[On-demand] The fate of restaurants in an aggregator economy

A few weeks ago, I wrote about the food delivery industry, analyzing the economics of food aggregators and how the industry's recent changes could impact its stakeholders.

Last week, I came across a letter from a restaurant owner to the Noon Food leadership, sharing their pain and asking them to reconsider their acquisition strategy, which prompted me to dig deeper into the impact of food delivery wars on restaurants.

This is the second part of my ‘Food economy’ series, throughout which I plan first to provide an overview of the evolution of food delivery and its economic impact on restaurants. Then, I’ll share some ideas on what restaurants can do to retake control of the narrative.

Evolution of food delivery

The history of food delivery over the past 20 years has been a long story of gradual outsourcing, as restaurants outsourced what they perceived as non-core activities in the value chain:

• Food delivery started as a local play, with customers collecting menus and restaurant flyers in their kitchen drawers. They would call to order food (mostly pizza and Chinese) from neighborhood restaurants whose in-house delivery workers delivered the food and collected money in cash.
• The model changed in the early 2000s when players like Grubhub and Seemless took the ordering and payment process online. As traditional marketing channels had low ROIs, these platforms helped restaurants access new customers at a reasonable cost (i.e., 15% of order value). This was the first generation of food delivery.
• Doordash was founded in 2013, giving birth to the second generation of food delivery. In addition to its mobile ordering app, the company offered delivery services by leveraging independent contractors and enabled restaurants with no in-house delivery capabilities to enter the game. Most restaurant owners, who didn’t see delivery as a core activity, fired their delivery workers and fully outsourced their ordering and delivery operations to these third-party providers.
• More recently, the emergence of cloud kitchens introduced new supply to the mix. Virtual restaurants (with no dine-in location) emerged, and anyone can now sell food online and at scale. All they needed was a menu, a kitchen space to rent out, and a small team of chefs and food workers. I’ll discuss virtual restaurants and cloud kitchens in a future post. This piece will focus on restaurants with physical locations.

In summary, the evolution of food delivery looks something like this:

Impact on restaurants

Restaurant owners initially welcomed innovation in food delivery. They were pleased to outsource delivery as it allowed them to focus their time and resources on what matters: menu design and food preparation. While the heavy commission fee (30%) hurt their economics, they didn’t mind paying it because they hoped that:

1. Online orders would represent a small share of total orders.
2. The additional orders would allow them to better utilize existing resources, leading to lower average fixed costs.
3. Newly acquired online customers will build affinity towards their brand and eventually visit the restaurant’s location.

Unfortunately, the pandemic and ensuing lockdown turned the model upside down. What used to represent 15% of total orders suddenly accounted for 90% of them, and the low contribution margin of online orders drained the profitability from restaurants.

Let’s explore why by looking at the economics of running a restaurant.

Unit economics in restaurants

Profitability in the restaurant industry can be broken down into three components:

1. Contribution margins of online orders
2. Contribution margins of on-location orders
3. Fixed costs associated with running a restaurant.

The formula would look something like this:

To evaluate the impact COVID-19 had on restaurants, I’ve put together, with the help of a friend (restaurant owner), a simple model that roughly estimates the average profit per order as the mix of orders (online vs. offline) changes.

The below table shows three such scenarios: an 80/20 offline-focused mix, an 80/20 online-focused mix, and a 50/50 mix.

As you can see, average profits per order decrease as the percentage of online orders increases. Many restaurants lose money when online orders account for a significant share of orders.

The model is available here if you’d like to make changes to the assumptions that I’ve used. (The sheet is locked, but feel free to copy the structure into another sheet and make changes).

Lower barriers to entry

In addition to worsening unit economics, innovation in food delivery and cloud kitchens eradicated all barriers to entry and made it significantly easier for new players to enter the space (i.e., set up virtual restaurants and sell their food online).

Without real differentiation in the product, and with every piece of the supply chain easily outsourced or contracted/ rented out, the fight moved towards on-app marketing and customer acquisition. Given virtual restaurants have a leaner cost structure and faster experimentation cycles, they aggressively discount to acquire customers, forcing restaurants to do the same.

Besides, the abundance of new entrants reduced the restaurants’ bargaining power with delivery aggregators, who are confident that if a restaurant leaves, three others would take its place.

As a result, the industry as a whole deteriorated, and profits leaked from restaurants (especially small and medium ones) towards service providers: Food aggregators and cloud kitchens.

Noon Food’s reduced commissions

Noon Food’s reduced commission structure improves the economics for restaurants but will do little to alleviate the pain over the long term. As the competitive rivalry among restaurants and their virtual rivals intensifies, any gains made on lower commissions will eventually be passed away to the consumer as lower prices and discounts.

