Time for thoughtful planning and execution ahead.

The industry has made it successfully into mid-September, seasonally the second slowest point of the year. Cable TV is full of QSR brands running discount-oriented offers (Dominos Pepperoni Bread, for example), and others that are in a much stronger position like Olive Garden have a TV flight featuring “more”, a benefit of Olive Garden. The industry is struggling with guests who haven’t come back from the Pandemic break, inflation, too much unit growth (see below), and more.

Several macro-econometric developments are converging this fall that we all need to be aware of for better planning. This is not a call for more discounting, which is the industry’s usual quick-term reaction. The restaurant industry is resilient, and the progress we have made since the Pandemic is amazing. But, for us, it seems like there is “one more banana peel after another” on the road ahead.

Gasoline prices rose to $3.87 nationally per the AAA just after Labor Day.  Prices are still rising. This rising pattern is unusual and unwelcome coming after the peak summer driving period has ended. [1] Lower gasoline prices are an important potential positive adjustment to consumer discretionary income that we need.

Labor strikes. The UAW has active strikes against all three Detroit major automakers.[2] This takes autoworkers and restaurant consumers’ frequency down in those strike cities as one would expect.

Of the critical impact on our industry, I feel, is student loan repayment must begin again in October.[3] It is estimated that 27 million borrowers will guggle a new monthly payment of $350. [4] As this group skews younger, restaurants can expect a hit.

DC Shutdown? Finally, the House and Senate need to pass spending bills by September 30 to keep the US Government in operation. While stop-gap, temporary measures are the norm, this year there is abnormal tension in the House. [5]  Full government shutdowns disrupt the economy.

What to do….

So these issues speak to the need for the new budgeting and planning cycle that has been discussed in this column before. It is a model of Mike Bloomberg’s advice to do a good operations and capital budget, but with identified options and reaction levels to react quickly. No one ever knows exactly what the future brings but we can do a limited number of “what ifs drills” to be mentally agile. I worked 20 years in corporate staff roles and now another 21 years via my consulting firm, and my observation is it is true it takes a long time for some companies and cultures to “turn the battleship”. Don’t let that happen. CEOs, force the various corporate disciplines to work together to evolve solutions that everyone owns.

McDonald’s Takes Surprising Action…

In a move bound to be copied worldwide, McDonald’s announced it would phase out the self-serve beverage stations over the next several years. Its stated objective was to achieve a consistent dining room look and appearance worldwide.[6] This move comes at an interesting time as guest traffic eating in is at a low ebb historically (but still up a bit from the COVID-affected months). During that time, some operators came to appreciate a drive-thru-only operation.

McDonald’s no doubt took a look at syrup yields, which I imagine had to have deteriorated over the years.  There are some questions looking at this. No doubt dine-in or take-out guests might consider self-serve a benefit, an ability to customize or mix their drinks.  Also, for families, a core McDonald’s group, the self-serve fountain is always an area of activity. The kids love it. That in the future is taken away. McDonald’s will have to find some other personalization benefit to replace that value removed. We’ll see.

Analytical Notes   

The very long-running Subway/DAI auction was concluded on September 6 with Roark purchasing the franchise at a certain $8.95 billion price, with a potential up to $9.55 billion via an earnout clause. Given the estimated DAI annual EBITDA of $750M, that is a floor multiple of 11.9X. Subway will be its entity in the Roark organization. No doubt, international growth will be the key to making this transaction work. There will be both US and International franchise structure reorganizations coming. To make their proforma, I would bet there would be changes in the supply chain operations and the Area Developer structure. Subway has said in the US it doesn’t need Area Developers anymore, but in international markets, that is a future question. Some discussion has recently emerged about what kind of review the FTC will make of the merger, since similar, sandwich brands are involved in the Roark portfolio.[7]

US store growth situation: In doing work for a client recently, I noticed that US restaurant store counts have grown again more than expected. This is one of the big reasons that industry same-store sales growth has been declining, even before the Pandemic. [8] As of Q1 2023, restaurant count was 695,821, versus 654,207 in Q4 2019. [9] The point is that the erosion of restaurant counts during the Pandemic years has been offset even more over time.

The issue becomes that new sites and new concepts absorb customers faster than existing base brands can generate or regenerate them. Our industry has always had elements of trial and new guest appeal in it, hence why new concepts get a look once they achieve scale and have a story to tell.

What to do?  At the very least, the publicly traded franchise brands have to balance their earnings commentary from focusing so much on unit growth. There are many other metrics of a quality franchise organization that can be highlighted. Some brave CEOs have discussed the benefits of pruning very old franchise systems of older, economically unviable units that are a waste of both franchisee and brand resources.  

M&A Market Note:

It is commonly acknowledged that the IPO and franchise markets have improved finally. The CAVA IPO this summer was the US equity star for several days and has had its first earnings call. Other IPOs, including FAT Brand’s profitable Twin Peaks brand, are planned for 2024. A theme is experiential works which bodes well for FSR. In franchise activity, buyer and seller activity has picked up.  Rates are still high but EBITDA trends are slightly better now with food cost percentage reductions seen.

About the author:

John A. Gordon is a long-time restaurant industry analyst and expert, with 20 years in restaurant corporate staff roles (Finance FP&A), and 21 years via his founded restaurant consultancy, Pacific Management Consulting Group. He works on complex operations and managerial finance engagements for all kinds of clients who need a deep restaurant perspective. Call him anytime at 858 874 6626, email, jgordon@pacificmanagementconsultinggroup.com

[1]   New York Times, Marie Solis, September 15 2023.

