Ghost Kitchens Could Soon Displace 50% of Restaurant Volume. Here’s Why

Albert Einstein famously said that compound interest is the most powerful force in the universe. Einstein even likened it to the 8th wonder of the world. That’s great news if you’re an investor.

But maybe not so much if you’re a restaurant.

That’s because the industry is going through a fundamental crisis that nobody seems to appreciate. In a nut shell food consumption is moving off-premises (i.e. the percent of food consumed inside a restaurant’s four walls is shrinking, and quickly). Third party ordering and delivery companies (3PD) have been the necessary catalyst to demonstrate just how overbuilt the US restaurant market is, and how little consumers actually care to partake in “the restaurant experience.”

We’ll start by examining the inarguable trend of off-premises dining. Then we’ll use two examples to discuss the speed at which this industry transformation might actually happen. Lastly we’ll close with our perspective for why this shift is happening and what we expect the foodservice industry to look like in the (maybe near) future.

The Inarguable Trend of Off-Premise Dining

Let’s look at the numbers. Third party delivery is growing at an alarming 43% CAGR (compound annual growth rate) according to Thanx, who probably has the best handle on the market across all the published data we’ve seen. While it’s estimated that online ordering/delivery from third parties represent roughly $10B of restaurant sales today, at its current rate of growth third party delivery could represent over $100B in restaurant sales by 2025.

The US restaurant industry grows at around 3% annually. After accounting for inflation growth is pretty much flat – maybe 1% in real terms. At this rate by 2025 one could expect the industry to be on pace to hit over $1T of sales. Some quick math tells us that third party delivery could be 10% of industry volume at that juncture.

But this could be the base case. What do we mean? Well, we’re only counting the off-premises orders emanating from a third party delivery marketplace. According to a report by William Blair:

$400B, or 55% of restaurant spend will be off-premises by 2022, and it doesn’t look to be slowing down. See the below chart.

Despite the shock, this number is actually lower than other studies. The William Blair report was published in 2018. Now we’re in 2019 and have the benefit of an additional year of data. Granted the methodologies may be a bit different, but here’s a 2019 study from Technomic conducted for the National Restaurant Association which shows that 60% of restaurant orders are already off-premises. If we apply William Blair’s CAGR of 10% to the Technomic numbers we calculate that 80% of restaurant orders will be off premises by 2022.

Yowsers.

Some ghost kitchen startups, like Cloud Kitchens, believe the entire off-premises volume could or will shift to delivery. There are some assumptions around regulation and economics (i.e. regulators don’t kill the economics or there’s a large leap in autonomous driving that makes delivery really cheap relative to today’s costs) but it’s a pretty bold statement. We would agree with the sentiment: if delivery were cheap enough why wouldn’t (nearly) all off-premises dining be delivery? It would save you from having to leave your house (or wherever you’re ordering from).

Either way a large increase in off-premises dining means the fundamental business model of the conventional restaurant starts to break down rapidly. But how fast might it actually happen? If we can believe the Technomic numbers, is the 10% CAGR a realistic growth rate? It deserves further analysis.

How Fast Does A Snowball Roll?

It’s easy to get caught up in the rapid rise of the shift to off-premises and think the world is ending. Maybe it is…. but maybe it isn’t. This is the problem with prognostications: people only pay attention when you’re right; we often forget all the predictions that never came to pass.

We thought to highlight two examples that help will help us wrap a time range around monumental shifts of the past. Make no mistake about it: the rise of delivery is a change as fundamental to the business of dining as was the discovery of petroleum, which is where we’ll turn next.

In the 1800’s whaling was the breadwinner of our energy needs. From the whale blubber came oil, which many global denizens used to power lamps in their homes. At peak whaling, which is estimated to have been 1858, the US owned between 200 and 640 whaling ships (accounts vary). Within 50 years whaling collapsed by 90% and petroleum was our new energy love affair, as is made clear in the below graphic.

