Toast: Sticky SaaS - [Business Breakdowns, EP.247]

18:58Business Breakdowns Hosts:I think this is probably a part of the story that deserves more time. At Counter, we talk a lot about product and profits, companies that can lead with innovation, lead with product-led growth, but also do it with really high profitability. There aren't that many companies in the world that can do that, that can sustain really high growth with great profitability at the same time. Toast is definitely one of those companies. We talked about 97th percentile gross profit growth in public markets, pretty exceptional. And management says they can maintain 20 plus percent growth for many years ahead.

19:32Business Breakdowns Hosts:They just actually said that yesterday at a conference again. At the same time, margins have gone from minus 16 percent in 2022 to roughly 35 percent today, going to 40 plus percent, which management has said is a line in the sand, and then they'll continue from there. There's a ton of operating leverage in this business where they've seen operating leverage is certainly in sales and marketing, where that number has come down a lot as a percent of revenue. GNA naturally as a company scales, you've seen GNA come down quite a bit as a percent of revenue. And then R &D, this has been a really interesting new lever for them as they've incorporated AI into the business internally.

20:14Business Breakdowns Hosts:They've shipped more product in the last two years than I've ever seen them ship. We'll get into their AI offering. It's super advanced. It's very impressive. And in the last two years, R &D expense in dollar terms has not grown, basically barely grown. So you've had a business that's doubled in size and R &D has been relatively flat. They're starting to grow R &D again. They'll continue investing. This is an innovative team that thinks super long-term. They're not going to sacrifice their long-term opportunity, but there's been a lot of operating leverage in the business. And we just see that continuing as the business scales.

20:49Sean Barrett:Maybe you can get into that AI offering and what they're shipping. How does that show up? It's interesting to hear. We hear a lot about experimentation. I think we're all doing a lot of experimentation. It's another thing to ship things that your customers are using. So how does it show up in the business and what does it look like for customers?

21:07Business Breakdowns Hosts:AI is the best thing to happen to Toast since their founding, probably. Product has always had advantages versus the incumbents and versus the competitors. But you fast forward to today, the product has substantial data advantages. So they have 160 ,000 restaurants on the platform, They see local data everywhere, but they can see that because it's a multi-tenant SaaS cloud platform. Not to get too advanced here, but with multi-tenant SaaS, you can see all the data in real time. You can give product updates in real time. And then the gap against your competitors gets much wider. If you look at an on-premise offering, OpenAI is coming out with a new model every week.

21:48Business Breakdowns Hosts:Cloud's coming out with a new model every week or two. If you're an on-premise platform and you have to send a technician out to a restaurant to update the server every couple weeks. I mean, good luck. It's not going to happen. And it doesn't make any sense. It's not rational from a financial perspective. So AI is widening the gap for Toast versus its competitors. I think just to give you a couple examples of where they're innovating and what they've done in AI, the first thing they came out with was something called Toast IQ, which is their AI offering. Customers love it. It's effectively a conversational AI offering that combines it with a system of action.

22:26Business Breakdowns Hosts:So you can talk to your Toast IQ. You can ask it questions. You can make menu changes across the board. That sounds simple, but if you have multiple locations and you want to change prices or change menu items, and you're also hooking up to the marketplaces, that used to take an owner all weekend. Now you can just talk to your Toast IQ and make it in real time. You can have real-time analytics. You can have custom analytics. So let's say you have multiple locations. You want to say, hey, Toast IQ, can you tell me what this location is doing year over year with these menu items? And you can break it down into a bunch of ways of looking at it.

23:04Business Breakdowns Hosts:It also is real-time inventory management, where if the restaurant's running out of produce of a certain kind at night, the system will actually automatically order new produce, fresh produce from Instacart Business or other local vendors. It's agentic in nature. It's an advanced AI model in nature. And the customers absolutely love it. I mean, we've heard 50 % of customers are actively using Toast AI, Toast IQ on a weekly basis. The new offering that just came out that's super exciting is called Toast Grow. And it's within the AI offering. It's an automated marketing engine for restaurants. Restaurants spend a lot of money on marketing.

