Toast's Long-Term Prospects Remain Savory Despite Macroeconomic Pressures

Equity Analyst

Sean Dunlop

We take a positive view of Toast's strategy, which seeks to capitalize on two major tailwinds in the restaurant industry: the adoption of cloud-deployed point-of-sale systems and the uptake of technology-enabled solutions, with operators looking to improve operating efficiency as industry margins remain tighter than ever. One epiphenomenon of pandemic-induced lockdown restrictions, in our view, is a structural increase in consumer acceptance of digital channels, with restaurants increasingly needing to offer some combination of delivery integration, online ordering, and rewards programs to meet the evolving needs of today’s restaurant consumer.

As the market leader in a growing vertical, heavy investments in onboarding new units, building out platform functionality, developing an ecosystem of partner application programming interfaces, or APIs, and filling holes in the platform through targeted roll-up acquisitions strike us as appropriate.

Within the firm's targeted independent and midmarket segments, we see growth coming from two sources: the addition of new restaurants, both domestically and in select international markets in the mid- to long term, and greater capture of technology wallet share within its existing customer base. Our estimates suggest that Toast currently captures just 0.4% of partner restaurant sales through software subscription fees, with plenty of headroom between that figure and the 2%-2.5% of sales that the average restaurant spends on IT.

Longer term, we view investments in horizontal expansion (other industries) as prohibitively unlikely, but see upside from vertical expansion, principally upmarket to enterprise buyers—as plausible. Success in that market would be predicated by broadening the firm's partner ecosystem, with enterprise clients preferring to stitch together a suite of best-in-class point solutions in lieu of adopting a single-vendor platform. On the lower end of the spectrum, the expansion of Toast Capital (working capital lending) could help Toast capture more share of the independent restaurant space, in which Square (a narrow-moat Block subsidiary) has historically outperformed.

Business Strategy & Outlook

We believe that Toast warrants a narrow economic moat rating, with mission-critical business applications, impressive net revenue retention and attach rates, and a commanding database of customer interactions across its platform underpinning our rating. The firm sits at the confluence of two intriguing secular trends—the accelerated adoption of technological solutions in one of only a handful of end markets left largely untouched (until recently) by the cloud software revolution, and a mix-shift toward digital ordering channels in an industry heretofore beholden to retail catchment areas. Its business model is bipartite, with a cloud-deployed point-of-sale system addressing independent, midmarket, and regional chains’ needs for order sequencing, online order integration, and payment processing, while a host of restaurant-specific software solutions free Toast customers to focus on what they do best—serving guests and preparing food. The model is highly complementary, with payment processing feeding a stream of high-value data into software applications, while standalone modules in the software stack, like white-label online ordering, can catalyze adoption of adjacent software solutions or the entire Toast POS and hardware suite. Ultimately, we view our enterprise software moat framework as the most appropriate for the company, given that the lion share of its gross profit (60%-65% in 2032, by our calculations) will ultimately sit in the software segment, though the two divisions are highly interdependent. Our 10-year average adjusted ROIC forecast of 18% embodies this view, with ROICs normalizing in the mid-20% range, healthily outstripping our 9% cost of capital estimate.

Our analysis will sequentially consider the problem that Toast’s products solve, our qualitative take on the firm’s competitive position, its products’ centrality to restaurant operations, and quantitative performance benchmarking against software peers that boast an economic moat. Finally, we consider how the company’s extensive database of payment and software interactions figures to strengthen the ecosystem, with success in each of those business units reinforcing the value proposition of the other.

Pandemic-induced mobility restrictions amid COVID-19 meaningfully quickened what has been a persistent undercurrent in the notoriously slow-footed restaurant industry: adopting modern, technology-enhanced solutions to address structural operating inefficiencies. In an instant, restauranteurs were forced to cobble together a suite of off-premises solutions to navigate complete lockdowns, reaching guests through various combinations of white-label websites, third-party delivery platform integration, turnkey mobile applications, and loyalty programs. The pace of innovation, arising after years of tight margins and often irrational promotional activity, too frequently resulted in poorly thought out, expensive, and often overlapping point solutions, with owners indiscriminately adopting any platform or service that they thought might keep them afloat in a challenging environment. Now, as the dust settles, lockdowns ease, and consumers tilt their spending toward services, we expect that the days of myriad disparate applications for online ordering, customer relationship management, gift cards, payment processing, and delivery are numbered. Restaurant operators don’t want to navigate five separate order channels, with delivery aggregators’ volumes each coming through a separate iPad at the register, nor do they want to spend hours stitching together payroll, cash management, and delivery platform data to close tills or to balance a checkbook. As a result, we’ve already begun to see meaningful consolidation in the restaurant technology space, with a handful of acquirers (Toast included) rolling up complementary niche service providers and building more robust, one-stop platform services.

