The catering industry is brutal. Most restaurants fail at some point, citing lack of technology as the reason. Software company toast (TOST -0.46%) could be a possible solution.
Toast went public in the summer of 2021, a good time for companies to conduct an initial public offering (IPO) as the market is optimistic. Today, the stock is trading more than 75% below its all-time high after rising interest rates dampened the outlook for several high-growth stocks.
In this case, the penalty for selling shares might have gone too far. Here’s why investors should consider Toast stock today.
A wild and fragmented industry highlights the value of toast
Gastronomy could be one of humanity’s oldest business models. It is a part of cultures around the world and a popular idea that comes to mind of most entrepreneurs. There are nearly 750,000 restaurants in the United States alone.
But the restaurant business is competitive and far more complex than most people realize. Entrepreneurs have to manage perishable supplies and their finances, create a good product and a welcoming atmosphere, and do everything as cost-effectively as possible. This juggling act helps explain why poor technology can lead to restaurant failures.
Toast is an ecosystem of hardware and software designed specifically for the hospitality industry. It helps restaurants with payment processing, payroll, inventory management, marketing to customers, and more. It adds technology to virtually every aspect of restaurant operations – a complete, one-tool solution.
Today, Toast serves a total of nearly 100,000 locations. Approximately 75% of new Toast locations come from inbound inquiries and 20% come directly from customer referrals. This speaks for customer satisfaction with the product. Word of mouth is powerful.
Toast sees improving financials
The company’s financials could be better, despite annual revenue of nearly $3.5 billion. The culprit is a paltry gross margin of 21%. Toast sells its hardware at a loss to attract customers, relying on recurring, more profitable revenue from subscriptions and payment processing fees.
The good news is that Toast is getting big enough to keep its finances moving in the right direction. Free cash flow was $38 million in the most recent quarter and was nearly positive over the past year. Look for free cash flow to grow faster as Toast grows.
According to generally accepted accounting principles (GAAP), earnings should ultimately develop positively. The company also still has $1 billion in cash and short-term investments with zero debt.
Competition is always a threat, but the restaurant industry is so big that it may be less important. Toast management estimates that the global market opportunity is worth over $110 billion, so there are so many opportunities. And the company is unique compared to the competition block (parent of Square) and Lightspeed Commerce because it was designed from the ground up for restaurants.
Execution is never guaranteed, but there is no obvious barrier to Toast continuing to grow its sales and profits in the years ahead.
Is the stock being penalized excessively?
The timing of Toast’s IPO is reflected in its valuation, which once exceeded a price-to-sales (P/S) ratio of 24, a staggering price for a company with such low gross margins. But today it is far more reasonable, at just over 2 it is even too low.
How should I know? Because the company’s improving financials could completely change the picture in a few years. Analysts agree; Current estimates are that Toast’s earnings per share (EPS) will turn positive and rise to $0.50 by the end of 2025, about two years from now.
The stock’s price-to-earnings ratio is currently around 30, according to these estimates. Earnings could grow 20 to 30% annually after 2025, which seems reasonable given the market opportunity, current growth rate (around 40% in sales) and It is Billions of dollars in cash. That’s a price-earnings-growth ratio between 1 and 1.5, a lot.
It’s impossible to know exactly what Toast will do in the future, but long-term investors might eventually be glad they bought the stock at these levels.
Justin Pope has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Block and Lightspeed Commerce. The Motley Fool recommends toast. The Motley Fool has a disclosure policy.