Toast, Inc. (TOST) Earnings Call Transcript & Summary

All right. My name is Josh Baer, software analyst here at Morgan Stanley. We are joined by Toast CFO, Elena Gomez. Thank you so much for joining us.

Yes. Thanks for having me.

Great. And first, some research disclosures. For important disclosures, please see the Morgan Stanley research disclosure website, www.morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales representative.

So there's a lot of great debates and topics that I want to discuss today, starting with macro and what you're seeing in the environment today as it relates to consumer spending and GPV per location. So you've talked about increased uncertainty around macro. But so far, we've generally seen strong demand trends. So I wanted to ask what you are seeing in the consumer dining behaviors? Are you seeing trading down headwinds to restaurant GPV over the past several months?

Yes, that's a great question. Thanks for having me. So at the highest level, consumer demand continues to be solid. And for us, GPV per location in Q4 was up 7% year-over-year. And seasonally, obviously, Q4 tends to be -- was in line with historical patterns and tends to be a lighter seasonal quarter for us, GPV wise. Similarly, we're still seeing the same seasonal pattern in Q1, which also tends to be a lower seasonal quarter for us. And the thing I'd point out about this Q1 is, last year, we had the Omicron impact, and so you'll see a bigger year-over-year compare in Q1. But for the most part, demand feels pretty healthy and the funnel is strong, and we're seeing our reps really execute well.

Great. And what assumption around consumer spending in macro is embedded in the '23 outlook?

Yes, it's a good question. So a couple of things. Just the reminder that, in past recessions, what we've seen is restaurants have been fairly resilient. So as I thought about -- we, as a team thought about guidance, we've considered a bunch of facts. One of those is how did restaurants fare in prior recessions? Fairly resilient. And you can see that they held up fairly well relative to things like travel and things like apparel. So we have that data point. And then we look at our own dynamic within our business. I mean Q1 tends to be seasonally a slower GPV per location quarter. And so when you think about that, you think about the biggest quarters are ahead for us in terms of our business. And so that, layered on with a macro backdrop, we thought it would be best to be somewhat prudent in that guidance given that we have a lot ahead. But for the most part, we feel restaurants are resilient, and we're still seeing pretty good momentum.

All right. Looking at past downturns, is there a more optimistic standpoint when you factor in inflation and restaurants passing on higher prices and maybe some reopening, continued reopening tailwinds as well?

Yes. So when we look at -- definitely inflation has played a role in 2022 and probably -- and will play a lighter role in 2023. What we've seen in that dynamic is in a recessionary time period, restaurants, even though net adds may be declined, total locations did not. So that presents an opportunity when a restaurant is looking for a player who's going to help them drive efficiency, especially in this backdrop, and we think we're really well positioned to capture that growth.

Okay. Great. I wanted to shift to location additions as it's really -- and touch on TAM and competition. And I think you ended last year with 79,000 locations, less than 10% of the overall U.S. restaurant population. Wanted to ask, does it make sense to look at TAM that way to include all U.S. restaurants, including chains, enterprise, quick-serve? Or another way to put it, what is your realizable TAM that you can address today?

Yes, it's a great question. So one meta point is we believe that the entire U.S. restaurant market is available to us and something we can service now. The way we think about it internally is there's different segments of the market, of course, whether it's SMB, which has been our bread and butter, whether it's mid-market, whether it's enterprise or even very small businesses. And so when you think about the SMB space, which is where we've proven that we can succeed there. We've proven we can build out flywheel markets. We're going to try to continue to do much of the same around that. And then you layer on mid-market, which we've proven as well that we can win mid-market. Philly's Pretzel is a good example, our Barbecue Holdings a great examples of mid-market restaurants with over 150 locations. So that -- those are proof points that we're resonating in that space, and we'll continue to do that. And then you think about enterprise, which has a completely different dynamic. They're focused more on above-market operations, whether it's reporting, whether it's security, et cetera. So we feel we're -- and we already have a handful of enterprise customers in Jamba Juice and Nothing Bundt Cakes. So when you think about that, we're able to serve customers in the enterprise market already. We've proven that, and we are getting pulled upmarket. And so we're building some of that capability already. And then -- and we'll be able to penetrate that market deeper as we continue to innovate in that space. When you think about the very low end of the market, you can also see an opportunity there for us to, through different pricing and packaging, also landlord customer. And regardless of the segment, we'll obviously keep that payback period and unit economics in mind, but we do feel that we'll be able to penetrate the entirety of the market over time.

