Meal kit providers, kitchen-only restaurants and other industry disruptors change the face of foodservice.

As the overall foodservice industry continues to generate single-digit growth rates, one segment — consumer-direct operations — continues to outpace the competition by a significant margin.

Consumer-direct operations include delivery-only restaurants, third-party delivery companies, meal kit providers and more. Experts report consumer-direct operations continue to experience double-digit growth. “We’re seeing growth in this channel of between 30 percent and 40 percent annually, with 2017 sales totaling $5.2 billion,” says Erik Thoresen, principal at Chicago-based Technomic. “Delivery-only, or ghost kitchens, are still a relatively small part of the market at $150 million, while meal kits surpassed $2 billion in sales last year.”

Kitchen-only Conundrum

With more than 400 brick-and-mortar locations, the Chicago-based Potbelly sandwich chain entered the kitchen-only segment back in May of 2010 to support its catering and delivery programs.

“We have such a density of locations in the Chicago area, it made sense to go this route rather than provide delivery directly from our downtown locations,” says Chris Birkinshaw, Potbelly’s director of franchising.

Food quality and brand integrity are key factors in the consumer direct segment.Kitchen-only sites allow Potbelly to design production areas for efficiency in the catering and delivery portion of its business, without the need to factor in pedestrian traffic. That proved so successful that Potbelly expanded the idea into the basement of an existing New York City location, as well as one in northern Virginia. Another kitchen-only location will open in Frisco, Texas, this year.

“Our model so far has been to open these catering facilities in major media markets that have additional opportunities for catering and delivery,” says Birkinshaw. “This way, we can take some pressure off our traditional restaurants.”

Kitchen design in catering-only facilities becomes more ergonomic since, unlike traditional locations, there is no need to accommodate space for face-to-face customer interaction. Instead, the layout centers around the operational needs of the space, which includes dedicated staging areas for rapid meal pickup.

“From an equipment standpoint, we’re able to combine spaces for a better delivery-only model,” says Birkinshaw. “Instead of a front line to take care of customers and a back line for catering and delivery, we can have a full team working off one equipment line in kitchen-only operations.”

Although Potbelly currently uses this concept as a supplement to current locations, Birkinshaw sees growth in the delivery component.

It’s difficult to dismiss the benefits of kitchen-only restaurants, which include less overhead and the potential to draw customers from a wider area. However, the segment is still relatively new, which means some growing pains. “There’s no doubt the market is undergoing an early life crisis, as it has been very challenging with high customer acquisition costs and financial performance that has not met expectations,” says Bob Goldin, co-founder and partner at Pentallect, a Chicago-based food industry consulting firm. “Still, we’re optimistic about the growth of kitchen-only businesses, as it makes a lot of sense for those heavily oriented toward delivery [to go this route].”

Though delivery comprises just 3 percent of restaurant ‘visits’, according to Port Washington, N.Y.-based NPD Group, it continues to grow at double-digit rates. “This is due to third-party providers,” says Bonnie Riggs, director and industry analyst at NPD Group. “The need for meal convenience started with Baby Boomer women entering the labor force, then it waned a bit, but now it’s back up with Millennial moms and convenient mobile apps that can be used for ordering food.”

Meal Kit Potential

Like kitchen-only restaurants, the meal kit market continues to show great potential. “Customized meal kits are about a $2 billion market now and will grow to $6 billion in the next five years,” says Goldin.

One of the leaders in the space is Germany-based HelloFresh, which launched in 2012 and provides recipes and ingredients by mail. It works with a network of hundreds of suppliers in categories that include produce, poultry, beef, seafood, dairy, grocery and packaging. The company also works directly with growers and packs and ships its product from distribution centers in New Jersey, Texas and California.

The majority of the ingredients, such as sauces, spice blends, pasta and protein, are HelloFresh private label items. Because HelloFresh sources mainly pre-prepped ingredients, the company does not use a kitchen.

