The market was in an unforgiving mood last week when Toast (NYSE:TOST) shares were chopped 14% in a single day following earnings that were received poorly.
As is often case, the report wasn’t actually that bad but analysts didn’t hold back in downgrading estimates on the back of management’s forecasts for slower growth.
Year-over-year annual recurring revenue was up an eye-popping 40% but the revenue forecast of around $1 billion represented a sequential decline that disappointed Wall Street.
Now the question is will Toast stock bounce back?
Why Did Toast Stock Go Down?
It’s important to keep in mind when stocks fall as precipitously as Toast did that if expectations fail to match analysts forecasts, the market will close the gap. So, a falling share price isn’t always representative of poor fundamentals, but perhaps just ones that aren’t as stellar as originally projected.
That seems to be very much the case with Toast given that EBITDA swung from a loss a year ago to a $35 million profit this year. Total revenue was up 37% on an annual basis too. Another factor in favor of Toast was its growth in locations, now sitting just 1,000 shy of 100,000.
All of these factors suggest that Toast has good long-term potential but has disappointed investors not only by its reduced top line projections but also EBITDA forecasts that are set to fall to a range between $5 million and $15 million.
Undoubtedly, the short-term momentum is bearish but will the stock bounce back in the medium to long-term?
Will Toast Stock Recover?
If there were reasons to be concerned about the prospects of TOST stock, they would largely be found on the income statement, and in particular operating costs.
The company doesn’t report particularly bad gross margins, nothing of the sort. Typically, in any given quarter, gross margin will come in around 20% or higher. They are not as high as digital payment competitor Square (NYSE:SQ), which frequently reports gross margins in the 30-35% range, but it’s not a bad comparable given the business model.
Where the issues can be found is lower down the statement, operating costs, and specifically marketing costs that continue to grow and in the prior quarter eclipsed $100 million for the first time.
When you combine that number with $92 million in R&D and $84 million SG&A, you end up with operating income falling into the red by quite some margin. In the past twelve months, only one quarter has been reported with EBIT not exceeding a nine-figure loss.
That’s a serious concern for investors but it gets worse. In the past twelve quarters, just one has been reported with a positive operating income number, and that was just $2 million in Q4 2021.
The sustained losses have accumulated over the years and taken a real toll on balance sheet cash levels, which have fallen from $809 million in Q4 2021 to $488 million last quarter. If needed, management can tap into further liquid reserves in the form of short-term investments that sit at around half a billion dollars.
On a brighter note, levered free cash flow just turned positive in Q2 2023 after a series of quarterly earnings reports in the red. Indeed only twice in the past three years has levered FCF been reported in the black, but the move into the positive this year was a sign of perhaps good things to come.
Now that the stock has been punished so severely the question is whether Toast is a buy.
Is Toast Stock Undervalued?
Toast stock is undervalued by 33.3% according to the consensus price target on the stock of $23.22 per share from 18 analysts.
After running a discounted cash flow forecast analysis, we see upside potential also but are less optimistic. A DCF analysis reveals a fair value share price of $19.83 per share, corresponding to a potential gain of 16.2%.
For Toast, a conventional metric like price-to-earnings ratio doesn’t make much sense given that earnings have been negative. However, TOST’s price-to-sales over the past twelve months of 2.8x is not especially lofty.
The stock’s reaction to the Q3 2023 report is certainly offering a more attractive entry point when viewed through the lens of margin of safety. The danger, though, is momentum is clearly bearish and it’s probably wiser to wait for the stock to find a low, build a base, and break back bullish before betting heavily on the fundamental thesis.
Warren Buffett famously said he mused one day while looking out the window about how to capture just a nickel from each car that passed by. Of course, state government figured out the answer to that puzzle by introducing toll roads. In the world of digital transactions, Toast acts as a virtual toll road, taking its share of each item bought.
Whether you buy a coffee at a local farmer’s market or add a tip following a purchase at a local store, there is a good chance Toast is racking up a small portion of the purchase.
That seems like a good business model at first glance but there is no free lunch in the business world, and the cost of Toast’s business is so-so gross margins and, up until now, a long string of operating losses.
EBIT and EPS have been in the red for quite some time, and Wall Street got spooked when management announced in its most recent earnings report that growth is forecast to slow.
Clearly, the short-term trend remains sharply bearish but the medium to long-term could offer hope for patient investors. A valuation analysis supports the idea that Toast will recover over a longer time span but don’t expect too much from TOST share price near-term.
Management has made it clear that macroeconomic factors could weigh on the stock near-term and, absent a growth catalyst, it’s unlikely the share price will bounce back with much conviction.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.