23:47Business Breakdowns Hosts:Generally, a restaurant will spend$1 ,000 to$2 ,000 a month with a marketing agency for Instagram and local marketing, and they don't see a lot of uplift. They still have nights of the week that are just going to be empty or going to be more quiet by nature of local behaviors. What Toast Grow does, it looks ahead and it takes data from the past and it takes data from restaurants around you. And it might look and say, okay, this next winter Tuesday in Boston historically is really, really quiet. Let's go out and do a local promo with SMS texting to people who have been here before. Let's put up deals on the website.

24:25Business Breakdowns Hosts:Let's do an Instagram promotion. It does it all in real time automatically. And it does that for about$500 a month. Historically, just over the last month or two, as people have started using this, they've seen an 8 % uplift in total revenue. Remember, we talked about a restaurant on average for toast doing about 1.3 million of revenue. So this product that costs$500 a month as a SaaS module, by the way, nice uplift, could be 100 % uplift to SaaS ARPU, gives you about a 20x ROI right out the gate. So that's the kind of stuff they're doing in AI. We talked about some of the internal leverage as well that they're getting with R &D.

25:06Business Breakdowns Hosts:But the product roadmap is largely AI driven. It's largely agentic driven. And then management would tell you, as they did at a conference yesterday, that this is going to be the next leg of their revenue opportunity as well.

25:19Sean Barrett:The 8%, whether you measure it in 20x or just think about restaurants, the margins that they operate at, how razor thin it can be. It is material for that customer base. On the competitive landscape, I truly fail to appreciate how much Toast was doing for customers, just in terms of how deep into the restaurants operating activities they could be when it relates to inventory management, marketing, all of these different things. How do you define the competitive landscape? And I'm curious how many others are doing quite as much just in terms of the breadth of different activities.

25:56Business Breakdowns Hosts:The competitive landscape, I think, is a real strength of the story here. Just to start out before we jump into specific competitors, big question is like, why does Toast win. They win because they have great product that we talked about. They have happy customers. And then importantly, they have more profitable customers. A typical restaurant might have 10 % margins. It's a low margin business, as you mentioned. A typical toast customer from our work has something more like 15 % margins. So they're taking home 50 % more dollars for the restaurant owner. It also means that toast restaurants survive more often.

26:31Business Breakdowns Hosts:That leads to higher retention for Toast, and it leads to happier customers. The interesting thing about the competitive set, I would break it into legacy and modern. You've got about half of the market that's still on legacy platforms. So that's stuff like NCR Aloha, Oracle Micros. Those are companies with on-premise software, on-premise servers. Generally, as we talked about, a bad fit for a kitchen. You don't want a hot server sitting in the back of your kitchen or in a closet near your kitchen. That's what really opened up the door for Toast to be the first successful scale cloud-based disruptor.

27:07Business Breakdowns Hosts:On the more modern side, you've got Square. They have about 5 % to 10 % of the restaurant market. They do really well in the lower end or the smaller end of the market, where it's a less advanced offering, really more just a payments dongle. Now, they are innovating, and they're innovating at more rapid pace than they used to, because I think they see the restaurant industry is actually really attractive, they aren't winning from Toast. They're mostly winning from Legacy and, we think, from Clover. Clover has about a 15 % share. That's the subsidiary of Fiserv. It's been publicly noted that Fiserv's been over-levered.

27:46Business Breakdowns Hosts:They've acquired a lot. The stock has been a mess. And I think they have some real issues to deal with with regards to leverage if they want to survive. As a result, they're not innovating and customers have noticed. And so they've been losing share, even on the modern side. One player to watch right now is DoorDash. It's no secret DoorDash has been out piloting POS solutions with their customers. But I think maybe they did that in response to Toast, which very famously about a year ago started offering free delivery. That's a real innovator's dilemma for DoorDash all of a sudden. DoorDash has a 15, close to a 15 % take rate for their deliveries.

