Many more miles to go for food delivery

Many more miles to go for food delivery

The global online food delivery market has grown at an impressive 80% per year since 2018. However, despite rapid growth it is still regarded as an emerging market, with online food delivery accounting for less than 10% of the total food service market (charted below).

Market growth has been spurred on by the obvious convenience of ordering takeout, where the wide range of choice and improved price transparency has resulted in a customer experience far superior to the traditional call-and-collect way of ordering takeout. As geographic coverage expands and broad consumer awareness increases, so the market continues to grow.

The food delivery model is also highly attractive for the restaurant industry, which typically does not have the scale, financial resources, digital marketing capabilities or technical expertise to generate online demand as efficiently as the leading food delivery players.

This large growth opportunity has attracted significant investor capital in recent years, which has resulted in a rapid rise in competition. However, most food delivery platforms are currently loss-making and the ongoing battle to attract customers adds significant uncertainty to the potential evolution of profitability for the sector.

The global online food delivery landscape
While competition is fierce, regional markets tend to be dominated by only a small number of firms, with Uber Eats arguably the only true global player. As illustrated below, North America is dominated by Door Dash, Grub Hub and Uber Eats. In Europe, Delivery Hero and Uber Eats lead the pack, while Just Eat Takeaway commands an impressive 50% share of the UK market. Emerging market food delivery companies hold strong positions in their respective markets, including IFood in Brazil, Swiggy and Zomato in India, Food Panda, Go-Jek and Grab in Asia (ex-China). China, however, accounts for a massive 55% share of this market, where Meituan and Ele.me dominate, together commanding around 98% share. With over 500 million users at present, Meituan is the only profitable food delivery player in the world, as it benefits from unmatched scale and several unique market factors including lower customer subsidies, low incentives for drivers and relatively high urban density.

The food delivery model
While food delivery is a global business, local market factors evidently affect long-term success and profitability. Like other platform businesses, competitive advantages are established through valuable local network effects: as more customers join a platform, orders increase; growing demand attracts new restaurants that in turn benefit from increased volume; and greater volume and network density provides more earnings opportunities for delivery partners – encouraging more efficient and timely delivery. As a result of a wider choice and a more efficient and reliable delivery network, customers order more frequently and for a broader range of occasions, establishing a virtuous circle that is continuously reinforced to the benefit of all participants within the network.

There are currently two prevalent business models in the online food delivery industry:
• A marketplace or third party (3P) model is capital light and structured so that the food delivery platform acts as the agent – charging a fee for bringing together buyer and seller. This model is well established with gross margins typically in the 55-65% range.
• The first party (1P) model has evolved from the original marketplace model, whereby the delivery platform also provides delivery services for an additional fee. This enables platforms to include many more restaurants and to better control the quality of delivery – directly impacting the user experience.

All food delivery companies are now shifting to a 1P model, however this comes with significantly higher capital investment, which materially changes the underlying economics of the business model.

Unpacking the economics
Food delivery platforms generate revenue mostly by charging commission on the order value. Industry commissions (take rates) currently sit at 25-30%, which we believe cannot be raised much more over time as commission is already very high in the context of the gross profit margin for independent restaurants (estimated to be 60-70%).

Key expenses in the fulfilment of an order include customer acquisition costs (vouchers or discounts on meals) and marketing, delivery and payment costs (related to completing the transaction). We estimate most food delivery platforms outside of China are loss making before even accounting for indirect costs (ie operational overheads, central marketing and funding). See chart below.

Ideally, the platform will scale over time, generating much higher revenue at only a small incremental increase in costs. However, it is problematic that a large proportion of costs are variable and will, therefore, grow as the volume of orders increase. Delivery fees remain a primary fixed cost item, but it is unclear whether this can be sufficiently reduced with scale, given the point-to-point nature of the delivery service that is generally quite inefficient. For example, a typical food delivery driver travels the same route several times a day, utilisation of the delivery network is low outside of mealtimes and the small size of the vehicles used places a limit on the number of orders that can be delivered per trip.

Generating sufficient fixed cost leverage is challenging and large global delivery/logistics companies eke out very slim margins despite achieving significant efficiency from well-established hub and spoke delivery models1.

1These models avoid route duplication and allow for optimal scheduling/efficient transit routing and high asset utilisation.

Long-term success factors
Due to the hyperlocal nature of food delivery models, there are often several market specific factors that can have a large impact on profitability. Tipping culture, customer price elasticity to delivery fees, traffic congestion and weather are just a few examples of these. Common factors that we believe are critical to long-term success include:
Demographics and urban density: Urban density is a key driver of profitability and the economics of delivery is likely to be better in countries where a significant proportion of the population reside in a few large cities or close together.
Low competitive intensity: The cost of acquiring new customers is lower in less competitive markets as less marketing spend is required to attract new customers and keep existing customers on the platform. Scale is not as costly to achieve as the pool of potential customers are divided between fewer players. Furthermore, better scale leads to improved pricing power (ie higher commission rates) and thus, better economics.
Flexible labour laws: Ridesharing and food delivery business models have become heavily reliant on the so-called “gig economy”, referring to the trend of hiring contractors, freelancers, contingent workers and other similar roles instead of traditional full-time workers. This benefits fast growing companies through lower labour costs and increased labour flexibility. Delivery models are more likely to succeed where labour laws remain flexible but there is a growing risk that governments and regulators will intervene to ensure workers are better protected and receive equivalent benefits to permanent staff.

Evolving models encourage novel thinking
The recent introduction of “dark kitchens” is evidence that food delivery models are evolving and they are a small but growing addition to many delivery business models. Dark kitchens are fully equipped commercial kitchens created solely with the aim of fulfilling online delivery service orders. They are often built using prefabricated structures or shipping containers, which are quick to set up and allow food delivery companies to easily grow supply in under-served areas with good demand. Delivery platforms are adept at capturing user data and the use of algorithms enable them to accurately match newly created supply to current customer demand.

The online delivery platform often incurs the upfront cost of setting up these kitchen facilities and, typically, multiple restaurants operate out of a single dark kitchen, with each restaurant employing its own staff and managing its own operating costs (generally far lower than a traditional restaurant). This allows for lower meal prices, in turn improving affordability and further stimulating demand.

Possibly a long road ahead
While the potential growth opportunity for online food delivery platforms is exciting, we remain cautious given the uncertainty around the longer-term profit evolution of 1P food delivery business models. In our view, profitability is likely to vary significantly by market due to the impact of unique factors on the overall economics of delivery. Additionally, given the nascent stage of these business models, investors should be prepared for many years of material investment ahead. Our clients have exposure to these businesses via our Prosus and Naspers holdings.

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