An Investor’s Look at Toast and Shopify

In this podcast, Motley Fool host Ricky Mulvey and analyst Tim Beyers discuss:

• Toast‘s quarter and its move into convenience stores.
• Shopify‘s impressive profitability and what could put a damper on the e-commerce platform’s growth story.

Then, Motley Fool host Mary Long and analyst Asit Sharma discuss how to write an investment thesis.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on August 08, 2024.

Ricky Mulvey: Toast isn’t playing ball, but you’re listening to Motley Fool Money. I’m Ricky Mulvey, joined today by Tim Beyers. Tim. How you doing?

Tim Beyers: Doing well, fully caffeinated, ready to go.

Ricky Mulvey: I’m going to ask you that question a second time because, the market’s been a little nuts this week, and Mary and Asit are going to talk about mindset later in the show. How are you right now as an investor? How’s this past week been for you?

Tim Beyers: This is the market that is great for me. I know it’s not good for a lot of people, and I will not dismiss that, Ricky. But for me, this is when I am at my absolute best as an investor. I get nervous and anxious when the market is going up into the right for reasons that I cannot explain. When we have irrational sell offs, I’m great, man. I’ve bought two stocks, new positions this week, which I can’t talk about because of our disclosure rules. You can ask me about that another time, maybe next week. This is when I am at my absolute best. I love it when the market decides to do full Kermit and run around with its hands in the air and just cannot figure out which way is up.

Ricky Mulvey: Have also been buying. I talked about it with Gillies a couple of days ago. Let’s dive into some individual companies you can talk about. One of them your favorites, I should say. I don’t know if it’s your favorite.

Tim Beyers: That’s still my favorite.

Ricky Mulvey: That is the payment software that asks you a question after you check out and get your cup of coffee. Tim, before I get into the numbers, there was a moment in the Q&A, where an analyst asked the CEO, basically, about the international and retail expansion. I was hoping you could touch on that and maybe use a baseball analogy. What inning are we in in terms of building out the platform for these new verticals? I think that’s a fair question. I’m not going to use a baseball analogy. Yep. Then described what was happening. Let me throw that at you, Tim. When you look at Toasts quarter, how would you describe it using a baseball analogy?

Tim Beyers: I would say it’s very early innings. I’d say, you know, first or second inning. I think to Aman Narang’s credit, he’s one of the co founders, said, I’m not going to use a baseball analogy, but I will say that, our core business is 11-12 years old, we’re one, not even really two years in, so you could draw a similar conclusion here. We’ve barely talked about the first 10% of the opportunity here, and we may be even earlier than that. I think in terms of their expansion opportunity outside their core business, we’ve barely scratched the surface. Overall, remember, this is a company that originally targeted 800,000 US restaurant locations as its core market. That’s an immediately serviceable market. Now they have said, and I know we’re going to get to this a little bit later. There are some other areas they can expand into that open up another 220,000 locations to them. Now we’re talking over one million. Right now they’re at 120,000 locations. Are we in the earliest of early innings? Yes, we are. Absolutely.

Ricky Mulvey: Let’s look at some of the highlights from the quarter, adding 8,000 new locations, so the total now stands at $120,000 positive gap operating income by a SMIG, $5 million, but that’s enough to make it positive Tim, and annualized recurring revenue at $1.5 billion. That is a 30% increase from last year. Sounds like good numbers to me, but what from the quarter really stands out to you?

Tim Beyers: Toast has said that one of the ways you want to measure them is on their core profitability metric. Their core profitability metric. I’m going to say this twice so you can do this math for yourself because they report all of these numbers. They take adjusted EBITDA. That is the numerator. Adjusted earnings before interest, taxes, depreciation, and amortization, they report that on every press release. This quarter, it was $92 million. You take that and divide it by the sum of their subscription gross profit. That’s a core piece of their business. They sell subscriptions to the core Toast software, the platform that restaurants subscribe to, and then the FinTech gross profit, which is their share of the business that they help process at all of their restaurant customers. They believe they can get that margin, Ricky up to somewhere between 30 and 35%. They said they can get that stable at that level over the long term. In the latest quarter that is now up to 27.88%. That was a year ago at 5.79%. This is one of those businesses where Toast is saying, here’s our target, here’s where we think we can get to, and they have unrelentingly marched toward that goal. They haven’t slowed down. It’s interesting to me that the market says, we don’t care about that.