28:24Business Breakdowns Hosts:But all in from a customer and restaurant perspective, it can be 30 % of the order that goes to fees. Toast just flipped that whole thing on its head. We think 80 ,000 customers or half of the Toast restaurant base now has signed up for the Toast ordering module, which effectively gives you free delivery in partnership with Uber Eats from the restaurant perspective. We always try to go out and do our homework on the ground. And so we ask the question of which restaurants would be likely to switch from Toast to DoorDash if DoorDash were to offer POS for free even. There are a few things worth noting.

28:59Business Breakdowns Hosts:One, the unit economics of switching from Toast to DoorDash are non-rational. You're effectively saying you might save 50 bips on payments, which is not substantial, to go over to DoorDash where you're paying 13 % to 15 % take rate on deliveries. And that's a really meaningful difference, that take rate. You can actually do this, Matt. So if you go to your favorite local restaurant, decent chance now that they have Toast deliveries and DoorDash deliveries enabled, pull up the delivery on DoorDash. You can get all the way to the order page. A$40 delivery on DoorDash will usually cost you something like$30 to$35 if you continue to the delivery page on Toast.

29:39Business Breakdowns Hosts:It's a really great offering. Restaurant customers love Toast. Net promoter scores of 50, customer satisfaction rates of 95 plus percent. Those customer satisfaction rates are substantially higher than what we see in our surveys on DoorDash. The third thing is we always put boots on the ground to test our hypothesis. So my colleague actually went up to San Francisco the other day, just this week, and walked into 30 or 40 restaurants that have DoorDash and Toast enabled, bought something, be a good customer, but asked them, how likely would you be to switch from Toast to DoorDash if it was free?

30:15Business Breakdowns Hosts:We couldn't find a single customer that said they would switch if DoorDash offered free point of sale. We think both these companies can coexist and grow and be successful. Where I think DoorDash will find more success is in quick service restaurants that are delivery first restaurants versus where Toast plays really well in the full service neighborhood restaurant.

30:38Sean Barrett:I can speak from personal experience, the frustrations that have existed from delivery fees from restaurants over the years are quite strong too and vocal. and it's just not something you hear as it relates to any other part of the business. I think that's out there. I respect the channel checks, 101 boots on the ground that remains alive. That's incredibly interesting information to get back on that whole concept of switching and whether we call it churn, how much does the industry switch year to year? I almost put aside the fact that the restaurant industry sees a lot of turnover. We have a lot that goes out of business, a lot that comes into business.

31:17Sean Barrett:But do you have any concept on how sticky it is and just

31:21Business Breakdowns Hosts:general churn? It's pretty well documented. The industry churns at something like 15 % a year. And so if you think about 800 ,000 restaurants in the US, something like 100 or 120 ,000 of them shut down and then generally restart every year. It's a tough business. What you see is that the business is really tough the first couple of years. And then restaurants that survive for the first three to five years actually tend to survive for a very, very long time. The interesting thing from a churn perspective is that it's actually a huge positive for the challenger like toast. There are some industries out there with 99 % retention.

32:01Business Breakdowns Hosts:There's no churn. And even if you have a better product, you come in with a hugely advantaged product, customers aren't going to churn and you're going to get 1 % of the industry. You're going to get 1 % at bats every year. You look at Toast as the challenger, let's say 100 ,000 restaurants reopen or open every year, Toast is winning about 50 % of those, we think, on a gross basis. They wouldn't get all those at-bats if it was a higher retention industry. It's a strength for the challenger. I think the big debate or the big question is, so what happens in five years when Toast is 30%, 40 % of the overall market?

32:38Business Breakdowns Hosts:Do they look more like the market and does their churn go up? that's been a debate since 2020, 2019. As they get bigger, surely their churn will go up. We haven't seen noticeable changes in churn. And the reason for that, we think when we talk to customers, their businesses are so much more profitable using toast than they were otherwise, that they just become healthier businesses that survive more. So there's a big survivorship bias in the industry within Toast customers.

