Feeding The Rebels
The most important shift in restaurants in the past decade has been the rise of online ordering and delivery. UberEats, Postmates, Doordash, and a handful of other apps have been knife-fighting (in extremely uneconomical ways) for the privilege of becoming food delivery aggregators. Own enough customer demand, the thinking goes, and not only will restaurants go through you to reach customers, they’ll pay you 30% of each order and thank you for sending them business that would have gone elsewhere!
But delivery apps have problems on both fronts. Because the supply of restaurants on these apps is mostly commoditized, customers will go wherever they get the best deal, which means the apps are constantly spending on marketing and discounts to reacquire churned customers. On the restaurant side, margins are already so thin that shifting the channel mix towards delivery quickly becomes unsustainable.
For the past few years, restaurants and delivery apps were putting on a delicate balancing act trying to make this model work. Coronavirus has blown it all up. Customers still demand delivery but it’s now obvious that the existing delivery app business model is not sustainable for restaurant owners. And since these apps are very much not in the business of running restaurants, if it’s unsustainable for their suppliers, it’s unsustainable for everyone.
The takeout and delivery business needs to be rethought. I see two new popular paths emerging. They represent diametrically opposing views of this space. Investors and operators need to realize what they’re signing up for before they go too far down a path that promises only the same unsustainable economics as our current crop of delivery apps.
One path is exemplified by CloudKitchens. At its core, CloudKitchens is simple: Build commercial kitchen spaces in less-trafficked areas and rent them out to operators to run delivery-only food businesses. Add some additional services, enable inventory pooling through bulk purchasing shared across all tenants, and you have a solid business model.
Ever since the CloudKitchens concept first started floating around the startup world, it’s been a subject of fascination — due more to the presence of Travis Kalanick than anything else. If you take them at their word that this is a real estate play, it’s… well, it’s just okay. It’s a nice business with a real point of view on what a delivery-centric future should look like and a go-to-market strategy to match.
This month, however, CloudKitchens took the wraps off some new branding for “Internet Food Court.” Then they tried to put the wraps back on because that launch was an accident. Even though they already have a physical storefront operating with that same branding. (Who among us has not taken $400 million from people who are beholden to an actual murderer and then botched the rollout?)
Whatever happened, Internet Food Court does not look like your standard commercial kitchen space-for-rent real estate play. This looks like a consumer brand.
Per a report by HNGRY, Internet Food Court represents two new steps for CloudKitchens.
- They’re building an umbrella brand that encompasses pre-existing third party food brands like Charcootz, LA Breakfast Club and B*tch Don’t Grill My Cheese as well as many more new CloudKitchens-only “facility brands”
- According to their analysis of a new permit granted by the City of Los Angeles, CloudKitchens is going to roll out its own delivery service to compete against the existing apps
CloudKitchens wants to integrate every step in the value chain from raw ingredient delivery to marketing to assembly to delivery.
A vertically-integrated, multi-cuisine, direct-to-consumer food production and delivery service is not entirely new — Rebel Foods, Zomato, Swiggy, and Kitopi have all built versions of this in India with results that, for restaurants and the delivery apps alike, seem uncertain at best and evoke the Groupon era at worst — but it is relatively new to the U.S. The Internet Food Court model deserves more analysis in the American context. And when you take a closer look, some major flaws emerge.
Let’s take a look at the Five Forces-style interplay between end customers, existing delivery apps, their restaurant suppliers, and substitutes who don’t compete on the same terms as the delivery apps.
Start from the customer perspective: If a customer has installed your delivery app, there’s a pretty good chance they’ve also installed a competitor’s app. The average restaurant is on multiple apps because they want to be wherever their end customer is. That gives the apps power over restaurants. But the customer has the ultimate power because it costs them nothing to switch between the apps. It also costs customers relatively little to go outside the apps to fulfill their need for convenient food in some other way. This is why delivery apps are constantly running discounts, credits, and other expensive marketing campaigns to reacquire customers who have churned out. This is why we see unsustainable economics for suppliers as the apps continue to put pressure on the only real lever they have.
Internet Food Court actually sidesteps the supplier economics problem in a clever way by bundling in-house supply with in-house production for external brands. And they’re likely betting that exclusive supply will translate to more repeat business and lower customer acquisition cost. In other words, they’re betting that they can build loyalty.
Yet two problems remain: the new entrant problem and the substitute problem.
The new entrant problem: If this model successfully removes or abstracts all of the factors that differentiate a food business in favor of distribution with a dash of branding, then this inevitably becomes a capital-raising game between new entrants running competing platforms with the same model. And sure, Travis Kalanick almost won the entire American ridehailing market playing that game (with emphasis on “almost”).