Americans first drilled oil in 1859, but in 1848 a clever Canadian discovered how to refine kerosene from bituminous tar and was beginning to test his products in American markets. Regardless, let’s just say a refined petrochemical substitute for whale oil first hit the US markets by the mid 1850’s with the floodgates opening in the early 1860’s (because petroleum still needed to be refined and distributed before it could become a mainstream product). Petroleum surpassed whale oil by the mid 1870’s, roughly 15 years after its “first” introduction.

Now we’ll turn to our next example which might be a little closer to home.

The drive through was invented by In-n-Out in 1948 (though the claim is not without debate). Adoption of the drive through was accelerated by two trends: car ownership and the proliferation of our national interstate system, neither of which was an overnight phenomena. It’s why Taco Bell operated without a drive through until 1967, Wendy’s until 1971, and McDonald’s and Burger King until 1975. Ironically Jack in the Box opened stores as drive through-only operations starting in 1951.

McDonald’s might have hit the timing just right. A few months after opening its first drive through, McDonald’s opened its second one and sales jumped 40 percent in just two months. By the end of 1979, ~2,700 of the nearly 5,000 US McDonald’s restaurants had drive throughs, according to restaurant spokesperson Lisa McComb. Drive throughs are

Now, of course, the success of the drive through looks obvious. Today, most QSRs experience far greater than half their sales coming from the drive through. McDonald’s realizes 70% of their sales from the drive through and some brands view drive throughs as their only areas of growth opportunity.

We tried getting a visual but none of the usual outlets were tracking off-premises or drive through data in the 1960’s. NPD has the closest bit of data that coincidentally reaffirmed an article we wrote long ago (i.e. restaurant traffic wasn’t growing but restaurant sales were up in dollar amounts because restaurants were just increasing prices).

Total customer traffic at commercial restaurants hasn’t grown in 14 quarters (with the exception of January, February, and March of 2019), with no growth expected through the end of 2020. More people are eating at home, 80% of annual main meals are sourced from home, and 20% are purchased away from home (in both restaurants and general foodservice).

Per NPD, delivery represents about three percent of all restaurant visits (orders) whereas carry out represents 45%. On-premises represents 32% of orders and drive through the other 20%. Interestingly digital carry out orders are growing faster than delivery orders.

That said, even all these QSR’s still pay for front of house operations and those costs add up. Larger footprints with parking lots and dining rooms. Front of house staff. Consumer-facing technology (like multiple POS registers and kiosks) and even the basics like table and chairs cost money. What if a location had, let’s say, 100% of off-premises consumption? What changes then?

The Future of Foodservice?

We’ve seen that there are already strong market forces at work; off-premises dining is growing rapidly, though we could debate the speed and ceiling of such a shift. We’ve also seen that industry-redefining trends can happen relatively quickly, with 10-15 years being a realistic range of time even in capital intensive industries like foodservice.

What we need to next examine are the economics of such a shift. For example, if 30% of your customers prefer off-premises dining, what needs to change at your existing business? And what modifications are necessary when even more of your business moves off-premises? Do the same bandaids work when 50%+ of your customers don’t care to visit your business in-person?

One could look to Panera as the most tangible example of the off-premises remodel. In all it cost Panera $120M over three years to redesign stores to accommodate the rise in off-premises dining. We did some math to break down these costs, and Panera probably overspent by 100%.

But Panera still counts nearly 40% of its store traffic as on-premises so they need a front of house. Next we’ll turn to the far extreme of the ghost kitchen to see what financial benefits might be had if an operator eschews the on-premises business altogether.

According to a Cowen report, the cost to build a ghost kitchen facility is $3-5M and with that you get 10,000 square feet. This facility houses 12-15 different kitchens and thus different 12-15 tenants, with 650 to 850 square feet per tenant. Ghost kitchen providers, like Kitchen United, charge tenants a monthly fee and aim to earn a 20% margin, paying back the total upfront cost of development in 2.5-4 years.

