Toast S-1 Filing: 5 Key Takeaways

IPO Activity Resumes

The period of initial public offerings is once again underway.

While avoiding the term "hot liquidity summer," the cycle of public offerings has returned following a quieter August. Recent filings have come from Warby Parker, Toast, and Freshworks.

We have already analyzed Warby Parker’s filing. This week, our focus shifts to examining the details of the other two debuts, beginning with Toast.

Understanding Toast's Significance

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What makes Toast noteworthy? It is a technology-driven startup, achieving unicorn status.

According to Crunchbase data, the company secured over $900 million in funding during its private phase. Furthermore, Toast is a prominent member of the Boston startup ecosystem.

The company uniquely integrates subscription revenue, transaction processing fees, hardware sales, and lending income.

Its business model is multifaceted – a positive attribute – and offers valuable insights into how software companies evolve when they incorporate more extensive financial services into their core offerings.

Toast presents a compelling case study, particularly considering its initial substantial impact from the COVID-19 pandemic.

We will review the company’s financial performance, analyze the effects of COVID-19 on its operations, assess the evolving composition of its revenue streams, evaluate the importance of its fintech-related earnings, and estimate its potential valuation.

Let's begin this detailed analysis.

Toast is Experiencing Accelerated Expansion

A detailed examination of the company’s revenue generation methods will follow shortly. It’s important to note, however, that Toast derives income from multiple sources, each possessing a distinct gross margin. Therefore, the subsequent discussion will not be limited to high-margin software revenues alone.

The following data illustrates Toast’s revenue performance for 2019, 2020, and the first half of 2021, as reported in its S-1 filing:

A quick review reveals that the company experienced growth from 2019 to 2020, though at a relatively measured rate. More recently, the final two columns demonstrate a significantly faster rate of growth. Specifically, Toast achieved a 24% increase in revenue in 2020 and a substantial 105% increase in the first half of 2021.

Considering the impact of the COVID-19 pandemic on the restaurant industry, the observed growth in 2020 appears particularly robust. Despite considerable market disruption, Toast still managed to expand its revenue base.

The company’s results from the first half of 2021 suggest that the product development efforts undertaken during the pandemic have proven successful. This has enabled Toast to accelerate its growth rate by a factor of four in the most recent two quarters, compared to the overall revenue expansion rate of 2020.

This data also clarifies the timing of Toast’s initial public offering. Having navigated the challenges of 2020, the company now presents a picture of accelerating growth and substantial top-line gains. Toast appears exceptionally strong, and a period of positive financial performance is an ideal time to pursue an IPO.

Toast’s Resilience Throughout the COVID-19 Pandemic

Analyzing the impact of the pandemic on Toast requires a review of its quarterly revenue performance. The following data illustrates this, with Q2 revenue specifically marked for easy identification:

The quarter ending June 30, 2020 – Q2 2020 – presented significant challenges for the company. Revenue experienced an approximate 25% decrease compared to the previous quarter, representing a substantial setback, particularly for a rapidly expanding company like Toast.

A primary factor contributing to this revenue decline was a reduction in gross payment volume, or GPV. The company’s own reporting confirms this:

The decrease in GPV signaled a decline in the total volume of restaurant transactions. This aligns with general recollections of the economic climate during that period.

However, a positive trend emerged in the latter half of 2020. As demonstrated in the data for the quarter ending September 30, 2020 – Q3 2020 – revenues showed a swift recovery.

Despite this relatively brief downturn, the impact was felt. Toast implemented staff reductions and provided invoice assistance to certain clients:

These difficulties proved temporary. From Q3 2020 onward, Toast demonstrated consistent growth, culminating in a particularly strong Q2 2021 in terms of expansion. The following sections will explore the factors behind this successful turnaround.

The Resilience of Toast’s Varied Revenue Streams

During the challenging second quarter of 2020, heavily impacted by the pandemic, Toast experienced a decline in its fintech revenue, encompassing areas like payment processing. Simultaneously, revenue generated from hardware, including terminals and displays, also decreased. Professional services revenue similarly saw a reduction during this period.

However, amidst these declines, Toast’s software revenue demonstrated resilience, showing incremental growth. While modest, it increased from $22 million in Q1 2020 to $22.8 million in the subsequent quarter.

Since then, Toast’s primary revenue contributors – software and fintech – have consistently expanded on a quarterly basis. Hardware revenue has exhibited slightly more fluctuation, but is currently trending positively and achieved a record high in Q2 2021.

The presence of software revenue significantly mitigated the impact of the downturn in the second quarter of the previous year. Furthermore, the continued growth of its payments revenue, categorized under fintech, has been instrumental in driving overall impressive growth.

Toast’s deliberately diversified revenue model has effectively minimized potential losses while simultaneously creating substantial opportunities for expansion. This strategic approach has proven its value.

Startup founders should closely monitor Toast’s revenue growth across different categories over time. It demonstrates that a diversified approach to revenue generation can function as a robust defensive strategy, as well as a proactive offensive one.

