Feeding The Rebels
By: Jeremy Diamond
Tags: Food, Business Strategy, Delivery, Restaurant, Business

One path is exemplified by CloudKitchens. At its core, CloudKitchens is simple: Build commercial kitchen spaces in less-trafficked areas and rent them out to operators to run delivery-only food businesses. Add some additional services, enable inventory pooling through bulk purchasing shared across all tenants, and you have a solid business model.

Ever since the CloudKitchens concept first started floating around the startup world, it’s been a subject of fascination — due more to the presence of Travis Kalanick than anything else. If you take them at their word that this is a real estate play, it’s… well, it’s just okay. It’s a nice business with a real point of view on what a delivery-centric future should look like and a go-to-market strategy to match.

This month, however, CloudKitchens took the wraps off some new branding for “Internet Food Court.” Then they tried to put the wraps back on because that launch was an accident. Even though they already have a physical storefront operating with that same branding. (Who among us has not taken $400 million from people who are beholden to an actual murderer and then botched the rollout?)

Whatever happened, Internet Food Court does not look like your standard commercial kitchen space-for-rent real estate play. This looks like a consumer brand.

Per a report by HNGRY, Internet Food Court represents two new steps for CloudKitchens.

They’re building an umbrella brand that encompasses pre-existing third party food brands like Charcootz, LA Breakfast Club and B*tch Don’t Grill My Cheese as well as many more new CloudKitchens-only “facility brands” According to their analysis of a new permit granted by the City of Los Angeles, CloudKitchens is going to roll out its own delivery service to compete against the existing apps

CloudKitchens wants to integrate every step in the value chain from raw ingredient delivery to marketing to assembly to delivery.

A vertically-integrated, multi-cuisine, direct-to-consumer food production and delivery service is not entirely new — Rebel Foods, Zomato, Swiggy, and Kitopi have all built versions of this in India with results that, for restaurants and the delivery apps alike, seem uncertain at best and evoke the Groupon era at worst — but it is relatively new to the U.S. The Internet Food Court model deserves more analysis in the American context. And when you take a closer look, some major flaws emerge.

Let’s take a look at the Five Forces-style interplay between end customers, existing delivery apps, their restaurant suppliers, and substitutes who don’t compete on the same terms as the delivery apps.

Start from the customer perspective: If a customer has installed your delivery app, there’s a pretty good chance they’ve also installed a competitor’s app. The average restaurant is on multiple apps because they want to be wherever their end customer is. That gives the apps power over restaurants. But the customer has the ultimate power because it costs them nothing to switch between the apps. It also costs customers relatively little to go outside the apps to fulfill their need for convenient food in some other way. This is why delivery apps are constantly running discounts, credits, and other expensive marketing campaigns to reacquire customers who have churned out. This is why we see unsustainable economics for suppliers as the apps continue to put pressure on the only real lever they have.

Internet Food Court actually sidesteps the supplier economics problem in a clever way by bundling in-house supply with in-house production for external brands. And they’re likely betting that exclusive supply will translate to more repeat business and lower customer acquisition cost. In other words, they’re betting that they can build loyalty.

Yet two problems remain: the new entrant problem and the substitute problem.

The new entrant problem: If this model successfully removes or abstracts all of the factors that differentiate a food business in favor of distribution with a dash of branding, then this inevitably becomes a capital-raising game between new entrants running competing platforms with the same model. And sure, Travis Kalanick almost won the entire American ridehailing market playing that game (with emphasis on “almost”).

But there’s no defensible network effect here. Internet Food Court will never have a monopoly on supply — the brands that really pull their weight will have outsized power and value and CloudKitchens won’t be able to keep them from competitors indefinitely. There’s no way to build a dominant position, which means they’ll have the same churn and reacquisition problem whether they’re competing against new competitors with equivalent models or existing delivery aggregators.

The substitute problem: Even if CloudKitchens somehow outlasts every other delivery app and every opposing ghost kitchen and owns the supply side, they can never lock in demand (and never exercise any kind of pricing power) because they still have to compete against every other food option. Restaurants that leverage proximity to the customer (i.e. real estate) or an experience-led brand (i.e. differentiated labor) are playing a different game that has been demonstrated to be sustainable long-term. It’s a game based on repeat business and loyalty within a community.

It’s the humble family-owned diner leveraging its fixed costs by building a presence in the community and compounding that investment over time. Leveraging fixed costs is one of the best ways to build a sustainable business. For example, paying for a popular retail footprint is not wasteful on its own terms; it is an investment that allows a business to acquire and retain customers based on proximity.

CloudKitchens is trying to win a similar game by bundling brands together. But their cost structure isn’t optimized to win this game. It’s optimized for winning in a delivery app world where the only channel to the customer is the phone. The delivery game isn’t about customer lifetime value and retention. It’s about customer acquisition cost in the context of performance marketing: a variable expense optimized within an inch of its life to drive almost every single order and constantly reacquire customers.

CloudKitchens can raise unprecedented amounts of capital and still not outlast the brick-and-mortar restaurant industry. And that matters because they’re always competing with every restaurant, not just engaging in a head-to-head with your local favorite. No amount of performance marketing will ever kill off this threat.

Not in the normal course of business, anyway.

But we are not in the normal course of business now. A lot of those substitutes and local favorites are going to close permanently due to coronavirus. And one school of thought suggests the CloudKitchens model will benefit enormously: When people aren’t spending any significant time out in their communities or traveling to restaurants, it’s tempting to bet on the business that is optimizing for a world where those things matter much less.