AI-Driven Fear Slashed Toast Stock by 43%, Even as Free Cash Flow Hit Records

Key Points
Selling hardware at a loss to lock in accounts works for independent operators.
Scaling that model for national brands is a different ball game.
As the cost of custom development falls, large chains have even more incentive to build their own systems.
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Uncertainty is what markets hate most, and artificial intelligence (AI) has brought it to software stocks in full force. Toast (NYSE: TOST) is down more than 40% from its summer high, swept up in a sell-off that's erased nearly $1 trillion from the industry this quarter. Some of the sharpest criticism is now coming from the same venture capitalists who helped fund the software-as-a-service (SaaS) boom.
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Toast built the operating system that roughly one in five small- and mid-market restaurants in the U.S. use to run their businesses. It bundles terminals, payments, online ordering, and payroll into one system. Once it's installed and the staff is trained, switching costs become real for the whole operation.
The company added a record 30,000 net locations last year, and for the independent restaurant owner, the system is hard to walk away from. The build-versus-buy decision isn't as clear for a national chain as it is for a smaller operation.
The growth story has an enterprise problem
The next leg of growth is expected to come from restaurant chains, international markets, and retail. Together, those segments currently account for about 5% of annual recurring revenue. The company's biggest customers so far are sit-down chains like Applebee's and TGI Friday's, not fast food. McDonald's, Chick-fil-A, and Domino's already built their own.
Meanwhile, the company's helping its own customers get started with the recent launch of its AI assistant, Toast IQ. The tool quickly performs tasks and analyzes data to aid owners and staff in making quick decisions.
Advancements in AI are lowering the cost and timeline for building software solutions, and the customers Toast needs most are the ones most capable of doing it themselves. A family diner wants one vendor and less hassle.
A national chain with an engineering team wants flexibility, and committing to proprietary hardware when the software landscape could look different in three years is a tough sell. Toast's hardware bundle may be a moat for small operators and a barrier for enterprise buyers.
The software premium is the vulnerable layer
Toast is a payment facilitator, not a processor. It routes payments and keeps a premium spread because the software bundle makes the system more useful. If AI reduces software costs over time, that premium gets harder to defend even if Toast's core customers never leave.
The company's software gross margins reached 80% in the fourth quarter, accounting for roughly 45% of total gross profit, despite payments being 82% of total revenue.
Toast went from burning cash just three years ago to nearly doubling free cash flow last year to $608 million. Given its growth rate and the recent sell-off, the stock is reasonably priced at just 27 times trailing FCF.
But for a company whose pricing power and growth depend on selling point-of-sale hardware into an industry where competing alternatives are set to expand, the discount is understandable. When investors start worrying about long-term survival, the premium multiple fades fast. In this case, it's likely warranted.
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Bryan White has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Domino's Pizza and Toast. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.