Toast Q3 2022 Earnings Review: a marginally better quarter
Toast Q3 2022 Earnings Review: a marginally better quarter
Toast (NYSE: TOST 0.00%↑) delivered another quarter of strong revenue growth, as it keeps winning new clients and increasing the number of restaurant locations. However, this time the company also managed to make strong progress toward improving its gross profit margins. Gross profit margins improved for both subscription services and financial technology solutions, and the company is now losing less on hardware sales and professional services. If you read my previous reviews of the company, you’d know that I have been quite critical of Toast’s complete lack of focus on profitability, so it was encouraging to see this development.
I believe that the next logical step for Toast would be to achieve profitability (at least on an adjusted basis), which requires further improvements to the gross profit margin and a focus on achieving greater operational efficiency. Nevertheless, adjusted profitability is within reach should the company’s management commit to this target. In the meantime, let’s review the company’s Q3 2022 results!
If you are new to Toast, I suggest reading my previous reviews:
👉🏻 Toast Q2 2022 Earnings Review: strong growth, terrible margins
👉🏻 Toast Q1 2022 Earnings Review: revenue growth at all costs?
👉🏻 Toast: a Fintech that aims to become the operating system for restaurants
Gross Payment Volume
Toast reported $25.2 billion in Gross Payment Volume in Q3 2022, which represents a 52.7% growth compared to Q3 2021, and an 8.2% growth compared to Q2 2022. GPV is the key driver of Toast’s revenue and is a function of a) growth in restaurant locations and b) growth in average GPV per location. Over the last couple of years, Toast GPV has been benefiting from both, growth in restaurant locations (as the result of consistent sales efforts), and growth in average GPV per location (as the result of restaurants reopening from COVID-19 lockdowns and inflation).
Thus, restaurant locations reached 74,000 at the end of Q3 2022, representing a 42.3% increase compared to Q3 2021, and an 8.8% growth compared to Q2 2022. It is amazing how consistent the company is in terms of the restaurant location growth rate (41-45%). I believe this is a combination of a sales quota assigned to sales representatives and a large addressable market that allows them to consistently hit this quota. The company keeps scaling its sales team (sales and marketing expenses, which primarily consist of personnel-related costs increased 50% YoY), so hopefully, it will be able to keep the growth momentum.
The average annualized GPV per restaurant location was $1.42 million, representing a 7.6% increase compared to Q3 2021. The second and third quarters are the high season for Toast’s clients, so we should see a sequential decline in the average GPV per location in Q4 2022 and Q4 2023. It will also be interesting to see how the average GPV per location evolves in 2023 and 2024. I believe 2022 numbers were still partially “boosted” by reopening from COVID-19 lockdowns and historically-high inflation, so growth in 2023 and 2024 can only come through onboarding customers with a higher GPV per location.
Revenue and Gross Take Rate
Toast reported $752 in total revenue for the quarter, which represents a 54.7% increase compared to Q3 2021, and an 11.4% increase compared to Q2 2022. Subscription services revenue increased 95.7%, financial technology solutions revenue grew 55.4%, and hardware sales declined 12.9% compared to Q3 2021. The share of subscription services revenue increased from 9.5% in Q3 2021 to 12.0% in Q3 2022, while the share of financial technology solution revenue increased from 83.1% in Q3 2021 to 83.5% in Q3 2022.
Subscription solutions revenue grew faster than financial technology solutions revenue (both QoQ and YoY), which is great given much better gross profit margins. However, I would argue that the financial technology solutions revenue contributes such a big share of total revenue, that it remains the key driver of Toast’s revenue. Financial technology solutions revenue growth is the function of growth in GPV and the gross take rate change. GPV grew 52.7% YoY, and the gross take marginally improved (see below); hence, total revenue grew 54.7% YoY.
Toast reported a decline in hardware revenue both compared to Q3 2021 and Q2 2022. Hardware sales are a leading indicator, as you need to sell a POS terminal to a restaurant before you start processing this restaurant’s payments. In its 10Q the company notes that “the decrease in hardware revenue … was due to lower upsell revenue from sales to existing customers and the impact of pricing and packaging, partially offset by an increase in hardware sales to new locations.” What the company is saying is that previous hardware sales were “inflated” by pricing promotions and reopening of restaurants after COVID-19 lockdowns.