[2]   New York Times, Ivan Penn, September 17 2023

[3]   Due to Supreme Court Decision in 2023.

[4]   New York Times, Holman, Smialek and Karian, September 15, 2023.6

[5]   New York Times, Carl Hulse, September 17 2023.

[6]   https://www.restaurantbusinessonline.com/operations/mcdonalds-getting-rid-its-self-serve-drink-stations

[7]    NY Post, Josh Kosman, September 17 2023.

[8]   Black Box come up with same opinion in 2022.

[9]   Bureau

Marketing Innovation https://www.adweek.com/category/marketing-innovation/)

It won’t be easy, but experts have a few ideas on where to start

By Robert Klara |10 hours ago

The CMO/franchisee relationship is often contentious.

Credit:Boris Zhitkov/Getty Images

If you want a snapshot of the sort of conflict that’s always simmering between the CMO’s office and a company’s franchisees, you might start by asking Bruno Cardinali.

For three years, Cardinali was the CMO of Popeyes, where he presided over one of the most successful promotional blitzes in recent history—the
Popeyes Chicken Sandwich
https://www.adweek.com/brand-marketing/what-popeyes-chicken-sandwich-can-teach-us-going-viral-connectingcommunities/)
. Introduced in August 2019, the item awakened passions rarely seen in fast food. Customers formed lines around the block, waiting an hour or more to sample the crispy chicken breast on a brioche bun with pickles and Cajun sauce. Jimmy Kimmel tweeted about the sandwich. Saturday Night Live parodied it. And as 20 competing chains scrambled to mount their own
versions—touching off what would later be called the Chicken Sandwich Wars—Popeyes notched a quarterly sales spike of 38%.

“It was a massive sales return for everybody,” said Cardinali, who earlier this month took the marketing helm at fast-casual chain Oakberry. He’s referring to corporate performance, of course, but also to the revenues of franchisees, who operate 99% of the Popeyes system. Some units generated an extra $400,000 thanks to the sandwich alone.

You might think that franchisees were overjoyed at such a windfall. But it’s not that simple.

Cardinali recalls, not uncharitably, that he received an earful from some franchisees who bristled under the operational strain of serving so many sandwiches. One franchisee whose restaurant served up 1,200 chicken sandwiches per day told The New York Times: “It was so stressful. I’m amazed that team members stayed. It was absolutely just mayhem.”

And while he’s still proud of the promotion, he told Adweek that “increasing traffic created a lot of need for everybody to rethink a lot of the processes to make it smoother.”

Popeyes’ sandwich pandemonium is only a recent manifestation of a familiar dichotomy within sprawling chain systems where franchisees work the front lines. Following the usual remit, a CMO focuses on big picture marketing to generate buzz, increase customer counts and boost top-line growth. But a chief marketer also has a responsibility to work on behalf of franchisees—and
their
day-to-day realities are different from (even at odds with) what happens at the head office. In theory, a CMO should devise marketing initiatives that benefit both parties. But a host of issues conspire to make that task a difficult one.

Difficult—but not impossible. Adweek asked a range of experts to share their thoughts about why the CMO/franchisee relationship is so often contentious, and to suggest ways it could be improved.

Cut out for conflict

To a great extent, the competing interests of the CMO and the franchisee are baked into the franchising model itself, which relies on disparate skillsets in order to work.

“This problem is old as the hills because the marketing people, the operations people and the finance people are different personality types,” said John A. Gordon, founder and principal of Pacific Management Consulting Group, which specializes in restaurant finance and franchising issues.

CMOs are inherently optimistic and often cook up clever ideas, Gordon said, but they “don’t understand store economics very well.”

Franchisees, by contrast, eat and sleep store economics. That singular focus can admittedly make them resistant to ambitious marketing campaigns—yet the franchisees are also the ones with the most skin in the game. “Franchisees are generally small to midsize businesspeople,” Gordon said. Unlike the CMOs who enjoy a regular paycheck, “They have a note on their property. They have to pay royalties. They’re in it for the long term.”

As the founding partner of franchise law and commercial litigation firm Zarco Einhorn Salkowski, Robert Zarco has represented franchisees from more than 550 brands over the course of his 38-year career. From his perspective, franchisees are not only subject to the caprices of marketing decisions made at headquarters, they’re bound by the terms of contractual agreements that maneuver them into an inherently disadvantaged position.

Not a fair shake

For example, a promotional program developed by a CMO might well generate additional revenue—but it can also force franchisees to sell items under cost. In many instances, “the franchisee is undertaking greater expense in delivering that promotional product to the consumer than the profit that that transaction would bring to the franchisee,” Zarco said. “In fact, those transactions typically are losing transactions.”

The textbook case is Burger King’s double cheeseburger fiasco. In 2009, BK rolled out a promotion that dropped the price of a double cheeseburger to $1. At the time, the home office in Miami hailed the marketing campaign for delivering “exceptional value.” A value for customers it doubtless was, but not for franchisees, who found themselves selling a premium menu item at a loss. They sued, and BK settled in 2011.

Here’s a more recent example. In 2017, McDonald’s corporate began pushing its franchisees to sell soft drinks for $1. Franchisees didn’t like it, but when inflation began driving their costs through the roof in 2022, they revolted. Eventually, headquarters backed off. “The issue there is that the pathway to riches in a fast food operation is French fries and soda,” Gordon said.