Ricky Mulvey: What is that I heard the formula for it? What is that profitability metric? What’s the story behind it?

Tim Beyers: The story behind that profitability metric is, let me put it this way. When Toast goes into a new restaurant group, They will essentially add a loss. They’ll do this as a loss leader. They will deploy a bunch of people to help you install their software, and they’ll put hardware in your hands, those little tablets that you have seen, if you’ve gone to a restaurant and you’ve checked out with Toast, and a server has come up and had a little tablet in their hand, and it says Toast on it. That’s all stuff they sell at a loss. Then on the back end, they believe that they will make a significant long term profit, by doing right by you and getting their software and hardware into your hands and helping you do more business at your restaurant group over time. The subscription gross profit and the FinTech gross profit reflect that belief. That the more that you use our products, the more subscription gross profit, the more you will make inside your restaurant group, FinTech gross profit, and for us, once you strip out all of the things that we spend in order to put all this stuff in your hands, the core profits, the adjusted EBITDA, we’re going to make a lot of money and so are you. Everybody’s going to win here. It’s a metric that’s designed to reflect what that win, win, win dynamic of the Toast business actually looks like financially.

Ricky Mulvey: One of the stories we got in the earnings call was Taziki’s, and they explained how they’re able to help them, essentially with the Toast Point of Sale system. They upsell different food items that go well with different drinks. Tim sounds like you’re pretty happy with Toast right now, but it doesn’t seem like the market is happy with Toast after this earnings release. You said they were unrelentingly going toward this profitability goal. That’s usually a good sign for a company. What’s the market so unhappy with?

Tim Beyers: I have no idea. The market seems like a teenager that you cannot say anything right like, we’re going to get pizza tonight. I’m a vegetarian, and all you ever do is order pepperoni pizza. It’s that sort of thing. It feels ridiculous. I do not understand it. I think the guidance was reasonable. It was in line. They didn’t beat guidance by any means, Ricky. But the last two quarters, when they have issued guidance on adjusted EBITDA, they’ve smashed it. They have absolutely smashed their guidance numbers. I don’t get it. I don’t know why there’s so much angst here, but I will say this. I do think this is a good sign for anybody who has not yet opened a Toast position because the market has not yet chosen to believe that what Toast says defines value inside the business. The market is not valuing the company according to those metrics. They’re just ignoring it. What I told you about, that core profitability metric, the market doesn’t care. They’re not paying attention to it. That is not how the market is valuing this business. They’re using something else. I don’t know exactly what else they’re using, Ricky, but they are using that core profitability metric. The institutional investors, do not believe that Toast can scale up its free cash flow margins to much higher than they are today. They just don’t believe it. If it does happen, which I believe it will, then I’m going to get paid, and other Toast investors are going to get paid quite well.

Ricky Mulvey: I hope so as a Toast investor. Let’s talk about the new verticals. Toast is trying to move into grocery convenience stores, bottle shops. So far, they’ve got 1,000 new customers in this space. I think of Toast as a restaurant company, but what do you think about this move, and does it affect your thesis for the company?

Tim Beyers: It doesn’t affect my thesis yet. It’s way too early. I like the idea, especially the idea of putting Toast into liquor stores, because liquor stores have something in common with small restaurant groups that have dedicated owners, because that’s really where Toast sweet spot is. It’s not in the one, like, somebody who has a bakery shop in one location. That’s not Toast score market, nor is it like RBs? It’s not that, either. It’s in the middle, sit down restaurant, Bistro restaurant group of, 5-20 locations. Liquor stores are like this. Liquor stores, like in a regional area, you might have a group that owns, 5-8 liquor stores. That’s actually a great market for Toast, and they tend to use really old Point of Sale technology, and they could benefit. They have to manage a lot of logistics inside those liquor stores because that’s a high turnover business. People come in, and they’re buying wine, beer, hard liquor, they’re buying it all the time. You have lots of supply chain logistics. You have payroll and inventory, just like anything else. You have the other common things that are, areas of interest and or pain for a retail business. I think it’s a very smart idea. Regional grocery stores, small markets, local liquor store groups, I think that’s an excellent place for Toast to strategically expand.