Great. Really helpful on TAM. And then from the competitive perspective, who do you see most often? And can you give a sense for win rates?

Yes, sure. So the competitive landscape hasn't changed. It continues to be point solutions, legacy players, modern cloud players. And we see all of them in the market. And the good news is when we're in a competitive deal, we win the majority of the time. And that has continued and been very consistent. When we think about -- and that said, we don't win all the time, obviously. And so why do we not win? Is it someone needs a specific solution if they have an executive sponsor? So there's definitely reasons that we don't win. But for the most part, if we're in a deal, it's a competitive deal. We found that our win rates are -- we win the majority of the time and have been relatively consistent. And so what is driving that win rate is really back to the differentiation we talked about at the IPO, being purpose-built for restaurants, being specifically focused and able to deliver product that resonates with customers, Tips Manager is a great example of that and other products where that land and resonate really well with restaurants. So overall, very healthy win rates and the competitive landscape is generally the same as it has been.

Okay. Great. Really helpful. And so putting together TAM and competition, the end result for everyone's models is locations, location additions. So considering sort of your commentary on what you're seeing in the market, is adding 5,000 to 6,000 locations a quarter or maybe 20,000 to 25,000 a year, like is that a realistic outcome looking ahead?

Yes. I'll share a couple of things. One, it's both locations and ARPU that we are very focused on. But we stepped up to the 5,000 to 6,000 range in 2022. We think that's a pretty healthy clip over time. And as we add more flywheel markets, obviously, we are able to consistently deliver that growth rate. At the same time, we're building emerging markets. And then longer term, if you think about the opportunity that we have with international enterprise, those could serve as ways to sort of bend that curve over time, but they're early. So that's not a near-term dynamic, but you should see that over time.

Great. You mentioned ARPU. So I want to start with software ARPU and touch on a dynamic from Q4, where we saw strong growth in sequential SaaS ARPU and SaaS ARR, but weaker sequential increase in subscription revenue. So I was hoping you could dig in a little bit to that dynamic and provide some context on the difference between SaaS ARR and subscription revenue.

Yes. No, it's a great question. So first, zooming out, if you think about what's driving SaaS ARPU, we have seen momentum throughout 2022, and that's driven because our customers are adding more of the platform upfront, which is obviously, a good testament to what the reps are doing on the ground, and we are investing in upsell. So the combination of those two drive that ARPU that you're seeing. When you look at the actual data points that we're talking about, SaaS ARR grew 60% year-over-year and double digits in terms of sequential. And then SaaS ARPU in Q4 grew 20% and sequentially also grew. So when you think about that, that's just a testament to what I just talked about, which is landing more of the platform upfront but also building that upsell motion, which we're very encouraged by as well as with -- embedded in the upsell motion is also to shop where customers can go into our -- into their Toast web and purchase product. In terms of revenue, which is really your question, how do we think about revenues. So every quarter, we have 606 adjustments, which -- there's puts and takes every quarter. Certain quarters they could benefit us, certain quarters that could be a negative impact to our revenue. So that, coupled with some prior period adjustments, is what you're seeing play out in Q4. But again, zooming out, there's nothing structurally that has changed. We've continue to have momentum with upsell. And as we innovate more, we'll continue to see SaaS ARPU continue to grow.

Just a follow-up on the 606 adjustments. Is it related to the allocation of bundling because...

Yes. Right on point. So there's -- so depending on the dynamic of the quarter, the various product lines could benefit more or less. And so that's the dynamic that played out in Q4. And that's the dynamic we see every quarter. This was disproportionate this quarter in Q4.

Okay. And so going forward, from a sequential standpoint, it is like the -- sequential Q3 to Q4, is that on the revenue side for subscription, is that right way to think about going forward or the seasonality from prior [indiscernible]...

Yes, I would point everyone back to the earlier part of the year. That's a good question. I wouldn't use a sequential from Q3 to Q4 as a proxy for the future.

