FRANCHISES

In Search Of The Perfect Business

Successful franchise marketing leads a deli business to explosive growth.
Advertisement

Put yourself in Rick Cardin's shoes.

You've got a Harvard B-school doctorate, you've done a decade of prestigious and lucrative consulting work, and now you want to build a business of your own. What kind? You don't know. All you know is that you want to do it right. So starting from scratch, you systematically devote all your skills, training, and experience to determining what would make the single best start-up concept in the land.

It takes three years.

This is what you come up with.

As any venture capitalist, securities underwriter, or marketing type will tell you, sometimes a company's appeal has less to do with its product than with, well, its story. Here's Rick Cardin's.

It's 1981. Cardin, 35, is in Massachusetts, where he's spent most of his life being the kind of guy you wish you could hate: Phi Beta Kappa at Tufts; Harvard M.B.A. with distinction; Harvard doctorate; director at a renowned management-consulting firm.

Except you can't hate him. He's tall, charming, smart, and modest -- a disarming combination. And he works hard. While billing -- billing -- as much as 70 hours per week to major international companies for advice on strategic planning and organizational structure, he has also helped grow the consulting firm threefold. He's a success. He's making $175,000 a year.

But he'll tell you, looking back, that by 1981 something had happened to him. After seven years solving other people's problems, and all the overachieving years before that, he'd come to a pair of conclusions. First, it wasn't fun anymore. "To be a successful older consultant, of which there aren't many," he says, "you have to enjoy one specific field and stick to it." Cardin's loves, however, were general -- and generalists have no future. Especially when it comes to money.

Which brought him to his second conclusion: if he'd devoted the same seven years of skill and effort to an enterprise of his own, he'd have built a company by now. He'd have a stake, not just a paycheck, however plump. "And making the business grow was what I'd loved most all along," he says. He'd have been more satisfied, happier, possibly even rich. So at year end he quit. Rick Cardin was now an entrepreneur.

One problem, though. He was an entrepreneur who had no idea what business he wanted to build. He knew only that whatever it was -- remember his résumé? -- he wanted it ambitious. He wanted the perfect start-up. And he was convinced that logic could get him there.

Because he'd had no time to spend it, he'd piled up enough cash to live on for a while. He took a year to travel, read, relax, and think. Then he began his search -- conducted with his customary analytical vengeance. For six months he wandered through the offices of more business brokers than he could count. What's for sale? he'd ask. What are buyers after? How about pricing? Cash-flow expectations? Typical seller financing? Tell me what you know.

If there is an epiphany at the heart of every business, then this is when Cardin had his. In office after office, whether flyblown or plush, he'd find more people looking for companies than there were companies for sale. He'd see letters from would-be buyers stacked two inches high, dwarfing the quarter-inch of businesses being offered. He'd hear brokers telling him: forget the specifics. The product most in demand is businesses themselves. Period.

That's when Cardin got his idea. His simple, straightforward idea -- "so obvious that an idiot could have thought of it," he says today. His business, he decided, would be the creating and selling of businesses.

At this point in the story we'll skip some steps -- though you can be certain Cardin didn't. He moves to San Francisco. Time passes. There's this woman.

By late 1983 he's concluded that creating and selling businesses means franchising. With companies going for only three to five times cash flow, there wasn't enough return in a straight sale to make starting them worthwhile. As a seller, you needed recurring revenue. You needed royalty checks.

Franchising made sense for buyers, too. "It takes almost the same steps to start a small business as a large one," Cardin remembers thinking. "You find or design a product; you negotiate a lease; you find equipment to manufacture that product. Whether for a $10-million factory or a delicatessen, it takes all those steps. And if you do it once, for the first and maybe only time in your life, you're a rank amateur dealing at every step with people who do that step as their lifework." People need help. He could start a company to provide it. "Basically," he realized, "franchising is the consulting business." Except you keep getting paid. This revelation in mind, he spent the next year trying to divine the ideal franchise concept (see "Cardin's Guide," page 5).

In the end (to skip still more steps), all indicators pointed to the last place Rick Cardin, Ivy League theoretician and globe-girdling bon vivant, ever expected to end up: sandwich shops. As the Guide explains, it was the business that best met all criteria -- stable, nonfad, recession-proof, limited risk, potentially public, pleasant to work in, easy to add value to, and more.

It was late in 1983 -- when he was stalking every franchise-world notable who'd help -- that Cardin met Joseph S. Sanfellipo, whose own résumé read like night to Cardin's day. Then 35 and co-owner of a transmission-repair franchisor that he had expanded in five years from 5 to 100 units, Sanfellipo had founded or cofounded a dozen companies, mostly in franchising, since quitting school and leaving home at age 12. He had been a millionaire at 24, bankrupt at 30, and a millionaire again a few years later, as he pushed Gibraltar Transmission Corp. to a position among the market leaders.