Taking the worst case/most aggressive cost situation ($5M build cost with only 12 tenants and a payback of 2.5 years) means a monthly rent of $13,900. We can go ahead and add a 20% margin in here for the ghost kitchen operators which gets us to $16,700, but the margin may already be included in the $13,900 figure. The other end of the spectrum ($3M build cost, 15 tenants, 4-year payback with 20% margins) is a monthly cost of $5,000, so it’s pretty big difference – more than 3x.

A survey of 722 restaurants found that the average restaurant had a kitchen with a little over 1,000 square feet of space. From the same survey:

The average kitchen size is 30 percent of the total square footage of the restaurant, reports food-service consultant Chuck Currie. In fast-food or other quick-service restaurants, which range in overall size from 1,375 to 4,250 square feet, the lion’s share of space is devoted to kitchen and storage areas. Seating space typically makes up less than 45 percent of the total area. In full-service restaurants, a 60-40 ratio is sometimes quoted as a starting baseline for divvying up space, with 60 percent devoted to the front of the house and 40 to kitchen, storage and prep areas.

https://yourbusiness.azcentral.com/national-average-size-restaurant-kitchen-29446.html

It’s a fair assessment to say that the 800-square feet of space provided in a ghost kitchen is comparable to a full kitchen in a traditional restaurant. In other words, an 800-square foot ghost kitchen could put out enough product to achieve revenues of several million a year.

If we can agree that the productivity is the same we can do a one-to-one cost analysis in comparing the startup costs of the two. Let us begin with a rough bottoms-up analysis where we break out costs into major categories.

1. Rent

We’re going to assume your restaurant would need to be at least 3x the size of the 800 square foot ghost kitchen – so 2,400 square feet. You can really get crazy with numbers based on location, but a quick search for a moderately priced city – Dallas – shows monthly rents of $3 per square foot. That’s $7,200 per month.

2. Kitchen Appliances

Another large expense are kitchen and bar appliances. A study showed the average expenditure here was $115,000. We can round this down to $100,000 to keep the math simple. Assume the average restaurant is solvent for 30 months and it’s a monthly cost of $3,300.

3. Furnishing/Decoration

If you have a front of house you also need tables, chairs, flatware, dishware, and customer-facing technologies like multiple POS registers, kiosks, pay-at-the-table devices, and more. For large restaurants this can really add up. Let’s go ahead and put a flat amount of $30,000 on this for easy math; over 30 months that’s $1,000 per month.

4. Miscellaneous

We’re not going to add any dollar values to this category, but we want to point out that things like utilities, insurance, and administrative costs can be higher for restaurants with larger footprints.

Our lazy-man math gets us to the follow expenditures table.

The biggest variability in these numbers will be the rent. In some more populous metro areas the rent will be 5x as much, which would make traditional restaurants look really expensive by comparison.

The next area of scrutiny would be labor, since it’s a huge component of the business. When you eliminate the front of house, you eliminate a lot of the labor complexity. Not only do you have fewer employees to pay, but you also simplify the operations of the business dramatically. Obamacare employer mandates, predictive scheduling, and other regulatory hardships get much easier. And there’s also the benefit of cashless payments – i.e. no direct cash theft.

Traditional restaurants run labor in the 30% of sales area while ghost kitchen operators are reporting that their labor is under 20% of sales. Kitchen United has echoed similar claims by stating that their tenants are achieving EBITDA margins of 18-26%, which are up to 5x those of traditional restaurants. Of course to achieve this the ghost kitchen operators would need to mark up their fare to cover 3PD commissions.

If it’s not already becoming clear, ghost kitchens offer an operating model with superior economics if you believe the future of dining skews heavily towards off-premises consumption and if you believe delivery is the viable distribution engine to move food off-premises. And it’s how ghost kitchen providers are pitching the story to investors – the below slides from a ghost kitchen’s pitch deck.

The people that think ghost kitchens are just a fad are dangerously wrong. Here’s why we think the shift to ghost kitchens will accelerate over the next decade.

First, delivery is proving without a doubt that “the restaurant experience” doesn’t matter. In fact consumers care so little for it the most amount of effort they’re willing to put in is a few lazy clicks on a third party delivery site. And if you’re not there, well, here’s to any one of the other 100 substitutes. Literally every off-premises order is a free market vote that the customer would prefer not to visit your establishment. Delivery only furthers to surface this customer behavior since it provides a relatively economic alternative from visiting a restaurant.