An aggravating factor in cases like these is that, while the CMO and his marketing department might be aware that its promotion is a hardship for franchisees, there’s no disincentive to going ahead with it anyway.

“Not only is headquarters not going to feel any pain—headquarters is going to feel a profit,” Zarco said. “Because, while the individual transaction in the corporate stores may not generate a profit at the unit level… corporate-wide, there’s a tremendous uptick in profitability because of the additional royalties and marketing fees and service fees, and all other fees that are tied to the gross-revenue business model.”

Can’t we all just get along?

The obstinance of these problems begs some difficult questions: Can anything be done to fosterbetter cooperation between a CMO ensconced in a carpeted suite and a gaggle of franchisees on thefront line? Is it possible for a CMO to create campaigns to satisfy corporate’s growth agenda thatfranchisees will also like? At least one prominent CMO thinks so.

Eric Keshin spent 30 years at
McCann WorldGroup https://www.adweek.com/agencies/how-mccannworldgroups-
internal-sustainability-tracker-steers-it-toward-net-zero/)
, where his clients included Wendy’s, Burger King and Applebee’s. In 2014, he signed on as chief marketer for Great Harvest Bread Company, a bakery-café concept with more than 200 franchised locations. Keshin’s long experience has taught him that, sooner or later, many franchisees “feel like the franchisor is a little out of touch or is making them do things they don’t want to do.”

His solution? Stop making them do it.

At Great Harvest, Keshin has no national marketing program. Instead, he focuses his energy on unit-level marketing, and on winning the trust of franchisees with an initiative called “Guaranteed to Break Even.” In this setup, headquarters devises regional marketing messages (usually some variant of “baked fresh every day”) and furnishes templates for franchisees to implement them—copy for Google display ads, for example, or crib sheets for local radio DJs to read on the air. The franchisee is under no obligation to buy into Keshin’s strategy. But many do, because Keshin has the data to prove that it will increase their sales.

“I’m able to compare the universe of the test market versus the universe of the people that aren’t doing anything—and I could show a 5% to 15% improvement in comps,” he said. “I guarantee [my
franchisees] that it’s going to pay back. But if for whatever reason it does not, then we would cover the cost.”

Hybrid marketing

In addition to her work as a certified franchise executive, Kristen Pechacek is also the chief growth officer at St. Louis-based MassageLuXe. When she joined the luxury spa chain in the summer of2020, she set about finding ways to foster a more productive working relationship between the home office and the franchisees who operate all of the brand’s 69 locations. Even now, she said, maintaining those good relations is “the hardest part about my job.”

Why? On the one hand, “franchisees didn’t get into business to be marketers,” Pechacek said. At thesame time, franchisees don’t appreciate the CMO shoving onerous marketing ideas down theirthroats. To address this paradox, Pechacek created what she calls a “hybrid approach.”

As you might expect, the home office in Chesterfield, Missouri handles PR duties and runs national marketing. (While Pechacek does do pricing promotions, “we tier them based on [a franchisee’s]normal pricing and geographic areas, so there’s a little bit of flexibility.”) Meanwhile, on the locallevel, franchisees handle marketing on their own, most often relying on support from Pechacek andher staff.

For example, while headquarters expects individual stores to be active on social media, it knows that most operators don’t have the time to keep coming up with fresh ideas for content.

“We have to find a way to get that local content out,” Pechacek said. “One of the ways that we do that is by telling [franchisees] what to post. All they have to do is hand [the briefing] to their manager and read the prompt that says, ‘Interview that massage therapist about why they love their job.’ Boom—post it.”

Pechacek also encourages her franchisees to engage in local civic activities. But since few franchisees relish the task of writing a speech, “[we] give them the actual script—exactly what to say,” she said.

Courtesy calls

Of course, the boutique approaches that Great Harvest and MassageLuxe have developed would be challenging to implement in a system that has 20,000 franchised locations instead of 200.

But according to Gary Stibel, most any CMO can foster a better working relationship with his franchisees by doing something that too many senior executives don’t do: talk to them. “The biggest challenge is to remind those two sides that they aren’t in competition with one another,” he said. “They’re in competition with other chains.”

Stibel is in a position to know. As founder and CEO of the New England Consulting Group, he’s worked for major chains (“all of them,” he said) and for large franchisee organizations. Stibel advises all CMOs to make time to reach out to franchisees.

“Involve them all, so they feel like they’re part of the process,” she said. “Human beings rarely object to aligning behind any strategy if they’ve been consulted in the process. Meet with your franchisees early and often—not just your supporters—they’re already in your camp—but your outliers.”

The rubber stamp committee

Many CMOs would say they already do practice this type of outreach in the form of their company’s franchise advisory council, a group of operators chosen by the C-suite that—to cite the International Franchise Association’s definition—is “charged with enhancing communication,
working together to improve the system and helping resolve challenges that impact the franchise system as a whole.” By this standard, if a proposed promotion from the CMO’s office secures a thumbs up from the advisory council, the brass assumes its franchisees are cool with it.

But Zarco is deeply skeptical of the setup. The councils, he argues, are too often made up of handpicked yes men whose approval means very little. If a CMO really wants the support of franchisees, he said, then the CMO should be willing to consult a true cross-section of his operators.

“Have the CMO make a business case for why this particular marketing program will work and how it benefits the franchisor, the franchise system and the franchisee,” Zarco said. “And then invite these people to comment on why it’s good or it’s bad or it’s both or it’s not a question of degree, and ask them: ‘How will this impact you?’ And then listen—literally—and not shove it down their throat.”