Ricky Mulvey: Let’s move on to Shopify where we are getting a free cash flow story. Yesterday was some welcome relief for Shopify Investors. Last quarter, shop told investors to expect some margin pressure, and this quarter it beat expectations handedly. Free cash flow is up about 250% from the prior year. Tim, I know you like talking about unit economics. That’s a unit economic story. What’s going on at Shopify?

Tim Beyers: We hope so. It does seem like it. I think it’s more a cost management story. I think they’ve done a really good job of getting on the other side of selling the logistics business and getting back to core principles, so in that sense, sure, it absolutely is a unit economic story here. But what we’re seeing is that Shopify is expanding its influence and it’s doing good things to capture a larger market. There’s just more business being done on Shopify. As they scale up, they do get the benefit of it. As long as they keep their unit economics relatively steady, they are going to get that benefit of rising cash flows, rising margins, as their customers take them up on, just give more responsibility to Shopify overall. You could certainly see that. The gross merchandise volume was up substantially to $67.2 billion, I believe. Now you are at, what is that? $252 billion in annualized gross merchandise volume. That is that’s serious business, Ricky.

Ricky Mulvey: Shopify crossed 1 trillion total in gross merchandise volume. President Harley Finkelstein would like us to reflect on that. I think there’s another number you want to reflect on. You’re giving me a shrug of emoji right now, Tim.

Tim Beyers: Harley Finkelstein is a terrific salesperson, and he he is a brilliant hype man for Shopify. I think you need to know that that he’s a brilliant hype man and not take him exactly at his word. He’s very good, though. He’s a really good servant for Shopify. I don’t think that one trillion metric matters all that much. What I will say is that the value that, Shopify can compound value for investors is when that gross merchandise volume number grows, and with it, the attach rate. As really the way that Shopify goes up into the right and gets real hockey stick growth for investors is if there’s more business being done on the platform, more sales, more payments processed. Then more of that activity accrues to Shopify. It’s roughly stayed stable, though, Ricky. The attach rate isn’t going up. It’s going down, but I would say it’s largely flat. In the latest quarter, that attach rate was 2.98%. The way you get that is two billion in revenue. Divided by 67.2 billion in gross merchandise volume. It’s about 2.98%. A year ago, it was at 3.09%. Down a little bit. I would call that roughly flat. The way that Shopify from here at its valuation. If you want today’s valuation to look cheap, get that attached rate up to 3.5%, get it up to 4%. If you have vendors, shoppers, the entire ecosystem of people that are participating in the Shopify experience. If they are giving more dollars to Shopify, look out. Today’s valuation will look very cheap. If the attached rate doesn’t move that much, Ricky, then I think you could make an argument that Shopify is maybe not outrageously priced, but probably at least fairly priced. You need that attached rate to go up.

Ricky Mulvey: You’re saying you need them to flex their pricing power a little bit for some hockey stick growth?

Tim Beyers: Yes, I need them to be involved in more parts of the transaction. Yes.

Ricky Mulvey: Any yellow or warning flags in Shopify’s quarter. You said Harley Finkelstein is a great salesperson, but, this is also a company where less so to do with the company, more to do with the valuation. It’s gotten ahead of its snowboard before. Any signs of caution stand out to you.

Tim Beyers: I don’t know that this is a cautionary note, but it is something to be aware of. Payments are now 61% of gross merchandise volume. The business that’s being done on the Shopify platform, all of those dollars, a lot of it that, Shopify gets credit for is there, not because there’s a lot more commerce being done on the platform. Although there is, there is more commerce being done on the platform. The growth is coming from Shopify being involved in more of the payments, more of the transactions. That’s not necessarily a bad thing, but it is at least a risk because it puts Shopify at conflict with payments processors. They do need to not forget their roots. Shopify needs more commerce to happen on its platform, not just more involvement in payments on its platform. I think that’ll happen. They are talking about, greasing the skids for things like international sales. That would be good. You need that. You need more commerce on the Shopify platform, and you need Shopify getting involved in more of those payments transactions. If those things happen, and they don’t need to happen overnight, Ricky. This can be slow and steady wins the race here. A little bit at a time. We’re expanding the reach of the commerce platform. We’re seeing more commerce from more regions on the Shopify. That’s a good thing. Then if there’s more payments, and there’s more Shopify involvement in those payments, that is also a good thing. You don’t need much. Like, little incremental improvements will generate big leaps in cash flows. I am cautiously optimistic about the way that Shopify is going about its business. Let’s not pretend that this is, smooth sailing from here. There’s work still to do.

