Initial Report: Toast Inc. (NYSE:TOST), 49% 5-yr Potential Upside (Elaine CHIA, EIP)

Elaine presents "BUY" recommendation based on strong product-market fit, aggressive growth strategy, and robust financials, making it a promising investment

LinkedIn: Elaine Chia

1. Company Overview

Toast, Inc. operates a cloud-based, all-in-one digital technology platform for the entire restaurant industry in the United States (US), Ireland, and India. The company was formerly known as Opti Systems, Inc. and changed its name to Toast, Inc. in May 2012. Toast, Inc. was incorporated in 2011 and is headquartered in Boston, Massachusetts.

It is a software suitable for all type of restaurants including Full Service, Quick Service, Fast Casual, Fine Dining, Bar, Café, Bakery, Food Truck, Hotel Restaurant and Pizzeria.

Majority of Toast’s clientele belong to the US SMBs or the mid-market restaurant segment. They also continue to pursue customer growth within enterprise segments of the restaurant market in recent years.

They serve as the restaurant’s operating system, connecting front of house and back of house operations across various service models such as dine-in, takeout, delivery, catering retails. The company offers both software and hardware products for restaurant operations and point of sale (POS).

Some recent notable customers include Sonny’s BBQ, Uni Pizzeria & Grills and PPX Hospitality Group (who owns brands including Legal Sea Foods, representing commitment more than 200 locations in the US).

a. Business Segment

Toast’s business model comes from a blend of subscription fees, transaction-based fees, hardware sales and value-added services. The mix of recurring revenue and transactional revenue create multiple streams of revenue for Toast to capture more value from each restaurant it serves.

There are 4 revenue streams:

Firstly, subscription services. This includes Toast POS, Toast Now, Multi-location management, Kitchen display system, Toast mobile order & pay, Toast catering & events, Toast invoicing, Toast tables, Restaurant retail, Toast online ordering & takeout, First-party deliver, Third-party delivery, payroll and team management,

Secondly, financial tech solutions. This consists of revenue from payment processing, toast capital and purchase plans.

Thirdly, hardware. This consists of revenue from sale of hardware such as Toast Flex, Toast Go 2, Toast Tap, Kiosk, Delphi by Toast.

Lastly, professional services. This consists of revenue deriving from services such as marketing & loyalty, team management, supply chain & accounting, data analytics, training, data migration, support & maintenance, installation and setup fees.

Customers can opt for individual service at ala-carte price or tiered-based subscription package plan for a single monthly price, depending on their operational needs.

b. Sectoral Performance

Revenue breakdown by segment

Overall revenue has grown by 27% YoY, from US$978M in 2Q’23 to US$1.2B in Q2’24.

Highest growth seen from revenue from Subscription Services with 37% YoY growth to US$166M, mainly driven by continues growth in restaurant locations on Toast platform, along with higher product adoption and hence, higher share of wallet across customer base. This shows that more restaurants who are utilising a broader range of Toast’s solutions are joining the platform.

Revenue from financial technology solutions saw a 27% growth YoY to US$1.0B, mainly driven by increase in restaurant location who are using Toast’s payment processing and other financial services such as toast capital and purchase plans. This indicate that Toast’s financial technology sector benefited from higher transaction volume as no. of restaurant onboarded increases.

Revenue from hardware and professional services increases by 8% YoY to US$53M, reflecting demand from POS hardware and professional as customer base grows.

Gross profit breakdown by segment

Overall gross profit margin improved slightly from 23% in 2Q’23 to 25% 2Q’24. Financial Tech gross profit margin remained relatively stable at ~21%. Subscription services gross profit margin improved slightly due to 3% reduction in subscription services COGS as % of revenue. We see the highest improvement in hardware and professional services gross profit margin but still in the negative. This is likely due to offset by pricing and cost of packaging relating to bundled sales.

c. Growth Strategy

Increase location growth with both new and existing customers

Despite the rapid growth and scale, their current customer based are estimated to only account for ~10% of total restaurants in the United States (US). Hence, Toast believes that there is substantial opportunity to grow their location footprint in the US. Toast wants to invest in its go-to-market strategy and prioritize customer success through combination of tailored onboarding services, customer support, simple & intuitive product design and investing in R&D of new product to serve evolving needs or restaurants. They aim to onboard new customers and existing customers as they expand into new locations.

