The Four Horsemen of the Restaurant Apocalypse?
By: Zach Goldstein
Tags: Marketing, Loyalty, Customer Engagement, Restaurant, Delivery

So restaurants continue to pursue growth where they can readily find it, but at what long-term cost? “Annual profitability for restaurants across all segments in the US is considerably less than 10%; losing up to 30% of top line revenues is not a path to a successful future even if total sales increase by 20%,” assessed Boston University professor Christopher Muller, Ph.D., a leading academic expert in the field of restaurant management.

Everything certainly appears on track for a successful future for the delivery marketplaces themselves — the top four in the US are flush with billions of dollars in capital investment. Uber and Grubhub are already public; Doordash and Postmates are expected to join them soon. But are these rapidly-growing delivery juggernauts technology partners ushering in a new era of restaurant innovation or are they the Four Horsemen of the restaurant apocalypse (at least for restaurants as we know them)?

“Annual profitability for restaurants across all segments in the US is considerably less than 10%; losing up to 30% of top line revenues is not a path to a successful future even if total sales increase by 20%.”

The Question of Incrementality

Michelle Gauthier, CEO of NYC-based Mulberry & Vine, did the same math as Muller. “We are losing money on delivery orders, or, best-case scenario, breaking even,” she told The New Yorker last year, citing the 30% surcharge levied by the delivery giants. Her math puts her at odds with that of the delivery apps themselves.

Delivery orders show considerable downward pressure on gross margin but are still profitable if you count costs of goods sold (COGS) only and attribute none of the operating costs of running a restaurant (e.g. facilities, insurance, taxes, managers, and other overhead). Source: Wall Street Journal, “Consumers Love Food Delivery. Restaurants and Grocers Hate It,” March 9, 2019

According to the 3PD marketplaces, restaurants are already burdened with costs that do not increase at additional order volumes — overhead (including facilities, insurance, etc.) and labor (presuming the kitchen is not already operating at max throughput). Therefore, a single additional order fulfilled by a restaurant incurs food cost (generally 30–35%) but no other added spend; even after the 3PD takes 15–45% off the top, restaurants are still left with plenty of profit to justify the delivery. The argument holds up with a single order from a net-new customer — its gross profit that flows straight to the bottom line. But the numbers morph into a far less rosy picture if the transaction is instead from a customer who would have visited the restaurant (to dine-in or pickup). This potential cannibalization comes in two forms: direct and indirect.

But when considering the net operating margin of the restaurant as a whole, each delivery could be a money-losing proposition.

A 3PD order that would have come to the restaurant for that same dining occasion creates direct cannibalization. For example: a mom who would have stopped by Popeye’s (or picked up drive-thru) with her family on the way home from work, but instead ordered via a delivery app. In the case of a $40 family dinner (assuming she orders the same items), the restaurant trades $40 in revenue and a $4 profit for $30 in net revenue (after 25% delivery fee) and a $6 loss (if all other contribution costs are held constant). According to a 2017 Morgan Stanley report, 43% of delivery customers say it replaced a meal at a restaurant (up from 38% the year before). Even with a 15% price increase on the delivery passed on to consumers (on top of the $5+ in fees also charged to the consumer), Popeye’s still makes no money.

Indirect cannibalization is harder to measure, coming in the form of delivery orders which eliminates a dine-in meal at the same restaurant another time. For example: a millennial who orders Shake Shack on Wednesday with his roommates and decides to readjust the location of his date on Friday because he “just had Shake Shack on Wednesday.” Indirect cannibalization has a similarly problematic economic impact but requires far-longer to observe.

Gauthier’s experience has shown these indirect, harder to measure costs to be just as big of challenge as the 3PD fees. “On paper, delivery costs 30% per order. But that’s not taking into account the other costs of delivery,” Gauthier told me a year after her New Yorker interview. “The amount of money spent on re-sends or refunds (for missing items, spilled items, etc), the amount of time spent fielding calls about those issues or customers wondering where their order is, plus the negative reviews we get due to the deliverer, not us. It’s far more costly than most operators even realize.”

