Executive Insights | August 2010 | By Peter Romeo

Subway, Unscripted

Subway president Fred DeLuca started his sandwich chain 45 years ago and now opens new restaurants at the pace of one every eight hours. What does he know that you don’t?

When 17-year-old Fred DeLuca decided he’d try to earn his college tuition by launching a sandwich shop, he and partner Peter Buck set a goal of opening 32 outlets in 10 years.

“We fell a little short,” DeLuca recalls 45 years later. “I think we had 24 open” by 1975.

It might’ve been the last time his brainchild, now known as Subway, would miss an expansion target. Last year, at a time when the restaurant industry appeared to be contracting, the chain grew by 1,153 units in the U.S. alone. That’s roughly an opening every eight hours.

The brand has grown by at least 1,000 stores each year since 1987, and DeLuca doesn’t see that pace slowing. Indeed, he says, it’s getting easier. He sees capacity for another 5,000–7,000 U.S. outlets, based on current sales-to-penetration levels and his expectations for new traffic generators.

Still, predicting when Subway might hit the wall has become a sport of sorts among quick-service watchers. “After a while you run out of real estate,” says David Henkes, vice president of the research firm Technomic Inc.

Even DeLuca seems to foresee a day when the saturation point might be reached. Through another company, Franchise Brands, he and Buck are supporting two franchise upstarts, Mama DeLuca’s Pizza and Bajio Mexican Grill.

But for now, the speculation doesn’t faze DeLuca, who’s heard it incessantly since 23,000 Subways followed the Pete’s Super Submarines he opened with Buck’s $1,000 in 1965. “We get that question all the time,” he says with a hint of weariness. “‘How many stores can you build?’”

Franchisees have often been the ones asking the question, though with a decidedly sharper edge: How many units can the all-franchised chain hammer into the U.S. market without eroding their sales and profits?

Or as competitors might less kindly put it, how long can Subway stay on its tear?

Differences in the answers have led to battles over the years between the franchisees and franchisor, which has traditionally operated just one unit, a training facility near its Milford, Connecticut, headquarters. “You have franchisees who aren’t too happy when they’re opening a Subway a half a mile away from their stores,” says Technomic’s Henkes.

Tensions have also escalated when franchisees feel a home-office initiative boosts sales, the base of the franchisor’s royalty revenues, without increasing their profits. Most recently, about a third of the operators resisted the addition of breakfast, says Loren Goodridge, a 17-unit franchisee (with two under construction) and past head of the North American Association of Subway Franchisees (naasf). The a.m. menu was rolled out in May after being extensively tested in more than 7,000 restaurants.

“There was a concern among franchisees about losing money on it,” says Steve Forbes, a two-unit Vermont franchisee who serves on NAASF’s board. He counted himself among them.

Nonetheless, all parties attest that relations between licensee and licensor may be at an all-time high.

Part of that, they stress, is the rosy afterglow of doing well—all the sweeter when so much of the chain market has been gasping. “The sandwich category is doing better than most sectors, and it’s hard to tell if Subway is benefitting from that or driving it,” Henkes says.

But franchisees and franchisors also cite a new sophistication to their interactions, to the approach to the business, and even to the licensees themselves. Although “we still get a lot of new Americans” as owners, DeLuca says, the roster now includes many sizeable companies with dozens or hundreds of stores.

“We might be a lot smarter now about when we develop and where we develop,” Forbes says.

That savvier group has come to understand “it’s a lot better to own a Subway down the road from your store than to have it be a Jimmy John’s or a Quiznos,” says Bob Horner, a Houston-based partner in five franchisees and an area developer with oversight of 375 stores operated by others.

And breakfast appears to be winning over at least some of the skeptics. “I thought I’d lose money on it for six months, but I’ve been pleasantly surprised,” Forbes says. “Forty-five days out, I’m breaking even, so things are pretty good at the moment.” He even says the morning meal is the chain’s greatest opportunity.

“It all depends on consumer demand—if a lot of people want to buy your product, then you need more stores to satisfy them,” DeLuca says. “Right now, we have on average about one store for every 13,000 people in the United States. I’m confident one store per 10,000 people is achievable and beneficial.”

The key, he says during an exclusive interview with QSR, is keeping that demand stoked. Breakfast is the first phase of a long-range initiative to boost traffic outside of lunch, Subway’s stronghold. “We’ll do the same with snacking, the same with dinner,” DeLuca says. “There’s big opportunity there in daypart expansion,” but “we’ll probably need a couple of years to get it right.”

He also cites the benefits waiting to be reaped with new technologies. “There’s huge opportunity to marketing to customers more effectively and more efficiently,” he says. “There’s a lot to be done there.”

DeLuca cites the phone app that’s being tried by a franchisee in Los Angeles. “It’s this silly, quirky texting system—I say ‘silly’ because it’s so simple and easy,” he says. “You can stand outside the restaurant and use it to order just the way you’d order a sandwich inside—‘I want this bread, I’ll have cheese, some lettuce.’ This unsophisticated device is really working. It’s a great little thing.”

