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Why Subway is facing a crisis

The Bottom Line: Overexpansion, marketing problems and intense competition have hurt the chain's sales. But it can recover.

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Media outlets have been all over complaints from franchisees about the state of Subway, the latest coming from Business Insider, which reported today that many operators believe the company needs a new CEO.

All of these reports describe a restaurant chain in crisis. With traffic down by 25% since 2012 and operators in open revolt, the sandwich giant faces a potential closure of thousands of locations if it can’t reverse its sales decline.

It’s happened before: Sandwich chains Quiznos and Blimpie both suffered from steep declines in unit count over the years—in part at Subway’s hands.

But getting to this point, from being the restaurant chain killing its rivals to one that faces its own deterioration, was the result of numerous decisions going back years, as well as some bad luck and a consumer that continues to change.

Overexpansion

A decade ago, when Subway was destroying competitors with its $5 Footlong offer and a reputation for health thanks to its Jared commercials, the company expanded aggressively. The chain’s founder, Fred DeLuca, at one point said that Subway could have 100,000 global locations.

At the end of 2006, the chain had 20,721 locations. By the end of 2011 it operated 25,285 units, a unit growth of 22%. Keep in mind that period included the worst recession in 75 years and one in which the restaurant business lost sales.

Operators have repeatedly told us they had little choice but to develop new units because if they didn’t, other franchisees would open them instead. So, they opened new units to protect their existing locations.

But that expansion didn’t slow down even as the chain’s traffic started to fall—though it did slow. From 2012 through 2016, the company’s unit count grew by more than 7%, or nearly 2,000 additional locations.

Subway’s unit count declined by 355 in 2016 and, based on reports and indications from franchisees, by another 900 last year. Yet the chain still has more locations than any other restaurant company in the U.S. By far.

Loss of its marketing advantages

Subway’s immense growth could be attributed to a pair of marketing campaigns: Jared and the $5 Footlong. It lost both of those.

It’s difficult to overstate the problems created for the company by the 2015 arrest of Jared Fogle to child sex charges. Fogle had helped give Subway the perception that it was healthy, and that perception carried the chain for years and even lifted other sandwich chains’ own health perceptions.

And, you know, it’s just never good when your longtime spokesman gets arrested.

Yet Subway’s traffic and sales were declining even before then, and some of that could be attributed to a loss of value perception after the chain went away from that $5 Footlong.

Perhaps the company kept that Footlong offer too long. But much like McDonald’s struggled after shifting away from its Dollar Menu around the same time, Subway struggled to overcome the loss of its value perception after that offer ended.

Now, given the small size of many of its franchise operators, their low ($420,000) unit volumes and rising labor costs, franchisees are revolting against a $4.99 offer.

Subway has struggled to develop marketing campaigns to follow these. That’s been a real problem, especially given the increase in unit count.

The breakfast failure

Hey, remember when Subway went big into breakfast back in 2010?

The company put much of its marketing muscle behind the introduction of breakfast items that year. But that move hasn’t worked to bolster sales.

To be fair, breakfast is hard. It is the most habitual of dayparts. And there are remarkably strong competitors, including McDonald’s, Starbucks and Dunkin’ Donuts. Getting consumers to break their breakfast habits by going to Subway takes a lot of time and effort.

But Subway’s inability to find new sources of income for its franchisees has been a problem as the chain has expanded. Companies like McDonald’s and Starbucks, two other high-unit count chains, have worked hard to expand dayparts.

Competition

Subway’s decline has come as several other chains specializing in sub sandwiches have grown.

In 2016 alone, for instance, Subway’s domestic system sales declined by $200 million, according to Technomic's Top 500 Chain Restaurant Report.

Meanwhile, Jimmy John’s, Jersey Mike’s, Firehouse Subs and Potbelly, the company’s four biggest sub sandwich competitors, grew by $540 million. Oh, and Arby’s grew by $200 million.

In short, it’s just a much different market than it was a decade ago. That was when Quiznos had more than 4,500 locations and a marketing advantage in toasted subs. Subway added toasters, priced subs at $5, and basically destroyed its competitor.

But Jimmy John’s is a far stronger competitor, and has delivery, which Subway has not bothered with—leaving that rival able to operate fewer, stronger units.

Internal strife

It’s a big chicken-and-egg question: Do sales problems cause internal strife, or does the strife lead to sales problems? For Subway, it’s probably a bit of both.

The franchisee strife has been well documented. Several media outlets, including Restaurant Business, have written about it. The Business Insider piece has operators saying the chain needs a new CEO.

Then there was the New York Post story last year quoting Dr. Peter Buck, who co-founded Subway and owns 51% of the chain’s stock, saying that the company should consider opening more premium sandwich concepts.

Regardless, the strife has made it more difficult for Subway to accomplish its goals.

Can it recover?

Of course it can.

Arby’s had unit volumes of about $700,000 (on much higher occupancy costs) in 2011, when the chain was sold to Roark Capital and went on a six-year run of same-store sales increases.

KFC was terminating franchisees for years before the company invested $185 million in the brand and went on its own same-store sales run.

Both chains went through major declines before recovering and getting back on track. So there’s clearly hope for Subway, whose primary shareholders have committed to investing $25 million in the brand.

The company has a complex problem—too many locations, value challenges, small unit volumes and angry operators. But a few quarters of sales increases can fix many of these issues. Sales are, after all, the silver bullet that fixes everything.

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