The question of incrementality is core to the raging debate over whether restaurants (in their current form) can sustain the cost of third-party marketplaces. Earlier this year, Wingstop’s CEO Charlie Morrison said he believes 80% of the chain’s delivery business to be incremental. How he arrived at that number is a little less clear, but that would be strong; most brands would need 70% of third-party orders to be truly incremental for a third-party relationship to be margin neutral. For smaller or higher-end brands with increased costs (such as Gauthier’s Mulberry & Vine) the number may be higher. But even for those making it work today, can they sustain it? And what happens once restaurants cede control of the customer and dining experience — customer lifetime value (LTV) may be even more encumbered than single-visit profit margins.

Two statistics suggest any existing incrementality is short-lived. First, “U.S. consumers spend more at restaurants as a percentage of their food dollar than any other country on earth. While that doesn’t necessarily mean that it won’t continue to increase, there are limits” (Restaurant Business). Furthermore, in-store traffic has been steadily declining in most restaurant segments for years (down 4% in the most recent TDN2K Black Box research). So where’s all this incremental spending supposed to come from — do we really believe delivery will result in consumers eating more or that’s it’s all coming at the expense of grocery?

Greg Flynn, CEO of Flynn Restaurant Group, the largest restaurant franchise company in the country, recently ran a test eliminating delivery at some of his Applebee’s locations. The results suggest delivery was already cannibalizing sales: “So far, we’re seeing our dine-in and carside-to-go business rise faster in the markets where we canceled delivery than in markets where we still maintain it,” said Flynn.

“[Online travel agencies] permanently took 10% out of the profit structure of the hotel industry as traffic came through their channel. I believe the restaurant industry is at [a similar] inflection point,” Flynn said in May. He’s right — though the impact was likely even larger.

We’ve Seen This Story Before: Hotels and Online Travel Agencies

In the early days of online travel agencies (OTAs), commissions typically averaged 5–10% and the partnership was a no-brainer way for hotels to sell excess inventory. Hotel rooms and airlines seats are perishable; an unused seat or room is meaningful lost revenue in a highly fixed-cost business so a new channel to ensure peak utilization was welcomed by the operators. But instead of being a source of supplemental income that had no impact on the core business, the ease offered by OTAs rapidly attracted consumers who wanted to avoid calls with travel agents. In recent years, not only has the share of transactions booked through OTAs risen drastically, but so too has the commission rate, now as high as (an eerily-similar) 30%.

In the early-2000s, OTAs still represented a relatively small share of industry revenue (for an unbelievably-detailed narrative of the birth and evolution of OTAs, check out Skift’s The Definitive Oral History of Online Travel). But starting in 2011, OTAs experienced a meteoric rise. Commissions captured by OTAs grew more than 50% over four years (2011–2015); hotel revenues grew at half the pace. OTAs were beginning to assert a stranglehold on the industry.

By 2015, the top four OTAs — Priceline, Expedia, Orbitz, and Travelocity — controlled 95% of the online travel market, each with multi-billion dollar valuations. The first iteration of the Four Horsemen, perhaps? Today, Expedia owns Orbitz and Travelocity; Priceline is under the Booking Holdings umbrella which also includes Kayak (and OpenTable) among others. Two Mega Horsemen. The consolidation only further strengthened their negotiating leverage with hotels and airlines. By most estimates, OTAs now control 40–70% of all hotel bookings in the US. Bookings Holdings and Expedia Group combined for more than $25B in revenue in 2018 and are collectively worth more than $100B. Marriott, the world’s largest hotel chain, is worth just over $40B at time of publication. This follows so-called Aggregation Theory which describes how platforms “come to dominate the industries in which they compete in a systematic and predictable way” (Ben Thompson of Stratechery).

