Reforming Retail

Our Analysis of Toast’s $250M Fundraise

Before we even get into our analysis and prognostications we must give our thoughts context. We do not hate Toast. People – many of whom work at Toast – assume that we dislike them. This is untrue. What we don’t like are practices and tactics that are often used to chase growth at all costs.

While we can make no declaration that Toast categorically employs or will employ the following tactics, we think they are important in understanding our frame of reference for this article.

  1. We do not like business models that obfuscate costs to customers. Brick and mortar merchants, on the aggregate, are inarguably the least sophisticated group of people we have ever interacted with. Even so, that does not mean that they deserve to be taken advantage of. Lowering the upfront costs of your offerings only to make it up hand-over-fist on the backend via fine print in a contract is not a respectable – or ethical – business practice in our opinion. There are many people in the payments processing industry who have made much more money than we likely ever will, but at least we can look at ourselves in the mirror in the morning.
  2. We do not like perverting market economics with a balance sheet. Payment processors, and companies like Toast that have raised large amounts of capital, throw around their balance sheets as a strategy. We find this morally reprehensible if the product being offered is not materially innovative or improved. For example, Walmart has allegedly used its balance sheet to suppress prices when it moved into new territories. What consumers in those territories ultimately got, however, was a retailer that would offer the same commoditized goods at lower prices. Walmart, through its scale, massively disrupted retailing for the better. Using your balance sheet to offer “free POS” or analogous only so you can ratchet processing rates later is not a form of innovation.
  3. We do not like companies that intend to monopolize the entire stack. It’s impossible to build everything. To believe this untrue is to go against the very spirit of entrepreneurism. Companies that set out to monopolize the stack ironically write their own undoing, but in the process they significantly hurt their customers and vibrant third party ecosystems, the latter of which springs to life true innovation on the fringes. The pain is often experienced for a long time, and growth across the board slows dramatically. It is never good for industries when market leaders adopt this position.

Now that we’ve mentioned things we’re against, let’s talk about things we’re openly for.

  1. We like competition. Competition, when done fairly, is good. It produces better customer solutions and eliminates providers with waste in their business models. When large incumbents attempt to monopolize the stack, innovation stalls and entire industries suffer (note: Micros and NCR must admit that they share a large portion of the blame for brick and mortar’s anachronistic status quo).
  2. We like innovation. Companies that are truly disruptive force industries to rethink their values. Innovation, along with competition, increases quality and lowers costs. Coincidentally this is the aim of technology, generally. Companies that cannot innovate should be replaced. Business models that do not support innovation – like locked-in processing or walled gardens for integrations – are bad for industries.
  3. We like transparency. Everyone screws up. Admit it, explain what you’ve learned, how you’ll change, and move forward. The same should be said for your business models and economics. Companies that are clear with their motives, goals, and outcomes build better trust among customers and their business partners. Obfuscation is only a strategy when you have something material to hide.

Toast’s latest round of $250M brings their total raise to over $500M. That’s a lot of money, but in the context of the size of the restaurant industry, and the potential of the restaurant industry internationally, it’s actually quite small. Think about the math this way:

The US restaurant market does $800B in sales. Assume Toast captures 2% of the market, accounting for $16B in sales. Of that $16B further assume that Toast takes 2% through processing and other operational expenditures related to the POS. That’s $320M in revenue, and at an 8x multiple (because Toast is a combination of SaaS – 10x – and payments – 4x – that’s a $2.56B business, or roughly the valuation they raised at ($2.7B) for their last round.

Toast has some “outs” that work in their favor:

  1. Toast can ratchet rates since their merchants have no other payment alternatives. Replacing POS is painful, and merchants can be stuck between a rock and a hard place
  2. Toast can expand internationally. The infrastructure for cloud is not as good abroad, but Toast already has a Dublin office and can point to companies like Touchbistro and Lightspeed that have found success overseas
  3. Toast can try their hand at monopolizing the stack and forcing out partner solutions. This would entitle Toast to higher revenue per account

We think the reality for Toast entails a mix of all of the above.

Toast’s CFO stated that their revenues grew 148% versus the same period last year. During their last raise we pegged their revenues at $70M. This would mean Toast’s revenue today is roughly $175M.

Toast’s CFO did not say that their location counts grew at the same rate. Toast is adding about 1,000 locations per month, and they had 10,000 locations when they raised their last round 9 months ago: this puts Toast at 20,000 locations, or 100% unit growth. The additional 48% growth in revenue means Toast is earning more per locations. How did they achieve that additional growth? Likely through higher payments processing rates and more “modules” per account.

Still though, at a constant growth rate 1,000 new locations per month (plus some account for churn) this would mean that Toast ends 2019 with close to $225M in revenues. That’s because each location is worth $8,750 in annual revenues ($175M/20K locations) and Toast will add 6,000 locations before the year is out.