Second, the costs to start and operate a ghost kitchen appear so superior that investors will quickly discover that ghost kitchens offer the highest chance at returns. Let’s look at this math for an example. Assume a current restaurant has profit margin of 5%, which is actually quite good. The ghost kitchen model puts restaurant economics on steroids:

• Revenues/margins increase by 3-8% by eliminating cash shrinkage
• Margins increase by eliminating front of house staff and associated complexity
• Better use of transaction data allows for accurate demand forecasting and menu predictions. Expect 5% margin efficiencies here
• Increase revenue another 5-10% through smart pricing using clustering algorithms. Kiosks already prove a 20% increase to average check and an online order is a mobile kiosk
• Better customer data yields better promotional lift, probably worth another 5% of sales
• Cheaper real estate with smaller footprint and less desirable locations

The ghost kitchen, by definition, needs delivery to survive, but if you’re betting on this trend it is clearly the preferred operating model. And since the restaurant market is overbuilt, those investors who get in first will likely benefit the most: the economic benefits of being a first mover disappear as the rest of the market matures. Expect the first successful outcomes to greatly accelerate the investment in ghost kitchens over the next decade.

Third, people don’t seem to be that concerned with quality if it’s “good enough”. Look at the growth of franchise models that offer relatively low quality food; have you ever heard someone say they love Dominos or Pizza Hut products? That they’re better than the local pizza joint down the street? Yet each of those brands racks up billions in annual sales. If companies can replicate their products across global franchisees then the product can surely survive the move to a ghost kitchen.

Lastly, the ghost kitchen model benefits business people more than it benefits artists. That’s because you’re really talking about ghost kitchens as a way to lower the cost of experimentation. And when you’re talking about experimentation you’re talking about speed of iteration based upon data analysis, and those are things that restaurants have struggled with under a heavy CAPEX model that drove away sophisticated talent. Here’s a guy who literally sold frozen DiGorno pizza on UberEats. Barriers to entry, what?

The term “cloud” kitchen is a bit of a misnomer but we could understand the analogy people are really getting after: the cost to start and operate a restaurant drops precipitously, democratizing the foodservice industry and ultimately benefitting those who are superior operators. This was the same trend that disproportionally benefitted software when companies like Amazon democratized access to cloud computing, no longer requiring businesses to stand up (and support) their own server farms and IT infrastructure.

Which is why, as we’ve said, we think the natural evolution of the ghost kitchen is a verticalization by the 3PDs themselves. DoorDash burger, Uber Ramen, Grubhub burrito – it’s coming. These companies are built on a data culture and if they can reach 80/20 in food quality (which is not that hard per the above franchise analogy) they’re going to gobble up the market over the next 10-15 years, and with it the entire ecosystem around the foodservice industry. Think about it: food and beverage distributors, analytics, inventory, labor scheduling, POS, ordering, payroll and compliance – all will be brought in-house as the 3PDs verticalize.

It’s not all doom and gloom. Just like Amazon didn’t kill retail, ghost kitchens won’t kill the restaurant industry. At least not entirely. But some categories will fare better than others.

First, white table cloth “experience” restaurants are pretty well insulated. Need to impress a date, celebrate an occasion, or consume something that only tastes great straight out of the kitchen? Fine dining is your huckleberry.

Second, bars and nightclubs are probably okay. Single people want to get out and be seen as this increases their chances of mating (biology works, though Tinder is reinventing social norms). Plus nobody really cares for the food at a bar or nightclub anyway – at least not without throwing back a few drinks first.

Third, until transportation changes dramatically QSR eateries on the sides of highways will still see drive through traffic. People need bathroom breaks and don’t always want to eat in the car, especially when traveling with children.

But the industry needs to be prepared for the ghost kitchen world and what that means for their existing lines of business. The compounding math just makes too much sense to ignore.