The above letter by Jennifer Ridgway (Freshii’s owner) highlights the impact that Noon’s customer acquisition strategy, centered around discounts, might have on restaurants: As she explains, this strategy will attract discount chasers, who are generally not easy to retain. Growing a customer base accustomed to discounts will also push restaurants into a perpetual price war against virtual restaurants, which enjoy a leaner cost structure and will always be better positioned to offer discounts.

In light of these deteriorating conditions, restaurants have three choices:

1. Close shop and fully embrace the virtual/ cloud model and redirect the money saved towards customer acquisition and menu experimentation. This is an attractive option for restaurants that don’t expect a return of footfall.
2. Continue as is, hoping that as vaccinations ramp up, customers will return to restaurants, and the share of online orders drops to pre-pandemic levels. A risky assumption given a lot of behaviors gained throughout the pandemic might be here to stay.
3. Fight back, realizing that although customers will return to restaurants in the short term, the share of online orders will gradually increase over time.

How can restaurants fight back?

Fighting back does not mean getting rid of the relationship with food aggregators. They still represent a critical customer acquisition channel and should be treated as one channel to acquire new customers but not the only channel for food delivery.

Fighting Back: Modularization of food delivery

Fortunately for restaurants, the food delivery space continues to evolve. New startups have emerged to help them more effectively capture direct demand through their individual apps/ website by combining traditional online ordering with sophisticated CRM/ marketing systems and accessible order tracking APIs.

We are in the early stages of the third generation of food aggregators, which have once again modularized the value chain:

As a result, a restaurant is able today to build its own website/ app using Bikky or GoParrot, work with ChatFood to manage and process orders, and contract a third-party delivery platform (with tracking capabilities) to deliver food to the customer.

Order processing platforms have been around for a while, but their adoption is accelerating in the US and Europe, as they have effectively integrated with third-party delivery providers, making them a substitute for food aggregators. Companies like Uber, Doordash, and Deliveroo have noticed and have started promoting their logistics-only delivery service to restaurants instead of just the full-stack service.

Similarly, Careem is transitioning from a second-generation food aggregator to a third-generation one. The company’s updated fee structure consists of a subscription fee (~2AED per order), a transaction fee (2.95%), and a fixed delivery fee (6.5AED per order), signaling a move towards a modularized service model. I expect the ride-hailing giant to soon roll out a delivery-only service for restaurants that wish to serve customers through their own apps.

Fighting Back: A multi-channel approach

Taking advantage of these trends, restaurants should build their delivery strategy around three channels:

1. Food aggregators should continue to represent a critical discovery and acquisition channel for new customers and a great channel for customers that infrequently order from a restaurant and therefore are less inclined to enroll in your direct ordering platform.
2. A restaurant’s physical location should serve as a discovery and aquisition channel. As such, touchpoints with customers in these locations should be tactically managed to improve loyalty and incentivize customers to order online from these restaurants.
3. Restaurants with large online order volumes should build direct ordering channels for their consumers, leveraging widely available ordering services (i.e., ChatFood) and third-party delivery platforms.

However, all this is easier said than done, and moving customers away from the ease and convenience of ordering through food aggregators towards direct ordering won’t be easy.

To do so, restaurants should cater to the customer’s most basic decision-making drivers: Their stomach, heart, and mind.

• The stomach: The main reason food aggregators have been so popular, while individual restaurant apps haven’t (i.e., Za’atar w Zeit), is their ability to provide a seamless experience around food order and tracking. Nothing is worse than being hungry and unable to track your food or estimate the time it takes for it to reach you. To succeed, restaurants that plan to build direct ordering systems should invest in providing a similar experience and the same level of reliability. 
• The mind: Restaurants should build a structured loyalty that offers to return customers discounts and rewards for their orders. Enrolling in the program should be intuitive, and customers should be easily able to collect rewards when ordering offline or online. Koinz recently raised money to do just that. The startup allows restaurants to nurture their customers’ loyalty through a seamless onboarding experience. Through the platform, customers receive rewards whenever they order food at their favorite restaurants. The app also allows online ordering and is currently integrating with third-party fulfillment providers to offer restaurants a full delivery service at a fraction of the rates they pay for food aggregators.
• The heart: Restaurants should also cater to customers’ hearts/ emotions and directly ask for their help, explaining how ordering directly from them (or through alternative platforms) helps their profitability and allows them to better serve their customers.

Regardless of how things go, the future looks bright for this industry, and restaurants should soon be able to get some power back!

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