What’s all the hype around cloud kitchens?

Will this new business model be the savior of the restaurant industry that it's cooked out to be?

I was at a friend’s place for drinks a couple of weeks ago when amid all the general discussion the topic of cloud kitchens came up. A couple of our friends who weren’t present had just launched an online-only delivery restaurant (i.e. one without a physical storefront, but with a brand presence on social media and/or aggregators like Swiggy or Zomato) and were already in the process of launching another. I made my opinion known – that I didn’t think the delivery-only kitchen model was as hyper-scalable as people thought – and got a couple of incredulous questions: “So what, are cloud kitchens a fad?”, “Is everyone else wrong about the explosive growth we are about to see in the space?”

I don’t think either of those things. However, I do think there is a lot of confusion around what the term ‘cloud kitchen’ actually means and how rapidly and successfully scalable new, individual brands really are. That’s not surprising, as the space is new and business models are evolving constantly. I spent the past year and a half working at a food solutions provider that worked with cloud kitchens extensively. I’d like to help demystify some of what’s going on, and talk about some of the opportunities I think exist in the space.

What are cloud kitchens?

First of all, cloud kitchens in the most basic sense are just facilities built to produce food that is specifically meant for delivery. They usually don’t have a store front, and are sometimes also referred to as dark kitchens or ghost kitchens. They are commercial spaces that are outfitted with the kitchen appliances and labour necessary to run a kitchen, and can house one or multiple restaurants or brands.

In a nutshell, cloud kitchens were born out of restaurants’ need to solve a two pronged problem: 1. Perennially increasing margin pressure due to rising input costs (raw materials, labour) and rent/real estate costs 2. An increase in demand for delivery food (vs dine in) due to the adoption of technology and demand for convenience by the consumer. The segment is new – it started in earnest in the early 2010s – and has been growing and evolving rapidly. The rapid growth has led to fast funding and consequently, a lot of hype around anything related to the space. The rapid evolution, on the other hand, has led to multiple business models, which seem to have all fallen under the blanket term of ‘cloud kitchen’.

What are the core business models?

The original premise of a cloud kitchen was that the space that produced, stored, and sold the food didn’t have to be associated with an actual physical store front. At a very basic level, there are two core business models that look to take advantage of that premise.

A single restaurant cloud kitchen

Here, a restaurant owner buys or rents out an entire commercial space to launch their own delivery-only restaurant, also called an ‘internet restaurant’. Because there doesn’t need to be a façade or any signage, the owner of the space isn’t limited to running just one brand out of it. The cuisine they produce isn’t restricted by the theme of the restaurant because there isn’t one. Not a brick and mortar one anyway. The restaurant operator takes care of the labour, operations, and supply chain, and while some may have their own delivery capabilities, most end up using the aggregators (Swiggy, Zomato) for last mile delivery since they depend on them to generate demand for their offerings in the first place.

For example, if I wanted to open a restaurant called Jaisal’s Momos that services a high-traffic region in South Bombay, I could rent out a 300sqft warehouse even 25-30min outside of that region to lower my rent cost, put a dumpling steamer and hire 2 workers, market entirely on Swiggy or Zomato, and my end consumer would theoretically never be able to tell the difference between my restaurant and Shomo’s Momos (fictional), which runs a fancy dine-in operation in say Breach Candy at 2-3x the cost.

However, when you move to delivery-only, even if you have your own delivery fleet, it is likely that 70-80% of your orders will still be serviced by an aggregator, who will charge a hefty 20-30% commission. What then ends up happening is nearly the entire margin improvement you get from going ‘dark’ is eaten up by that commission. That’s not counting the marketing spend that actually gets your brand noticed on said aggregator. The point being – it will take either a. multiple successful brands out of the same location to absorb enough fixed costs for the model to economically make sense or b. ownership of the entire customer experience, from discovery to delivery.

The pros of this model:

1. Your operating margin structure is theoretically more efficient because your rental cost drops significantly (say 30-40%) as you go from a ~1500sqft space to a ~350sqft space and don’t need to have a prime real estate location

2. Further, your labour cost also drops as you don’t need to have wait staff and you can reduce your kitchen staff – delivery ready food is meant to be easy-to-cook and require minimal prep

3. You are not committed to one brand and can experiment frequently

4. You can ‘leverage’ the space by generating multiple revenue streams (for example, once I’ve successfully setup Jaisal’s Momos, nothing is stopping me from setting up another brand called say Pizza Town from the same space – I get leverage by doubling my revenue stream while keeping all my fixed costs constant; my variable costs of course move in line with scale)

5. Your upfront cost is lower and involves setting up your equipment and land

The cons of (and as a consequence of) this model:

1. Like I mentioned earlier, the major con is that despite the apparent operating margin improvement, it is likely that 70-80% of your sales are now subject to a 20-30% commission (+ ad spend) from an aggregator (Swiggy/Zomato), so leveraging multiple brands is essential for the model to succeed

2. The barriers to entry to starting a restaurant are now even lower than they were – which means more competition, which is bound to push prices down further

3. Without a physical presence you have to work harder (and spend more) on your digital marketing efforts, including creating a following – how do you differentiate yourself when you are another icon on an app?