Increase adoption of Toast’s products

Toast believes that they are well-positioned to sell additional products to existing customers through sales & marketing efforts and product-led growth. They have used strategies such as bundling, upselling and cross-selling its products. Toast aims to broaden the subscription services and financial technology product offerings.

Further develop its partner ecosystem

Toast’s integrated platform connects customers to over 200 partners to provide customers with the tool that they need to run their businesses. Partnerships have expanded Toast’s product offerings to employee management, inventory, accounting, loyalty, mobile pay, gift cards, online ordering and digital signage.

International expansion

Toast believes that there is significant opportunity to expand usage to markets and clients outside of the US. It is still in the early stages of expansion and is a long-term initiative.

2. Industry Outlook

Restaurant industry is one of the largest industries. In the US, there are ~875K restaurants which are highly diverse and complex. Outside of the US, Toast expects a restaurant TAM of 280K international restaurants.

Market pain point among F&B restaurant lies within low margins, high employee turnover, highly perishable products, and complex regulations. On top of these challenges, restaurant industry experiences foundational changes driven by changing consumer preferences and there is a rising demand for restaurants to utilize technology and data to innovate.

The need for efficient scaling

Modern POS system has become essential in today’s F&B scene. The move to cloud-based POS systems has made business management more flexible, efficient and cheaper.

Global cloud-based POS market is estimated to be at US$4.7B in 2023 and expected to grow at a CAGR of 18.2% from 2024 to 2030 (Grandviewresearch, 2024). To scale effectively, businesses need to achieve operational efficiency, which drives investment in cloud POS systems.

Changing mode of payment among consumers

We have seen an increased popularity of cashless transaction such as credit cards, debit cards, mobile wallets and other digital payment solutions. Firstly, Contactless payments has been a game changer for F&B industry. This has been particularly noticeable in customer facing businesses like coffee shops, eateries and breweries where speed and convenience is highly valued. Secondly, trend would be in mobile payment and apps. According to tech.co 66% of the restaurants in the US and Canada accepted mobile payments in 2023. Thirdly, QR code payments has become a vital part of payment infrastructure.

No. of cashless transaction globally totalled to US$1.3B in 2023 and expected to reach US$2.3B in 2027. In the US alone, cashless transaction totalled to US$232B in 2023 and expected to reach US$298B in 2027 (Statista, 2024).

3. Key Operational Metrics

a. No. of Total Live Locations

Total locations increased by 29% YoY to ~120,000 locations as of Q2’24. Toast added ~8K net new locations in Q2’24. In 2023, Toast launched their brand in Canada, Ireland and the UK as an initial effort to unlock significant opportunity outside the US. Toast has onboarded 2K international location as of Q2’24.

b. Gross Payment Volume (GPV)

GPV increased by 25% YoY to US$40.5B in Q2’24, indicating strong business growth. This means that Toast is expanding its customer base and there has been an increased in usage of its platform by its existing users.

While Toast’s gross margins are expanding, GPV per location declined by ~2% YoY to US$338K on Q2’24, mainly driven by a decrease in transaction volume while average ticket size remains relatively stable. This reflects some pressure on same-store sales growth, likely reflecting persistent macroeconomic headwinds, where inflationary pressure reduces consumer spending and increases operational costs have contributed to slower transaction volumes at existing locations.

c. Annualized Recurring Run Rate (ARR)

ARR grew by 29% YoY to US$1.5B as of Q2’24. Toast currently generates !40% of its recurring revenue from software and payment processing. Toast is aiming to tilt the mis towards software revenue as it adds and cross-sells new products to its client base. In Q2’24, Subscription ARR grew by 35% YoY to US$730M (accounting for ~50% of total ARR) and Payments ARR grew by 24% YoY to US$743M.

Several factors may affect ARR such as customer’s satisfaction on platform, pricing, competitive offerings, economic conditions and overall guests’ spendings.

ARR per location experienced a slight dip in Q4’23 to ~US1,150K. However, it has recovered to the same level as of Q2’24.

