Couch Potato #3: Toast Q2 Earnings

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Hello fellow couch potatoes,

Toast ($TOST) announced their Q2 earnings last week. As the poster child for up and coming vertical software companies, so many investors (like me) like to keep up with the company’s progress. Can’t dream about little baby vertical software companies without knowing (one possible) future path. As a student of the game, Toast has it all - SaaS, fintech, hardware, risk-based capital models, network effects, and a sprinkle of unprofitability. Here is what stood out to me when they announced Q2 earnings:

1) Vertical Software 101: the Everything Platform for restaurants

If I learned one thing watching Kitchen Nightmares on repeat growing up, it’s that restaurants are hard, complex businesses to run. This complexity has increased with the addition of multiple modalities. Catering, delivery, takeout. Toast is a good example of the effectiveness of product verticalization to solve all problems for a targeted customer segment. Get under the hood with a wedge, POS and payments and then learn about your customers to expand your offering. Today, Toast has near end-to-end coverage for a restaurant. This graphic below from their Q2 earnings presentation captures its impact.

Fundamentally, this business model breaks down into three core business units (and a fourth, smaller services line item). Subscription services (SaaS), payments, and hardware. Hardware enables Toast to wedge in, Services creates the implementation framework to upsell into SaaS and Payments.

2) Expansion into enterprise

A surprising, yet clever, strategic partnership with Marriott opens up a lucrative new market for Toast. Hotel restaurants. Think about it. Toast has best in class software for restaurants. Hotels are in the business of renting out living spaces and hotel cafeteria and restaurants are predominantly ancillary businesses. Most hotel chains are not built to support and scale a restaurant business. Naturally, Toast’s entry into this space can help hotels “soft-outsource” this ancillary business unit to an expert software platform. But entering a new market is never straightforward.

Enterprise customers have vendor lock-in. Marriott already has a payment provider integrated into the central nervous system of their bookings platform. They are unlikely to want a second, fragmented vendor for their restaurants. To enter this market, Toast partnered with FreedomPay - one of the payments gateway partners for Marriott and large restaurants like Shake Shack. Since these customers are locked into POS and payments contracts, usually across geos, and business units - it’s prudent for Toast to get in first via partnership to sell in SaaS and services and hope to eventually displace payments.

Hotels are not the only enterprise customers in town. Toast announced that they have signed several large new customers including Wetzel’s Pretzels which has 300+ locations. While sales cycles are much longer, ARPU is likely significantly higher and where Toast can displace incumbents and become a single end-to-end solution, LTV and lock-in will yield dividends down the line.

3) Strong flywheel and referral loops

Toast benefits from a powerful flywheel. Toast creates a frictionless experience for consumers at the point sale which drives an increase in order value and customer satisfaction. Which in turn drives repeat business for the restaurant. As the business grows, the business can drive higher margins. Which leads to better wages and job satisfaction for operators and employees and spur business expansion into other modalities. If you can think of it, Toast probably has an upsell module for it.

The cross-referral loops on the consumer side are likely weak or non-existent. It is unlikely that customers refer their friends to a location because of their “delightful POS system”. Instead, think of it as as self-referential loop. While you might visit a restaurant only once in a while, you might increase your frequency through other modalities - pickup and delivery. Powered by Toast.

Cross-referrals are likely more powerful at the operator level where operators are routinely sharing best practices with each other. I have seen first hand how multi-unit operators are frequently making large software purchase decisions based on recommendations from their owner-operator friends. Toast benefits from that. 20% of Toast’s locations come from direct referrals. Despite the size of the company, it has barely scratched the surface of the behemoth US restaurant space. I expect this referral channel to grow another 5-10% over time as Toast gets to critical mass in most geographies.

Closing Thoughts

82% of Toast’s revenue comes from payments. As a result, Toast is being valued more like a fintech / payments company than a true software company. Recently, the markets have beenheavily penalizing transactions based companies and as a result, fintech companies are trading 20-40% below median SaaS comps. Despite growing over 50% YoY, Toast is still trading 50% below high growth vertical SaaS comps (see below).

If we adopt a sum of parts approach and apply market median multiples to each individual segment of Toast’s business - we arrive at a value 37% higher than Toast’s current market cap. Admittedly, this is a rough estimations for several reasons: (a) Toast’s payment revenue includes risk bearing Toast Capital which must trade at a lower multiple than their core payments business, and (b) I am likely being overly conservative valuing their hardware and services business at 1x revenue. Again, rough estimates with several more granular assumptions getting obscured. It helps highlight one key aspect - that the revenue breakdown makes it likely that ultimately the multiple likely blends up to the fintech median multiple. I am no equity researcher and this is not financial advice, Toast’s multiple recovery is something to track as the market recovers.

Marketplace Multiples 8/22/2023

Vertical Software Multiples 8/22/2023

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