Ricky Mulvey: Good place to end it. Tim Beyers. Appreciate coming on, and thank you for your time and your insight.

Tim Beyers: Thanks for Ricky.

Ricky Mulvey: As we wrap up, just wanted to note our latest premium podcast launched this week. It’s called Epic Opportunities. This is available to members of Epic and the Motley Fools advanced investing services. You can catch the show on Spotify by linking your Motley Fool account or through the Motley Fool App. We’ll put links to all of those in the show notes for today’s episode.

Ricky Mulvey: All right, up next. We’ve got a volatile market, and Motley Fool Senior Analyst Asit Sharma joined my colleague, Mary Long to discuss how to write an investment thesis and how a journal can help when markets get choppy.

Mary Long: Asit, it won’t come as any surprise to you when I say that this week opened with a whole lot of market turbulence. For today, we’re going to focus less on what happened, why that happened, and more talk about what do you do when this stuff happens? Because whether the market stays in correction territory, reverts, re corrects, goes up, goes down, what have you. The fact of the matter is that when you’re investing, there will be times when the stock market gets spooked. There will also be times when it gets unspooked, and then spooked again. With all that in mind, what do you do when volatility and uncertainty seem to be everywhere you turn.

Asit Sharma: Mary, there are a few things that I do. One is just totally related to the investing side of it. I try to double down on businesses that I like. Few reasons for this. One is the obvious. If volatility is in full swing, prices are all over the map, then maybe you get some buying opportunities for companies that you already have conviction in. It pays to go back to your watch lists or businesses that you’ve studied. The second is more of a mindset thing. The market’s going crazy. Where do you want to focus your attention on like the flashy news sites that are trying to draw you into more angst? Or do you want to go to a safe place, which is like let me go back to that transcript where Satya Nadella talked about how Microsoft was going to destroy its competition. He didn’t use those exact words, but he talked about all that great CapEx investment. That’s a place where my mind should be, I think, in times of volatility, focusing on what’s going to make money. It’s the business results, not the share price.

Mary Long: Fair point, but I have to hone in on something. Is Satya Nadella really your happy place? The Microsoft Earnings call transcript is your happy place?

Asit Sharma: Not really, but this is an investment focus podcast. People don’t want to hear about the mundane ways that I get to my happy place. Which is this zig zagy route. Sometimes it starts with just cleaning the inside of my grill. I think I’m starting to resonate here with some people. It may end in a paperback novel, I don’t know. This is off topic for us. This is not what folks want to talk about. The market is so volatile You want to hear about that investing happy place. (laughs) That’s why I went first.

Mary Long: The investing happy place. We can bring it back to the investing happy place. Here, I’ll make a smooth segue. You mentioned Paperback Novels. The other day, on our Members only Live Stream, right in the midst of this Monday, market, mania, whatever we want to call it. You talked a bit about keeping an investment journal and the importance of that and how the idea was that, when times are tough, you’ve got this written record of why you believe in a company that you can return to. Talk to us a little bit about your investment journal and what goes into it. How do you write an investment thesis right off the bat?

Asit Sharma: So many great questions. First of all, an investing journal it means different things to different people. For some of us, it’s a place to deal with our emotions when the markets are really coasting and we see our wealth expanding. It could be a way to just keep ourselves grounded. Just jot down those emotions. I feel really great, but I’m scared at how well this is going, or it could be the opposite. It could be a time like this where you see so much volatility in the markets, and you just want to document that it’s unsettling. Maybe just write down what those long term goals are, the ones that got you into your whole investing journey, that’s always helpful. For other people, these aren’t exclusive sets. It could be more about trying to document why you like a company, what you think its characteristics are that are going to advance it past other competitors in the business world and that’s the share price should follow why the share price will rise versus other companies or the market in general. That’s always fun to return to, which gets us to your third question here, which is, how do you write a business thesis? What is it? I will tell you when I started in this game, I thought it was about a lot of facts and figures. In fact, if you’d asked me to write a business thesis or an investment thesis about a company, I don’t know 10, 15 years ago, I probably would have returned you three pages to prove a point. What’s that point? I’m Smart.