Toast reported a minor improvement in the Gross Take Rate from 2.45% in Q3 2021 to 2.49% in Q3 2022 (Gross Rate Rate is calculated by dividing Financial technology solutions revenue by Gross Payment Volume). Given $100+ billion in annualized GPV, a one basis point (that’s 0.01%) improvement in the gross take rate leads to $10 million in additional revenue. I don’t know if Toast has the capacity to increase its Take Rate without sacrificing competitiveness and growth; however, the impact of even a slight improvement can be meaningful.
The company’s management guided for $730 - $760 million in revenue in Q4 2022, and $2,692 - $2,722 million in revenue for the full year 2022. This guidance represents a 43-46% YoY growth for the quarter and a 58-60% YoY growth for the full year. Please note, that the guidance implies a sequential decline at the midpoint of the guidance range ($752 million vs. $745 million).
Gross Profit
Toast reported $151 million in gross profit for the quarter, which represents an 81.9% increase compared to Q3 2021, and a 33.6% increase compared to Q2 2022. Gross profit from subscription services increased by 117.9% compared to Q3 2021, and 24.5% compared to Q2 2022, while gross profit from financial technology solutions increased by 74.0% compared to Q3 2021, and 17.5% compared to Q2 2022. Toast continues to lose money on hardware sales and professional services.
Toast made a massive leap in gross profit in Q3 2022 (see the chart below). Sequentially (Q2 2022 to Q3 2022) GPV grew 8.2%, revenue grew 11.4%, but gross profit grew 33.6%, which suggests that the “magic” lies in a significant improvement to the gross margin. Toast has (finally) reported an improvement in the gross profit margin from 16.7% in Q2 2022 to 20.1% in Q3 2022. If you read my previous write-ups on Toast, you’d know that I was quite critical of the company’s low gross profit margins. It seems that Toast is finally showing signs of hope…improvement.
The most encouraging part of this improvement is the fact the gross profit margin expansion was a result of multiple drivers. Thus, the gross profit margin for subscription services increased from 64.5% in Q2 2022 to 67.8% in Q3 2022, and the gross profit margin for financial technology solutions increased from 20.3% in Q2 2022 to 21.3% in Q3 2022. Moreover, although the company is still losing money on hardware sales and professional service, it started losing less. Thus, in Q3 2022 hardware sales and professional services had a negative gross profit contribution of $43 million, compared to a negative contribution of $49 million.
The evolution of the company’s gross profit margin is something to closely monitor going forward. The progress this quarter was very encouraging, let’s see if the company can deliver further improvement. Over the medium term growing the share of subscription services is an obvious driver for margin expansion, while in the short term the trick could be in increasing the take rates and further limiting the losses from hardware sales and professional services.
Operating Expenses
The company reported $236 million in operating expenses for the quarter, representing a 71.0% increase compared to Q3 2021, and an 11.3% increase compared to Q2 2022. Loss from operations was $85 million, compared to $55 million in Q3 2021, and $99 million in Q2 2022. Sales and marketing expenses represented 35.6% of total operating expenses (down from 41.3% in Q3 2021), R&D expenses represented 31.4% (up from 29.% in Q3 2021), and G&A expenses represented 33.1% (up from 29.7% in Q3 2021).
Relative to total revenue, operating expenses increased from 28.2% in Q3 2021 to 31.4% in Q3 2022; however, there was no increase compared to the previous quarter (see the chart below). The company will continue reporting an operating loss for as long as the operating expenses relative to the revenue exceed the gross profit margin (i.e. 31.4% vs. 20.1% in Q3 2022). Please note that an “improvement” in operating expenses in Q2 2022 and Q3 2022 is the effect of seasonality in revenue. Thus, any increase in operating expenses in Q4 2022 or Q1 2023 will increase the expense-to-revenue ratio assuming flat revenue growth.