Okay. Very helpful. And then taking a step back and talking about the software ARPU, it's always a moving target around like the fully baked. What if the hypothetical customer spend on software if you adopt all products because you have innovation, new products and do M&A. So what are we up to the hypothetical million-dollar GPV restaurant if they adopted all software? And is there opportunity to expand that fully baked?

Yes, it's a good question. We get that a lot. So one way to frame it is, when you think about the percentage of sales that a restaurant spends on technology, it's been around 3%, and we think that's going to continue to grow. But if you just take that example of $1 million of GPV per location, we're slightly higher than that. But for easy math, let's just take the $1 million. If you take that math, you would have -- that would imply a 30,000 of SaaS ARPU, which is what's possible if we innovate and continue to innovate and drive more to our platform. Today, we already have customers paying on SaaS alone $10,000 of ARPU, and that's not unusual. We even have some customers paying us in the mid-teens. We have a P3, I think, is Arizona that has -- it has APIs, it has online ordering, it has payroll, it has Sling. It's adopted definitely the breadth of the platform, and they're kind of in the mid-teens. So we have examples of that already. And some of that is our upsell motion. Some of that is landing bigger upfront, but we believe that we can replicate that over and over.

Great. Moving on to the payment side of the equation. You mentioned -- and maybe starting with Toast Capital. The nonpayment fintech products contributed $24 million to gross profit last quarter. Most of that was Toast Capital. Maybe to start, if you could outline what has driven Toast Capital's success? Like how do you think about that opportunity for Toast Capital?

Yes, it's a great question. So the -- at the highest level, I think if you just zoom out, you think about the fact that we have the payment rails gives us that opportunity to offer more products to our customers that are not just payments alone. And Toast Capital is a great example of that. When you think about Toast Capital, the idea was formed on the fact that we know our customers, our restaurants are underbanked, and we know they need access to capital. We know they have liquidity needs, whether it's to redo their patio or get new kitchen equipment. And so we found that the fact that we can see their data, their payment volume puts us in a unique advantage. We can see that data day in and day out. So that data is what helps inform our models on who we can lend basically capital to. And that creditworthiness gives us -- knowing that creditworthiness gives us the conviction that we can, therefore, lend and meet that customer need at the moment they need it. So we've developed a very sort of friction-free, easy way to get access to that capital. In 2022, we launched a 360-day product towards the end of the year, Q3 into Q4. And so on the whole, the impact of Toast Capital for the full year was about $58 million. And we exited Q4 with a $24 million impact to our gross margin. So that's a great proxy to think about for 2023, that exit rate because we did launch that 360-day product towards the back half of the year.

That's really helpful. I guess how do you weigh some of the risks associated with Toast Capital with the contribution to your bottom line?

Yes. So it's a question that we are answering a lot. And part of it is just to make sure that it's understood, we're being completely measured about the investment here. And part of the -- there's a few things that we think about to measuring risk. One is we have access to the data, which I talked about. And that data gives us the indication of the creditworthiness of the customer, that's number one. It's a unique advantage. Number two is we capped the losses at 15%. So the partner that we work with issues the loans. We get a servicing fee for that loan. And then three, we have a risk-dedicated team just focused on looking at the performance day in and day out. And then finally, the way that the customers pay us is a fixed percentage of their payment volume. So it's a way to have predictability of the program and manage that risk very carefully. The other thing I would tell you is we have the opportunity, and we have done this before, to throttle back and forth if we wanted to. If we started to see performance that was what we didn't want, then we would throttle it back if we needed to. So that's number one. Number two, the performance has been exactly what we expected in line with our expectations. And in fact, a lot of our customers have come back for another loan, 80% of our customers, in fact, have come back for another loan. So that tells us a couple of things. One is we wouldn't give them another loan, obviously, if they had performance dynamics that we didn't like. But two, it's really resonating. And the more we're testing, for example, we started with 90-day loan program, we went to 270, and then we launched 360. So you'll see some of that testing and learning before we go too far, and we're trying to be incredibly measured about that risk. So it's something we're paying attention to. And so far, has had great success with the customers we have.

Great. More broadly on net take rate, where are we today? How should we think about the trajectory going forward? And how does scale or reduction in transaction costs, mix changes impact that take rate?

