INDEX
Overview
What are cloud kitchens?
Key Benefits of Cloud Kitchens
Cost savings
Convenience and distribution
Faster expansion
Flexibility
Types of business models
Brand Owned Cloud Kitchens
Pros
Cons
Aggregator Owned Cloud Kitchens
Key success factors
Frugal cost structures
Supply chain management
Brand Marketing
Unit Economics
Offline restaurants
Cloud restaurants
Way forward
Dark kitchen. Cloud kitchen. Virtual kitchen. Ghost kitchen. They sound like settings within a sci-fi movie more than real-world assets (metaverse wut?).
But we live in a country where the online food ordering space is one of the paragons in the internet-led business space. A country that orders 115 biryanis a minute and 5 million samosas a year.1 Macro trend like increasing internet penetration, higher ordering frequency, expanding reach in smaller tiers, and expanding network of restaurants on food delivery platforms pan India, continue to drive momentum in the sector.
Both restaurateurs and food delivery entrepreneurs have taken on this challenge of fulfilling the insatiable appetite of the Indian customer and have invested in kitchens, supply chains, delivery infrastructure, and more. India’s food delivery market is pegged at USD 5 Billion now and poised to grow at 28% CAGR to USD 20 Billion by 2026.2
However, fat markets don’t mean fat profits. Almost no one in the food-tech market has made any money. Swiggy and Zomato collectively have accumulated losses of over USD 1 billion in the last couple of years. Already burdened with high startup and operating costs, restaurants were further bogged with lower margins due to high commissions and discounts demanded by the angry Gods of aggregators.
Finding a stable business model that works for both sides of the table is the need of the hour.
Enter Cloud Kitchens.
What are Cloud Kitchens?
Just a basic kitchen with bare interiors. No flourishes, no high street storefront, no seating, no waiters. The space is optimized for food orders taken from food delivery aggregators and apps, cooked, packed, and sent off with delivery executives. Restaurant business unbundling at its finest.
They are faster to set up and cheaper to run than typical quick-service restaurants and can be designed to offer more culinary options than a Las Vegas Casino hotel. There is no hassle of maintaining human resource overheads, dine-in operations overheads, and high street rentals. Cloud Kitchens are the knights in shining armor who have to come to save the food tech industry.
Key Benefits of Cloud Kitchens:
Cost Savings for owners:
Cloud kitchens don’t need to be located in a high-visibility area or even on the ground floor. Rather than paying for accessibility, better-developed complexes, or even a large parking space, owners can concentrate on having enough kitchen space in a decent area near the target market.
Convenience for users:
Lower costs of entry and operational costs, in theory, mean that more obscure food options should be able to exist that previously wouldn’t have made economic sense (think standalone Kombucha brands). Users will benefit from the sheer number of options and choices that cloud kitchens can offer. It is not a stretch to think that cloud kitchens can also pass some of the cost benefits to the customers and can undercut full-service restaurants on the pricing front.
Faster launch and expansion timelines:
One cloud kitchen setup can hold multiple brands and types of foods coming out of the kitchen. The restaurant can launch multiple storefronts in the same locality all plugged into one cloud kitchen in the backend hence grabbing more eyeballs. Simple setups also imply faster expansion into new areas/localities(provided processes are sound).
Flexibility:
Operators of multiple cloud kitchens (chains) can leverage analytics data to tweak product and pricing options and retain the freedom to shut down or relocate underperforming stores without incurring loss and losing public goodwill.
Cloud Kitchen Business Models
Two core business models have evolved around the cloud kitchen model:
Brand Owned Cloud Kitchen:
In this model, the restaurant owner buys or rents out a specific low-cost commercial space to launch their delivery-only restaurant(s). The owner takes care of the labor, operations, and supply chain and uses the aggregators (Swiggy, Zomato) for last-mile delivery while also depending on them to generate demand for the restaurant.
Since there is no requirement for a storefront, ambiance, or specific signage; the restaurant owner is free to operate multiple brands and cuisines from the space. The end customer is none the wiser regarding the origins of the ordered food. Theoretically, it is entirely possible for a young upstart brand operating with minimal overheads to compete with multiple specialty dine-in restaurants and undercut them on price in the same locality.
The challenge with moving to a ‘delivery-only’ model is that the restaurant will become dependent on the aggregators for sourcing all their orders. The aggregators have of late been charging commissions as high as 30% for orders serviced by them. This essentially wipes out all the margin gains from moving to a cloud kitchen. Add to this, there is also constant pressure to spend on discounting and marketing on the aggregator platforms as well as on social media to ensure high brand recall.