33:09Sean Barrett:On the broader perspective of competitive advantage moats, we talked a little bit about hardware, software, logistics. I guess, just how would you frame it to the extent that we have mentioned a lot of varying things, but how would you package that together and just talk about their moat?

33:26Business Breakdowns Hosts:There's been so much negative news on software in the last six months. We really wanted to simplify it. And we always come back to what we call the laws of physics here at Counter Global. Charlie Munger used to call them his mental models. But these are rules that have been durable for investing for decades, and they hold true. And so we rely on those superpowers. We rely on those laws of physics. Toast is a mission-critical operating system. They have strong network effects. The industry is standardizing on this platform. They have huge data advantages. They have domain expertise. Speaking of Charlie Munger and his mental models, one of his actual mental models that he used to talk about a lot was that in any capitalist system, the specialist wins the outside share of the economics.

34:14Business Breakdowns Hosts:He famously quoted that in a lot of his speeches. We believe in these laws of physics, these mental models. And the interesting thing for Toast is that it really checks all the boxes. The two structural modes that I think people don't talk about enough are hardware and how complicated it is for Toast to deliver this great hardware and then the distribution advantages they have. Starting with hardware, it took them many years to build purpose-built hardware for the restaurant industry. But it's not just about the design. It's about the supply chain, the chips, making sure you have the right amount of inventory for your share gains.

34:53Business Breakdowns Hosts:It's very, very complicated. And then the distribution is also really complicated. Toast has feet on the street in every major city in America. And those advocates walk into restaurants all day long, talk to owners, make sure they're being served properly by Toast. It's a huge part of the story that's really hard to replicate. I would just give you an example. A year or two ago, a high profile startup launched. It's supposed to be AI native serving the restaurant space. And I think they thought probably with AI coding and all the advances going on with AI, that they could copy Toast's product and have something up and running pretty quickly.

35:35Business Breakdowns Hosts:Fast forward to today, we aren't seeing them at all in the market. Last I heard, they extended their roadmap. They think it's going to be at least another two years before they have something that looks like toast. And then at that point, good luck building the supply chain, good luck building the hardware. And then you've got to get feet on the street in every major city in America and abroad. I think it's just way harder to disrupt this space because the moats are so powerful.

36:00Sean Barrett:We haven't talked about the management team or just culture within the business. Tell me a little bit about who's behind it and anything that's unique about the culture to the extent there is something unique.

36:13Business Breakdowns Hosts:It's a really phenomenal culture. The restaurant business has had a lot of ups and downs over the years. It's a culture of people who are really resilient. They put the customer first. So it's product-led, it's resilient, and it's customer first. And that's how I would describe their culture. from the top, it's a founder-led team. It's a handful of really, really good people running this business. At Counter, we evaluate our management teams on three pillars. We talk about this a lot. It's integrity, ambition, and innovation. So when you think about integrity first, and you look at this management team, Amon Narang and Elena Gomez, they're really great managers.

36:53Business Breakdowns Hosts:They tell it like it is. They're super high integrity people, and the people around them are super high integrity. On ambition, it's probably one of the more ambitious teams that we see in public markets. And they've been this way for many, many years. In 2020, I remember, I think they had 20 ,000 or 30 ,000 restaurants on the platform. And they were talking about their path to 200 ,000 restaurants, and then their path to 400 ,000 restaurants. And everyone thought they were crazy. The TAM can't support that. You'll never innovate to open up new TAMs. It'll be really hard. Well, they're probably going to hit 200 ,000 restaurants this year or early next year.

37:31Business Breakdowns Hosts:Now they're doing$2 billion of gross profit. And they're talking about their path to$10 billion of gross profit. And I think there's some skepticism out there. They have the track record of doing it. And so that gets to the third pillar we think about, which is innovation. This is the team you want in an AI world. It's three co-founders who met getting their computer science degrees at MIT. They really understand the technology. They really understand AI. And I can tell you from spending time with them, they're more invigorated and more excited than I've ever seen about the opportunity because it allows them to accelerate the roadmap, open up new TAMs, and just serve the customer in a way that wasn't really possible a few years ago.

