Toast Q1 2022 Earnings Review: revenue growth at all costs?
Toast ( TOST 0.00 ), a company that aims to become the operating system for restaurants, reported Q1 2022 results on May 12, 2022. The company grew its Gross Payment Volume by 98% YoY and revenue by 90% YoY….yet, the gross profit grew only 29% YoY. I read a number of positive reviews about the company’s earnings, but for now, I don’t understand the excitement. Toast is primarily a payments business with low (and compressing margins), profitability is not on the horizon, and the economic outlook is quite dark. I am definitely missing something here, so let’s break down their numbers.
If you are new to Toast, I suggest reading my profile of the company, “Toast: a Fintech that aims to become the operating system for restaurants”.
Gross Payment Volume
Toast reported $17.8 billion in Gross Payment Volume in Q1 2022, which represented a 98% growth YoY. Payment processing (and POS hardware sales) generate most of the company’s revenues; thus, Gross payment volume is the key non-financial driver of the company’s performance.
The company also reported 62,000 restaurant locations at the end of the quarter, which represented a 44% growth YoY. As can be seen, the growth in Gross Payment Volume came from both, growth in restaurant locations and an increase in the average GPV per location.
Toast is clearly a beneficiary of the post-pandemic reopening of the economy and the increased consumer spending on eating out. However, it is really difficult to foresee the GPV growth rate going forward. The company has been consistently increasing restaurant locations at 40%+ YoY rate; however, GPV per location in the last two years most likely is not representative (underspend during the lockdowns, and overspent as the economy reopened). Moreover, a potential economic recession will definitely challenge restaurant revenues and Toast GPV per location.
Revenue and Take Rate
The company reported $535 million in revenue for the quarter, which represented a 90% growth YoY. As I mentioned earlier, payment processing (or “financial technology solutions”) represented 82% of the total revenue. Hardware sales contributed an extra 5.4%, and software sales (“subscription services”) an extra 11.8% to the revenue.
As the result, the revenue growth is closely following the growth in Gross Payment Volume. As the chart below illustrates, the company delivered extraordinary growth during the last four quarters, due to restaurant reopening (and easier comps vs. 2020). Software revenue should be less responsive to restaurant turnovers (and is mostly driven by the number of locations and number of products used); however, its share in the total revenue grew only marginally (11.8% in Q1 2022 vs. 11.0% in Q1 2021).
The Take Rate (Financial services revenue divided by the Gross Payment Volume) has been quite stable over the last four quarters. Therefore, denoting the company’s revenue as a function of Locations * Average GPV per Location * Take Rate + Software revenue makes it even more obvious that the number of locations and average GPV per location are the key drivers behind the company’s revenue. As discussed, the company has been consistent in the growth of the locations, but I wouldn’t bet money on the average GPV growth given the economic turbulence.
The company guided for the revenue in the range of $635 to $665 million in Q2 2022, and $2.5 to $2.55 billion for the full year 2022. This would represent 49-56% growth YoY on a quarterly, and 47-50% on an annual basis.
Gross and Profit
Toast reported $89 million in Gross profit for the quarter, which represented a 29% YoY increase. The company calculates gross profit by deducting directly attributable costs (COGS) from the revenue. In the case of financial technology solutions, the costs of revenue are primarily the scheme fees, interchange fees, and payment processing fees. Costs of revenue for software business are primarily salaries of support staff, hosting costs, and amortization of the software development costs.
As you might have already spotted, there is a strong disconnect between revenue and gross profit growth (90% YoY vs. 29% YoY). First of all, “Hardware” and “Professional services” had a negative contribution to the gross profit (-$23 million and -$16 million respectively). Secondly, gross profit for “Financial solutions” and “Subscription services” grew at a slower rate than revenue, namely, 65% YoY ($91 million) and 81% YoY ($38 million) respectively.