4. Investment Thesis

a. Payment and Software combination increases monetization opportunities

Toast’s combination of software and payment revenue is attractive and puts the company at the heart of restaurant operations, resulting in a growing ARR. The platform’s breadth and depth of product solutions have increased monetization opportunities.

This is shown in the increased of SaaS ARPU to US$30K in Q1’24, from US$20K in Q1’2021 (a 50% increase) while Locations with >US$10K SaaS ARPU increased to 14$ in Q1’24 from 2% in Q2020.

Toast have also done several strategic acquisitions to expand its payment and software’s product portfolio. An example would be the acquisition of Sling in 2022, an employee scheduling, communication and management solution, to expand into team management space.

Hence, with continuous addition of features to its original platform and increased opportunity to upsell (explained in the next point), Toast should be able to further drive its ARPU and ARR growth.

b. Focus on upsell and product-led growth initiatives delivers more value to customers, leading to ARPU growth

Over the past 2 years, Toast has been refining its up-sell and cross-sell strategy to complement its new business acquisition efforts as they recognized that there are substantial opportunity to drive Average Revenue Per User (ARPU) growth from existing customers. This strategy has driven the ARR growth by 29% YoY to US$1.5B as of Q2’24.

As customer realized the value of Toast’s full platform, the company has seen an increase in product adoption rate across its portfolio. As of 2023, ~43% of Toast locations used >6 products on top of its integrated POS system and payment solutions (an increase from ~32% in 2021, 41% in 2022). Toast is also seeing positive reception to its tiered, bundled product suites, which simplify sales process and drive product adoption. To date, ~30% of locations that adopted Digital Storefront Suite had upgraded to the Pro-tier, signalling further potential for ARPU growth.

Toast has made various R&D efforts and expanded its partnerships network to offer a broad range of features and solutions, ranging from guest management to employee scheduling and financial technology integration. The new feature adoption is also key to driving per-location revenue. Notably, the launch of AI-powered CRM and Sous-Chef platform has been crucial to driving further engagement from existing customers.

Furthermore, Toast has been optimizing their upsell team to better integrate with the new business team to ensure that both new and existing location receive comprehensive support to maximize product adoption.

Hence, with continuous addition of features on top of core POS and payment processing and opportunity to upsell to increase, Toast is poised to achieve long-term ARPU and ARR growth.

c. Expansion into New Markets, Adjacent Verticals and International Growth TAM

Toast's strategic expansion into adjacent markets, including retail and international sectors, has shown early traction. The company aims to leverage its core expertise in the restaurant industry to disrupt traditional sectors like retail. Toast’s entry into retail has gained traction, with 1,000 locations booked in the first few months, indicating strong demand for cloud-based integration solutions in this market. The retail sector presents a significant opportunity for Toast, with approximately 220,000 locations and a $660 billion spend in the U.S.

Internationally, Toast has also seen promising progress, onboarding over 2,000 locations in markets such as the United Kingdom, Canada, and Ireland (with a total TAM of ~280K locations opportunity). A key factor in this success is Toast's localized go-to-market strategy, tailored to meet the unique needs of each region. Features like Online Ordering, Mobile Order & Pay, Gift Cards, and Kiosks have been well-received, with adoption rates surpassing expectations. In June, about 50% of international bookings included Toast’s Online Ordering solution, reflecting strong demand among international customers. To further drive international growth, Toast plans to introduce additional features, such as marketing tools, Toast Tables, and Hotel Property Management System integrations.

As a result, Toast is positioned to deepen its market penetration internationally, driving future ARR growth.

5. ESG factors

Based on the SASB Standards, we have identified the following key ESG factors:

a. Energy Management: given the nature of business utilising cloud, this industry operate or rent increasingly more data centres. Hence, managing water and energy use associated to IT infrastructure is relevant. Companies with high energy and water usage will face reputational risks, particularly with increasing global regulatory focus on energy efficiency.

b. Customer Privacy: As Software & IT Services entities increasingly deliver products and services over the Internet and through mobile devices, they must carefully manage the use of customer data and handling of access to a wide range of customer data. Companies who fail to effectively manage data privacy will face regulatory and reputational risks that may translate to decreased revenue, reduce market share and potential financial impacts such as fines and associated legal costs.

c. Data Security: Software & IT Services entities are targets of growing data security threats from cyberattacks, which puts their own data and their customers’ data at risk. Companies who fail to prevent, detect and remediate data security threats may suffer reputation damage which will result to reduce demand, decreased market share, increased turnover and financial impact from expenses associated to remedify data breaches.

