How Burger King Cooked Up a Franchise Rebellion

Date AddedNovember 23, 2009 12:32:38 PM

Author

When the going gets tough, the tough discount. That has long been a truism in retailing, and the going hasn't been this tough since the Great Depression.
But hundreds of Burger King franchise owners are drawing a line on a decision by Burger King Holdings Inc. to dictate price discounts. The issue has been brewing for months and finally came to a head in October when the corporation ordered franchisees to sell a $1 double cheeseburger as part of a "Value Menu" promotion.
The company claimed the move would lift sales by as much as 5 percent in the down economy and was a response to similar promotions by rivals McDonald's and Wendy's. But franchisees argued that they are losing money on every double cheeseburger they sell.
Like most so-called "loss leader" promotions, the idea is to make up the difference by selling customers additional items; in this case, higher-margin French fries and soft drinks. Cash-strapped customers, however, just aren't willing to shell out more money in the current economy, according to franchisees.
The dispute caused both sides to start parsing their franchise agreement, and last week, in a widely publicized move, the National Franchisee Association filed a class action on behalf of its 850 Burger King members. The suit claims the company has no right to dictate "maximum pricing" on menu items.
What's more, the lawsuit argues that Burger King's action goes against a long-standing company policy to honor the wishes of its franchisees on such matters. In two separate votes over the summer, franchisees overwhelmingly rejected the promotion.
Burger King, of course, argues that it is well within its rights. It cites a decision earlier this year by the U.S. Court of Appeals for the Eleventh Circuit. The court, which is one step below the U.S. Supreme Court, held that the franchise agreement gives Burger King the right to mandate participation in its Value Menu program.
Lawyers for the association counter that mandating participation in the program is one thing; dictating maximum prices is another. On that point, the courts will ultimately have to decide exactly how far Burger King can go.
Whatever the legal merits, the dispute couldn't come at a worse time for the fast food chain. The publicity alone has been a major setback for the corporation, and you have to wonder what Burger King executives were thinking when they let matters get out of hand.
McDonald's faced a similar upheaval earlier this year when franchisees protested the addition of a low-priced cheeseburger to their value menu. The fast food chain wisely compromised. It adjusted the product, removing some of the cheese, to lower cost and boost its margin.
Fast food promotions are nothing new, but in better times they were fewer and farther between, and up-selling was easier. In the current downturn, however, competition is cutthroat and fast food value meals have become a fixture in the quick-serve restaurant (QSR) segment of the dining industry.
A survey in May by Smart Money magazine found that a number of QSR chains were offering deep-discount promotions, often at the expense of their franchisees.
Baskin-Robbins set franchisees back on their heels when it came up with a "31-cent Scoop Night" promotion in April. That sharply discounted the regular price of $2.29 per scoop, without regard to franchisee costs, estimated to be 60 cents for the ice cream and cup and another $1.15 a scoop to cover overhead, such as rent, utilities, and labor.
The McDonald's Dollar Menu has been around for six years, but franchisees grouse that they make a slim 6 cents per cheeseburger after product costs, rent, labor, and utilities are deducted.
Quiznos, which has had bitter relations with its franchisees for years, forced them to swallow its Million Sub Giveaway promotion. The first million people who registered got a free sandwich. Franchisees say they lost as much as $2.25 per sandwich, even after reimbursement from the company for some of the costs. Fortunately, the program ended in March.
Why are promotions so good for the parent company if not for their franchisees? The answer is simple, according to franchisees. The company makes money from fees assessed against gross profits. Franchisees must rely on net profit. The promotions may boost gross profit, but at the expense of lower margins, which cut net profits.
Burger King franchisees also argue that the corporation is playing to a different audience: Wall Street.
During the downturn, all of the major players have been under pressure to maintain or increase sales to support their stock prices. There is also a belief among some analysts that the QSR segment can no longer support all of the chains and that a shakeout is looming.
Aside from powerhouse McDonald's, the rest of the chains are in danger of being perceived as the segment's "weak sister," which could affect share price as well. So far Wall Street seems to be split on the Burger King's cheeseburger promotion.
Stifel Nicolaus restaurant analyst Steve West downgraded Burger King's stock to a "hold" rating in September and cited the promotion as one of the reasons. "If you don't get enough sales, you're shooting yourself in the foot," he wrote. "History has shown that this doesn't work."
But Tom Forte, a restaurant analyst with Telsey Advisory Group, said the benefits outweigh the costs in the current climate. "What's the alternative? Not discounting and losing traffic to the competition," he noted.
Burger King posted weaker-than-expected quarterly results last month, and missed analysts' expectations, an all-important measure, as it lost ground in the segment to McDonald's. Among the factors, Burger King cited significant discounting.
Perhaps not so coincidentally, the $1 double cheeseburger promotion was announced just before the earnings release. Company chairman and CEO John Chidsey told analysts it was too early to assess the impact of the program, but predicted a 5 percent increase in sales.
The company clearly took a gamble by defying its franchisees and miscalculated. The impact of the lawsuit on sales is also unknown, and in the days since it was filed, the publicity has only gotten worse.
In a letter to Burger King's board of directors, dated November 11, franchisees said a series of decisions by current management were "ill-conceived" and put their businesses in "deep trouble," prompting one analyst to remark that the dispute could be a serious problem, if it "continues to fester."
As Sun Tzu wrote in The Art of War, the ancient Chinese book of military strategy, "regard your soldiers as your children, and they will follow you into the deepest valleys ... [but] when the army is restless and distrustful, trouble is sure to come..." Burger King should give that some thought as it looks for a way out of its current predicament.