By Julie Jargon
Subway, suffering through its biggest slump in years, is testing
just how sprawling a fast-food chain can get before it becomes too
big.
In its 50-year history, the sandwich chain has penetrated
seemingly every commercial nook in the U.S., from strip malls to
laundromats to car dealerships. With more than 27,000 domestic
restaurants, it boasts far more U.S. outlets than any other
retailer. McDonald's Corp. has about 14,300, and Wal-Mart Stores
Inc., about 5,200. The only thing comparable is the U.S. Post
Office, which manages 31,662 retail offices.
But Subway's expansion has hit hurdles. Sales at its U.S.
restaurants dropped last year for the first time in more than a
decade, falling 3.3% to $11.9 billion. That made it the only major
sandwich chain besides Quiznos, owned by QCE Finance LLC, to suffer
a sales decline in 2014, according to restaurant research firm
Technomic Inc. Franchisees are frustrated, with some selling their
restaurants at reduced prices, and perceptions of Subway's food
quality slipping, according to franchise owners, attorneys and
restaurant consultants.
Priyal Patel sold his Subway in Prospect Heights, Ill., in May
for $77,000. He bought it in 2006 for $195,000 and spent $85,000 to
remodel it. "No one wants to buy a Subway now," he said. "People
are selling for whatever price they can get." Don Fertman, Subway's
chief development officer, said the transfer rate of stores from
one owner to another has been steady for a number of years.
Subway, which is incorporated as Doctor's Associates Inc., has
slowed its expansion, but is far from halting it. It has been
opening about 400 stores a year in North America since 2013, down
from 800 to 1,200 before that and as many as 2,000 annually in the
late 1990s. "I don't see us going back to that level, but 800 is
possible," Mr. Fertman said in an interview.
Darren Tristano, executive vice president at Technomic, said
Subway is already nearing the limits of growth. "The problem is
that new restaurants have to steal share in order to be
successful," he said. "A lot of the weaker brands that Subway has
fed off, like Quiznos and Blimpie, are not around as much. They're
going to struggle to steal enough share to be able to keep opening
more stores."
Mr. Fertman says Subways aren't cannibalizing each other and
that restaurants in the most Subway-dense markets actually have
higher average sales. Subway's international growth remains strong,
with system sales up 12% last year to $7.7 billion.
Subway owes its growth in part to an aggressive franchising
system. Other big fast-food chains, including McDonald's,
Restaurant Brands International Inc.'s Burger King and Wendy's Co.,
long owned and operated a portion of their restaurants--in part, to
test new products and study their customers. Recently, those
companies have been selling those outlets to cut costs and focus on
rent and royalty fees--a strategy that can mean more stable revenue
and higher profit margins but that also risks undermining chains'
ability to maintain consistent quality in restaurants.
Subway, co-founded in 1965 by aspiring doctor Fred DeLuca,
started franchising nine years later, and today its restaurants are
100% franchise-owned. To boost growth, it has used an unusual
system of "development agents," often former or existing
franchisees who buy the rights to develop a region. For adding more
stores, agents receive a portion of the 8% royalty fee Subway
collects as well as half the initial $15,000 franchise fee. The
agents can earn bonuses for opening restaurants ahead of
schedule--or be penalized for falling behind, according to Subway's
franchise documents.
Opening a Subway typically requires an initial investment of
just $116,600 to $263,150, compared with $1 million to $2.3 million
to open a McDonald's. Subways also need less real estate: their
assembly-line system means kitchens can be as small as 300 square
feet--less than a third that of the smallest McDonald's. Operators
attend a two-week training at Subway's Milford, Conn.,
headquarters, whereas prospective McDonald's franchisees must take
extensive courses online and at Hamburger University, usually over
two years, according to franchise documents for both companies.
Most restaurant companies employ their own people to scout for
locations in the U.S.--in part to ensure new outlets don't compete
with old ones. And other chains have actually cut store counts when
growth has overreached. Starbucks closed hundreds of stores in
2009. McDonald's closed restaurants in the early 2000s and has been
trimming its U.S. store count this year.
Hardy Grewal, Subway's largest U.S. development agent, said that
while the system incentivizes expansion, "development agents aren't
stupid. We don't open stores to close them." Mr. Grewal owns five
Subways in Los Angeles, and his agent territory includes 910 stores
in Southern California and 1,000 in the mid-Atlantic. He said he's
focusing on moving restaurants to better locations and only
expanding in properties with captive audiences, like airports.
"Any time you open more and more units, there's always some
impact," he said. "People are still making some money--it's just
not what they used to make."
Average sales per Subway restaurant in the U.S. declined last
year by 3.1% to $475,000, according to Technomic. John Gordon,
founder of restaurant consulting firm Pacific Management Consulting
Group, found in a 2012 survey of sandwich-chain profitability that
Subways average annual profits of $70,000 a store. With sales down,
he estimates that number has fallen to a range of $30,000 to
$40,000. Mr. Fertman said Subway doesn't have a full picture of
franchisees' profitability because they aren't required to share
that with the company.
Despite its scale, Subway's sales are relatively small--$19.6
billion across about 44,000 outlets world-wide last year, compared
with total sales of $88 billion at the more than 36,258 global
McDonald's restaurants.
Subway is facing other challenges. It suspended ties with its
longtime pitchman Jared Fogle in July after federal authorities
raided his home as part of an investigation that officials have yet
to disclose. Mr. Fogle, through his attorney, has said he is
cooperating with authorities. And Mr. DeLuca, the 67-year-old chief
executive of Doctor's Associates, who has been battling leukemia,
has turned over management of daily operations to his sister.
Subway also scored five percentage points or more below the
average of the limited-service sandwich category on food and
beverage attributes in a recent consumer survey, according to
Technomic.
Les White, who owns 47 Subways in Arizona and is chairman of an
association that represents 6,500 Subway franchisees in North
America, said Subway is working on initiatives to improve food
quality, including the removal of preservatives and artificial
ingredients. "What's difficult about trying to change a company
this large is it's difficult to change things immediately," he
said.
Mr. Grewal said he expects sales to turn positive again in
another year or two. "We've never had a hiccup like this before,"
he said," but we'll bounce back."
Write to Julie Jargon at julie.jargon@wsj.com
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