It is fair to say that the COVID19 pandemic has not been good to most businesses, but one of the hardest-hit sectors has been the restaurant industry. The mid-term effects have yet to be fully seen, but in the interim, the ‘Cloud Kitchen’ (or Ghost Kitchen) model has emerged in an effort to help reinvent the restaurant business model.
What are Ghost Kitchens?
Cloud/Ghost Kitchens are commercial kitchens dedicated to the creation of virtual, delivery-only restaurant brands. Typically, an operator will own/lease the commercial kitchen space and sublease to multiple ‘virtual brands’ who will sell to clients via a delivery-only model. The concept originated a few years back as a way to repurpose space but has now accelerated exponentially thanks to the pandemic and the pressure it has put on the restaurant business model.
The main problem with the restaurant business model is the high fixed/labour costs. The business model has always been tied to a physical space, which is a big part of what creates the ambiance and loyalty to any brand(s). When you think of many of your favourite meals in restaurants, the space itself plays a large role in the overall experience. Entire brands have been built on the creation of a certain experience for customers.
Unfortunately, in a pandemic, the physical spaces quickly become a liability. The restaurant business model is hard enough to make work in the best of times, let alone in times when regional closures, consumer fears, and capacity bylaws (ie. allow 50% of max capacity) make it impossible to turn a profit.
The first layer in the business model that the ghost kitchen concept targets is the rent. While it could represent 5-10% of total revenue, the variable costs related to insurance, electricity, staff, and equipment for physical restaurants are significant; plus the lease contract is typically 5-10 years, giving proprietors and entrepreneurs no flexibility in situations like we are in now. Ghost Kitchens create flexibility by lowering the cost base for restauranteurs to sell food.
In a ghost kitchen, the main variable costs of ingredients and staff are compared against the revenues that can be earned through delivery-only channels; the idea is that certain brands can incubate new concepts, while others can survive over some interim period of time until we return to ‘normal.’ Not that one would expect a digital-only, delivery model to compare to a bustling physical location in terms of sales, but the net profitability may be enough to kickstart a new brand or sustain an existing one. Rent is dramatically cheaper (typically $5-7K per month) and more flexible, meaning concepts can be scaled up or down quickly.
Undoubtedly, the concept would have its detractors given the ‘techy’ feel to it. Nothing can replace the in-person restaurant experience. Trust in places you can’t see, physically, is arguably the biggest question mark from the consumer’s perspective. The question is whether or not ghost kitchens are an anomaly over the next year or two or the beginning of a new trend that will fundamentally reshape the restaurant business model. Not as a replacement for in-person dining, but as an adjacent industry to incubate new ideas and keep others afloat while restrictions on mobility and travel are in place.
How Do They Work?
Before trying to determine whether or not ghost kitchens will become a $1T industry, we need to understand better the mechanics of how they work.
Typically, you will have a professional operator that operates one or multiple kitchens across a certain jurisdiction or region. They provide space, along with the required cooking equipment, and sometimes even technology for logistics.
The US has companies like Cloud Kitchens, Reef Technologies, Zuul, and a host of others. Deliveroo is starting-up the concept in the UK/European market, while in Canada, Recipe Unlimited has jumped into the game with their Ultimate Kitchens concept for mainstream brands.
You can see from the way that these sites are branded, they focus on lowering the capital cost of opening a brand and take care of all the logistics. The above-listed companies are not small players by any means. Cloud Kitchens has the former Uber founder and $400M behind it, Reef is backed by Softbank, and Deliveroo was invested in by Amazon last year. Each major player has different incentives and types of food businesses they are trying to attract into their space, but the main advantage to them is their ability to fund the lease and equipment costs for the spaces they run.
At a level beneath these larger-scale operators, we see mid-sized ghost kitchens that operate spaces where 5-10 restaurant brands are located. An example is Kitchen Hub in Canada, which currently has 8 restaurants from the Toronto area listed on its website. Some of the brands listed on the site are well-known, others seem to be new, and when you click on the menu link you can see them all listed on one menu.
Part of the value proposition of these types of ghost kitchens is that customers can order multiple different types of food from one menu, and have it delivered together. In this way, various concepts can be combined to create one type of menu or brand.
An extension of this concept is Kitch in Lisbon, Portugal, which recently raised a €1M seed round. They curate the entire experience and provide a branded environment for chefs to thrive in the creation of dishes designed for delivery.
Looking at these three examples, we can see how the concept involves space, a bundled menu, and brands dedicated to the end-to-end experience of eating delivery. Fundamentally, the pandemic has accelerated the shift of all restaurants’ delivery business.
