Inventing ARR
Sorry Toast, but this just doesn't make sense.
The image below shows Toast's definition of "ARR" from their latest 10-K.
"Annualized Recurring Run-Rate."
Huh? Run rate of what? Which part is recurring?
While there isn't any GAAP definition of ARR, I think the generally accepted idea matters: it has something to do with revenue, annualizing and recurring.
The ARR definition most people agree on in the software world is: Annualized Recurring Revenue.
The idea is that you take earned revenue that is recurring (i.e. subscription contracts) and then annualize it to better understand the current velocity of the business.
Toast uses a very different definition of ARR as one of their three core KPIs. They explain it on page 72 of their 10-K. The other two are: Gross Payment Volume and Net Retention Rate. These two KPIs both make a lot of sense for this business and as a result, the explanations for both of them are concise and clear, unlike their definition of “ARR,” which I assume you didn’t read and know that you didn’t understand (because it doesn’t make sense).
The biggest issue I have with their definition is what they are doing with the Payments Revenue Component. They explain how they calculate it as "four times the trailing three month cumulative payments component." They then add this to the subscription component to get to the total "ARR."
Here's where we diverge:
Subscription revenue = Recurring.
Payments revenue associated with subscription revenue = Re-Occurring.
What's the difference?
The subscription contract.
If the payments revenue was recurring, then it would be adding apples-to-apples, but it does not recur, it re-occurs. These few letters make the world of a difference.
The reason this matters is that the VALUE of contractually recurring revenue ("subscription services") is greater than the value of re-occurring revenue ("financial technology solutions").
In this case, it is for 2 reasons:
The subscription contract means that it's more reliable and therefore more valuable in the future (it's locked in, higher NPV).
The associated gross margin: 67% vs 22% (subscription revenue hits the bottom line much stronger).
Contrast this with Shopify, who does not talk about ARR at all and instead simply refers to: "subscription solutions," which is 81% gross margin and "merchant solutions," which is 39% gross margin. And adds them together to get Total Revenue. From there, you can annualize as you please.
The major takeaway here is that it is actually OK to annualize anything. But it's not OK to call that anything ARR unless it's recurring because that is what it implies.
Toast’s legal caveats in the 10-K are accurate, but saying that "ARR is not a forecast of future revenue" defeats the purpose of ARR as a metric altogether. The reason we use ARR is that it implies that it WILL be there reliably over the next 12 months and therefore is a forecast. (See reference to velocity above, which by definition is a forecast for distance to be covered.)
This underpins the point of the subscription model: You will be able to keep what you have, in other words: it recurs.
So to the IR team at Toast: just do what Shopify does and call it like it is...
Simply show quarterly revenue split out by these two types, let people multiply it by 4 if they want to annualize it. Playing games with metrics usually means you’re trying to hide something or you don’t know what you’re talking about.
OR... call it ARRR and make the whole 10-K pirate-themed.
Note: Shopify trades at 9.0x 2024 revenue and Toast trades at 2.8x 2024 revenue.
Toast 10-K: https://www.sec.gov/ixviewer/ix.html?doc=/Archives/edgar/data/1650164/000165016424000084/tost-20231231.htm
Full definition of Toast “ARR” here:
We monitor Annualized Recurring Run-Rate as a key operational measure of the scale of our subscription and payment processing services for both new and existing customers. To calculate this metric, we first calculate recurring run-rate on a monthly basis. Monthly Recurring Run-Rate, or MRR, is measured on the final day of each month as the sum of (i) our monthly billings of subscription services fees, which we refer to as the subscription component of MRR, and (ii) our in-month adjusted payments services fees, exclusive of estimated transaction-based costs, which we refer to as the payments component of MRR. MRR does not include fees derived from Toast Capital or related costs. MRR is also not burdened by the impact of SaaS credits offered. The MRR calculation includes all locations on the Toast platform and locations on legacy solutions, which have a negligible impact on ARR.
ARR is determined by taking the sum of (i) twelve times the subscription component of MRR and (ii) four times the trailing-three-month cumulative payments component of MRR. We believe this approach provides an indication of our scale, while also controlling for short-term fluctuations in payments volume. Our ARR may decline or fluctuate as a result of a number of factors, including customers’ satisfaction with our platform, pricing, competitive offerings, economic conditions, or overall changes in our customers’ and their guests’ spending levels. ARR is an operational measure, does not reflect our revenue or gross profit determined in accordance with U.S. Generally Accepted Accounting Principles, or GAAP, and should be viewed independently of, and not combined with or substituted for, our revenue, gross profit, and other financial information determined in accordance with GAAP. Further, ARR is not a forecast of future revenue and investors should not place undue reliance on ARR as an indicator of our future or expected results.