4. Without a physical presence you make fewer ancillary sales (sides, drinks), which tend to be higher margin items

When I said I didn’t think the cloud kitchen model was as hyper-scalable as people thought, this was the model I was referring to – opening a new brand with a digital-only presence and trying to expand it rapidly. I think the concept of cloud kitchens itself is healthy for the entire restaurant industry. Lower upfront costs and more flexibility will enable a larger number of restaurant entrepreneurs to enter the space. The ease of piloting a new brand once you’ve set your space up also means restaurants will be able to run cheaper pilots, and use successful brands to then leverage their space. It will also help existing restaurants that have developed brands already to increase their distribution footprint at a lower upfront cost with lower risk. All good things. However, what this will do is increase already rampant competition. At the end of the day restaurants (and their brands) may be able to setup and scale quicker, but they still have to generate the demand to keep up with the scale. To create that demand without a storefront they will have to work on cultivating a following, and spend on marketing. Neither of which are easy or cheap. That doesn’t mean there will be 0 success stories. Like there have been successful brick and mortar restaurateurs, there will be enterprising internet entrepreneurs with a good eye for demand trends and marketing strategies who will make this work.

Personally, I believe if you’re trying to start a brand from scratch and don’t already have a captive audience, your best bet is to find a niche that you think hasn’t been plugged, develop a “cult” following for your product, take time to develop your brand, try and own as much of the customer experience as you can – including the platform you use to generate demand, and last mile delivery. Developing customer stickiness is essential, otherwise you risk failure even if you are able to scale your distribution (i.e. kitchens). I think the right model is probably a mix of old and new – smaller physical storefronts and dine-in spaces in high-traffic metro areas complemented by satellite cloud kitchens that enable delivery reach. I think that to connect with the consumer and cultivate a brand, particularly in food, and especially when there is such a large supply of restaurants and marketing $, storefronts are necessary. Even if they are smaller, and fewer and farther between. Maybe what I’m suggesting doesn’t sound as good from a venture capital lens, but maybe the VC growth way isn’t the way to go.

Running shared kitchens for multiple brands

This is the second core cloud kitchen model. As the demand for kitchen space has increased, cash-rich entrepreneurs and businesses have looked to capitalize on this demand by setting up large scale commercial spaces fully stocked with the equipment and utilities necessary to run multiple kitchens. Imagine a large 3500sqft warehouse with 10 kitchen “slots” with stoves and gas lines that are entirely ready to use for a brand that just wants to plug and play without the hassle of setting up their own kitchen. For providing this service, the owners of the space charge users a rent or commission on every order they service. Of course, the success of this model is entirely predicated on keeping a certain minimum capacity filled at all times. It also involves high upfront costs, and works best when the lessor has access to geographical demand data so they can predict what brands or cuisines would do best in a given area.

Pros:

1. You don’t actually have to develop and market a specific brand

2. You diversify your risk across multiple restaurants/brands

Cons:

1. Large upfront costs to do with acquiring and outfitting the space

2. Must ensure minimum capacity is always occupied so your net income is positive

To make this model work, you have to be able to predict what brands or cuisines consumers within your delivery radius desire and what gaps currently exist, and then outfit your commercial kitchen with restaurants that fulfil those gaps. Players with access to consumer data are at a huge advantage here – hence it is no surprise that Swiggy and Zomato have both set up versions shared kitchens in different avatars – the former under the Swiggy Access umbrella, and the latter under Zomato Infrastructure Services. Players like Swiggy and Zomato who own so much of the customer experience already, doubly benefit by charging brands rent to operate out of their stores, and commissions to deliver the food they make in those stores. They often also demand exclusivity in the locations where brands are operating out of their commercial kitchens.

Ancillary businesses:

Like I said earlier, I am confident that the cloud kitchen business in India is going to continue to expand rapidly over the next decade. According to RedSeer Management Consulting, the industry is slated to expand in India from $400m in 2019 to $2bn in 2024. Cloud kitchens offer a business model improvement to an industry has been desperate for change for years. The new model also comes at an opportune time – the pandemic has only accelerated the shift towards delivery and app-based ordering by Indian consumers that had already started to take hold over the past decade. The more attractive upfront economics and flexibility also means there will be no dearth of supply in restaurants using the format. Aggregators are also incentivized to promote these online-only kitchens, as barring an unlikely new entrant in the food delivery space, the majority of the order flow (and hence commission $) is going to be driven through just 2 players. As the segment grows, it will create along with it a whole set of ancillary businesses and also serve as a tailwind to existing businesses in the food service space.