That’s why the Cloud/Ghost Kitchen ‘trend’ is bound to help at some layer of this shift given the ultimate effect to lower risks and capital costs associated with the restaurant business model. Having some BMi (Business Model Innovation) in the restaurant industry seems essential at this point. How deep the shift goes is the question. Social, regulatory, and safety questions remain unanswered, and margin pressure from delivery companies create enough uncertainty about the net effects being positive or negative for the industry.
There are two different sides to the Customer Acquisition funnel for ghost kitchens – restaurants and consumers.
Restaurants being drawn towards the ghost kitchen trend – whether existing brands or new – are likely to hear about it through those in their industry, either via referral or through publications. Using Google Search Trends as a proxy, we can see how interest in the concept (as measured by search volume) has been increasing steadily before a huge spike in interest caused by the pandemic.
The biggest segment of new ghost-kitchen signups is likely to be chefs, as they are the segment that can help drive the adoption of this concept most rapidly. Whether they bootstrap themselves or are backed by seasoned entrepreneurs/financiers, there is a learning curve that needs to be addressed, as the concept is dramatically different from dine-in restaurants.
Having top chefs under specific brands will help bring more consumers into the market and help bridge the trust gap that exists around the industry. While consumers are becoming increasingly habituated to ordering food online due to Uber Eats, Deliveroo, Just Eat, and others, they typically will do so from brands that they already trust.
For an existing restaurant brand to drive customers towards online ordering is different from a new brand acquiring customers from scratch, especially when there is no physical connection to the brand. Online delivery services themselves can serve as acquisition channels but the cost is high.
Digital marketing through the traditional channels (Facebook, Instagram, etc) could help drive adoption, but that CAC (Customer Acquisition Cost) will cut into margins as well, meaning that the only real way for new kitchens to acquire customers and maintain a high LTV (Lifetime Value) will be through word-of-mouth, referral, and loyalty programs. Historically, a restaurant’s physical location would be the principal factor in determining its discovery; therefore, the new ghost kitchens will need to get quite creative in their marketing strategy to bring in new customers who will be loyal to the brand and help drive word-of-mouth referrals. Without brand stickiness, many new concepts are likely to fail.
As this is a relatively new concept and we are in the midst of a pandemic that is having a huge effect on the industry, it is likely that competition will be very regional in the next few years.
While we are used to seeing tech Unicorns scale-up their brand to go global once they have traction in a specific market, the growth of this industry will likely be more nuanced based on regional factors. The $1T future market prediction is broken down into several different categories.
We have talked about some of the major brands operating on the infrastructure (or Kitchen-as-a-Service, KAAS model) in the US such as Cloud Kitchens, Reef, and others. Dubai-based Kitopi recently raised a $60M round and has a footprint in more global cities around the world.
But major restaurant brands have also begun to enter the fray. We mentioned Canadian-based Recipe Unlimited above, a publicly-traded corporation that has seen its market cap cut by 2/3 over the last 5 years. A couple of big US chains are also experimenting in the market, and would probably love to ride this new wave if it can increase their profitability – Bloomin’ Brands stock (BLMN) is down about 50% over the last 5 years, the majority happening as a result of the COVID19 pandemic.
There are also the big commercial real-estate firms to think about. They potentially have the most to lose, especially if in addition to lost rents they lose the food brands that make their commercial spaces vibrant for their tenants.
Perhaps the most interesting shift here will be from the combination of new talent among those entrepreneurs, chefs, and staff who jump on board early and collaborate together within these spaces over the next number of years. Backing the talent (á la the Kitch model) could lead to the creation of new consumer food brands across multiple categories, not just restaurants.
The competition for market share will probably be less about who wins the ghost kitchen market and more about who wins consumers’ hearts and minds with new food concepts that can drive high margins during an extended period of global uncertainty.
As we saw with coworking, the sudden COVID19 pandemic meant that many spaces were emptied instantly and the coworking business model became unglued. But those businesses and brands who inhabited coworking spaces continued to WFH (work from home), and something similar could happen in this space depending on how the macro environment takes shape over the next 5-10 years. For example, if the current crisis causes a massive loss of tenants for commercial operators and tax revenue for cities, will some cities begin creating incentives for new physical restaurants to pop up again?
In the end, there are many investors who will bet big on ghost kitchens and a more automated industry in the future, helping to reduce capital, labour, and variable costs. And yet others who will back new food entrepreneurs and creative industry veterans who seek to use this as an opportunity to reinvent the restaurant/dining/delivery experience itself. No doubt, a lot of capital will move into the space and a few pioneers who are lauded for years to come.
Consumers, however, will be the ultimate judge.