Many of Subway’s most successful demand-builders have been copied in recent years by other quick-service brands. Cutting the price of the Subway Footlong to $5, an idea hatched by a franchisee, was “huge” and a major reason “we’re way up over last year,” Goodridge says. Recently, $5 deals were hawked by Quiznos and Arby’s, among other direct competitors.

Subway also feels a lot of hands grabbing at its claim to fame: being fast food’s healthful alternative. “We have a lot of credibility on the nutrition and fresh-food fronts,” DeLuca says. “Now we have a lot of competitors who are doing a lot on that front. We need to maintain our lead.”

The new breakfast menu fits that attempt. Subway, a latecomer to the morning market, offers egg-white-only versions of the new sandwiches, which can be made with whole-wheat breads. Selections can also be garnished to order with any of the fresh vegetables the chain uses on its Footlongs, like peppers and tomatoes.

The chain is also looking at the composition of the foods on its menu. “We’ve been working for the last two years on sodium reduction,” DeLuca says.

The breakfast initiative, he says, “is doing OK” and “our owners are very happy with it.” Like all of the franchisees who spoke with QSR, DeLuca stresses that the venture didn’t require much of a ramp-up. Managers and some crew already arrived early to bake bread for lunch. “It’s just a matter of coming in an hour or two earlier,” DeLuca says.

The program was apparently not expected to light a rocket under sales, at least initially. Projections called for an increase of just $265 per unit per week, franchisees say. But that was against a labor investment of just five to seven additional man hours per week.

Meanwhile, the program is paying dividends that have nothing to do with egg sandwich or coffee sales.

Licensees say a noticeable number of breakfast patrons also buy a cold sub they can store in the fridge at work and eat for lunch at their desk, boosting sandwich sales without lengthening the midday lines that can discourage would-be customers.

In addition, “it helped us be better prepared for our lunch rush,” Horner says. “With that extra hour of prep time, everything’s ready and fresher looking. The real benefit is the stores are better run at lunch.”

That payback addresses what DeLuca cites as a major challenge to the brand. Fueling demand is important, but so are the quality and consistency of stores’ efforts to satisfy it. Operations are a particularly crucial concern when a chain has as many franchisees as Subway does, not to mention when it faces considerable direct competition from a pack of upstart fast-casual challengers.

“I tell my team all the time, ‘The biggest chain in the world used to be Howard Johnson. Now no one eats at a Howard Johnson,’” DeLuca says. “The world doesn’t stand still and we don’t deserve to be where we are unless we stay ahead of things and take the necessary steps to remain competitive.”

Inertia can also be a factor after at least a seven-year run of strong sales, Horner says. “How do you keep successful owners fresh, how do you keep them interested and motivated enough when they’ve paid off their house and are living well?”

Providing consistent quality is “probably our biggest challenge,” and will be addressed in the five-year strategic plan that the home office and franchisees are about to draft for the brand, says Goodridge, who’s on the committee writing it.

DeLuca says that some operational problems are allayed through a process he instituted two years ago to foster improved communications and hence better relations with franchisees. “We started having these massive conference calls. I’d invite a whole mess of multiunit operators, maybe 60, 70 people,” he says. “I get maybe 50 people at headquarters to participate.”

Franchisees are invited to raise any issue or concern on their minds. “One operator brought up some equipment problem he was having,” DeLuca says. “I asked all the other operators on the call if they knew about it, and every one of them did. No one here [in headquarters] knew about it.” It was subsequently fixed.

In addition, DeLuca says he spends time in the field visiting stores. “My typical way to spend a day is to get in the car with a local development agent and drive from here to there, visiting stores in between,” he says. “Obviously he’s talking to me between stops about what’s going on, what he’s hearing. I pick up these little things and fit them into the puzzle.”

Franchisees say DeLuca is still the ramrod who pushes ideas through the system. A franchisee was the source of $5 Footlongs, but DeLuca pushed the permanent discount as a way of simplifying menuboards, which were turning patrons off with their complexity. Franchisees also cite DeLuca as the proponent of controversial ideas like cutting the price of six-inch subs to $2.49 in some markets.

“Fred blows me away with some of his goals and projections,” Horner says. “I wonder where he gets some of those things.”

With a 2009 net worth pegged at $1.5 billion by Forbes magazine, DeLuca could arguably do nothing but sit back and count the money coming in. “They’ve got great marketing, they’re positioned well, they were ahead of the curve with the health positioning, they have a halo in the mind of the consumer, and they have a franchising model that’s been very aggressive,” Henkes says.

Meanwhile, Subway’s lead over the competition is enormous, particularly in terms of breadth. “It’s almost eight times as large as Arby’s, six times as big as Quiznos, and 20 times as large as Jimmy John’s,” Henkes says.

But DeLuca isn’t ready to hand the bread knife to a successor anytime soon. “There are many, many people who could step in with the skills and talent needed to do the job,” he says. It’s just that golf, sailing, or other retirement pursuits just don’t interest him as much as franchising.

“I work every day, and I can’t figure out why I enjoy it so much,” he says.

“I’ve been doing this for 45 years. Sometimes I think, ‘If I just keep at it for another five years, I could say I’ve done it for 50.’”

He pauses.

“When I hit 50, I’ll probably say, ‘You know, I could do this for 100 years.’”