Welcome back to IPO season.
No, we won’t call it hot liquidity summer, but after an August lull, the public-offering cycle is back upon us. Last week we saw filings from Warby Parker, Toast and Freshworks. We’ve dug into Warby already. This week, we’re tackling the details of the latter two debuts, starting with Toast.
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Why do we care about Toast? It’s a technology startup. It’s a unicorn. And it raised more than $900 million while private, per Crunchbase data. And the company is a leading constituent of the Boston startup scene.
Even more, the software-and-payments company combines subscription incomes, transaction fees, hardware revenues and lending earnings. Its business is complex — in a good way — and may help us better understand what happens to software companies when they build more financial capabilities into their original applications.
It’s an interesting company, one that was initially impacted heavily by the COVID-19 pandemic. Let’s go over the company’s overall financial performance, dig into how COVID affected the company’s business, consider how its revenue mix is changing over time, discuss how important fintech incomes are for the company and what it might be worth. This will be good fun. Let’s go!
Toast’s growth is accelerating
We’ll carve more deeply into how the company generates revenues shortly. For now, just keep in mind that the company has a number of revenue streams, each of which has a different gross-margin profile. So, we’re not only discussing high-margin software revenues in the following.
Here’s Toast’s top-line performance for 2019, 2020, and the first half of both 2020 and 2021, taken from its S-1 filing:
We can quickly see that the company grew from 2019 to 2020, albeit at a moderate clip. More recently, observing the two columns on the far right, we can see much more rapid growth from the company. In year-on-year comparative terms, Toast grew 24% in 2020 and 105% in the first half of 2021.
Thinking about how COVID-19 hit the food business, observing modest growth at the company in 2020 feels somewhat strong; despite huge market chop, Toast still grew nicely. And the company’s H1 2021 results indicate that the product work that Toast engaged in during the global pandemic has worked well, allowing it to accelerate growth by a factor of four in the last two quarters when compared to 2020’s overall pace of revenue expansion.
The above data also helps us better understand why Toast is going public now. After pushing through 2020, the company’s current portrait is one of accelerating growth leading to massive top-line accretion. Toast looks more than strong. And there’s no better time to go public than when you have numbers to brag about.
The COVID-19 pandemic did not derail Toast
To track how the pandemic impacted Toast, we need to observe its quarterly revenue results. Here’s the data, with Q2’s revenue highlighted in a small red box to save you time looking for it:
The June 30, 2020, period — Q2 2020 — was not good for the company. Revenue fell by around a quarter from the preceding period, a catastrophe for any company but doubly so for a high-growth unicorn like Toast.
What drove the revenue declines? Falling gross payment volume, or GPV, to a large degree. Here’s the company:
Due to the impacts of the COVID-19 pandemic, our GPV declined by 24% in the second quarter of 2020 as compared to the second quarter of 2019. With the gradual reopening of restaurants in the second half of 2020, alongside our continued location growth, our GPV recovered over time, ultimately growing 17% year over year for 2020 as compared to 2019. While in-store dining saw a material decline during the COVID-19 pandemic, we saw a significant increase in orders placed by guests through takeout and delivery channels.
GPV fell, indicating that overall restaurant order volume dipped. That matches my memory of the time period.
But notably, by the second half of 2020, just one quarter later, things were getting better. As we can see in the September 30, 2020, period — Q3 2020 — in the above table, revenues rebounded quickly.
But the downturn, albeit short-lived, still hurt. Toast cut staff and had to help some companies with its software invoices:
We also completed a significant reduction in workforce in April 2020 to reduce operating expenses and have taken other measures to reduce discretionary spending while conditions remain uncertain for the restaurant industry. In addition, we contributed toward customers’ dedicated recovery efforts by providing over $20 million in direct SaaS relief credits as well as additional access to loans through Toast Capital.
The troubles did not last. Toast grew consistently from Q3 2020 on, including a simply excellent Q2 2021 in expansion terms. How did it manage that? Let’s find out.
Toast’s revenue diversity is a strength
In the pandemic-hammered second quarter of 2020, Toast saw its fintech revenues (payments, etc.) fall. Its hardware revenues (terminals and screens) also slipped. And the company’s professional services revenues dropped, too. All the while, its software revenues … crept higher. Not by much, but they did inch up from Q1 2020 top line of $22 million in revenue to $22.8 million in the next quarter.
From that point, Toast’s two largest revenue sources — software and fintech incomes — have posted constant growth on a quarter-over-quarter basis. Hardware revenues have proved slightly less consistent, although they are also moving in a positive direction this year and set what appears to be an all-time record result in Q2 2021.
Toast would have had a much worse second quarter last year if it didn’t have software revenues. And since then, its growth would not have been as impressive without payments revenues (its fintech line item, speaking loosely). The broad revenue mix that Toast built has proved to limit downside while opening lots of room for growth.