But there’s no defensible network effect here. Internet Food Court will never have a monopoly on supply — the brands that really pull their weight will have outsized power and value and CloudKitchens won’t be able to keep them from competitors indefinitely. There’s no way to build a dominant position, which means they’ll have the same churn and reacquisition problem whether they’re competing against new competitors with equivalent models or existing delivery aggregators.
The substitute problem: Even if CloudKitchens somehow outlasts every other delivery app and every opposing ghost kitchen and owns the supply side, they can never lock in demand (and never exercise any kind of pricing power) because they still have to compete against every other food option. Restaurants that leverage proximity to the customer (i.e. real estate) or an experience-led brand (i.e. differentiated labor) are playing a different game that has been demonstrated to be sustainable long-term. It’s a game based on repeat business and loyalty within a community.
It’s the humble family-owned diner leveraging its fixed costs by building a presence in the community and compounding that investment over time. Leveraging fixed costs is one of the best ways to build a sustainable business. For example, paying for a popular retail footprint is not wasteful on its own terms; it is an investment that allows a business to acquire and retain customers based on proximity.
CloudKitchens is trying to win a similar game by bundling brands together. But their cost structure isn’t optimized to win this game. It’s optimized for winning in a delivery app world where the only channel to the customer is the phone. The delivery game isn’t about customer lifetime value and retention. It’s about customer acquisition cost in the context of performance marketing: a variable expense optimized within an inch of its life to drive almost every single order and constantly reacquire customers.
CloudKitchens can raise unprecedented amounts of capital and still not outlast the brick-and-mortar restaurant industry. And that matters because they’re always competing with every restaurant, not just engaging in a head-to-head with your local favorite. No amount of performance marketing will ever kill off this threat.
Not in the normal course of business, anyway.
But we are not in the normal course of business now. A lot of those substitutes and local favorites are going to close permanently due to coronavirus. And one school of thought suggests the CloudKitchens model will benefit enormously: When people aren’t spending any significant time out in their communities or traveling to restaurants, it’s tempting to bet on the business that is optimizing for a world where those things matter much less.
So where’s the other path?
Last year, David Hansson proudly hailed Shopify’s success in “arming the rebels” of ecommerce. Facing a behemoth in Amazon (which regularly exercises its power to snap its infinity gauntlet and destroy third party sellers), Shopify’s business model is about investing in the technical, physical, and financial infrastructure to enable more than a million independent businesses to match Amazon’s customer experience. (Web Smith went much deeper in this article and analyzed where he saw Shopify falling short at arming the rebels.)
In food, this other path of arming the rebels is being explored by a handful of upstarts. But the company that is most clearly meeting the moment during the coronavirus lockdown is Tock.
Tock was founded by restaurateur Nick Kokonas, whose experience building celebrated restaurants like Alinea and Next led him to develop a new platform that expanded ticketing and reservation options for high-end restaurants, wineries, events spaces, and other experience-centric businesses. When virtually all of their customers were forced to stop service, the company adapted elegantly. In one week, they built and launched Tock To Go. Customers could plug it into their existing operations (or onboard separately) and start offering differentiated takeout options and unique at-home experiences. 24 hours later, they had signed up 250 restaurants.
Tock To Go represents the polar opposite of a ghost kitchen world.
Where CloudKitchens and its peers rely on centralized processing and a flattened, undifferentiated business model, Tock starts from the assumption of distributed processing and a business model that differentiates on its prime costs: labor and ingredients. It fits as neatly into the existing workflow of restaurant kitchens designed primarily for high-end table service as it does for ice cream shops who are now selling DIY sundae kits.
Because Tock To Go is an orthogonal extension of its real business, Tock can credibly (and by a huge margin) undercut the delivery aggregators on price. That’s because this isn’t a replacement for the real in-person experiences that Tock is known for. It costs Tock relatively little to run the service; meanwhile, the existing restaurants they help survive and the new restaurant customers they onboard are highly likely to convert to Tock’s primary business in the future. It’s an extremely high ROI marketing expense.
Tock To Go offers restaurants two huge advantages relative to other options.
- They don’t have to commoditize themselves, compromise their brands, and ruin their unit economics to sit behind a delivery app
- They don’t have to cannibalize their businesses in the long term by relying solely on gift card sales (or “dining bonds”) that will be worthless if the business never reopens
A restaurant can spend years — decades, even — establishing a reputation and building up a base of loyal regular customers. Delivery apps and gift card sales under duress represent drawdowns on investments in those areas.