6. ESG Assessments

Since there is no disclosure on Energy Management, we will be reviewing Toast’s GHG emission performance instead.

a. Greenhouse Gas Emission

Scope 1+2 emission increased from 1,169 mTC02e in 2022 to 0.52 mTC02e in 2023. At the same time, scope 1 + 2 intensity has slightly grew as well. However, intensity remained relatively low.

Scope 3 emission increased significantly and is concerning. However, it is mainly due to upstream emissions of goods and services purchased. Toast has launched several initiatives to tackle this matter. Firstly, hardware recycling where Toast works with a 3rd party recycler to recycle retired hardware and provides customers with carbon-neutral shipping labels to send their devices to recycler at no costs. Secondly, Toast is starting to track the GHG emission across its supply chain as well. Currently still in the midst of working to identify which vendors in supply chain.

b. Data Privacy

Toast adheres to standards such as Payment Card Industry (PCI), Service Organization Control (SOC 2), and Sarbanes-Oxley (SOX), as well as internal security policies rooted in the National Institute of Standards and Technology (NIST) guidelines. To align with the NIST control framework, Toast employs a variety of strategies, technologies, and controls. Under this framework, we also structure and assign responsibilities according to the American Institute of Certified Public Accountants (AICPA) three-lines-of-defense model, which defines roles for risk ownership, assessment, and monitoring by internal teams and external auditors. Our software development teams utilize a secure software development framework (SSDF) to mitigate the risk of software vulnerabilities.

However, information disclosed are all qualitative and there is no quantitative data disclosed in Toast’s ESG report. It seems that Toast is adhering to regulations and are aware of the importance of data privacy, but we have inadequate information to measure the actual performance and quality of Toast’s data privacy system.

7. Valuation

Based on the EV/EBITDA multiples method, EV/EBITDA is currently trading at an average of 24.23x resulting in an 3-year implied share price of US$37.16 (+24% upside) and 5-year implied share price of US$53.55 (+78% upside).

8. Risks & Mitigation

a. Macroeconomic Conditions Impacting Toast's Revenue: Toast has reported a consistent 3% decline in same-store sales (GPV per location), primarily due to broader economic factors. A slowdown in restaurant spending, driven by economic instability and shifts in consumer behaviour, could further reduce transaction volumes across Toast's platform and slow GPV growth, directly impacting revenue. Although restaurants have shown resilience, a significant drop in consumer spending would pose additional risks to Toast’s revenue growth and future projections. While the company is preparing for these potential challenges, it remains vulnerable to changes in the economic landscape.

b. Challenges in Market Share Expansion and TAM Strategy Execution: Toast is focused on scaling restaurant locations and growing its market share, but increasing competition and market saturation in key regions may limit its growth potential. The company relies on 'flywheel markets' for expansion, and any disruption in these areas could slow future gains. Additionally, Toast’s strategy to expand into enterprise chains, international markets, and food and beverage retail introduces operational complexities and demands significant investment, which could strain resources and divert attention from its core SMB and mid-market segments.

c. Customer Churn: Toast has experienced a slight increase in churn, with annualized churn now slightly exceeding 10%, mainly due to business closures. Although we have seen stickiness in ARR, customers have no obligations to continue the subscription plan after it expires. Typically, subscription contract lasts for 12 to 36 months. Hence, there is a risk that rising churn could jeopardize the company’s growth targets, particularly if it starts to significantly affect ARR.

9. Conclusion

To recommend a BUY on Toast, Inc (NYSE:TOST) with a 3-year target of US$37.16 and 5-year target of US$53.55.

*Do note that all of this is for information only and should not be taken as investment advice. If you should choose to invest in any of the stocks, you do so at your own risk.