It’s no secret that cloud-deployed, end-to-end service providers like Toast alleviate a key pain point in the restaurant industry. Cloud 1.0 (on-premises) solutions left owners staying late and needing to be physically in the restaurant to close tills, tweak the menu, and run reports. An unruly amalgam of third-party tech providers, many of which don’t easily integrate, added to their administrative burden, with key data often sitting siloed across point solutions like payroll, payment processing, and inventory management, leaving owners unable to capture and act-upon real-time insights. To this point, Hospitality Technology’s 2022 restaurant tech study suggests that nearly 60% of restaurant IT departments cite being held back by legacy systems as the biggest technology bottleneck in their business, with on-premises solutions remaining inflexible, difficult to scale, and integrating poorly with cloud-deployed applications. Full-stack platform operators, like Toast, offer solutions that can improve restaurant efficiency, deliver seamless omnichannel transactions, personalize guest experiences, address recruiting and retention concerns, and leverage data insights to appropriately develop menu architecture and pricing. The importance of real-time data and labor efficiency-driving solutions can hardly be overstated in the current environment, as surging food cost and hourly labor inflation and sky-high quits rates are leaving restauranteurs scrambling to make ends meet. Ultimately, we view integrated platforms like Toast, Square (a narrow-moat Block subsidiary), Clover (a narrow-moat Fiserv subsidiary), and Lightspeed POS as likely to carve up the domestic market, suggesting that a quickly growing, intensely fragmented space doesn’t necessitate a winner-take-all equilibrium.

We view the qualitative argument for switching costs (by far the most prevalent moat source in the software industry) as compelling, with a best-in-class POS system earning Toast the right to sell mission-critical software applications like payroll, inventory management, loyalty, CRM, e-commerce ordering, and first-and-third party delivery integration. For a restaurant to rip out and replace any of these modules, let alone a handful, would espouse hefty direct (hardware, running dual systems redundantly, retraining) and indirect (lost worker productivity, exposure of sensitive data, potential disruption to mission critical business processes) costs, meaningfully reducing the risk of customer churn, as we see it. The firm’s sprawling product suite offers meaningful room for a land and expand strategy, with about 65% of customers utilizing four or more of the operator’s software solutions at the end of 2022 (up sharply from 37% in 2019), and 41% using six or more. Importantly, our estimates suggest that this represents just 0.4% of average restaurant sales for Toast’s network of 79,000 restaurants, a figure we model nearly tripling over 10 years (to 1%) as the firm captures a much larger share of average restaurant technology budgets over time. Toast’s solutions are compelling, in our view, running the gamut from point-of-sale hardware to e-commerce, third-party delivery integration and key external API integrations. Ultimately, it's complementarity that we surmise will prove most likely to drive cross-selling, with a unified user interface lowering training costs, with bundled pricing dropping to the bottom line for customers, and with vendor rationalization reducing the administrative burdens of routine maintenance and contract renegotiation. Further, given the importance of the business functions with which Toast’s platform intersects, we remain dubious that the potential benefits of switching POS providers—pricing and the freedom to choose a backend payment processor—outweigh the headache of redundant costs, new hardware and installation, employee retraining, and potential loss or exposure of sensitive data during the transition. This view is strongly upheld by a low-single-digit monthly churn rate, which is extraordinarily impressive when juxtaposed against the National Restaurant Association’s estimates that 30% of restaurants fail or change hands in their first year of operations, or 60% within their first three years. Barring more effective restaurant selection, we surmise that the logical implication is that Toast’s platform helps its restaurant partners outperform the broader industry. This feels tenable, given a panoply of white papers and online training modules on its website, reliable hands-on support, and even working capital lending, with the Toast ecosystem seeming to drive both customer (restaurant) loyalty and profitability, considering that the aforementioned customer churn rate encapsulates both restaurant failure and migration to competitors’ platforms.

Zooming out, other hallmarks of moats in the software space include net revenue retention (with moaty operators generally exceeding 105% net dollar retention), strong attach rates, and any network effects, efficient scale, or intellectual property evidenced by the ecosystem. Considering these points in order, we believe that the firm’s historical net revenue retention (averaging 119% annually between 2015 and 2022) suggests a robust value proposition, with each successive cohort increasing its sales contribution year over year, stacking like layers of a cake over time and bolstering the firm’s sticky stream of “annualized recurring revenue.” Nothing in our analysis suggests that this is likely to change, with Toast continuing to invest heavily in platform development, adding functionality both organically and inorganically, and seeing double-digit annual increases in the mix of users using four or more modules since 2019. While we don’t view the firm as evidencing conventional traces of technology network effects (absent a proprietary coding language or developer ecosystem) or efficient scale (which is largely relegated to the IaaS space), we do view restaurant IP as a meaningful, if difficult to measure, differentiating feature. All of the firm’s largest competitors operate POS systems spanning multiple industries, with a lack of product focus driving certain small inefficiencies—failure to account for double-shot drinks for inventory management, or struggling to effectively split tips, for example—which, taken together, likely underpin a strong win rate for Toast against less specialized competition. To this point, two-thirds of Toast’s employees have worked in the industry prior to their time with the provider, with the platform widely touted as being developed by restauranteurs for restauranteurs.