As the result, a negative contribution from hardware sales and professional services, and lower gross profit margins on financial services and software subscriptions, lead to the compression of the total gross profit margin from 24.7% in Q1 2021 to 16.6% in Q1 2022. This is concerning and raises so many questions. First, is Toast “subsidizing” financial services and software subscription growth by underpricing their hardware and professional services? Second, should investors expect further margin compression? Finally, can the company reach profitability with a 20% gross margin on financial services?
Gross margin evolution is definitely a metric to closely monitor going forward. My thesis is that in the longer term the company could reach a 30% gross margin (20% margin on Financial services * 75% of revenue + 60% margin on software * 25% of revenue). This would of course require a neutral gross profit contribution from hardware sales and professional services.
Toast reported $190 million in operating expenses for the quarter (157% increase YoY), which lead to an operating loss of $101 million. Key types of operating expenses are “sales and marketing” (37% of total operating expenses), “research and development” (33% of total operating expenses), and “general and administrative” (30% of total operating expenses).
As can be seen from the chart below, the operating expenses stood at over 30% of the revenue in the last two quarters. As the company scales, the operating expenses should start increasing at a slower pace than revenue; however, that is not happening just yet. You can think of Gross profit as the money left for covering operating expenses (and generating profit for shareholders), and for now, we are looking at gross margins of under 20% and operating expenses in excess of 30% of the revenue.
Recently, as the market sentiment changed, many growth companies announced either hiring freezes or layoffs. I would expect Toast to also become more cost-conscious going forward.
Net Income (Loss) and Adjusted EBITDA
The company reported a Net Loss of $23 million (an improvement from a Net Loss of $99 million in Q1 2021), and a negative Adjusted EBITDA of $45 million (a decline from a positive $4 million in Q1 2021). The two key adjustments that the company is making in calculating Adjusted EBITDA are the stock-based compensation ($53 million) and the change in the fair value of warrants (-$79 million). The company repaid its convertible notes in June 2021; thus, there was no impact from the “change in fair value of derivative liability” in Q1 2022.
The company guided for an Adjusted EBITDA in the range of -$60 to -$50 million in Q2 2022, and -$195 million to -$175 million for the full year 2022. The full-year guidance essentially implies a negative Adjusted EBITDA in the range of $40 - 50 million in Q3 and Q4 2022.
At the beginning of the year, the company didn’t voice an ambition for reaching profitability in the near future, but things change rapidly this year and many companies try to bring profitability forward. It would be unreasonable to think that Toast will be an exception, so let’s wait for the news and management’s comments on how they address the profitability issue during the year.
Things to Watch in 2022
Given the bearish sentiment in the market, I will refocus my attention from the long-term prospects of the company to the short-term path to profitability.
Gross margins. Hardware sales and professional services have a negative gross profit contribution. I understand the issues with the supply chain, and perhaps, this is a temporary issue, but if this situation continues, we should start looking at these two positions as sales costs or subsidies for new customer acquisition.
Operating expenses. The operating expenses constituted 35-36% of the revenue, which is clearly well above the current and potential medium-term gross margin levels. So far Toast has not scaled back on hiring, but it would be unreasonable to expect that they will not follow the suit of other growth companies.
Revenue growth. If the economy goes into recession, it will be hard to imagine further growth of the average GPV per location, and thus, the number of restaurant locations will become the key driver of growth. However, if the company is pressured to end the hardware subsidies and scale down on operating expenses, the growth in locations might also get at risk.
Use of IPO proceeds. The company raised $950 million in its IPO last year. First, I hope they will not just burn through this money before reaching profitability. Second, I would also expect the international ambitions to take the backstage and would expect the company to use its cash to acquire struggling competitors and startups.
In summary….I don’t understand the excitement of some of the industry analysts about the company. I am clearly missing something, but low margins are a red flag for me, and I don’t see growth levers, at least in the short term. I hope I will be proven wrong.
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Source of the data used above: Investor Relations
Disclosure & Disclaimer: despite rocky performance in 2021 and early 2022, I have open positions in most of the companies covered in this newsletter, as I am extremely bullish on the transformation in the financial services industry. However, none of the above is financial advice, and you should do your research.