Toast has said they’re going to use the proceeds from the round to, “invest in building technology to help restaurants with marketing, recruitment and operational efficiency…” It needs to become abundantly clear, as we’ve pointed out on many past occasions, that Toast wants to monopolize the restaurant tech stack. Not only wants to monopolize the stack, but probably needs to monopolize it to make their valuation math work. If you’re a third party that integrates with Toast, do you think you’re going to be able to compete with Toast if they throw up integration tolls on your products? Toast already has customer data to know what solutions their merchants will need – you won’t be able to compete with fit and speed to market there. It won’t matter if your product is better because Toast can effectively force your product out. We’re tired of playing canary here.

As much as Toast has raised note that a relatively small (2% per our example above) market penetration satiates today’s valuation of $2.7B. Of course their investors are expecting 25% IRR which means they’ll need to double their valuation over the next three years, or have a valuation of roughly $4B when they (likely) run out of capital in 18 months. That’s a long way of saying that POS is not a winner-takes-all market, and there will be plenty of competition to go around.

An interesting thing of note is that $250M is not that much money to public POS competitors NCR and Micros/Oracle. For the latter it’s pretty much a rounding error, while the former does have a relatively large amount of debt outstanding. But even NCR produces enough free cash flow to finance their POS at this level if they so desired.

What NCR and Micros don’t have are the right people and processes to grow at the pace Toast is growing. Toast is engineered to achieve growth at all costs, happily losing tens of millions a year to get there. Micros and NCR have to answer to the public markets, and this is not an acceptable storyline unless growth is skyrocketing and there’s a competent team leading the initiatives. In the case of NCR, they don’t even have a relevant product to go to market with.

As a side note, a Toast location is worth 10x more than an NCR Aloha location. NCR’s enterprise value is $6.9B. Their hospitality group accounts for 12% of their value (roughly), or $832M, though we’d argue it’s actually quite less due to shrinking market share. Aloha has 60,000 sites. On a per-site basis, that’s $13,867 per site. Toast has ~20,000 sites at a $2.7B valuation. That’s $135,000 per site. If we may borrow from Adam Wyden, the founder of activist fund ADW Capital, who was instrumental in getting new leadership at PAR, NCR suffers from a management discount.

This math also begs another question: what is a merchant really worth? Or put into investor lingo, what’s the true lifetime value (LTV) of a brick and mortar merchant? Remember that LTV needs to be at least 3x customer acquisition costs (CAC), and that a company needs to recover CAC within 12 months.

Under Toast’s current model, their investors have said that number is $135,000. But as we calculated above, each Toast site is worth roughly $8,750 in annual revenues. Nobody should ever assume that brick and mortar merchants survive more than 2.5 years for accounting purposes, which means each Toast merchant is really worth 2.5 x $8,750 = $21,875. Let’s push it out to three years just to add some cushion: a Toast merchant is worth $26,250 over their lifetime.

Well, if investors believe a Toast merchant is worth $135,000, that’s more than 5x the current, fundament LTV of $26,250. Does that mean Toast needs to grow revenue 5x, either through expanding locations or charing more per-merchant, to justify the valuation?

It’s not that cut-and-dry because the market gives multiples to fundamentals. As an example, if Toast does $1M in SaaS revenues, the market says, “Hey a SaaS company is worth ~10x revenues.” And it’s not exactly that simple either but let’s stick with the 10x revenue multiple for easy math. So if a Toast merchant does $8,750 in annual revenues and the market gives that a 10x valuation, each location is “worth” $87,500. Using this math the $135,000 per location is only a 54% premium, which is not unreasonable when you consider that Toast is growing as fast as they are.

Another interesting tidbit is the revenue Toast is earning per merchant: at $8,750 per year, it’s only 0.875% of a $1M/year merchant’s revenues. This is not that high, and with the right products (which we’re not convinced Toast or any POS company will produce because you can’t do everything) we think a POS company like Toast can triple this amount… and that expanded revenue will come with even higher gross margins.

Ultimately Toast has delayed their financial future for another year. Here’s what we expect to happen:

  • If Toast IPO’s, they might need to fire a number of their employees to control burn
  • Toast will launch a number of new products that seem to clone the business offerings of third party “partners”. These partners will get indignant, but “we told you so” will feel good
  • Some merchants may start to see drastic rate increases. If Toast finds a strategic buyer (Worldpay, etc) then they can let their acquirer handle the mess of ratchets and employee firings. These are bad for company morale and will distract Toast from growing, and it’s thusly much more likely to happen under the watch of a new owner

Toast is neither good nor evil. They’ve done well to catalyze the market into action, but there are undoubtedly many downsides that could come to pass if their business model is not managed responsibly. At the end of the day Toast is a business and they must make money. Let’s not forget this reality.

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