SUBWAY’S SLOW MOTION TRAIN WRECK PICKS UP SPEED – ARE THEY OUT OF THEIR MINDS?

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SUBWAY’S SLOW MOTION TRAIN WRECK PICKS UP SPEED – ARE THEY OUT OF THEIR MINDS?

The latest contractual changes suggested to Subway franchisees who are scheduled to renew their original twenty year contracts seems completely out of step with the reality of the restaurant industry. It is no secret that the Subway system has been shrinking in size in recent years (a net reduction of 14% in units and 26% in royalty payments over the last three years), for a myriad of reasons that we need not detail here. Suffice to say that, in a brutally difficult competitive environment, compounded by a labor crisis that makes day to day staffing a real challenge, the Subway system needs to be reinvented if it is to stabilize and then begin to rebuild.

John Chidsey, an attorney by training, President and CFO of Burger King from ’04 to ’11 (when it was bought by 3G Capital), has been CEO at Subway for about eighteen months. Within six months of Mr. Chidsey’s tenure at Subway, tensions with franchisees surfaced, as operators complained about a 2-for-$10 Footlong Sub offer considered to be too large a discount. This aggressive discounting seemed reminiscent, during Chidsey’s tenure a decade earlier, of Burger King’s $1 Double Cheeseburger promotion that BK franchisees resisted. Worthy of note is that Chidsey has reached back into his Burger King days to fill out his management team. Ben Wells, CFO at BK from ’05 to ’11 was named CFO of Subway in December. Michael Kappitt, Chief Marketing Officer at BK from ’02 to ’11 was named COO at Subway in March. Ilene Kobert, a Director and Senior Attorney at BK from ’09 to ’11, was named Chief Legal Officer in February. While there are some dissimilarities (BK had 900 company operated stores at the time, and Subway is 100% franchised), it’s not a reach to suggest that the Subway system now gets the leadership that was at Burger King fifteen to twenty years ago, obviously not a great confidence builder for Subway franchisees.

With that background, the Contract being provided to Subway franchisees that are considering renewing their original twenty year agreement apparently calls for: (1) A store to remain open, barring an “Act of God”, unless “permitted otherwise”, with only one exception per year. Subway’s stated intention is to be lenient in the event of “an act of God”, but the franchisees are worried that snowstorms, electrical outages, or even slow days around Thanksgiving or Christmas could be in play. (2) Franchisees can make no negative comments, to media or even (especially restrictive) internal franchisee groups  (3) If a franchisee leaves the system, they must hand over, without compensation as opposed to removing brand identification, any property with the Subway logo (4) Franchisees that leave the system prematurely must pay three times the prior year royalties (5) The franchisor is allowed to set hours of operation and pricing (6) Franchisees will now pay $155/month for rights to Subway’s digital menu board.

A franchisee who is refuses to go along with the above items will be subject to a higher royalty (10%, up from 8%) going forward. Some observers suggest that the franchisor is making the new agreement sufficiently onerous that the franchisee will choose the 10% royalty, which will at least partially offset, for the franchisor, the shrinkage of the system. Personally, we find this argument a bit of “a reach”.

There are a lot of adjectives that could apply to the Subway franchisor in this discussion, and “tone deaf” and “bad optics” come to mind. As for the franchisee, the last thing he or she needs is the prospect of periodic legal disputes with their supposed partner. He or she will survive in the best manner possible for the time being, minimize personal exposure to the Subway system, allow old leases to run off and maximize cash flow in remaining stores. The last thing they are going to consider is investment in new equipment or unit expansion.

We wrote the article provided below two years ago, talking about the franchisor/franchisee economic relationship, and how the world has changed over the last fifty years. Chidsey and Co. could find it pertinent. The Subway system has shrunk by a cool five thousand USA locations over the last three years, with 1601 stores closed in 2020 alone. There are still 22,000 domestic locations, but I wouldn’t expect that number to increase any time soon.

Roger Lipton

The article below was published March 11, 2019

THE FRANCHISOR/FRANCHISEE ECONOMIC RELATIONSHIP – IT’S A NEW WORLD!!

Almost everybody has noticed that there is an increasing strain between franchisees and their franchisors.  It is no accident that new franchisee associations are being formed and existing organizations are getting more militant. There are many intangible reasons, as too many franchisors do not treat their “z’s” as partners. We have written many times that the “asset light”, “free cash flow” model is not reflecting the necessary investments in the system to keep franchisees as profitable as possible. Many franchisees are especially bothered by the fact that their franchisors are spending hundreds of millions, sometimes billions, of dollars buying back stock and making acquisitions, while leaving the franchised operators without the necessary new product development, technology upgrades, marketing initiatives, etc.etc.

With all of that in mind, the bottom line is the bottom line. Too many franchisees are suffering financially, under more pressure than ever. The typical franchise royalty is 5%, give or take a point, plus 2%, as an advertising contribution. There are often additional charges, not all that material in and of themselves, but adding to an already large burden. Let’s say the franchisee is fortunate enough to be making 17-18% store level EBITDA (and Depreciation is not free cash in the long run).  Rebating 7 points out of 17 or 18 points starts to feel like a pretty big load, and there is still local G&A to be carried. Even if store level EBITDA, before royalties, is in the low twenties, 7 points gets to be a bother.  Additionally: many franchisees, Dunkin’ Donuts and Burger King and Jack in the Box are just a few examples of mature systems where decent money is still being made at the store level because the store leases were signed ten or fifteen years ago, so occupancy expenses are lower than today’s economics would allow. That’s, of course, why so few new units are being built by many mature franchised systems, especially in the USA. Today’s economics do not allow it.

When Ray Kroc started franchising McDonald’s restaurants over 60 years ago, the royalty was 1.9%. By the 1960s, franchisors had started charging 2-3%, by the 1970s 3-4%, by the eighties 4-5%, and 5% seems to be the standard today, plus advertising and other fees.

At the same time, there are no material expenses that are lower, as a percentage of sales, certainly not occupancy expenses or labor, and food costs are unpredictable commodities. The biggest single negative trend, that nobody would debate, is the immense competition that has become commonplace. Even in today’s over-stored situation, there are more new stores being built, within chains, than closing.  This competitive pressure has also created the need for far more support from the franchisor, if the increasingly critical public is to be satisfied and the franchisee partner is to succeed.  Over the last fifty years, as the franchisor should be providing more support and burdening the franchisee less, the trend has been just the reverse.

The answer: lower fees, especially ongoing royalties. 

This specific suggestion will not be adopted by existing large chains, because it would be such an obvious reduction of the current royalty stream. However, well established franchisors could, and should, absorb more of the additional systemwide needs, such as technology upgrades. “Mid-stage” franchising companies could put some part of the following suggestions in place.

If I were running an early stage franchising company, I would put in place a sliding scale royalty system, charging 2.5-3.0% at a modest sales level, higher if the franchisee does better. Give them a little room to make money if the store doesn’t do quite as well as everybody hopes. If the store clicks, everybody is happy and 4-5% on the higher sales won’t seem like such a burden. For my multi-unit franchisees, I would charge lower up front fees for development of 2nd, 3rd and additional stores, and this is sometimes already being done (whether admitting it to Wall Street or not). This is logical and appropriate, because less franchisor support is required as a franchisee builds local infrastructure.

It seems likely that a young franchising company adopting this strategy would have a huge competitive edge and the total royalty stream is likely to build more rapidly using this progressive approach.  Profitable franchisees, and a more appropriate sharing of store level profits in today’s economic reality, make for a successful system in the long run.

Roger Lipton