Gordon agrees with that advice, adding that CMOs should also find time to visit franchisees’ units—not only to learn more about store-level economics, but also to observe how marketing initiatives translate into daily operations. “Get them into the field,” he said, “so they could see how the sausage is made.”

For his part, Cardinali can at least attest to how crispy chicken sandwiches are made. Theexperience of watching Popeyes franchisees execute his promotion in 2019 has given him much toreflect on. Asked what sort of advice he’d give CMOs these days, he said, “Communicate as much aspossible. It’s very important.

“I can have the best idea, the best innovation, the best product,” Cardinali added. “But if it’s very complicated for the restaurant, it’s not going to happen. It’s a marriage.”

© 2023 Adweek, LLC. All Rights Reserved.

The Bottom Line: Roark Capital reportedly has the inside track at buying Subway. But it also owns Jimmy John’s. Can the two chains coexist www.restaurantbusinessonline.com

Read the full article here: https://www.restaurantbusinessonline.com/financing/owner-jimmy-johns-makes-run-subway

by John A. Gordon, Principal and Founder, Pacific Management Consulting Group

The good news in June sales…. The Bank of America credit/debit report shows improved restaurant sales trends in June vs. May in all but one restaurant segment and in all consumer income cohorts. Versus a year ago, chains were up 5.1% in June vs. 3.1% in May. QSR less pizza was down slightly 7.3 %v 7.4%. Interestingly all of the other segments were positive, with a large positive movement to casual dining (-1.3% to 5.3%). Typically, North American restaurant seasonality peaks in June so we will check to see what happens in July.

The results by the brand continue to back up the “restaurants as splurge option”. In their June 2023 Consumer Update, McKinsey survey data from December 2022 noted restaurants as the top planned “splurge” event.

Tipping everywhere….The  US Census Department July food at home/food away from home numbers will be released soon. US restaurants are still taking price increases, now at a greater rate than grocery stores. That continues to be an item of great price/value concern for restaurants. This matter has become more complex because of the addition of tipping software. See Square. [1]Most common in some QSR and fast casual concepts, guests have the option to add on tips. The tips are starting to add up according to conversations I’ve had, to $3 to $4/hour. The tips are of course the property of the employees and are paid out. The issues are (1) guests have even more price messaging when we have taken so much and (2) for the US Census reporting, there may well be pollution in the so-called “restaurant pricing number” reported.

CAVA-momentum startles the IPO markets…. So we all knew it would happen and it did. The CAVA IPO was the international financial markets talk for about 2 weeks straight. As noted earlier, it is a good brand with great demographics already, strong AUVs, and company restaurant margins tracking north of 20% in 2023 to date. It does need more units of course, with only app. 260 now, to improve its current too-high G&A cost ratio. Analysts are just now offering up opinions, the first CAVA analysts call is still some time off.[2]

Throughout the roadshow period and IPO, the informal chit-chat comparisons were endless: this is the next Chipotle. The fact is, only the Chipotle of 2006 was the IPO version and the Chipotle of 2023 isn’t the IPO candidate. CAVA was built differently.

In its S-1 it forecasted a US unit potential of 1000. That was very reasonable. Since its stock price zoomed up to close at $54 in its high close to date, some security analysts will push the company to commit to even more units to make their price/earnings models work. However, US restaurant brands committing to thousands of new units in the post-pandemic era, either company owned or franchised, face tremendously difficult odds to do so. For one, many of the good sites are occupied by tier-one players now. Secondly, the industry, especially the largest, strongest brands is expanding now. It is still hard to find good staff, although CAVA will produce staff promotions from a great operations system. In this going forward, this is exactly where Chair Ron Shaich, who has been through the Wall Street pressure cooker for a decade earlier, can be very helpful and provide guidance to CAVA.

Subway Auction Update: “Continuing Drawnout”. Josh Kosman the M&A reporter from the NY Post confirmed[3] last Friday that the current auction cycle closing dates were…pushed back as Subway now thought they had one or two new prospects that may result in a more favorable bid amount than what all of the earlier months of rounds had resulted in. Time will tell if true.

This cycle of saying no to a final offer and going back to the drawing board is somewhat remarkable. Restaurant M&A theory is “time kills all deals” as often stated at the Restaurant Finance Monitor’s annual conference.  This process has been underway for 6 months to date. It is difficult for bookrunner JPM to keep market momentum for so long.

At least half of the net proceeds after expenses seem to be going to Dr. Buck’s designated will directive, a nature foundation in Maine. That won’t benefit the corporation. We can reasonably assume that servicing the debt on a 15% or so interest rate will be a terrible burden for the brand itself going forward, much like many other LBOs over the years. That raises the question: why fight so much for the highest possible sell price?

More Restaurant Developments, Both Surprises and Not:

McDonald’s and Grimace’s Birthday:  targeting one of their core markets, the Grimace LTO seems to have driven traffic nicely in June. According to Placier AI, a surge of traffic hit. The only question now is what happened to the ticket. There were 2 associated meals.

Another IPO following CAVA…  Gen Restaurant Group, symbol GENK, opened in June at $18. It raised $43M, more than expected. The second Korean BBQ concept is now public that really can be called action-oriented and “experiential.”

Checkers Drive-In Restaurants reached a deal with its lenders to give up majority ownership from its PE owner, Oak Hill Capital Partners. Checker’s debt will be cut by $225M and will receive $25M in new debt financing. IMO, Oak Hill’s prior investment level was mistimed and proves once again that owning franchised restaurant brands IS NOT NECESSARILY a goldmine.