The downward pressure on margins from the additional spending on marketing, discounting, and advertising forces the restaurant to operate multiple brands and cuisines so that the higher number of orders can help absorb the high upfront costs (high volume - low margin) or go all-in on the full-stack model where the restaurant owner owns all components from discovery to delivery in the purchase process (FreshMenu is a good example for this).
Rebel Foods, Box8, and CureFoods are a few examples of companies operating in this model.
Pros:
Reduced upfront setup costs as there is no need to invest in a storefront, dine-in space, and interior furnishings.
Reduced human resource costs as the kitchen can now operate with a skeleton staff and don’t need support staff like wait staff, floor managers, etc.
Better operating margins due to lower rental costs and operational overheads.
Flexibility to launch and experiment with multiple product offerings and brands.
Cons:
Low to zero customer stickiness as lack of physical presence makes it harder to have good customer recall.
Commissions and marketing spending wipe away any meaningful infrastructure cost savings and put downward pressure on profit margins.
The model creates dependence on aggregators and exposes you to associated risks (sudden hikes in commissions, deep discounting, etc.).
Aggregator Owned Cloud Kitchen:
The second model in this space is based on the principle of predicting demand and supply gaps in a target micro-market and then setting up large spaces with multiple kitchens that can be leased or rented out to various restaurant brands.
With the rise in online orders and the ever-changing demand for new culinary experiences; the demand for new kitchen space has skyrocketed. Deep-pocketed entrepreneurs can plan expansion and launch their stores (QSR model); however, for most operators, this is not possible.
Kitchen aggregator platforms rent large spaces and plan multiple (15-20) kitchen spaces within a single facility. All necessary infrastructure like gas, water, and electricity lines, stoves, and ovens are already ready to use and give a ‘plug and play’ experience for the restaurant operator.
For providing this service, the developers of the space charge users rent or commission on every order they service. Since this model has very high upfront and maintenance costs, the entire success of this model is determined by occupancy ratios. Food delivery players like Swiggy and Zomato have access to geographical demand data and hence, are in a position to understand the specific needs of each micro-market and make such investments.
Swiggy and Zomato both started their versions of the model, under the Swiggy Access and Zomato Infrastructure Services banners respectively. The growth of the Swiggy Access model slowed down significantly due to the pandemic and they had to shut down close to 75% of the 120 kitchens they were operating.3 Zomato exited the infrastructure business completely and invested in a competing platform Loyalty Restaurants (Kitchens-at) and exited that investment as well in 2020.4 Zomato is now exploring an entry back into the space with a new promise of ‘10 minute delivery’.5
Key Success Factors
For a cloud kitchen model to be successful, the key metrics are increasing organic demand, store-level profitability, and rapid geographic expansion. Some of the critical factors at play here are:
Frugal Cost Structures:
The kitchens need to be modeled in a way where the maximum throughput (in terms of number and type of orders serviced) can be achieved with the least amount of space and manpower required. Since, other costs like furnishings, front office costs, etc. have already been abstracted away; the only other remaining operating expenditure is the cost of the raw materials. The operators need to find a balance between the input cost and quality of the raw materials sourced as this has a direct impact on the final product quality.
Supply Chain Management:
As the space at the kitchen level is highly limited, the kitchens don’t have the luxury of maintaining high levels of inventory. Efficient management of the supply chain, including fresh produce, raw ingredients, and cold-storage items will have a direct impact on the cost structure as well as on the product quality.
Brand Marketing:
Ensuring high customer recall for the brand becomes important to avoid the vicious cycle of attracting customers with platform ads and deep discounts. This is especially critical in this context as there is no physical signage or high street storefront to effectively communicate the placement and type of product being offered.
An avg. customer will spend less than a minute going through the ratings and menu listed on the platform and hence, it is critical that they are aware of the brand and offering and the brand has high recall value even before the ordering process begins.
An interesting phenomenon to observe here is that between the high pressure on margins because of the commissions and discounts and the tight cost structures because of low price points; food quality decidedly takes a backseat. Cloud kitchens face difficulty in creating any meaningful product differentiation or new product categories and end up competing on price and quantity with brand marketing as their customer acquisition lynchpin.
