With 27,205 Stores, Subway Gets Indigestion

Julie Jargon
Copyright © 2015, Dow Jones & Company, Inc.

Aggressive expansion in U.S. leaves chain with crowded footprint and slumping sales

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 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.

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 cut store counts when growth has overreached. Starbucks closed hundreds 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 amount has fallen to $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.

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.

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