Tock To Go offers the chance to continue compounding those investments. It enables restaurants to preserve their relationships with experienced staff and trusted suppliers. They get to keep leveraging their existing real estate (albeit in a compromised way for now). And after they reopen for in-person dining, they can use Tock To Go to augment their business and offer another avenue to build affinity and loyalty with their customers.
Tock has taken a product that was designed for the world’s most experience-centric food businesses and built something that can arm any restaurant that has an ounce of differentiation and loyalty with the tools it needs to bring that experience directly to the homes of its most loyal customers.
What really drives value for a business?
I asked this question last year when I wrote about laundromats and appliances and the misalignment of paying a lot for a key input that offered no discernible differentiation.
What’s the equivalent for a restaurant? A typical independent restaurant business that does $1M in revenue at a location might look at its costs along these lines:
- Ingredients & consumables: $350k
- Wages: $300k
- Rent & utilities: $150k
- Marketing expenses: $50k
- Depreciation and/or new capex: $50k
- Insurance and other miscellaneous expenses: $50k
What’s here that’s truly defensible? Obviously insurance and depreciation are out right away. And, as I addressed above, when you operate restaurants as a performance marketing competition, the only real move available is to spend more.
By definition, it cannot be ingredients. Even leaving aside obvious commodities, any person off the street can buy flaky salt, join a CSA, and access high-quality meat. So unless you’re going to corner the market on ramps, morels, and Kobe beef, this isn’t it either.
That leaves two things: Labor and rent. Your people and your place.
In the before times, my wife and I ate at MOD Pizza at least once a week. It was part of our Saturday routine. Wake up, work out, eat at MOD, get groceries, spend time together. When we could still sit down and eat there, MOD fed a constant stream of students from the nearby high school, couples and families of all ages, birthday parties, and entire kid’s soccer teams.
In the corona times we find ourselves gravitating more to Veraci, an independent wood-fired pizzeria. Order a large fresh mushroom pizza for takeout. Walk over and pick it up. Eat it at home and watch McMillions. At Veraci, people say socially-distanced hellos to their neighbors and acquaintances and tip generously to thank the staff for their essential work.
These businesses aren’t similar because they make pizza — in fact they could not be more different. They are similar in how they inspire loyalty.
MOD has built its reputation on people; one of the key reasons the company was founded was to answer the question “How many people can we profitably employ?” They’re particularly well-known for hiring people who need a second chance (including ex-convicts) and building out programs that support their frontline staff. This is almost unheard of for a national chain. But the impact is obvious: In an industry where annual employee churn regularly exceeds 100%, many of the people who staff our neighborhood MOD have been there for years. And the impact on operations is real. I’ve visited fast casual pizza places up and down the west coast and MOD locations consistently offer a better customer experience and faster throughput. They also make it a point to integrate themselves into local communities, and they express that in multiple ways — from community giving programs to custom local store designs.
Compared to MOD, Veraci is tiny. But you can see the same elements at play. They got started by toting their hand-built oven to farmers markets. Their first full-time location (and the very same one we go to now) is an easy walk from the site of one of those farmers markets in a very small building that has a history of housing pizzerias. They started hiring from a particular set of people: school teachers and returned Peace Corps volunteers. More than 10 years later, they are still profitably serving the community where they were born.
When you combine the right people with the right place, you get something special. New customers discover you because you’ve joined their community. You create a delightful experience through a deft combination of hospitality, menu development, and kitchen skills. That feeling of delight compels customers to return. That’s loyalty in action. That’s why MOD and Veraci will continue to survive through this pandemic.
Like the restaurants on Tock, they spent years investing in a foundation of strong customer and supplier relationships. When the pandemic hit, they were not thrown into the delivery app maelstrom with everyone else. They made a few changes to their products and operations — MOD is notably doubling down on family-focused pickup and delivery products — and then continued compounding on those foundational investments.
At some point, successful restaurants don’t need to keep paying to acquire customers. The continued investments in their people and their communities generate repeat, loyal customers. Loyal customers don’t need to be reminded to come back. They just do.
You can follow me on Twitter or shoot me an email. You know the drill: Firstname.lastname@gmail.com.
Big thanks to:
- Adam Blakney for being a sounding board
- Chris Whitson for generously sharing his experience and expertise
- Brittany Walker for checking me on my assumptions
- Katelyn Donnelly for pushing me
- Packy for championing me (and giving me a chance to expound a little more in his newsletter)