Restaurant Staffing Stats:  Per WSJ, QSR employees now operating with 10% fewer employees per unit versus 2019, while full-service locations are down 7% over the same period.[4] In my opinion, I am not surprised by the QSR number but the full service number shows the industry still has work to do in recruiting and retention.  The Wall Street Journal piece was filled with a discussion of difficult restaurant service.

Future M&A Noted:  Listening to both Darden and YUM earnings calls recently, both mentioned that they would keep their eye out for future potential acquisitions that may enhance their portfolios. This is what good holding companies should do. Darden is just now integrating its Ruth acquisition, so its interest no doubt will be much further in the future.

About the author:  John A. Gordon MAFF is a long-time restaurant analyst and management consultant. He works on complex restaurant operations, organizational/brand assessment, and earnings topics for clients.   He has 20 years of corporate staff experience and 20 years via his founded consultancy, Pacific Management Consulting Group. He can be reached anytime at 858 874-6626, jgordon@pacificmanagementconultinggroup.com.

[1]   See: Squareup, https://www.squareup.com

[2]   https://seekingaplha.com/news3986553-cava-rising-analysts-space-for-growth

[3]   https://nypost.com//2023/07/13/subway-fails-to-get-10b-bid-for-chain-extends-deadline/

[4]   Wall Street Journal, June 27 2023, data by Market Intelligence by GuestXM.

What has been learned through the end of Q1 earnings:

Although surveys of consumer tightening of restaurant spending are everywhere (traffic oriented ), sales have generally kept pace, very strong at some concepts.  Looking at reported restaurant results in Q1, one sees only a handful of real problems, pizza for one.

What most concerns me is the reports from analysts that have an international credit card in their company that they can tap into (for example, Sara Senatore, Bank of America) that show May spending has continued weak in QSR pizza, casual dining has just turned weak. QSR x pizza is up slightly month over month and fast casual is slowing down.[1]

So, Q1 brand reported sales have kept up because of average ticket growth continuing.  Food at-home inflation (8.6% in April with a May report coming soon) is substantial and is powering sales, and beating out somewhat moderating cost inflation at the same time.   That helped margins. One interesting matter to keep a watch on is the tip function now added in so many places to POS units may be distorting the consumer food away from home CPI measure higher. As we all know, restaurants do not keep tips but customers may remember what they pay.

My working thesis remains that while there will be some brands that will suffer from mismanagement, lack of new product new news, and deteriorating demographics, those will be finite. We will not see the industry-wide declines ala the 2008-2009 recession this time.

Another important development is that the IPO window has finally reopened. As discussed here many times, there were several latent IPOs ready to go, waiting for optimum market conditions. The very important VIX rate, the CBOT measure of daily stock trading volatility, finally settled down and was close to ideal levels in late May. CAVA, the fast-casual, 253-unit bowl concept was the first to file its S-1, and its roadshow began last week. CAVA will debut this week on Thursday in a $19 to 20 range, upgraded once. Panera’s confidential filing was next noted, and FAT Brands’ signal to launch an IPO of Twin Peaks was noted last week. CAVA has strong demographics, SSS trends, and restaurant margins (20%) but operates at a prior-year loss that will disappear with debt payoff. The funds raised for all these IPOs will be used for general purposes, including paying down debt. There will be more, Fogo de Chao and others.

Restaurant Op-Tempo Conditions:  Among the company-owned concepts, there was more mention of concern of new unit ROI with rising construction costs, and more modest store development targets. On the franchise development front, development activity should be closely watched for those brands with listless marketing and new product activity.

Subway/Doctor’s Associates Auction Goes On…and On…

In February we learned that JP Morgan became the exclusive listing agent for Subway/DAI, the franchisor. Founders Fred DeLucia and Dr. Peter Buck kicked off Subway with a single sub sandwich unit in 1965 and had grown to some 43,000 by 2022. While an amazing American restaurant growth story, Subway picked up immense difficulties during its years that now hobble its franchisees, current management, and potential buyers. JP Morgan hoped for a $10 billion price, or about a 12.5X multiple of $800M adjusted EBITDA.

Several developments in Subway’s past have proven to be difficult over time. The first was the mindless overdevelopment and self-cannibalization in the US fostered by its development agent structure and endless expansion in the US. Yes, there really does become a point of too much. That and then coupled with a 15-year period of discounting and a listless new product and new concept period, both before and after DeLucia’s death equals a store-level economics disaster. Of course, Subway reveals no Item 19 numbers in the FDD, but the last external research I saw was an EBITDAR (not EBITDA) of 10.5% in 2019. The franchisees closed 6000 units in the US since 2015. The rate of net closings has declined but 2023 is still expected to be a net negative. [2]

John Chidsey of Burger King fame was hired as Subway CEO In late 2019. His chief accomplishments to date have been the “Subway Series”, a series of preset Subway sandwiches that they are advertising via expensive sports personalities. They have boasted that same-store sales are up and have recovered in absolute terms to that of 2012 (no typo). In addition, Subway signed an impressive 13 international master franchise agreements, including a large China agreement last week.