38:15Sean Barrett:On that$10 billion gross profit milestone and how you think about TAM. What is the runway here? Where does it come from? Is it US-based? Is it international? Talk a little bit about the path further out than the next three to five years, maybe.

38:33Business Breakdowns Hosts:From a big picture, just a review of the model and how the business model works because it's a beautiful compounder. So the things that matter are location count, SaaS ARPU, payments ARPU, margins and multiple. If you look at the location count, if you double the location count and then you can also grow your ARPU, you actually have the chance to 4X and then 8X the business over time. But we care a lot about the building blocks that get you there. That's how we need to underwrite it based on each specific TAM. The beauty of the Toe story is how they've sequenced their growth into new TAMs and opened up new TAMs over time.

39:10Business Breakdowns Hosts:We talked about the core SMB as the primary driver of the business many years ago. At this point today, probably 150 ,000 of their 160 ,000 locations are in that core SMB US market, and they're winning 50 % of new restaurant openings. On a local level, I would say the trends are even more impressive. So what you see when you go into the city level data is that they usually start with a 2 % market share, then maybe 4 % the next year, 6 % the year after. But when a market hits 10 % of market share, it becomes what management calls a flywheel market. And that's when the network effects take hold and the market decides it will standardize on toast.

39:55Business Breakdowns Hosts:And then you actually see market shares accelerate faster as they get bigger. We have data on some cities right now that are 25 to 30 % market share, and they're actually adding more market share in those cities than they are in the smaller cities. It's a great playbook. We think there's a long runway to go just in that core SMB, and certainly management thinks so as well. The interesting thing from there is that they've already innovated and built the product for four or five new TAMs beyond that. And now they're actually in market and it's all about execution. They're in market with a grocery store offering for grocery, liquor, and gas stations.

40:35Business Breakdowns Hosts:That market primarily is served by legacy technology where Toast has a huge right to win. Customers love the offering. We've talked to a lot of customers and we think there's a long runway there. They've started to win in hospitality. You saw a big win with Marriott. So they're winning hotel retail and F &B. That's a new offering in the last couple of years. Enterprise is really cooking, no pun intended, where they've won Applebee's and a handful of other really high profile enterprise customers that would have seemed impossible many years ago. So for people who thought that the TAM for toast would top out at four or 500 ,000 because they'll never get the enterprise, now the TAM in the US is actually bigger than the restaurant market.

41:18Business Breakdowns Hosts:It's enterprise SMB plus grocery plus hospitality. And then they quietly built an international business where they're in the market in UK, Ireland, Canada, Australia. Management would tell you that those markets are growing faster than toast grew in the US when they started here. I was in London last week seeing companies. You're seeing toast all over the place. And I wasn't seeking them out. I was just walking into random restaurants and toast is all over the place, they're winning there. Big picture, Toast has 160 ,000 locations on its platform today. Even if you take out China, they have a 15 million location TAM globally, most of which is served by legacy technology.

42:05Business Breakdowns Hosts:So we think they're just scratching the surface and they have the opportunity to take themselves from 2 billion gross profit today to 10 billion in 2035. But we actually just think that's a stopping point and they can keep going from there.

42:19Sean Barrett:When you think about valuing a business with that type of growth runway and ambition, what's your general approach for valuation for this business?

42:28Business Breakdowns Hosts:There are three ways that we look at valuation here. It all is in an effort to get back to intrinsic value. The first way you can look at it is on a multiple of 2027 gap earnings, which we talked about. It's trading at 18 times 2027 gap earnings. That would be an even lower multiple if you want to adjust for the almost$2 billion of cash they have on the balance sheet. For a 25 % gross profit grower and a 30 plus percent EPS compounder, that screen's tremendously cheap. More importantly, we think about intrinsic value and what kind of MOIC we should expect or multiple uninvested capital over the next 10 years.