Unit Economics
Offline Restaurants
Cloud Restaurants
The unit economics of both the models is self-explanatory at this point and it is no surprise that a majority of the revenue of cloud kitchens is eaten by the aggregators in the guise of commissions, discounts, and advertising expenditures. So, even if the introduction of aggregators can lead to a significant increase in the top line of the kitchen, it also affects the bottom line as almost 50% of the revenue is funneled towards the aggregators.
I have deliberately kept the delivery expenses out of the picture here as the kitchen operator can choose to use either the aggregators’ services or their delivery fleet for fulfilling orders in either case and hence, is a similar cost on both fronts.
Way forward
Cloud Kitchens would do well to take a closer look at the undisputable market leader in the QSR category as there are several invaluable lessons to be learned from them.
Domino’s India (Owned by Jubliant Foodworks) has carved a powerful stronghold in the Indian food space with over 1,500 stores across 290 cities. They have nailed the process of expansion and its vast supply chain and sourcing capabilities allow for considerable cost advantages. Everything from store location, delivery radius, kitchen layout, kitchen equipment design and sourcing, and standard operating procedures for food preparation have been optimized by the company and consistently applied across all outlets.
On the demand side, the company has been able to create brand awareness and loyalty through the two-pronged approach of successful ad campaigns and engineering new products tuned to local tastes and sensibilities.
Campaigns like ‘30 minutes or free’ and ‘Buy one get one free’ have created strong brand loyalty and enabled them to funnel ~85% of the customer orders through their brand app/website rather than through aggregators leading to significant cost savings.
Continuous investment in research and development to keep developing new and exciting products (‘Cheese Burst’ and ‘Paratha Pizza’) has also enabled them to create tremendous taste loyalty and helped them firmly entrench themselves in the Indian pop culture.
This disciplined approach to capturing mind and market share has led to Domino’s India having a topline over Rs. 3,300 Cr and EBITDA over Rs. 300 Cr.
The survival of cloud kitchens as a concept is necessary for the overall growth of the restaurant industry. Lower upfront costs and more flexibility will enable a larger number of restaurant entrepreneurs to enter the space. It will enable cheaper experimentation and more pilots from restaurant operators both new and old. Existing operators can venture into new segments/areas/cuisines without risking their core brand and continue to serve the changing consumer sensibilities. Overall, the impact of cloud kitchens on the industry is a net positive.
New operators entering this space should be mindful of the risks that a ‘cloud kitchen only’ business model carries and should be prepared to hedge them. The ideal scenario would be to quickly launch and test food concepts in a low-cost manner using cloud kitchens and when they have hit on a product/price mix that has gained traction in the market; move to a hybrid approach with storefronts and dine-in spaces in the high street and other high footfall areas (malls, food courts) and hub cloud kitchens in other areas to enable widespread distribution coverage. This will ensure higher brand recall and enable them to spend lower on marketing and get away from the vicious death grip of the aggregators.
Ultimately, the critical point for survival here is to own the customer and ensure high customer stickiness.
Looking at the whole ecosystem from the point of view of a venture capital investor; ‘cloud kitchen only’ restaurants can be treated with similar fundamentals as other consumer goods and d2c brands businesses in the food and personal care space. Both categories face headwinds like high acquisition costs, low customer retention, and high competition. The increasing awareness and rising consumer appetite for niche-products (Ex: increase in demand for S.Korean cuisine following the increase in S.Korean content consumption on Netflix) are the significant tailwinds in this sector.
Investors should be judging the operators on their ability to break through the clutter of competition, capture mind space for a particular category of food, ensure high brand recall, own the customer, and then scale quickly with a realistic path towards profitability.
Whether we like it or not, cloud kitchens are here to stay. Cloud kitchens may make it faster and cheaper than ever to order food. However, traditional restaurants are not going anywhere. The industry is in the middle of a tectonic shift where we will see the emergence of two distinct categories: Hybrid restaurants and delivery-only restaurants.
If you would like to discuss the food tech market or exchange notes, we can connect over a call!
https://kr-asia.com/who-leads-the-food-delivery-race-between-zomato-and-swiggy-in-india
https://www.businesstoday.in/latest/corporate/story/covid-forced-us-to-shut-three-fourths-of-cloud-kitchens-swiggy-ceo-313620-2021-11-26
https://www.vccircle.com/zomato-backed-cloud-kitchen-fluffs-up-with-cash-from-new-overseas-investors/amp
https://economictimes.indiatimes.com/tech/startups/zomato-in-talks-with-restaurants-cloud-kitchens-for-10-minute-deliveries/articleshow/90297503.cms