The problem with 2012 is that a whole decade of inflation coverage in the AUV is missing. On June 8, 2023, Jonathan Maze published Technomic numbers showing that Subway was dead last, number 500 of 500 in AUV loss in 2022 (estimated) versus a 2012 base with inflation included. [3]

Back to the auction: The auction began in February and attracted interest from private equity funds. Strategic purchasers, such as YUM Brands or RBI, had taken a look years earlier and passed; today much higher interest rates may be a show-stopper for them. According to press reports, Advent Capital, Roark Capital, and Sycamore Capital are still looking. JP Morgan offered up a $5B floor loan to get things started, with a 15% interest rate. The process was to have concluded by June 1, now it is later per press reports.

Key auction considerations issues going forward are: (1) can the PE firms fund this deal profitably with possibly a 15% interest rate or higher?  (2) Subway just announced a big China development agreement. What is the potential brand strength in China and elsewhere X-US? (3) How will the PEs exit their investment?  Does Subway have the potential to be a publicly traded company in 6 years? The PEs would desire to buy in at say, 8 times adjusted EBITDA and then exit at 13 times via an IPO. That would be a win/win. But is that even possible? No one just gives money away for nothing. For more comments on the issues of a potential Subway IPO, see Jonathan Maze, “Would Subway be better off going public?”[4]

My opinion: I can see how some kind of deal gets cobbled together at some interest rate, but the risk is stress on the brand, the CEO, the franchisees, the employees, suppliers, and the corporate infrastructure would be immense, with debt service potentially gobbling much cash flow. We have seen this movie before.

The lessons from Subway? Don’t overexpand in the US mindlessly; don’t let your concept and product development fall asleep;  start your international development sooner; put a lot of attention to your franchisee store-level economics.

Roundup of Restaurant Vitals Observed:

The US Economy dodged a huge bullet…with the debt deal that passed the House and Senate in time and was signed by the President. No matter your political outlook, this serious crisis was never about the US Government cash flow (we had it)..but about government Obligation Authority. OA is the permission to use the funds we have. It is solved for two years. The consequences of failure to us, who rely on consumer confidence and debt, would have been disastrous.

Food Commodities: Foodstuffs except beef moving in a favorable trend. Beef will be a problem. Some manufacturing, transport, and distribution costs are in better shape. Hat Hip: David Maloni

New concept unit growth patterns are seen everywhere: coffee, chicken, and taco themes. Source: NRN, Technomic Top 500, indies in the field per field trips.

AND FINALLY……

One of the reasons for negative restaurant traffic is…. US unit saturation. Too many restaurants, both chains, and indies. We see the units open number every month/quarter and year. By and large, that number is stable or up 1-2% per year in store count. A few brands are shrinking, like Subway, Hardees, and Burger King. Some of the casual diners earlier. We can pretty well predict which brands will shrink. We did have shrinkage in 2020 but that was swallowed into the chaos of the 2020/2021 base. But it was not enough. Unit count growth has exceeded US population growth for years.

Black Box Intel recapped this observation on May 18, urging brands to differentiate themselves a much as possible in terms of guest and employee experience.  Seems logical. This is why I support that low-yielding marketing and advertising spending come out to make room for the new.

ABOUT THE AUTHOR:

John A. Gordon is a veteran restaurant industry analyst and management consultant. He has 6 years of field operations, 20 years of corporate staff financial planning and analysis roles, and the last 20 years at his founded restaurant analysis consultancy, Pacific Management Consulting Group. He works on complex analysis projects for restaurant operators of all types, investors, attorneys, and others who need answers about restaurants. Call him at 858 874-6626, or email jgordon@pacificmanagementconsultinggroup.com for an initial discussion.

[1]   Bank of America Restaurants Spending Note, June 12, 2023

[2]    Per CEO interview at Restauant Leadership Conference , 2023.

[3]   Restauant Business Online, Jonathan Maze, june 8 2023 (paywall).

[4]  Id, June 12, 2023 (paywall)

By Ally Marotti

McDonald’s franchisees are making an unprecedented bid to alter the balance of power in their relationship with the Chicago-based hamburger giant.

Leading the push is the National Owners Association, an independent franchisee advocacy group that launched about five years ago and represents roughly 1,000 of McDonald’s 2,000 franchisees. Advised by a well-known franchise lawyer, NOA is backing state legislation that gives franchisees more protection and is working to get the Federal Trade Commission to rewrite franchise rules in their favor.

McDonald’s and its franchisees have always had their ups and downs, but experts say the latest faceoff goes deeper than familiar debates over new product offerings and store upgrades. This time, franchisees are trying to gain more control in a partnership long dominated by the company.

“It’s not just a menu or restaurant format topic,” said RJ Hottovy, head of analytical research at location analytics company Placer.ai. “This is a little bit more personal.”

In a sign of how divisive the battle has become, the Wall Street Journal reported last month that McDonald’s U.S. president, Joe Erlinger, said in a call with franchisees that those supporting legislation were dividing the company. “You see attacks happening, and those attacks are coming from within,” the Journal quotes Erlinger as saying.

Franchisees feel threatened by corporate moves to tighten franchise terms and get tough on renewals. They also resent edicts requiring them to spend more money as inflation squeezes their margins. The fortunes of McDonald’s and its operators have diverged recently — franchisees say their cash flow has shrunk while same-store sales increases boost corporate profits and McDonald’s stock price.

Tensions are rising as McDonald’s looks to accelerate growth by stepping up new-store openings, an initiative that needs support from franchisees, who operate about 95% of McDonald’s 13,400 U.S. restaurants. Experts warn that a rift between McDonalds and its restaurant operators could alter or slow the chain’s growth plans.