In summary, I didn’t see meaningful progress in operating efficiency, as operating expenses relative to revenue fluctuate from quarter to quarter, but still considerably exceed the gross profit margin. Of course, if we exclude the stock-based compensation, which in Q3 2022 represented 7.7% of the total revenue, the picture looks more promising. However, at some point Toast will need to show a path to GAAP profitability, which for now requires improving both the gross profit margin and the expense-to-revenue ratio.
Net Income (Loss) and Adjusted EBITDA
Toast reported a Net Loss of $98 million for the quarter, compared to a Net Loss of $254 million in Q3 2021 and a Net Loss of $54 million in Q2 2022. However, Toast’s Net Income is heavily impacted by the changes in the fair value of warrant liabilities. Adjusting for this impact would result in a Net Loss of $77 million in Q3 2022, compared to a Net Loss of $56 million in Q3 2021.
The company reported a negative Adjusted EBITDA of $19 million for the quarter, compared to a negative Adjusted EBITDA of $12 million in Q3 2021 and a negative Adjusted EBITDA of $33 million in Q2 2021. Toast calculates Adjusted EBITDA by adjusting Net Income with depreciation and amortization, interest expenses, stock-based compensation and respective taxes, changes in fair value of warrants, as well as one-time expenses. The largest adjustment was stock-based compensation, which increased from $36 million in Q3 2021 to $58 million in Q3 2022, representing a 61.1% YoY increase.
The company’s management guided for a negative Adjusted EBITDA in the range of $20-30 million for Q4 2022, and a negative Adjusted EBITDA in the range of $117-127 million for the full year 2022. Toast reported a negative Adjusted EBITDA of $45 million in Q4 2021, and a negative Adjusted EBITDA of $42.8 million for the full year 2021.
In the next reporting cycles, Toast’s management should guide for the full year 2023 target, and I wouldn’t exclude an ambition to reach profitability on an adjusted basis. An oversimplified illustration of how Toast’s path to adjusted profitability could look: 21.1% gross profit margin (+1.0% compared to Q3 2022) - 28.6% in operating expenses relative to revenue (-2.8% compared to Q3 2022) + 7.5% stock-based compensation (-0.2% compared to Q3 2022). I believe this looks within reach.
At the end of Q3 2022, Toast had $644 million in cash and cash equivalents, $409 million in marketable securities, and $330 million available under the credit facility, which implies that the company is not financially constrained.
Things to Watch
Locations / GPV per location. The company’s Gross Payment Volume had two tailwinds lately, growth in restaurant locations and growth in average GPV per location. While growth in the number of locations is something within Toast’s control (and the company keeps investing in its salesforce), the average GPV per location was temporarily “boosted” by inflation and restaurants fully reopening after pandemic lockdowns. I would expect further growth to come primarily from growth in restaurant locations, and an increase in average GPV per location to have a marginal impact going forward.
Take Rate / Gross margins. I was very encouraged to see Toast finally improving its gross profit margin. Over the medium term, increasing subscription services revenue (which has a higher gross profit margin than fintech solutions revenue) is expected to continue expanding the gross profit margin. However, I wouldn’t exclude the possibility that Toast might achieve further improvements also in the short term by either increasing the take rate or further cutting losses on hardware sales and professional services, or both.
Path to profitability. I believe the next logical step for Toast as a public company would be to achieve profitability (at least on an adjusted basis). As per my back-of-the-envelope calculation, adjusted profitability is within reach (i.e. next year), but requires further improvements in both, gross profit margin and operational efficiency. This year the company’s focus has been on growth, and you cannot see it making any meaningful progress on improving operational efficiency. This should change if the management commits to achieving profitability.
Economy. At least for now, Toast’s business has been insulated from deteriorating economic conditions. It was a high season (Q2 and Q3) and consumers kept spending on dining out despite historically-high inflation. However, one should keep the economic outlook in mind, as it can quickly translate into strong headwinds for the company.
As the title suggests, this was a marginally better quarter for Toast, as the company’s management finally made an effort to improve its gross profit margins. The growth remains strong, which, coupled with improved margins, should allow the company to achieve profitability in a reasonable timeframe.
Source of the data used above: Investor Relations
Disclosure & Disclaimer: despite rocky performance in 2021 and 2022, I own shares 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 own research.