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Apps and ‘dark kitchens’ are changing food delivery

In 2004, Matt Maloney and Mike Evans were working in Chicago as web developers for appartment.com, a platform that allows people to find rental flats online. The pair often worked late enough to order takeaway. Maloney recalled in 2014:

We were frustrated by the lack of dinner options as well as the pain in the ass of calling restaurants and reading our credit cards. That's when I heard the screeching wheels in my head: Why wasn't there something like (appartment.com) for food delivery?”

So appeared Grubhub, which now boasts 24 million regular users who can order from 300,000 restaurants in 4,000 US cities and London.

Grubhub is part of the world’s booming online-food-delivery industry that is expected to record global sales worth US$136 billion in 2020, a 27% increase from 2019. Altogether platforms have 1.2 billion patrons who like the convenience, speed, vast choices offered, ratings, reviews, recommendations and ease of paying via an app – especially of late when food delivery was one of the few luxuries people could enjoy during the lockdown phase of the coronavirus pandemic.

Platforms have proliferated because they think they can deliver meals to homes faster and cheaper than can restaurants, especially as they gather more data on diners. The industry’s emergence has given rise to ‘dark’ or ‘ghost’ kitchens or ‘virtual restaurants’, the name for commercial premises that prepare meals for platforms. Even as they are targeted for disruption, food providers can see advantages in cooperating with platforms. They offer restaurants a cost-effective route to an online presence, widen their customer reach, provide them with data on their patrons and deliver orders in a streamlined fashion.

So spectacularly has online-food delivery taken hold that UBS in 2018 issued a report titled, “Is the kitchen dead?” that judged food delivery as a “mega trend” that might make home cooking a rare practice by 2030. For this to be true, however, the food-delivery industry will need to sort the tough economics that govern the industry so the food preparers can flourish as much as the dominant platforms are bound to thrive.

Running a restaurant has always been a low-margin activity, even in buoyant economic times, because it is hampered by poor economies of scale (when higher output lowers fixed costs per unit of production). Cooked meals are hard to mass-produce efficiently because different ingredients need to be on hand, components and dishes have various cooking times and meals are typically made just in time to be consumed.

The appearance of platforms only made running a restaurant tougher. Any online orders are subject to a platform commission that can range from 15% to 35% and be raised at any time. Other drawbacks for eateries include that platforms can alter their algorithms at whim to shut out restaurants. Platforms are gaining the customer relationship, can force restaurants to discount and, sometimes, make them bear the costs of deliveries gone wrong. On top of that, delivery fees limit what restaurants can charge diners. To no one’s surprise, restaurant margins are falling to the point where many eateries are uneconomical.

Even as they grind down restaurants, established platforms in many countries (but less so China) are struggling to overcome some weaknesses of their economic model.

The first is that the food platforms rely on restaurants that are inefficient at producing à la carte meals. Dark kitchens, to be sure, have helped boost the efficiency of cooking for online delivery but only to a point.

A second challenge is that delivery has poor economies of scale because each order is different and has a unique delivery address.

A third pitfall of the platform model is the food-delivery industry has low ‘barriers to entry’, hence all the fresh, often loss-leading, rivals chasing the industry’s riches.

Other chinks are that platforms have no hold over their users, which means they must constantly promote themselves, and food delivery relies on gig labour but giganomics is coming under scrutiny for paying workers poorly.

The result is that an industry shakeout has started. Some money-losing platforms have vanished while others are in mergers and takeovers to ensure they are among the survivors that dominate this promising industry. Perhaps the biggest question to be settled is how the tussle within the industry between eateries and aggregators will play out so that both can find sustainable frameworks. The likely outcome for the industry is that a few prominent platforms have so many users they can operate a high-volume, low-fees model that allows restaurants to be profitable enough. But there is much to play out in the meantime.

Just to clarify, food delivery is an old concept. For all the gains of online ordering, ordering by phone is still a big segment. Many eateries will survive without much of a platform presence because people will still want to dine out. The barriers to entry protecting the platforms might rise once the industry has consolidated. The established food platforms are already profitable enough. It’s just that the tight margins for many food-delivery businesses reflect the challenging economics underpinning an industry that might only be at the start of the restructuring needed to become viable over the longer term.

 

Michael Collins is an Investment Specialist at Magellan Asset Management, a sponsor of Firstlinks. This article is for general information purposes only, not investment advice. For the full version of this article and to view sources, go to: https://www.magellangroup.com.au/insights/.

For more articles and papers from Magellan, please click here.

 


 

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