Value added ingredients

I’m going to sound like I am talking my own book here given that I used to work at and continue to be closely involved with an ingredients manufacturer, but I do think the food service/food ingredients manufacturing business is poised to ride this cloud kitchen wave. The entire premise of these dark kitchens is to make your restaurant more efficient by using tighter kitchen spaces and less skilled labour to consistently prepare simpler, delivery-friendly dishes of consistent taste and quality. This is precisely the purpose that value-added ingredients serve. I am sure you’re thinking, “What do value added ingredients even mean?” In a technical sense, these are food inputs that have gone through a cycle of R&D/manufacturing/qa/testing and have been scientifically developed to consistently create great tasting food while minimizing the steps to get there. One example of a very commonly used product is a chopped onion tomato gravy base. It is a ready-to-cook product similar to a kadhai type base, that is manufactured and sold in bulk packs to the HoReCa (Hotels, Restaurants, Caterers) segment all over the country. It eliminates the need to procure your own raw materials, it reduces your dependency on raw material prices, it reduces your need for labour (think about the work that goes into chopping onions and tomatoes in bulk), while still providing a consistent base taste to your dish. As kitchens get leaner and dishes get more fined tuned specifically for delivery, these types of ingredients, which already have a major foothold in the market, will only become more prevalent.

Tech (software) – Connecting kitchen supply with demand

If clouds kitchens proliferate the way they are expected to, restaurants will need help to streamline processes and operations to make them efficient and delivery-friendly across multiple satellite locations. We will see a whole host of software solutions arise specifically geared towards the restaurant space. I recently spoke with an entrepreneur with years of experience in the food delivery space, who is building a platform to connect restaurateurs who need kitchen space to set up delivery locations (demand), with excess capacity at kitchens of existing restaurants (supply). As food delivery continues its explosive growth, both sides of the demand-supply equation will increase dramatically. This concept further reduces the friction in setting up or expanding an internet restaurant by providing a ready-to-use setup with equipment and labour. Meanwhile, for the restaurants on the platform providing the capacity, this is a way to generate extra revenue out of resources that weren’t being used anyway, and squeeze the maximum revenue per square foot that they can. For providing this service, the platform charges the renter of capacity a commission per order – the majority of this goes to the restaurant, and a portion goes to the platform.

Tech (hardware) – Automating kitchens

As the industry increasingly starts to shift to a greater mix of dark kitchens vs. storefront restaurants, they will look to optimize their kitchen space as much as possible and maximize revenue per square foot. Leaders in the industry will work quickly to make their offerings delivery friendly by not only standardizing the inputs into the food (value added ingredients), but also the processes with which to make food. Of course, the entire end-to-end process of preparing a meal, even one for delivery, can’t be automated yet. However, the idea is to eliminate or automate as much of the rote work as possible, and complement the skill of chefs with standardization and automation so they can focus on the creative portion of the work. One leading manufacturer of kitchen robotics has created an IOT-enabled deep fryer, capable of automatically frying anything from samosas to chips to fried chicken with perfect consistency based on set standards. Perhaps even more impressively, they have also created a fully automatic portable dosa machine. The future is already here.

Conclusion

This pandemic has provided an irreversible tailwind to the shift towards delivery-based food consumption that was already underway in the Indian market. The business model evolution to cloud kitchens that this shift has brought, will be a positive for the entire ecosystem:

1. Consumers stand to win as they will get access to cheaper and more diverse options of restaurants to order from

2. Aggregators will continue to process more orders on their platforms

3. New restaurant entrepreneurs’ setup and operating costs will decrease, while their flexibility and ability to pivot quickly will increase

4. Existing restaurants and brands will have a cheaper, less risky way of both expanding their distribution footprint and trying out new brands

5. Food solution providers – who supply restaurants and brands with the R&D, expertise, and ingredients to optimize their kitchens and standardize their offerings to be delivery friendly – also stand to win

6. Additionally, there will also be an entire service and technology industry that rides the tails of this growth

If I were to step back and look at the entire ecosystem from an investor’s lens, I don’t think my best shot at maximizing my returns by riding this theme would be an individual brand or restaurant group, particularly a new one. From where I sit, I just don’t see how a new brand is going to break through the existing and impending sea of competitors, differentiate themselves, and scale quickly with a realistic path towards profitability, just by using a cloud kitchen model. I am sure several players will emerge victorious, but I imagine it will be with a model or combination of models we haven’t seen just yet.

I’d rather invest in a cloud kitchen enabler than a cloud kitchen owner, as I think that’s where the next phase of growth is going to come from (and funding is going to go to!). Some of these include:

1. Food solutions providers: who supply restaurants and brands with the R&D, expertise, and ingredients to optimize their kitchens and standardize their offerings to be delivery friendly

2. Technology providers – software: there will be a whole host of problems that require solutions as restaurants continue to try to optimize, scale, and profitably operate multiple kitchens across several outlets

3. Technology providers – hardware: as restaurants work to provide consistent, high quality food, they will start to look at ways to eliminate human error, and make tedious processes more efficient. Technology providers that automate processes using hardware innovation will help plug that gap

I have barely scratched the surface on what is evolving in the cloud kitchen space with this note. I could write an entire thesis on every permutation of the core businesses that players are trying, and every solution provider that is germinating as a result of the growth in the segment. I’d love to hear all of your thoughts and feedback, and happy to have a more detailed discussion at any time.

Reach out.