversations with former employees indicate that Toast management pushed internally for the sales team to capture more locations in the months leading up to filing for an IPO, resulting in slightly faster location growth (see the acceleration in Q4 ’21 of net adds) at the expense of subscription ARR per location. However, we believe this push has ended (given strength in ARR per location) and the recent acceleration in net adds has been driven by the beginning of the comparison against the EMV-induced purchasing cycle from ~5-7 years ago. Thus, contrary to investor beliefs, subscription ARR per location is likely to continue to accelerate.

V. Fintech Monetization

Core net payments take-rate will expand as Toast volume shifts towards CNP transactions & achieves volume discounts.

Toast’s payments solution is underearning relative to peers and has underappreciated pricing power. Toast currently generates a net take-rate on customer payment volume of ~50bps. This is a significant discount to similar peers like Square, which generates a >100bps net take-rate. Given Toast’s position as the operating system of their customers and the stronger relative value-add to Square, this gap will begin to close as Toast scales in volume and receives greater rebates from card networks. However, it is important to note that their peers’ customers skew smaller, so they will always get better take-rates. Despite this, Toast should see some gross margin accretion from scale due to better rebates from card networks, especially given its recent diversification to having two card processors (instead of just Worldpay).

Additionally, continued adoption of virtual ordering modules like Order & Pay (Toast’s QR code ordering solution) and Toast Delivery Services should support net take-rate expansion as the mix of card-not-present (CNP) transactions increases. Across their products enabling CNP transactions, we estimate only ~20% of Toast’s volume is CNP. However, this should increase over the next few years as these modules see increased attach rates (we estimate Order & Pay is ~25% attach rate today, which could double). Because Toast generates higher net take-rates for CNP transactions (~1.07% for CNP vs. ~0.37% for CP per our primary research), Street modeling of flat net take-rates is likely too conservative. Note that the inherent operating leverage in the business can be seen in the 2020 net take-rate. Because of the pandemic, a significantly larger percentage share of transaction volume was card-not-present when compared to 2021 and 2022. We underwrite that card-not-present as a percentage of overall volume will begin to trend back towards 2020 levels over the projection period, which should support a ~3bps uplift to net take-rates for Toast.

Core payments net take-rate was covertly increased by Toast last week without investors noticing.

Toast will be increasing its payments processing fees starting on December 1st, 2022, providing restaurants with two options to choose between. This was communicated in an e-mail to restaurants, and we have confirmed that a significant sample of restaurants received this e-mail by analyzing reactions on social media forums by restaurant owners.

Starting December 1st, restaurants can choose to either (1) accept a ~0.15% increase per transaction (offsetting Visa & Mastercard’s ~0.10% increase in card network fees in April 2022), or (2) avoid the increase in the interchange rate if the restaurant accepts a $0.99 fee per online transaction paid by the customers of the restaurant. 

This payment pricing increase is incredibly accretive to gross profit and will flow-through the P&L for one month of Q4 ’22 as well as all of FY ’23. We believe this announcement, though covert, is what drove the ~20% increase in Toast’s share price over the last three weeks. By our math, this pricing increase should drive a >5 bps increase in the net take-rate on the payments processing volume across the board, and even more if customers decide to adopt the $0.99 customer charge option. Per our analysis of Toast’s credit card data, the average order value for Toast is ~$35, which means a $0.99 surcharge drives meaningful upside to net take-rates for Toast. We believe the one-month contribution for Q4 ’22 can drive a ~2bps beat vs. consensus net take-rate assumptions for the quarter.

More importantly, this will flow-through the P&L from FY2023 and on. Even if only 2.5% of merchants opt for the $0.99 customer charge, Toast’s net take-rate should expand to nearly ~56bps (or 20% more fintech gross profit on the same volume). As a result, in an upside case where we credit Toast’s price increase, we believe Toast could beat 2023 Street Adj. Gross Profit estimates by >40%. To be clear, we do not underwrite the pricing increase into our base case yet, because it is not yet confirmed if this pricing increase is uniform for all merchants or simply a subset. However, given the widespread reactions on social media forums by Toast restaurant owners, we believe more clarity is imminent with substantial room for upside in the event that this pricing increase is rolled out to even a small subset of customers.

New financial technology products like Toast Capital and Toast Restaurant Card can ramp faster than anticipated.

Toast Capital was launched in December 2019, which enables Toast customers to take out working capital loans from Toast (with loans held on the balance sheet of the partner bank) at favorable rates. Because Toast has visibility into payment flows of the restaurant, Toast is able to better underwrite the risk of its customers when compared to traditional financial lenders. Moreover, instead of the restaurant paying back the bank over a structured amortization period, Toast simply captures daily payment transactions from the restaurant to repay the loan steadily over time.

Our checks indicate that Toast Capital has similar unit economics and monetization mechanisms to Square Capital, but Toast does not hold any loans on its balance sheet (vs. Square which holds a small percentage of loans). As a result, Toast receives a ~3% origination fee (vs. ~5% for Square) and a ~1.5% servicing fee for the volume flowing through Toast Capital. Similar to Square Capital, this revenue is incredibly high margin (>90% gross margin) and incredibly accretive to net take-rates. 

By teasing out Square’s historical financials by product (which turns out to be a non-trivial task given the disclosure), we estimate that Square Capital did $80mm of revenue and $1.6bn of origination volume four years after its initial launch in 2014. This corresponds to 2% of Square’s Seller GPV, and we believe that Toast Capital could undergo a similar ramp trajectory over the next two years. Though it has been two years since launch, keep in mind that Toast (and Square) halted lending during the early months of the pandemic given the uncertainty in the macroeconomic environment. Consequently, we underwrite Toast Capital contributing ~$140m in Gross Profit in 2026, which is ~6bps accretive to Toast’s overall net take-rate (note that Toast’s non-payments fintech gross profit is included in net take-rate, but nothing is added to GPV). We sense-check our ramp by contemplating the corresponding interest expense as a percentage of revenue for restaurants. 

