Toast, Recession Hedges, and the Flywheel
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Toast reported earnings last week, beating revenue and adjusted EBITDA estimates. Highlights from the call were the annual NRR update, the acquisition of Delphi Display Systems, and the continued emphasis on Toast’s flywheel effect.
NRR and Delphi Display Systems:
Toast’s ARR metric is a combination of payments gross profit and SaaS revenue, which is important to keep in mind when looking at revenue retention figures.1 Overall NRR for 2022 came in at 118%, lower than last year’s 135%, but higher than the forecasted 110%. 2021 benefited from artificially high card-not-present numbers, and so a YoY decline was expected.2 More importantly, SaaS NRR increased 5 points YoY to 128%. This SaaS number is the one that deserves more attention, as it’s indicative of Toast’s ability to build relevant products and upsell these products to customers. Great companies are built off of great products, not a temporarily high payments take rate because there’s a pandemic and everyone’s ordering online. Restaurants continue to buy more of what Toast has to offer, as evidenced by 65% of locations now using 4+ elective products.
Toast also has strong sense for smart product acquisitions, and will often partner with companies before offering to buy them. One such example is Sling, an employee scheduling platform that was acquired in Q22022. Sling was not only an additional product to offer restaurants, but also increased win rates for Toast Payroll.3
Given the macro-economic backdrop, Toast’s recent focus on the QSR segment is worthy of attention. The QSR offering was announced in Q1 of 2022, and by Q3 represented almost half of bookings. The acquisition of Delphi Display Systems, which provides digital display and drive-thru technology for quick service, helps Toast get deeper into this market. Management has insisted on earnings calls that dining spend remains stable during recessions, and thus far consumer demand has held up, but it’s fair to assume that in recessions the spending mix shifts more towards fast food than fine dining, particularly if you look at McDonald’s stock chart from 2008 on. Toast for Quick Service is a great way to take advantage of this spend shift, and was introduced at exactly the right time. The business already has a nice hedge against inflation with its POS, and the Quick Service offering provides a potential hedge against an economic downturn.
The Flywheel:
“With the restaurant industry in the midst of a generational shift to cloud-based digital solutions, we continue to seamlessly execute our proven go-to-market strategy to capitalize on that opportunity. As we increase density in more established territories, we benefit from the flywheel effect that drives referrals and inbound leads, driving higher and more efficient productivity. At the same time, we're gaining traction in less developed markets and are on a path to replicate that flywheel effect as we gain share.” - Chris Comparato, Q2 2022 Earnings Call
Typically as a company scales customer acquisition costs go up. This isn’t necessarily a bad thing. As Byrne Hobart has written in the past, companies that are too judicious about CAC can end up permanently behind a competitor that’s willing to spend more liberally. That doesn’t mean it’s not possible for a company to figure out a way to acquire customers relatively efficiently. Toast may be one such company, using a hyper-localized sales motion that ensures reps become intimately familiar with the communities they sell to. Management has continued to emphasize the flywheel effect that occurs in established geographies: as local market penetration increases, referrals and inbounds increase, driving both higher revenue and sales productivity. This emphasis appears justified, as 2/3 of new locations now come through inbound channels, and 1/5 of new locations come from other restaurants or partners. Toast’s management team estimates that current flywheel markets, defined as markets where Toast has a 20%+ share of SMB restaurants, comprise less than 10% of total SMB restaurants, and so the potential for faster growth is signifiant. These resultant sales and marketing savings can be plowed into R&D, in turn creating a better product and widening the gap between competitors.4 It’s difficult to see how a competitor like Square, which only recently began having dedicated Square for Restaurants sales reps, will be able to compete. There’s also reason to be optimistic about short term sales efficiency: Toast has completed its post-Covid layoffs sales hiring, and so as the ratio of ramped to unramped reps increases this flywheel effect should be further accentuated.
This isn’t entirely accurate. It’s technically fintech gross profit + SaaS revenue, but payments comprises the majority of the fintech piece at the moment. Toast Capital has started to contribute gross profit and will grow over time, but it can be ignored for now.
Toast’s processing fees are higher for card-not-present transactions, as the risk of fraud is higher.
Chris Comparato on the Q22022 earnings call: “After incorporating Sling into our sales motion, our win rate was higher when customers evaluated Sling and payroll together compared to when only quoting payroll. This offers early proof of how Sling complements our existing team management suite and can enhance overall value proposition to our customers.”
Netflix experienced a similar flywheel back when it was a DVD-rental company. As word of mouth growth increased, Netflix could spend more on quality DVD-inventory, which created a better product, which meant more subscribers, which meant more word of mouth growth, and on and on.