Mary Long: I’m smart. Look at your numbers.

Asit Sharma: Exactly. You should listen to me. Look at all this stuff. Look at these reams of data. I’m supporting my points. Sharma, what are your points? I don’t know. (laughs) Stocks are going to go up. I learned over time that an investment thesis is really simple. There was a great investor who used to work at the Motley Fool. Some of you may know him if you are in the gaming world. His name is Aaron Bush. At one time he posted on Twitter now X, really succinct bullet pointed list of things you should do as investor. One of the main tenets of that list is like, just narrow it down, dial it down, make it more succinct. Don’t overthink this. That is very true as I’ve come across other investors and learned from so many great investors here at the Motley Fool. An investment thesis should be simple, easy to grasp. You and I should be able to explain in this conversation, Mary, before people stop listening, two or three investment theses to each other, because what you’re trying to identify is the crux of why a company should succeed, and that usually is pointing to two or three advantages in the marketplace, how that company is going to capitalize on them. If there are a gazillion advantages that a company has, I will tell you that’s too good to be true. There’s something on the other side of that coin you may not have looked at. In my mind, it is something very simple.

Mary Long: In preparation for this conversation, I had asked you if there was a company or a stock that maybe you were revisiting in light of all the ups and downs over the past few days. If you wouldn’t mind sharing the thesis of that company with us, you took what should have been maybe a simple request, and you challenge yourself because you picked a company that’s hard to explain. Let’s see if you can do it. Could you share that thesis with us that you drafted up before this?

Asit Sharma: Sure. I want to talk about Lam Research. This company is a leader in the semiconductor industry. It makes machines that make silicon. You need complex machines to build integrated circuits. Lam sells these machines to companies that manufacture integrated circuits. I like this company because it’s yes, somewhat cyclical. Mary most of its equipment is used to make electronics. Computers, memory, etc. It’s cyclical, but it has a tailwind and an advantage in this economy, which is shifting toward Gen AI products. There are really a few things behind that. One is that Generative AI is increasing demand for a type of storage called N-A-N-D flash storage. That’s a type of memory that Lam’s tools specialize in. Also, Generative AI is pushing up demand for something called high bandwidth memory. This is really stacking memory on a chip that often surrounds the compute functions of the chip. It’s something that NVIDIA is requesting more of and AMD is requesting more of. Companies that make this type of memory or the tools to make this type of memory are going to benefit. Lam is going to benefit from that. It’s trading at really attractive forward multiples. The stock is down due to this volatility and a few other factors. I don’t know, Macro economic acceleration, more angst in the market, and some slacking off of Generative AI demand, which is going to happen at some point could push shares down further. Maybe they’re not such a bargain here. Also, I should note this geopolitical picture we have with China and the semiconductor back and forth between our two countries is going to catch some companies, perhaps like Lam in the middle, Lam has about 39% of its latest revenue (laughs) out of the greater China region. With that, I think my initial thought right now for Lam Research is actually to buy a few shares to dollar-cost average in. I don’t own any shares right now.

Mary Long: My next question was going to be, has your mind changed on this, but it sounds like maybe it’s a newer idea that’s been on your watch list for a minute that now makes sense to jump into.

Asit Sharma: Yeah I think my mind is changing because I’ve had it on a watch list for a long time. I’ve studied this company. It is a recommendation in Stock Advisor. There’s some free IP for those of you who aren’t members of Stock Advisor. We like this company very much. I’ve looked at it for other services. For me personally, I’m warming to it. The thesis is changing somewhat. Probably the price falling a bit is pushing that. Also, the more I learn about the trends within the Gen AI industry, the more I see that Lam is an essential player. It’s not that it doesn’t have competition, it does. I wouldn’t put it quite on the level of companies like ASML. Another specialized company which has literally no competition right now, but not a bad one to look at.

Ricky Mulvey: As always, people on the program may have interests in the stocks they talk about. The Motley Fool may have formal recommendations for or against buyer sell anything based solely on what you hear. I’m Ricky Mulvey. Thanks for listening. We’ll be back tomorrow.