“Our unique business model and proprietary technology platform makes HelloFresh fundamentally different than any grocer or retail platform,” says Uwe Voss, COO of HelloFresh U.S. “We use algorithms that enable us to constantly learn and improve. This feedback loop allows us to learn from new data and helps our culinary team create more menu options and globally inspired recipes tailored for our customers.”

The company adapts its product offerings based on customer feedback, while also taking into account seasonality, sourcing conditions and customer taste profiles.

“The industry overall is very underpenetrated and ripe for future opportunities to grow and expand,” says Voss. “On the operations side, we see a trend toward greater sustainability. Moreover, our business model significantly eliminates food waste, and any excess ingredients we have are donated to food banks on a weekly basis within the communities where our distribution centers are located.”

The success of meal kit companies like HelloFresh and Blue Apron have helped raise the profile of the meal kit category in recent years. “The meal kit concept is morphing rapidly and getting a lot of traction,” says Barry Friends, a foodservice distribution executive and consultant at Pentallect. “There are many business models [in this segment] and some will consolidate.”

Companies will become more localized, Friends predicts, allowing meal kit shipping from closer proximities. This will not only result in quicker deliveries, but also lower costs and potentially improved quality.

“Time and logistics are key,” says Friends. “Our proprietary research shows people love these programs, and there is a genuine market for meal kits, even though there is a fair amount of work involved with preparation at home.” Many predict supermarkets will become more of a major player in the meal kit market, which will change the dynamic and grow the category.

“Our perspective on the market is driven by the success of major meal kit players, but each is slightly different in terms of marketing and distribution,” says Technomic’s Thoresen.

The Roadblocks

Experts agree that consumer-direct operations deal with a host of challenges. For delivery-only or ghost restaurants, the cost of labor is one of the biggest issues.

“The cost of hourly wages for delivery workers has more than doubled since 2013,” says Peter Schatzberg of Green Summit, a New-York based kitchen-only concept. “Increases in minimum wage and delivery minimum wage became a hurdle for us the last couple of years we were in business.”

To overcome this issue, chains are partnering with third-party delivery services, such as Grubhub and DoorDash, to justify the costs and sidestep labor issues. However, this comes with its own set of risks that can impede food quality and, in the process, sully the restaurant’s brand.

“The virtual restaurant side of the business is where we’ve seen really big companies, like Sprig and Maple, go out of business,” says Thoresen. “The struggles were mainly with growth planning and expansion strategy. With consumer-direct operations, there also are more unknowns and bigger bets placed.”

In other words, what looks good on paper doesn’t necessarily translate to a successful business model. “Things like labor look good on a spreadsheet and end up costing more, which tends to be an area where struggles come up,” says Thoresen. “The solution is to have a phenomenal business, because if you have strong sales, you can absorb more mistakes.”

An Uncertain Future

Many feel the jury is still out on whether consumer-direct operations work, despite the success of HelloFresh and Blue Apron. While European companies are moving in the direction of vertical acquisition in this space, that’s not the case in the U.S.

“Internationally, other large companies are getting into the meal delivery program space, so we’ll see substantial production kitchens overseas, at least in the short term. Whether international players come into the U.S. remains to be seen,” says Schatzberg who, along with partner Todd Millman, started Green Summit , a New York-based kitchen-only concept that used third-party delivery companies like GrubHub to get its food to customers. Green Summit grew to multiple locations and more than $10 million in annual sales before closing. Its success and failure simultaneously tells of the potential and pitfalls for consumer-direct operations and the need for the players to iron out the kinks in their business models.

“We were pioneers in this space with respect to building an underground kitchen that had no retail presence,” says Schatzberg. “The whole idea was to take advantage of Grubhub’s consumer reach and captive audience. Instead of spending marketing dollars on customer acquisitions, we were paying Grubhub 17 percent commission on every order.”

With so many short-term successes and big failures, particularly with meal kit programs, there’s arguably much to be done to ensure profitability. “Consumer-direct operations make sense if the volume is there, since there is so much variability and low margin in the food space,” says Thoresen at Technomic. “Unit economics are the hardest thing for these emerging companies to get right.”