Toast S-1 Analysis: Part 2 of 3

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This is the second installment of our Toast S-1 analysis.

Let’s begin by looking at some financial metrics.

Toast Uses “Financial Technology Solutions” Euphemism for Payments Processing

Toast has cleverly hidden its processing revenues in a line item called “financial technology solutions”. According to Toast’s management,

Financial technology solutions revenue consists primarily of fees paid by our customers to facilitate their payment transactions.

Toast has said that there are other product categories in the FTS revenue line, but they’re less than 1% today. These would be things like lending and other financial products Toast wants to own (they have quite broad ambitions).

And by the way, Toast is killing it on “financial technology solutions”. Killing it so hard any logical person should wonder if Toast is literally killing their customers:

Our gross payment volume, or GPV, grew 17% year-over-year from $21.8 billion in the year ended December 31, 2019 to $25.4 billion in the year ended December 31, 2020, and grew 125% period-over-period from $10.4 billion in the six months ended June 30, 2020 to $23.4 billion in the six months ended June 30, 2021. We generate revenue through four main revenue streams: subscription services, financial technology solutions, hardware, and professional services. Our revenue grew 24% year-over-year from $665 million in the year ended December 31, 2019 to $823 million in the year ended December 31, 2020 and 105% period-over-period from $344 million in the six months ended June 30, 2020 to $704 million in the six months ended June 30, 2021. Our ARR grew 77% year-over-year from $184 million as of December 31, 2019 to $326 million as of December 31, 2020 and 118% period-over-period from $227 million as of June 30, 2020 to $494 million as of June 30, 2021. 

Looking at this graphically we can see that Toast’s real growth engine is payments processing.

In the below chart we’ve plotted NET payments revenue (in millions), which is what Toast charges (gross) minus interchange (COGS), to arrive at Toast’s take rate, which averages at 0.55%, or 55 basis points (bps).

Here’s our interpretation of the lines.

Despite nearly tripling the count of Toast POS systems in the market, Toast has not markedly increased revenues from services (installation and training) nor revenues from hardware. This is likely because 1) Toast is still playing some version of the “free POS” game, or merchants are installing their Toast POS systems using non-Toast resources (themselves or another contractor).

Not only are these revenues flat, Toast seems to be losing money on these efforts when you look at their associated costs.

Toast acknowledges that this is their customer acquisition strategy:

We utilize our hardware and related professional services as customer acquisition tools and price them competitively to lower barriers to entry for new locations.

Toast Management

If they lose this much money on the hardware and services, where do they make it up?

Payments.

In fact while software revenues grew a respectable 55%, payments revenue grew by 121%. On a margin-basis, Toast earned $45M of software margin while it earned $128M of payments margin over the same period, roughly 3x.

SaaS revenues continue to rise, and the constant looks to be a bit higher than 1, meaning that Toast is selling more SaaS solutions to each merchant over time. This helps explain some of the net retention numbers, but a more on that later.

Payments revenue overtook all others during the pandemic (Q2 2020 onward) and has become Toast’s growth vector because,

Toast is milking the crap out of card not present fees.

Here’s an earlier article if you want some math on this, but the long and short is that online transactions are much more punitive to Toast’s customers, and while Toast has full and complete control over their payments margins, they’ve distinctly chosen not to pass savings along to their customers.

“So while restaurants were literally struggling for survival during the pandemic Toast made more money on them than ever before, and they didn’t have to?”

Correct.

Toast makes mention of the free card not present margin growth but we think it’s irrelevant in the long run, which we will explore further in our last article in this series:

For example, during the COVID-19 pandemic we saw a relative increase in card-not-present transactions related to takeout and delivery orders. Card-not-present transactions typically generate higher payment processing revenue and gross margins for us than card-present transactions. As a result, the increase in the proportion of card-not-present transactions contributed to an increase in our financial technology solutions revenue and gross margins during 2020. To the extent that this trend reverses as the effects of the pandemic subside, our payment processing revenue and gross margins may be impacted.

Toast Management

How Sustainable Are Toast’s Payments Rates?

The question everyone is asking is just how sustainable are Toast’s payment rates? And it clearly matters because that’s Toast’s primary growth engine, especially over the first half of 2021, and that’s what’s making Toast’s growth look so spectacular.

There are two ways to look at Toast’s payments margins.

1. Top down
2. Bottoms up

Nobody knows what’s happening in the top down world and if they say otherwise they’re full of shit. Approaching from this frame of reference we’re all asking ourselves how much of the online ordering volume sticks, and how much goes back to pre-COVID routines of dining in-store.

We don’t think anyone is arguing that all the customer behavior reverts to 2019 patterns, but some surely does. The canary in this coal mine is Olo, whose livelihood is online ordering for large restaurant brands. Olo has continued to hit quarterly projections but we’re still dealing with COVID strains that make a baseline / equilibrium hard to transparently assess.

Bottoms up math is a little less opaque.

The rule of thumb is one support FTE for every 60 or so POS systems. Let’s say a fully-weighted support rep costs $100,000 per year.

In payments you can support 700-800 accounts with the same human capital.

Really.

When payments margins get too fat there’s a big risk of churn. Payments bros have claimed that if they own the software they can charge really high rates and get away with it but payments bros nearly exclusively ruin any software that they touch.

For Toast’s case let’s assume their average customer does $1M of annual GPV (gross processing volume). At 55 bps, that’s $5,500 in revenue. Across 60 sites that’s $330,000 in revenue, or about 3x expected support costs.

And that’s not including any of the SaaS revenues…

We’d say that a “fair” margin on your merchant doing $1M of GPV is less than half of what Toast charges – 20 bps. Assuming you’re using the payments stream to underwrite the cost of support for the POS, and not considering the SaaS revenues, Toast’s margins are high.

In our opinion, COVID was an outlier year for Toast’s payment growth, with Toast harvesting card not present margin like a 1980’s Columbian drug lord harvests coca in the swampy jungles of the Amazon. Toast consistently paints COVID like it was a bad thing in their S-1, but their numbers don’t lie.

See:

Toast hit then-record margins in July of 2020 while their customers were dying.

Toast even went so far as to brag about this, calling it “resiliency in our payments margin”.

Toast Spends R&D Like A Software Company

Unlike payments companies that happen to own POS assets (Heartland, Shift4, Fiserv), Toast is aggressively investing in new feature development.

Toast is spending $150M a year in R&D. Shift4 (and other processors by comparison) is spending less than 10% of that amount.

And that’s at the high end.

Gee, you wonder why Toast keeps taking market share?

We’re big believers that Toast’s aggressive R&D spend and access to data should result in something impressive… eventually. They’ve not built a network effect and they’ve also done a poor job of launching consumer tools, unlike Square. But it’s really hard to do everything well.

At this point if Toast doesn’t do something impressive with the data, who’s going to do it? Remember, the parties with the relevant data (POS companies) are nearly all too arrogant, corrupt, or greedy to figure out how to do anything useful with their own data.

If you’re a competitor and you have half a brain you should really worry about the data moat Toast is digging. Toast is smart enough to weaponize it eventually, and if they do it in a thoughtful way it could prove to be problematic for POS competitors.

An abrupt ending, and we’ll finish our analysis on the following article.