“It’s usually not a good business practice to piss off your core stakeholders,” said Sean Dunlop, an analyst at Morningstar.

The NOA has given some franchisees the courage to push back on McDonald’s in ways they haven’t before, said Robert Zarco, a franchise lawyer the group hired as counsel earlier this year.

“In the past, they were very concerned about retaliation, intimidation and threats,” said Zarco, speaking on behalf of NOA. “Now, because there is strength in unity, they feel more protected by each other.”

Last summer, McDonald’s raised the bar for renewal of franchisee agreements and implemented a stricter performance review process for restaurant owners. It also changed criteria for franchisees to pass their businesses to spouses or children, saying it would evaluate all potential new franchisees the same way.

Erlinger said at the time that the changes to the renewal process were “in keeping with the principle that receiving a new franchise term is earned, not given.” As for next-generation owners, Erlinger said that adopting a uniform approach to evaluating new franchisees “regardless of the pathway” would provide “a consistent process.”

A new law in Arkansas touches on both topics. The National Owners Association supported the bill, which Gov. Sarah Huckabee Sanders signed into law in April.

The law says a franchisor’s approval is not required to transfer ownership to a spouse, child or heir. Another change in the law bars franchisors from terminating franchisees without cause “as determined under objective standards.”

Some McDonald’s restaurant owners also supported an Arizona bill that protects franchisees. The bill failed to pass during the most recent legislative session, but the sponsor, state Rep. Stacey Travers, D, said she plans to introduce it again next session.

Additionally, NOA is encouraging members to submit comments to the FTC, which is soliciting information about franchisee and franchisor relationships. Of the first 100 comments submitted, more than a dozen were from McDonald’s franchisees. They raised concerns about noncompete clauses, increasing costs and the changes the company made to its store inspections.

“Although I believe that McDonald’s has the right to insure (sic) their standards are met, I do not believe that the level of intrusions by this franchisor is reasonable,” wrote William Brown, a franchisee from Pennsylvania.

In a letter to members in February, NOA’s board said franchisee cash flow dropped by about $100,000 per restaurant in 2022 and was expected to fall again this year.

“The gap in operating revenue performance is not sustainable,” said the letter, which Kalinowski Equity Research published in a report. “We should not, and can no longer, be accepting the burden of the entire impact of inflation.”

Throwing new standards at franchisees while they’re dealing with inflationary pressures is a recipe for pushback, experts say.

“We’ve had two years of double-digit cost inflation . . . things are just tough, particularly in the quick-service restaurant world,” said John A. Gordon, principal at consulting firm Pacific Management Consulting Group. “Where there have been strained relationships for a long period of time, the relationships haven’t gotten any better.”

McDonald’s told Crain’s that it has made concessions for franchisees as it has rolled out recent changes. It adjusted the new performance review program based on franchisee feedback, and implemented it after a pilot period, so franchisees could get used to new standards before they took effect.

CEO Chris Kempczinski said during McDonald’s April earnings call that U.S. franchisees returned to positive cash flows in the first quarter. McDonald’s sales and profit exceeded Wall Street expectations, with quarterly net income rising 63% to $1.8 billion in the U.S. Sales at U.S. restaurants open at least a year— a key metric that tracks store-level growth — jumped 12.9%.

At about $285 on May 31, McDonald’s stock was up almost 8% year-to-date, compared with a more than 9% rise for the Standard & Poor’s 500 Index.

“We’re operating from a position of strength,” McDonald’s said in a statement to Crain’s. “We remain focused on driving momentum and making the right decisions for the future of the business.”

Not all McDonald’s franchisees are at odds with the company. McDonald’s provided a statement that a group of 10 franchisees put out last month that said, “We are disappointed that a small but vocal group is pushing this counterproductive agenda, which threatens our business model and the livelihoods of future generations of franchisees.”

Additionally, the chair of the National Franchisee Leadership Alliance, a company-backed franchisee group, said in a statement provided by McDonald’s that the group has had “several productive meetings” with company leadership this year and “we are clearly moving in the right direction.”

It will be hard for franchisees to wrestle control away from McDonald’s, said Mark Kalinowski, CEO of Kalinowski Equity Research, which has been publishing franchisee surveys for two decades. Unlike many other franchisors, McDonald’s also serves as a landlord to many of its franchisees.

“That gives McDonald’s a lot of leverage,” he said.

By Ally Marotti

Ally Marotti is a senior reporter for Crain’s Chicago Business covering consumer products, food, restaurants and retail. She joined Crain’s in 2020 from the Chicago Tribune.

by John A. Gordon, Principal and Founder, Pacific Management Consulting Group

A look at the big picture…we are half way through Q1 earnings and the results have been good. The best QSR global brand indicators, McDonald’s (MCD) YUM and Starbucks (SBUX) posted very good US and international sales and earnings, but MCD warned of a Q2 recession while SBUX guided conservatively mentioning potential guest falloff in 2H.

On the full-service side, Darden (DRI) had a strong report of sales and earnings and increased full-year 2023 guidance. Their internal guest value metrics were strong.

McDonald’s forever has been concerned if an imbalance between food at home and food away from home inflation occurs. And sure enough now that has happened, as discussed here the last two months.  The US BLS survey says restaurants are taking price increases like a machine.

The industry’s analysts and observers, influenced by the lag effect of the FEDs actions raising interest rates, increased personal borrowing on credit cards, and consumer surveys indicating that guests would slow up the frequency of visitation, have mostly built in a mild 2H recession probability.  This weakness really has not shown up in the reported public numbers yet.  Strong brands remain strong, weaker weak.  Some QSR brands indicate that their portion of $75K plus consumers are up, but that doesn’t necessarily mean they are cannibalizing fine dining.