Similarly, Toast Restaurant Card is a debit card available for restaurants to use to purchase inputs and otherwise transact with the working capital of the business. We believe Toast Restaurant Card resembles Square Card, which is Square’s offering for their businesses. The monetization of this restaurant card is through corporate debit interchange, which is a ~2.0% gross take-rate and ~1.2% net take-rate. To consider the transaction volume flowing through Toast Restaurant Card, we conservatively believe the addressable market for Toast Restaurant Card is 30% of restaurant COGS and 25% of restaurant non-payroll operating expenses. We again look at Square Card’s ramp into their addressable volume as a guide for how large Toast Restaurant Card could be during our projection period. By our estimate, Toast Restaurant Card can contribute ~$16m of gross profit in 2026. In our upside case, we include Toast’s recent pricing hike and the incremental gross profit from Toast Capital & Toast Restaurant Card. In our base case, we do not include the pricing hike.

VI. Valuation

Toast trades at a well-warranted ~1.5-turn premium to Vertical SaaS peers given superior growth profile.

Toast trades on-the-screen today at a ~1.5-turn premium to its core peer set (Vertical SaaS) due to its much faster revenue growth (~42% 2022-2024 CAGR). While Toast’s valuation is certainly expensive, our base case does not underwrite significant upside to gross profit embedded in the recent pricing increase.

In our base case, we expect Toast to significantly outperform market indices over the next two years.

In a base case, our core insights lead us to believe that Toast will generate $2.7B of adj. Gross Profit in 2026 and see solid profitability (adj. EBITDA at ~20% of Subscription Revenue + Fintech Gross Profit). At a 9x forward gross profit multiple, we believe Toast will ~2.2x through the end of 2025, corresponding to a ~30% IRR from today’s investment. We believe ~9x forward gross profit is reasonable for a business growing high 20s in 2026, especially relative to both best-in-class integrated payments software companies (SHOP) and vertical SaaS players which command a multiple premium (PCOR).

We believe Toast will significantly beat consensus estimates and the stock should benefit from a positive earnings revision cycle. We are 26% higher than Street estimates on 2024 adj. Gross Profit driven by higher ARR per location (both subscription and fintech) and a +19% beat to 2024 locations. For more details on assumptions, please see the “Fan of Returns” section.

VII. Fan of Returns

We believe the risk/return profile is highly asymmetric, with 3.8x reward / risk over the next 3 years.

Assumptions:

1. Downside Case: Toast is a vertical SaaS player hitting saturation in its core TAM, with intensifying competition cutting at profitability and ability to monetize on fintech and subscription.

   1. Location growth stagnates in 2023/2024 as a recession hits and Toast adds ~13k locations in 2023 before re-accelerating back towards 2022 levels by the end of the projection period. Subscription ARR per Location decelerates to inflation-like growth, with minimal ability for Toast to upsell new modules. Similarly, net take-rates see deterioration as competitors undercut Toast on pricing.

   2. EBIT margins see de minimis operating leverage as Toast’s unit economics deteriorate and payback periods elongate. As a result, Toast does not see profitability (even on an adj. EBITDA basis) during the hold period.

   3. We use a ~6x fwd. Gross Profit multiple upon exit (in 2025) given inferior growth prospects, in-line with slower growing vertical SaaS companies like DCT.

2. Base Case: Toast benefits from the EMV-induced upgrade cycle lapping into the next two years, with more net adds during 2023 and 2024 as a result. 

   1. Toast adds locations at a 31% CAGR during the projection period, with meaningful upside vs. consensus estimates. Subscription ARR per Location grows based on our assumptions around attach rates as shown above, with ~$8.3k of Subscription ARR per Location in 2026. Net take-rates expand to ~0.55% as fintech products like Toast Capital and Toast Restaurant Card are overlaid onto core payment monetization. Toast’s pricing increase is not baked into this case.

   2. EBIT margins expand as Toast holds a payback period of ~15-17 months during the projection period, similar to pre-Covid averages and in-line with management guidance around S&M efficiency.

   3. We use a ~9x fwd. Gross Profit multiple (~35x fwd. EBITDA) given similar / superior profile to key vertical SaaS peers which trade at ~10x on average. Moreover, we conduct a next-buyer’s analysis (see bottom of Summary tab of the model), indicating that selling at ~9x fwd. Gross Profit would still net a Cost-of-Equity-like return for the following owner over the next three years.

3. Upside Case: Toast’s price increase flows into fintech gross profit, EMV-induced upgrade cycle getting lapped results in superior net adds, and Toast expands its subscription product portfolio with new products.

   1. Toast adds locations at a 33% CAGR during the projection period as the buyers, taking share and expanding particularly fast given the influx of demand due to the lapping of the EMV-induced upgrade cycle. Subscription ARR per Location expands to ~$8.6k as Toast expands its platform to new subscription products and upsells key modules like payroll. The December 2021 pricing increase and new fintech solutions flow into fintech gross profit, resulting in ~15bps of net take-rate expansion to 0.66% by 2026.

   2. We exit at an 11x fwd. Gross Profit Multiple (32x EBITDA) given rapid growth (>30%) and significant proof of profitability for investors.

Catalyst

Good credit card data

EMV revision cycle showing up in EPS prints in 2023

Pricing increase shows up in net take-rates