As their growth accelerated, the leading OTAs began to more aggressively court consumers, including through direct online advertising. “The concept promoted by the OTAs called the ‘billboard effect’ claimed the visibility given to hotels by listing with OTAs resulted in many more [direct to hotel website] bookings,” according to 2016 Kalibri Labs study “Demystifying the Digital Marketplace”. “The study indicates, unequivocally, this ‘billboard effect’ does not exist and it appears that the multibillion-dollar marketing spend by the OTAs has benefited the OTAs at the direct expense of [hotels].”

Not to skip ahead in our story, but the parallels are obvious with Grubhub’s hijacking of search engine advertising for restaurants (e.g. buying ads against a restaurant’s name which show up above the search results in Google), building Grubhub-owned websites that compete with a restaurant’s own site in those rankings (New Food Economy), charging for non-delivery phone calls (NY Post) and recently conspiring with Yelp to expand on that practice (Vice).

The same Kalibri Labs report (2015, 2016) showed from 2014–2016, while guest-paid revenue grew 4–8% year-over-year, hotels themselves captured ~0.5% less of the net revenue (~$600M and $730M in lost net operating income each year). “This additional cost reduced the asset value of the overall hotel industry by at least $7.5B [in 2015 and $9B in 2016],” the report concluded; a major economic redistribution.

It follows logically from Aggregation Theory that industries with greater supplier fragmentation (e.g. more suppliers to be aggregated by a platform) experience more severe disaggregation. And so it was with OTAs. While online bookings spread rapidly through both the airline and hotel industries, the impact was not as severe for airlines; the top four airlines in the country (Southwest, Delta, American, United) control nearly two-thirds of the North American market, according to 2018 data released by Upgraded Points. The top-10 own 89% market share. As a result, airlines are able to drive nearly 70% of bookings through direct channels (largely as a result of their investment in loyalty programs that drive repeat purchasing), a mirror image of the ratio in the hotel industry where there is a far greater diversity of options and operators. Restaurants face even more extreme supplier fragmentation. In fact, this concentration in the airline industry allowed them to more actively fight back, launching a joint venture in 1999 — Orbitz.com — an airline controlled OTA to combat the risk of disaggregation from third-parties.

Announcement of Orbitz.com, a joint venture of leading US airlines.

The rapid expansion of OTA market share from 2010–2015 had meaningfully slowed by 2017… 20 years after the launch of the first OTA (see chart at bottom of this section). The impact was already severe but hotels were ready to start fighting back.

In 2016, many major hotel chains spent hundreds of millions on marketing campaigns encouraging customers to join their loyalty programs and “Book Direct.” Major hotels had invested meaningfully in loyalty incentives and modern booking experiences on their websites (“owned” channels). Hilton’s “‘Stop Clicking Around’ campaign contributed to a 60% increase in HHonors enrollments and a shift toward direct channels in the third quarter of 2016” (McKinsey).

Marriott started promoting “Book Direct” in 2016.

The investments paid off as the period from 2016 to 2018 saw the exact opposite trend of the previous five years: “The increase for [direct to hotel booking] is 50% more rooms sold per month on average compared to OTA rooms sold per month during the same period,” (Kalibri “Book Direct Campaigns 2.0”). Furthermore, loyalty member direct bookings were able to drive a 9% price premium to OTA bookings, in large part due to upsell opportunities in the owned booking experience (in spite of most hotels guaranteeing lowest prices on their sites). Many analysts believe the industry has stabilized and a new equilibrium reached; but the impact of OTAs was permanent and had significant knock-on effects.

As the expected return on invested capital in the hotel industry declined in the face of decreasing profitability, hotels built fewer new rooms. Some analysts believe this under-investment in additional supply was instrumental in creating the opportunity for AirBNB to grow rapidly and become a massive new threat to hotels — recent estimates by Morningstar Equity Research suggest AirBNB could be worth $53 to 65B, making it far larger than Marriott.