But a new problem is coming at us more quickly.

News reports from DC indicate that the US Government’s borrowing limit—an authorization number that must be passed by both the House and Senate was technically breached on January 19, and Treasury has been operating accounting actions to preserve usable cash[1]  It seems that June 1 might be the first day in a range where government “usable “ cash falls to zero.  If this happens, the US may default on some of its debt, and payments to individuals. [2]  This is very political, but there is time to resolve it.

If it did happen, we can reasonably speculate there would be another financial market panic, along with a negative consumer reaction as payments are delayed and interest rates shoot up. While politicians always wait until the last minute to resolve disputes, I’d recommend restaurant operators of all sizes ensure they have adequate liquidity coming up so as not to be caught short like some chains during the onset of the Pandemic [3] You can never have too much cash.

Ruth’s Chris acquisition by Darden is an indication that strategic restaurant M&A is alive and well in 2023.

Darden’s interest in another brand was reported earlier first by Austin Fuller of the Orlando Sentinel and then was confirmed on earnings calls in 2022. The earnings multiple paid, 9.4X was healthy. RUTH is one of the few US fine dining brands ever to be able to operate franchise units, with 80 company units and 74 franchisees. Of note, 23 of the franchisee units are international, including Singapore, Hong Kong, and Tokyo.

As I was quoted in the Orlando Sentinel[4], Darden now gets Ruth’s international platform to leverage in Asia. In my view, that is a sorely needed platform for many US brands. As reported by many observers and most recently by Black Box, the negative traffic syndrome in the US is in part caused by too much new unit growth.

Must Look Under Every Rock Update:

Last month here, I introduced the idea that because the restaurant sector’s 2-year price advantage in terms of our inflation versus food-at-home inflation had ended,  this is why we can’t revert to taking price first and must look under every rock to find non-price revenue, cost, and CAPEX efficiencies.  The May 10 chart in Restaurant Business Online shows this.[5]  

A few practical examples:

Utilities: with summer virtually upon us and record gas and electric commodity inflation underway earlier, restaurants are burning way too many BTUs, especially fast casuals and QSRs for their size. It makes no sense for freezing dining rooms on cool days or at night. Starbucks (SBUX) and Chipotle (CMG), this includes you. Yes, this may entail dual makeup air units on the roof, but these investments have a payback. Bad HVAC turns off guests too.

Repetitive devices misworking: At a McDonald’s (MCD) franchisee I visit, there is an electric door opener that opens and closes about every 20 seconds whether a guest is in the doorway or not. Using electricity, grinding out gears, and perhaps a guest accident at some point will result.

Waste in new unit construction/CAPEX: the Quiznos franchisor attempting a turnaround of its 20-year record of store operational failure, developed a “Quiznos Grill” new store prototype where the buildout apparently was $2 million. The short story: it talked a franchisee in, sales were less than $400K per year and the franchisee failed. There will be more to this story, but the sheer waste of financial and human resources is breathtaking.

Finally, and most essentially, restaurants should take the long game and protect and get their most important delivery product mix AWAY FROM the third-party delivery agents (3PD).

As Joe Guszkowski from Restaurant Business Online reported [6]Friday, the 3PD folks are after us to lower our delivery markups, designed to cover our variable costs! IMO, this is bold on their part because their own P&Ls generally operate at a loss!

On LinkedIn on Friday, May 15, I noted several executable ideas, such as: (1) deliver your big orders and leave 3pD or others for the much smaller orders  (2) Get to understand OLO and call founder Noah Glass. Understand his vision and how developing your website with as much traffic as possible is very important. (3) Keep phone numbers, and use a service. (5) Maintain and enhance your restaurants’ website, with easy ordering portals (6) In smaller urban/dense suburban areas, chain unit clusters and indies can form a delivery co-op. It’s been done before. Where you have some geographic scale and keep it simple, ROI is possible. This will produce nonprice revenue efficiencies.

About the author:

John A. Gordon is a long-time restaurant industry veteran with 20 plus years of experience in restaurant corporate staff financial planning and analysis roles and the last 20 years via his founded firm, Pacific Management Consulting Group. He performs complex analysis, advisory and investigative engagements for restaurant operators, investors, attorneys, and security analysts. He is always contactable at 858 874 6626, jgordon@pacificmanagementconsultinggroup.com.

[1]   The Government actually has real cash flow but it might not be usable.

[2]    https://www.nytimes.com/2023/05/09/us/politics/us-debt-celing-x-date.html

[3]    See for example, Cheesecake Factory, 10Ks, 2020, 2021, SEC Edgar.

[4]  https:// www.orlandosentinel.com/2023/05/04/ruths-chris-deal-could-bring-darden-expansion-to-asia/

[5]   https://restaurantbusinessonline.com/financing/inflation-fast-food-restaurants-show=no-sign-of-slowing

[6]  https://www.restaurantbusinessonline.com/technology/doordash-restaurants-odds-over-price-markups

The Bottom Line: Engaged Capital, the same activist that took on Del Frisco’s and Jamba, is now targeting the fast-casual burger chain. But what would it do differently?

By Jonathan Maze on May 15, 2023

Please click the link to see the full article:

https://www.restaurantbusinessonline.com/financing/activist-investor-apparently-sites-its-sights-shake-shack