Toast (NYSE: TOST) offers a unique opportunity to its clients and investors alike. Instead of acting as a general fintech like the Square payments platform provided by Block, it tailors itself specifically to the needs of the restaurant industry, which gives it a competitive advantage within that customer base.
Unfortunately, Toast stock may also face significant challenges that may not be immediately obvious. Thus, investors should be aware of three key risks before deciding whether or not to buy the stock.
1. Competition within the payments industry
Admittedly, for a restaurateur, the appeal of Toast over Square may appear immediately obvious. The fact that it targets restaurant and restaurant-related businesses might tempt such companies to choose Toast.
This targets all types of restaurant-related businesses, including some that one might not think of as "restaurants," such as breweries, food trucks, or hotels. One can also use its platform online or offline, which makes it more versatile in a variety of circumstances.
Still, Square offers a variety of add-ons that one can tailor to any business, including a product specifically for restaurants.
Additionally, Square's more extensive ecosystem may entice some of these businesses to choose the platform. Once established in Square's ecosystem, they may choose to stick with their platform rather than endure the disruption that might come with switching to Toast, which presents challenges to the restaurant-oriented fintech stock.
2. The nature of the restaurant industry
Moreover, the diversity of the restaurant industry works both for and against Toast. It can include an international restaurant chain such as McDonald's or a family-owned small business far from a major metro.
However, the industry as a whole experiences significant turnover. According to the National Restaurant Association, the long-term success rate for restaurants is only about 20%, with 60% failing in their first year of operations. By extension, this means that Toast investors should likewise expect a high turnover rate.
This did not stop Toast's customer base from growing 29% to about 120,000 in the second quarter (ended June 30). Additionally, the company turned profitable, earning $14 million in the quarter. With its price-to-sales (P/S) ratio of just under 4, investors might feel tempted to open a position.
Nonetheless, they should keep in mind that Toast is likely to deal with numerous lost clients regardless of economic conditions, and that factor could eventually hamper customer growth. Considering such difficulties, Toast stock may struggle to attract a premium price.
3. The macroeconomy
Furthermore, economic forces do not work in Toast's favor. The National Restaurant Association estimates about 749,000 restaurants currently operate in the U.S. However, that number was around 1 million before the pandemic, a testament to the damage the pandemic caused the industry.
Also, restaurants have faced an additional hurdle with the rampant inflation since the pandemic. The Bureau of Labor Statistics estimated that menu prices rose 27% between February 2020 and June 2024. With salaries not keeping pace, consumers have had to trade down or avoid restaurants.
Amid the shrinking addressable market, the aforementioned 120,000 customer base is equivalent to about 16% of the U.S. market.
Toast has expanded its addressable market by going into Canada, Ireland, and the U.K., and it will probably move into other countries over time. Still, cultural challenges often hamper international expansions. Without laying out a clearer plan of how large its addressable market will grow, it is difficult to gauge its future growth trajectory.
Investment risks and Toast stock
Ultimately, Toast offers a compelling product with an obvious competitive advantage in the restaurant industry. Nonetheless, its challenges may mean investors should turn cautious.
Admittedly, the competitive advantage and 29% growth rate in customers may make investors want to buy the stock. Unfortunately, it faces competition, and outside forces compel Toast to compete for customers in a shrinking industry with a high turnover rate.
Indeed, it has already begun expanding internationally, which can help maintain its growth rate. However, it remains unclear how Toast will perform outside the U.S., and given the industry's offerings and challenges, Toast may be better for its customers than its investors.
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Will Healy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Block and Toast. The Motley Fool has a disclosure policy.
