Subway Revitalization: What Is Needed to Make It Work

August 18th, 2016

<p>Coinciding with the Olympics, Subway has unveiled a new logo and a new round of advertising touting the new advertising themes. But a lot more than that is needed to revitalize the brand.</p>

<p>Pulling off reimaging of both products and facility is vitally important for a brand that has clearly lost US momentum over the last three years, in a fiercely competitive business, where sales per unit are half that of major competitors and where franchisee “cash flow” is very thin. It takes time to transform franchisee brands since the funding traditionally comes from “other people’s money,” the franchisees.</p>

<p><img alt="New Subway logo" src="http://www.bluemaumau.org/sites/default/files/resize/080516_1708_Subway…; style="width: 148px; height: 151px; float: right; margin-left: 4px; margin-right: 4px;" /><strong>Expected Subway Remodel Economics</strong></p>

<p>The cost of the 2017 vintage remodel (the capital expenditures, or CAPEX) is reported to be in the $80,000 to $100,000 range by multiple sources. That hefty investment represents about half of the cost to build and open a new Subway, almost four years’ worth of store EBITDA, at its current run rate.</p>

<p>Some franchisees may have unencumbered available cash that they can inject directly into their stores to pay for the remodel and not take on any debt. Many others will not have available cash and must borrow, since Subway US sales and profits have fallen for three years. Assuming debt is necessary, see Table One, below, as illustrative of key financial hurdle rates.</p>

<div class="photoright"><strong>Fully Loaded Projected US Subway Remodel<br />
Economics, Debt Scenario, Years 1-5</strong>

<table>
<colgroup>
<col style="width:225px" />
<col style="width:105px" />
</colgroup>
<tbody>
<tr style="background: #70ad47">
<td style="padding-left: 7px; padding-right: 7px; border-top: solid #70ad47 0.5pt; border-left: solid #70ad47 0.5pt; border-bottom: solid #70ad47 0.5pt; border-right: none"><span style="color:white"><strong>Measure, Per Unit</strong></span></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: solid #70ad47 0.5pt; border-left: none; border-bottom: solid #70ad47 0.5pt; border-right: solid #70ad47 0.5pt"><span style="color:white"><strong>Annual Value</strong></span></td>
</tr>
<tr style="background: #e2efd9">
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: solid #a8d08d 0.5pt; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt"><strong>Subway US AUV</strong></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: none; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt">$430,000</td>
</tr>
<tr>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: solid #a8d08d 0.5pt; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt"><strong>Total Store Buildout, Pre-remodel</strong></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: none; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt">$189,975</td>
</tr>
<tr style="background: #e2efd9">
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: solid #a8d08d 0.5pt; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt"><strong>Reported Remodel Cost</strong></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: none; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt">$90,000</td>
</tr>
<tr>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: solid #a8d08d 0.5pt; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt"><strong>Remodel Cost of Initial Build</strong></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: none; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt">47.3 %</td>
</tr>
<tr style="background: #e2efd9">
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: solid #a8d08d 0.5pt; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt"><strong>Projected Annual Debt Service</strong></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: none; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt">$23,400/unit</td>
</tr>
<tr>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: solid #a8d08d 0.5pt; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt"><strong>Adjusted EBITDA before Sales lift</strong></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: none; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt">$25,600</td>
</tr>
<tr style="background: #e2efd9">
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: solid #a8d08d 0.5pt; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt"><strong>Number of Years Adjusted Profits Consumed</strong></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: none; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt">3.52 years</td>
</tr>
<tr>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: solid #a8d08d 0.5pt; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt"><strong>Breakeven Sales Increase Required, % of AUV</strong></td>
<td style="padding-left: 7px; padding-right: 7px; border-top: none; border-left: none; border-bottom: solid #a8d08d 0.5pt; border-right: solid #a8d08d 0.5pt">10.9%</td>
</tr>
</tbody>
</table>
</div>

<p>About an 11 percent sales increase is needed to cover the interest and arrive at free cash flow to pay back the principal. That is a moderately high number, compared to other brands, a norm might be in the mid-single digits.</p>

<p>Like many capital investments, the profit flow through will be much larger after the remodeling note and the interest is fully paid back, in years 6 and out. However, maintenance CAPEX and further remodeling will be necessary after the remodel effect tails off. In restaurant financial management circles, remodeling is justified on a mandatory basis, that is, if it is not done, sales (and profits) will turn negative without a doubt.</p>