Yes. There's so many dynamics that impact take rate. So no question, it's something always top of mind for us, whether it's scale and volume. We added a redundant processor at some point in the last six quarters. That's been helpful. And then really just thinking about when you think about the net take rate, we both have ability to test pricing, so we also have the ability to optimize as we scale, and more volume will naturally get us that as well.

And it's not in the near term, not -- in our model, not in your margin outlook, but how would international or moving more significantly upmarket to the enterprise impact the take rates?

We -- it's too early to tell on those two segments. They're super early in our impact to the financials, as you point out. I would say a good proxy to use for overall take rate, including Toast Capital for 2023 is in that kind of low 50 basis points range, and we talked about that on the earnings call. I think that's a healthy -- obviously, we'll always try to optimize over time, but that's probably a healthy range for us right now.

Great. I'll ask a few on margins, and then I'll see if anyone in the audience has questions. So I wanted to ask about the first long-term target model introduced last earnings for 30% to 35% EBITDA as a percent of fintech and subscription gross profit. The levers appeared balanced across OpEx and reducing the hardware and services mix. But I wanted to ask you about the time line associated with that target or scale because it's sort of open-ended. In my mind, if you cross $2 billion in gross profit, that would mean at scale. But like what do you think about that assumption? And what could push that target time line out further or bringing it in closer?

Yes. It's a really fair question. At the highest level, if you just kind of zoom out for a second, let me put it in context. In 2022, you saw us deliver consistent margin expansion, and that was getting more disciplined and really focusing the organization on driving more operating leverage. You'll continue to see that from us in 2023, and our guidance reflects that. We're going to have over $100 million of improvement in our EBITDA in 2023. It's implied in our guidance. If you think about longer term, which is what you're talking about, there's a couple of things I would point you to. One is it's -- in our control, the timing. The timing is in our control in terms of when we get to that adjusted EBITDA. But there is a framework we're thinking about, which is we want to consistently beat the Rule of 40 over time. And so when you think about that, you think about the scale in the multibillions, as you suggest, is not unreasonable. But at the same time, we want to have that flexibility because as the market evolves, we want to be able to capture the growth opportunity ahead of us. And so I would tell you that you may not see a linear path to that 30% to 35%, but you'll definitely see a continued focus on discipline in how we manage the business, and that's really important to us.

Great. I wanted to ask about at least one of the components of the levers of that margin expansion being software subscription gross margins. I believe in the past, you've talked about mid-70s as a potential sort of medium-term path for that -- for software gross margins. With ARPU continuing to increase, is there anything structurally stopping Toast from achieving 80% gross margins on the software side?

Yes. No, you're right on point. I think as we continue -- you're right on point on this ARPU point. As we continue to scale and drive more ARPU, that's going to drive, obviously, the SaaS revenue. But we also want to balance that with really good customer support. And as we build out enterprise and international, like we've got to make sure we're supporting those customers. We have really low churn rates, and we want to continue to sustain those. So some of that comes with investment and customer support. But of course, over time, we're going to look for ways to optimize the gross margin over time for SaaS specifically.

Great. And then on the hardware margin side, they got worse because of supply chain and several other impacts. And I guess like what is the trajectory of the hardware gross margins? Do we go back to where we were in 2019, 2020 or...

Yes, it's a good question. So the way we think about it and what has happened, you're right, during COVID, shipping costs went up, and product costs actually also went up at the same time. So that was burdening our hardware margin for the last several quarters. What you started to see in 2022 towards the end is some improvement in shipping costs. We started realizing lower shipping costs. You'll see a little bit more of that in 2023, we'll benefit from lower shipping costs. But at the highest level, we have a supply chain we're managing, and we've got to manage that very effectively. And so that could mean anything from relationships with the vendors that supply our products to just optimizing the negotiations we have with those vendors, et cetera. So anything we can do to ensure we still get hardware in our customers' hands at the right time, but balancing that with a very tight supply chain optimization focus program on that. So that's what you'll see. But that's over a longer-term trajectory, not necessarily all in 2023.

Great. Helpful. Let me pause there and take some questions from investors. There's one up front.

