Three Longs & Three Shorts

Fast food chain Subway got too big and its franchisees paid a price

Author: Tiffany Hsu & Rachel Abrams
Source: New York Times (https://www.nytimes.com/2019/06/28/business/subway-franchisees.html)
One of the first things we learnt when we started investing in India is that any business where barriers to entry are low will sooner rather than later become a cesspit as the lack of profits will make the stakeholders go for each others’ throats. Quick Service Restaurants (QSR) fits this bill perfectly – it is next to impossible to make Return on Capital in excess of Cost of Capital from this category. And what applies to India also applies to the USA, the country where QSR format was born. This New York Times article details how Subway, a chain with a basic menu and a commoditised product, managed to get into an adversarial relationship with its own franchisees.
The basic problem seems to be that there are now too many Subways in America because the owner did not keep a grip on store numbers and hungry immigrants (lots of them Indian professionals) flocked to open franchisee stores: “Subway is the largest fast-food company in the world by store count, with more than 24,000 restaurants in the United States alone. It got that way thanks in large part to entrepreneurial immigrants. Unlike at chains such as McDonald’s and Burger King, where many franchises are operated by investment firms, Subway owners are mostly individuals and families. The company’s co-founder, Fred DeLuca, made stores easy to open; most new franchisees are charged a $15,000 initial fee, compared to $45,000 at McDonald’s. In exchange, Subway operators must hand over more revenue than at many other chains — 8 percent of gross sales — while also agreeing to other fees and stipulations.”
The problem of too many stores hit home after Mr DeLuca died in 2015. His sister, Suzanne Greco, took over and she seems to have hit upon a solution: “In 2016, for the first time ever, more Subway stores closed than opened. But while many franchisees shut down because of underperformance, others operating profitable locations began to feel targeted, too.”
This NYT article says that certain Subway stores were targeted for shut down and to make them shut down the company would send inspectors to nitpick on the store: “Manoj Tripathi couldn’t shake the feeling that someone had a vendetta against his Subway sandwich shop. A franchisee for nearly two decades, he had done everything he could to keep his restaurant, in a strip mall in Northern California, in perfect condition. But lately it seemed like someone was out to get him.
It was the middle of 2017, and inspectors sent by Subway’s regional manager were finding a new problem to cite each month: a handprint on the glass door, the wrong brand of bathroom soap, cucumber slices that were too thick, he said. They seemed to be little things, but with each write-up, Mr. Tripathi’s grip on his store weakened. If he racked up enough infractions, Subway could terminate his contract and take control of the business.
When an inspector named Rebecca Husler arrived one day that September, Mr. Tripathi thought his restaurant was pristine. Then he noticed that a single light fixture needed a new bulb. Mr. Tripathi rushed out to buy a replacement, but by the time he returned, Ms. Husler had marked it as a violation. A year later, just as he feared, he lost the Subway.”
These store closures have left many of the franchisees – hard working first generation immigrants to America – nursing huge losses. Some of them are in litigation with Subway but that won’t address the basic economic issue i.e. it is hard to make money in QSR because the barriers to entry are so low.