Wrapping up our analysis of switching costs, we view two final pillars as underpinning our thesis: one- to three-year initial contracts, an unusual feature in the space, and a clientele that skews independent and midmarket, adopts more modules, and thereby finds its success more closely tied to the Toast ecosystem. Toast’s initial one- to three-year contractual period weds operators to the platform, driving organizational inertia and pulling the restaurant through the bumps in the learning curve. As operators grow comfortable with the user interface, trial integrations through an API ecosystem that links more than 180 restaurant technology partners, and adopts other Toast software solutions, the likelihood of switching drops precipitously. Further, robust software gross profit margins (65% in 2022, which we anticipate expanding into the lower-end of the 75%-85% average SaaS range over time) drive payback periods in the ballpark of just one and a half years, suggesting robust return on advertising spending. Finally, midmarket operators tend to be quite sticky, playing into Toast’s long-term strategy. While this is a somewhat counterintuitive claim (churn rates tend to be higher and lifetime value lower in that segment, generally leading to stronger software moats upmarket), independent and midmarket restauranteurs often prioritize vendor rationalization, lacking the traditional IT teams we’d see upmarket that favor “best-in-class” point solutions, thereby allowing Toast to cross-sell a larger portion of its suite. As we outline in other research, a “good enough” solution, like wide-moat Microsoft’s “Teams” application, may provide sufficient impetus to avoid adding an additional vendor (like Slack), suggesting that Toast may be able to increase switching costs and incite users to adopt additional applications without necessarily being the best-in-class provider in each use case.

Turning briefly to intangible assets, we believe that an integrated platform, with operators contractually required to adopt Toast’s payment processing services, provides a unique opportunity to offer differentiated data and analytics tools to customers, underpinning a durable competitive edge. The software industry faces constant innovation, suggesting that moats built around analytics packages or enhanced functionalities are exceedingly likely to be replicated or supplanted—but a privileged proprietary database is much more difficult to displace. Toast’s access to data is wide-reaching, spanning menu item performance and attach rates, email campaign efficacy, labor analytics and elasticity to various retention initiatives, inventory efficiency, table turnover, sales and profitability by channel, order histories and suggestions, and demographics, just to name a few. The downstream use cases are myriad—personalization, demand forecasting, productivity management, virtual branding, and third-party rationalization—offering a competitive edge to restaurants in the Toast ecosystem (spanning roughly 12% of the firm’s addressable U.S. restaurant count in 2022, or 9% of the aggregate U.S. restaurant count, per our calculations and Euromonitor data). The firm’s required payments integration, unusual among cloud POS providers, also means that they have a cleaner look at more granular customer data and restaurant balance sheets, permitting the firm to intermediate working capital loans, a key pain point in the independent and small and medium business, or SMB, segment of the restaurant industry. 

With $92 billion in gross payment volume running through the firm’s processing rails in 2022, Toast would represent (on a standalone basis) the third-largest restaurant in the world (behind only wide-moat McDonald’s, with $116 billion in systemwide sales), linking together data for a historically fragmented midmarket restaurant space across different categories (cafe, burger, chicken, and so on) and formats (full-service, quick-service, fast casual). The firm’s insights can have meaningful top line (guest frequency, upselling and attach) and bottom line (lower food waste, stock-keeping unit rationalization) implications, while reinforcing switching costs by tying operators to the ecosystem, at least to the extent that they want to tap into what we posit is the most comprehensive independent restaurant database on the market. In effect, Toast controls flow of information through the pipeline, with partners linking to its ecosystem to access the data they need, paying a toll for the privilege.

Finally, while the route to profitability remains protracted—we forecast profitability on an adjusted EBITDA basis in 2024, but not until 2026 on an accounting basis—we note that this isn’t unusual for a software-intensive model that books acquisition costs up front and benefits ratably over customers’ useful lives, nor for an early software entrant investing ahead of the curve to capture market share. With stable to slightly softening returns on marketing investment and incremental research and development dollars, in tandem with a natural mix-shift toward the more profitable software segment, we view low-teens equilibrium operating margins as attainable, with our forecast for just shy of 25% adjusted ROICs by 2032 (inclusive of capitalized R&D and marketing spending) suggesting healthy economic value creation when compared with our WACC estimate of just 9%. None of this is to suggest that the competitive landscape isn’t stout, nor quickly evolving, but we view Toast’s comprehensive platform, mission criticality, and self-reinforcing ecosystem of financial technology and software solutions as paving the way for excess returns through the 10-year horizon suggested by our narrow moat rating.

Narrow

Economic Moat

Toast

Toast, Inc. engages in the development and provision of consumer payment application for restaurants. It offers terminals, kiosk, guest facing display, and system accessories. The firm also offers point of sale, reporting and analytics, online ordering and delivery, and kitchen display system. The company was founded by Jonathan Grimm, Aman Narang, and Stephen J. Fredette in December 2011 and is headquartered in Boston, MA.

Earnings data Q2 2023

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