So just to clarify on the margin piece, with the Rule of 40, we should think that you're not going to hit those margin targets until you're growing more like 10% or high single digits?

So what was the last part?

We should think about you hitting those longer-term margin targets more when you're at 10% growth?

I wouldn't say 10% is where we want to exceed the Rule of 40. So I wouldn't anchor us on 10%. I would anchor us on multibillion dollars as probably the right way to think about that. And that's over time. And the other point I would say is the point I made earlier about it not being linear. So we'll manage to try to exceed the Rule of 40 over time, of course, with trying to sustain growth rates over time. And actually, the other thing I'd point out on the long-term margin is it doesn't include international, it doesn't include enterprise. Those are opportunities for us to actually grow ahead of that.

And the Rule of 40 is revenue growth plus the EBITDA margin on subscription...

It's on the gross margin and the EBITDA, like the SaaS fintech gross margin and the EBITDA.

Great. Any other questions? There's another in the front.

Can you talk a little bit about the process of winning an enterprise customer? Because if you're running a 50-location store, they probably have a legacy or on-prem solution. A lot of the enterprises either have homegrown or built solutions or many franchisees or franchisors, whatever, who may decide for themselves if there's a corporate initiative. So it seems like a lot more of a complicated sales process. So how do you go about actually getting in there winning, getting a pilot, that kind of thing?

Yes. No, you're raising a really good point, which is selling to the enterprise, obviously, very different than selling to an SMB. The way -- and we have a sales team focused on that, which is different than the core field rep. It's not a very big team, but it's still a team that's dedicated. And to your point, the needs of an enterprise customer are very different. They have many -- much more above store needs like rich reporting and data security and all these things that may not be as important to an SMB. What I would tell you how we manage is, we're still going to make sure that, as a whole, the unit economics makes sense. And that's what's really important to us, managing to that payback period. But it's a great opportunity to continue to penetrate the TAM by going after that segment, but we're going to be balanced in making sure that the unit economics also makes sense.

Microphone is coming.

I had a quick follow-up on payment volumes. How do you think about the cadence this year given the Omicron comp from last year? And I know you talked about a slowdown in GPV per location seasonally, but how do you think about that in the context of the comparison? And then how might this year play out in the context of potentially tough reopening comps from last year? How do you think about that as it informs your cadence for this year?

Yes. So the first one is we continue to have the same seasonal pattern on our payment volume, and we don't have any reason to believe that will be that different. So far, both Q4 and Q1 are playing out in the way that our historical seasonal patterns have been. Omicron, obviously, makes it an easier compare. As you get into the summer months as they're our higher payment volume quarters, so you won't see that same easier compare, if you will. And then your second question was on locations. Was that?

Just reopening drag [indiscernible]

Actually, it may have played a factor but not material, not material.

Great. I'll ask another one. Most of the macro conversations have been around consumer spend and GPV per location. Wanted to ask on restaurant behavior? Are there any software modules that if a restaurant did feel pressure, would be lower on the list like how to think about the retention of -- on the software side?

Yes. I think what's interesting is we've had pretty consistent when we think about upsell and downsell. We've not seen so much of -- let me downsell this product, which is a pattern we pay attention to in addition to just overall churn. So we haven't seen enough pattern to say this particular module would be something that would be discretionary, if you will, in a recessionary environment. In fact, I would argue the counter, which is the platform actually resonates quite well in this environment because it's helping customers with things like detailed line item costs on their menu with supplier and accounting, it's helping them turn tables faster. So if someone is really looking for an efficiency play, we actually resonate quite well in this market. And so that's what our reps are really out there talking to customers about day in and day out.

Great. So there's a return on the software whether it's cost or revenue?

Yes. I mean, I think it could be -- this market could actually be a benefit to us because we have proven that we can help the restaurants be more effective and efficient.

Great. I'll ask one last question here. Just wanted to ask about stock-based comp and dilution and your philosophy on managing both?

Yes. We're paying very close attention to it. At the highest level, we want to take stock-based comp down as a percentage of recurring revenue over time. I haven't given a target specifically, but that's definitely something that's top of mind, a high priority for us.

Okay. Great. Thank you so much, Elena.

Thanks, Josh. Appreciate it.

Appreciate it.