Startup founders, take a minute to track Toast’s revenue growth per category over time. Sometimes diversified offense is functional defense, it turns out.
Toast’s growth is lower-margin than we might have guessed
But while the company’s software revenues proved to be stabilizing while COVID-19 first shuttered the world, fintech has been the key driver of growth for Toast. For example, in Q3 2020, Toast posted then-record software revenues of $27.4 million. In the same period, fintech revenues came to $188.2 million.
That differential has persisted. In Q2 2021, Toast’s software revenues set a new record of $37.6 million. In the same quarter, fintech revenues were $353.6 million. Between the company’s first pandemic accelerated quarter, then, and its most recent period, software revenues grew 37%, while its fintech top line grew 88%.
The two revenue lines have very, very different gross-margin profiles. Fintech revenues at Toast generate 20% gross margins, while its software revenue puts up 66% gross margins. This means that while Toast is a software business, its largest revenue line item has non-software gross margins. The company’s lower-margin revenue mix will impact its eventual public market revenue multiple.
What about hardware and services revenues? Are they gross-margin accretive? No. Toast sells hardware at slightly less than cost, which is smart because those tablets won’t work without Toast software and payments tech. And it sells human services at a steep loss, likely as a loss-leader to help customers get up and running with its software and fintech products.
In effect, then, Toast is a high-margin software business coupled to a far-larger, lower-margin fintech business — with some other bits glued on to support both key revenue categories.
Toast is worth a zillion dollars, more or less
What is Toast worth? To figure that out, we’ll need more than just revenue growth and gross-margin notes. Let’s talk profits and market depth.
Toast is running smaller operating deficits over time. After posting $220.2 million worth of operating losses in 2020, Toast lost just $56.8 million in the first half of 2021, in operating terms. Its H1 2021 result was also far superior to its H1 2020 operating loss of $124.6 million.
On a GAAP net income basis, Toast remains unprofitable. However, there’s nuance to that, including rising share-based compensation expenses and changes to the fair value of certain warrants and derivatives. So, we expect investors to be a bit more curious about the company’s adjusted EBITDA.
That metric is full of good news for Toast, as we can see in the following table:
Adjusted EBITDA at Toast sharply improved from 2019 to 2020, and, thanks to rising total scale in 2021, has turned around completely, pushing the company into the (heavily adjusted) black. Even more, free cash flow flipped positive in H1 2021. For investors, this should prove to be catnip. Strong revenue growth and demonstrated operating leverage thanks to improving FCF positivity and adjusted profitability? It all looks rather pleasant.
But what about future growth? It’s well and good to have posted historical growth, but what’s ahead? Toast has a pretty good explanation for its long-term bullishness:
We believe there is a substantial opportunity to continue to grow our restaurant locations across the United States. As of June 30, 2021, our presence in 47,942 locations represented only about 6% of the approximately 860,000 restaurant locations in the United States.
The company will never secure 100% of its market, but with just 6% today, it should have plenty of room to run.
Summarizing: Toast has a multipart business, rapidly accelerating revenue growth and has recently flipped to free cash flow positivity while generating material adjusted EBITDA. That’s worth a lot.
Toast was last valued at just under $5 billion when it last raised, per Crunchbase data. And folks are saying that it could be worth $20 billion in its debut. Does that square with the numbers?
Maybe: $20 billion is 11.8x the company’s Q2 2021 revenue run rate on an annualized basis. Why is that number not higher, given the multiples that we’ve seen from other companies going public in recent quarters? Because Toast is really a fintech company with some additional software revenues, as opposed to the other way around. Lower margin revenues mean lower revenue multiples, as lower-margin top line is simply worth less than higher gross-margin top line.
Does the 11.8x number fit the market? Let’s look at Olo, which also works in the restaurant software space, for help. However, its revenues are nearly all software incomes so they are not quite the same thing.
Olo posted $35.9 million in Q2 2021 revenue, putting it on a $143.6 million annual run rate. Worth $6.48 billion today, it’s valued at 45.1x its current annualized revenues. That’s rich for a software company, but not outside the realm of the well, OK, I can kinda make the math work.
Is Toast therefore cheap? It’s not as clear as you might think; because Olo has higher blended gross margins, its revenue is more valuable. At the same time, Toast is growing more quickly. If you think that growth matters more than revenue quality, you could argue that Toast doesn’t deserve as stiff a multiples discount as it might have to endure at a $20 billion valuation.
If that’s the case, you should expect the company to price above that dollar figure. But if you think that the company’s fintech revenues are of sufficiently lower quality as to warrant the discount, then you might hope for a more inexpensive pricing run at the company.
My take? Given its growth, scale and revenue mix, Toast will be able to go public at a greater-than-$20 billion valuation. More when we get a first price range.
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