<p><strong>Special Subway Situation Considerations</strong></p>

<p>What makes the Subway situation more challenging is the thin profit margin now, the size of the remodel expense and the massive number of units in the US.</p>

<ul>
<li><strong>Narrow profit margin dollars</strong>: $31,000, the best-estimated value of US franchisee EBITDA per unit is narrow; Subway’s AUV is only about half that of its major peers, Firehouse, Jersey Mikes and Jimmy John’s.</li>
<li><strong>Relative size of the remodel</strong>: While the Subway initial buildout cost is lower than many, the size of this remodel is expensive, over 47 percent of the cost to buildout and open a new Subway. That is higher than other QSR remodels and is about 3.5 years of franchisee profits, on average.</li>
<li><strong>Massive number of franchised Subway units in US means that remodels will occur slowly</strong>: Subway reported 27,129 units in the US in 2016. Assuming franchisees find sources of funding and plan the remodels, it could take several years for a majority of the US units to be remodeled.  I would expect sales lifts to be muted unless certain markets are done at one time, or unless the remodels happen more quickly. A remodel is a form of marketing and is best seen in mass form to make an impression on customers.   </li>
</ul>

<p><strong>Franchisor DAI Can Jump Start This Process</strong></p>

<p>The size of the US Subway system, the age since last remodel and the need to demonstrate something is new at Subway mitigates for faster action. Individual franchisee actions will take substantial time. The Subway franchisor, Doctors Associates Inc. (DAI) is not publicly traded, thought to be very low or debt free, and is estimated to generate over $400 million in worldwide annual EBITDA. DAI could underwrite or co-fund franchisee remodels in a number of ways, from co-investment, to a cash grant, to removing royalties for a period of time to give franchisees time to offset the new debt, or even create a very low-cost, subsidized loan pool with very low interest rates backed up by Subway cash.    </p>

<p><strong>What if the Franchisor Does Nothing?</strong></p>

<p>DAI, the franchisor, may opt to do nothing, let the franchisees fund the remodels, just as has always happened in the past. But Subway is in a more precarious position than ever before.</p>

<p>The number of both Subway and competitor sub shops has exploded thousands-fold since 1965, when the Subway predecessor was opened by Fred DeLuca and Dr. Buck. The problem is that time has passed and there have been multiple years of sales declines and corresponding per unit profit declines.  Even as low volume units close, that is a very slow mediation of the issue.  </p>

<p>The cost of doing nothing could be seen in further decline in the brand, and the force that has powered its growth, its franchisees. No one wants to see that happen to the world’s largest restaurant brand.</p>

<hr />
<p><strong>References</strong>:</p>

<div>Footnotes:
<hr align="left" size="1" width="33%" />
<div id="ftn1">
<p><a href="#_ftnref1" name="_ftn1" title="">[1]</a>  Midpoint of Item 7 Initial Investment Range, 2016 Subway Franchise Disclosure Document</p>
</div>

<div id="ftn2">
<p><a href="#_ftnref2" name="_ftn2" title="">[2]</a>  Per <u>Blue Mau Mau</u>, August 5, 2016.</p>
</div>

<div id="ftn3">
<p><a href="#_ftnref3" name="_ftn3" title="">[3]</a>  $90,000 per unit times 6% interest times 5 years, or $5400/year interest expense, plus note payback of $90,000 divided by 5 years, or $18,000, for grand total of $23,400/year, for years 1 through 5.</p>
</div>

<div id="ftn4">
<p><a href="#_ftnref4" name="_ftn4" title="">[4]</a>  $31,000 minus $5400 proforma interest expense, for first five years is $25,600/year of adjusted EBITDA, before sales lift.</p>
</div>

<div id="ftn5">
<p><a href="#_ftnref5" name="_ftn5" title="">[5]</a>  $90,000 remodeling cost divided by $25,600, adjusted profit.</p>
</div>

<div id="ftn6">
<p><a href="#_ftnref6" name="_ftn6" title="">[6]</a> $23,400 total debt service divided by .50, standard restaurant variable profit/divided by $430,0000 base AUV, or 10.9%</p>
</div>
</div>

Subway Revitalization: What Is Needed to Make It Work

john a. gordon