43:09Business Breakdowns Hosts:Because we have our TAM build, We have our segment build. We know the win rates. And we think it's a highly predictable outcome from a business perspective. So over the next 10 years, they're going to take gross profit, we think, from$2 billion to over$10 billion. At that point, you'll be left with a business that's doing over$3 billion of gap net income. And you will have generated your whole market cap in cash. So if you get a horrible multiple in 2035, you have something like a 4X MOEC. And if you have a NASDAQ market multiple, you probably have something closer to a 10X MOEC. And then just on a DCF, intrinsic value today, if you want to discount all the cash flows back, fair value today is something like$50 per share or more versus the recent stock price at$22 or$23.

44:00Business Breakdowns Hosts:dollars. No matter how we slice it near term, long term, we're really excited to continue to be on this journey with Toast. And we think it's going to be a good outcome for investors.

44:11Sean Barrett:What are the risks besides the obvious execution? What stands out the most to you?

44:17Business Breakdowns Hosts:There are three or four risks here that we think about and talk about and debate a lot. I mean, one is just macro exposure. And you hit the nail on the head early in the call. How much of that fintech grows profit is really recurring. And I think in this business, in the restaurant business, it is a tough industry in some ways. In other ways, it's also a really great industry. It's a big market with a trillion dollars of volume every year. It does grow. And in tough times, we've actually seen the restaurant industry is super resilient. So if you go back to 2008, 2009, I think the restaurant industry as a whole was down low single digits.

44:55Business Breakdowns Hosts:One of the better performing industries in the economy, because it turns out that no matter what's going on, people need to eat. And even in tough times, they want to go out and they want to eat and socialize with friends or family. The second thing we think about a lot, which we talked about today, is industry churn and how that plays out for Toast over time. So we follow the data. And so far, what we've seen and what we believe we'll continue to see is industry-leading gross retention for Toast versus the competition, but it's certainly something we want to stay on top of. The third thing we think about is the price sensitivity of the customer base and how much ARPU can you really squeeze out of the customer base over time.

45:38Business Breakdowns Hosts:If this was a price game and we were betting on a lot of growth to come from pricing, we would be more concerned about this. What we've seen from the Toast management team, which, again, is super innovative, thoughtful, customer first, is that they're coming out with products that can be meaningfully high ARPU for Toast, but also a really good ROI for the customer. Toast Grow Marketing is the perfect example. $500 a month sounds like a lot when you're talking about a customer that probably has$150 ,000 or$200 ,000 of profit per year. But then if you put it in the context of raising revenue for your customer by$100 ,000 and replacing another cost bucket that they have where they're already spending$10 ,000, it actually becomes a no-brainer and it's a win-win for Toast and the customer.

46:30Business Breakdowns Hosts:And then the last thing, I saved it for last, but it's probably the risk that we stay on top of the closest, is competition. We're always talking to customers. We're always surveying customers. we go put feet on the street and boots on the ground to make sure that Toast is winning in the wild. But it's something that we stay super close to.

46:50Sean Barrett:This has been timely and fascinating. And Toast is extended way further than I had imagined before researching the name. What stands out to you as a key lesson from this business that you could apply elsewhere?

47:04Business Breakdowns Hosts:I've known the Toast team a long time. The restaurant industry is really hard. and Toast has been through a lot over the years with COVID, now the SaaSpocalypse. They always come out on top. And so why is that? I was reflecting on why that is and what they've reinforced for me, I think, is a lesson of resilience. Work hard, expect the unexpected, put the customer first, learn from your mistakes and I'll leave you with a pun, stay hungry.

47:34Sean Barrett:I love it. Well, Sean, thank you again for coming on, sharing the knowledge, making it timely. This has been a true pleasure. Thanks so much, Pat. Awesome seeing you. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out joincolossus.com. That's J-O-I-N-C-O-L-O-S-S-U-S.com. The information contained in this podcast is for educational and informational purposes only and does not constitute and should not be construed as an offer to sell or a solicitation of an offer to buy any securities or related financial instruments. All opinions expressed by hosts and podcast guests are solely their own opinions and should not be viewed as definite or exhaustive.

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