Toast’s Expansion Exhibits Lower Profitability Than Initially Anticipated

Although the company’s software income demonstrated stabilization as the initial global lockdowns due to COVID-19 took effect, fintech has been the primary catalyst for Toast’s growth. As an illustration, during Q3 2020, Toast reported software revenues of $27.4 million, a record at the time. In contrast, fintech revenues for the same period reached $188.2 million.

This disparity has continued. By Q2 2021, Toast’s software revenues achieved a new high of $37.6 million. However, fintech revenues in that same quarter totaled $353.6 million. From the quarter where the pandemic initially spurred growth, to the most recent reporting period, software revenues increased by 37%, while its fintech revenue climbed by 88%.

These two revenue streams possess significantly different gross margin characteristics. Fintech revenues at Toast yield a 20% gross margin, whereas its software revenue generates 66% gross margins. Consequently, despite being categorized as a software company, Toast’s largest revenue source operates with margins typical of non-software businesses.

This revenue composition will likely influence the company’s ultimate valuation in the public market. The lower overall margin profile will be a key consideration for investors.

Concerning hardware and services revenues, do they contribute positively to gross margins? The answer is no. Toast intentionally sells hardware at a slight loss, a strategic decision as the tablets are dependent on Toast’s software and payment technologies. Similarly, human services are offered at a substantial loss, potentially functioning as a customer acquisition tool to facilitate adoption of its software and fintech offerings.

Therefore, Toast effectively operates as a high-margin software enterprise integrated with a considerably larger, lower-margin fintech operation, supplemented by additional components designed to support these core revenue streams.

Key Takeaways Regarding Toast’s Revenue Streams

• Software Revenue: Exhibits high gross margins (66%), indicating strong profitability.
• Fintech Revenue: Drives the majority of growth, but with lower gross margins (20%).
• Hardware & Services: Sold at a loss or minimal profit to encourage adoption of core products.

The Valuation of Toast: A Comprehensive Analysis

Determining the actual worth of Toast necessitates a deeper examination than simply observing revenue expansion and gross margin figures. A thorough assessment of profitability and overall market potential is crucial.

Toast has demonstrated a consistent reduction in its operating losses over time. Following operating losses totaling $220.2 million in 2020, the company reported losses of only $56.8 million during the first half of 2021. This represents a significant improvement compared to the $124.6 million operating loss recorded in the first half of 2020.

While Toast currently remains unprofitable on a GAAP net income basis, several factors contribute to this, including increasing expenses related to share-based compensation and fluctuations in the fair value of warrants and derivative instruments. Consequently, investors are likely to focus intently on the company’s adjusted EBITDA.

This metric presents a positive outlook for Toast, as illustrated in the following table:

Toast’s adjusted EBITDA has experienced substantial growth from 2019 to 2020. Furthermore, with increased overall scale in 2021, the company has achieved profitability – albeit after adjustments. Notably, free cash flow also turned positive in the first half of 2021, a development likely to attract significant investor interest. This combination of robust revenue growth, improving free cash flow, and adjusted profitability is particularly encouraging.

However, what does the future hold in terms of growth? While past performance is valuable, projecting future expansion is equally important. Toast offers a compelling rationale for its long-term optimistic outlook:

Although complete market dominance is unlikely, with a current market share of only 6%, the company possesses considerable potential for continued expansion.

In summary, Toast operates a multifaceted business characterized by rapidly accelerating revenue growth and has recently achieved positive free cash flow while generating substantial adjusted EBITDA. These factors collectively contribute to a significant valuation.

Toast’s most recent valuation, prior to its IPO, was just under $5 billion, according to Crunchbase data. Speculation suggests a potential valuation of $20 billion upon its public debut. Does this align with the company’s financial performance?

Potentially: A $20 billion valuation represents 11.8 times the company’s Q2 2021 annualized revenue run rate. The relatively modest multiple, compared to recent IPOs, stems from Toast’s core identity as a fintech company with supplementary software revenues, rather than the reverse. Lower-margin revenues inherently command lower revenue multiples, as they are less valuable than higher-margin revenues.

To assess the appropriateness of this 11.8x multiple, let’s consider Olo, a competitor in the restaurant software sector. However, Olo’s revenue stream is predominantly software-based, making a direct comparison imperfect.

Olo reported $35.9 million in Q2 2021 revenue, translating to an annual run rate of $143.6 million. Currently valued at $6.48 billion, Olo’s valuation is 45.1 times its current annualized revenues. This is a high multiple for a software company, but within the bounds of reasonable justification.

Is Toast, therefore, undervalued? The answer isn’t straightforward. Olo’s higher blended gross margins make its revenue more valuable. Conversely, Toast is experiencing faster growth. If growth is prioritized over revenue quality, one could argue that Toast does not warrant as significant a multiples discount as implied by a $20 billion valuation.

Should this perspective prevail, the company may price its IPO above that figure. However, if the lower quality of Toast’s fintech revenues justifies the discount, investors might anticipate a more conservative pricing strategy.

My assessment is that, considering its growth trajectory, scale, and revenue composition, Toast is positioned to successfully launch its IPO at a valuation exceeding $20 billion. Further insights will be available once the initial price range is announced.