Sanfellipo, a franchising insider, pointed Cardin toward at least two more top players: Neil Frumkin, a longtime franchise real-estate guru for many companies, including Pizza Hut Inc., which added 2,000 units under his direction in the late '70s; and Lester Singer, Touche Ross & Co.'s expert on restaurants and franchising. Both men came on as directors.

Sanfellipo himself, at Cardin's pleading ("One thing I've done is surround myself with streetwise guys"), joined the company as president -- receiving or buying from Cardin enough stock to become an equal partner. Today the two split about 60% of the company's stock.

At last, in November 1985, they opened their first O! Deli, the company-owned test store, on the corner of Market and Van Ness in San Francisco. They figured O! Deli would be a store that sold sandwiches to working people during working hours -- a chain of franchised sandwich shops, each open Monday through Friday, 7 a.m. to 5 p.m. The delis would serve healthy, high-quality sandwiches, soups, breakfasts, and snacks -- at fast-food prices -- from locations primarily in office complexes and financial districts. The company would grow to 500 units by 1993, and to 2,000 by 1998.

It would, pledged the characteristically ebullient Sanfellipo, "replace the mom-and-pop deli the way 7-Eleven replaced the corner market and McDonald's replaced the hamburger stand. This is one of the last segments of the food business that hasn't been franchised."

Said Cardin (momentarily immodest): "Ten years from now, we'll be able to do a case study of how to start a business right."

It's a nice story. And, as we'll explain later, it's probably what enabled O! Deli to go public last summer, netting $1.7 million in cash despite never having made any money and not yet fielding more than a handful of units. To paraphrase market maker Michael Underwood at Denver's RAF Financial Inc.: of a strong team and a sexy tale are attractive investment properties made.

Still, there are a lot of sandwiches to be sold on the way to 2,000 units. And a lot of franchisees to be signed up -- and kept happy. If the concept doesn't make sense at the store level, then it won't matter how well Cardin, Sanfellipo, and crew perform their "consulting" role. The mail sacks at O! Deli corporate won't be heavy with royalty checks if franchisees can't find customers.

Not to worry, claims Cardin. Signs of America's hunger for sandwiches are legion especially among O! Deli's target customers. A U.S. Commerce Department report estimates that franchised sandwich shop sales grew 31% in 1988, to $1.3 billion. Though that rate is more than double the growth of the runner-up among eight restaurant categories, the sandwich category remains in its infancy, accounting for less than 2% of the franchise restaurant market. "With a national trend toward more healthful eating," says the report's author, "lighter fare like sandwiches will be in demand, particularly for lunch. Sandwich shops appear to be one of the prime growth markets for prospective restaurant franchisors."

The healthier-food shift is widely acknowledged -- it's why McDonald's sells salads now, and it's why O! Deli sells nothing greasy, deep-fried, or grilled. And the lunch trade is O! Deli's chosen high ground.

Statistics indicate that almost half of all fast-food sandwich-shop traffic comes at lunchtime. Cardin will chase the lunch crowd, and its promise of lucrative repeat business, in two specific ways. First, by offering what he calls a "varied-taste" menu at fast-food prices, and second, by operating where the lunch crowd lives -- office complexes and industrial parks.

O! Deli's prices couldn't be higher than customers would be willing to pay every day. Research suggested that a "complete lunch" -- sandwich, drink, dessert -- should run between $3.50 and $4. That meant the average sandwich needed to go for about $2.50 or $3 -- which is low. To keep the prices there, while still using high-quality ingredients and preserving the 35% food and paper cost that protects gross margin, O! Deli serves slightly smaller portions than some sandwich customers have come to expect. (No problem, says Sanfellipo: "At O! Deli you pay only for what you eat," not for New York-deli inspired overflow.)

The taste, too, had to be a potentially everyday choice. Cardin likes to say that most fast-food chains, even such rival sandwich makers as Subway Sandwiches & Salads, Sandwich Chef, and Schlotzsky's Sandwich Shops, are "one-taste" concepts. Who, he asks, wants to eat an oil-and-vinegar splashed hero every day of the week? O! Deli counters with a studiously traditional and nonfad menu, raised on the pillars of turkey, ham, roast beef, and cheese.

What ties together these menu and pricing strategies, and perhaps does the most to differentiate O! Deli from its competitors, is the company's location strategy.

Follow the logic. Because the shops are relatively inexpensive to build and run (little space, no grilling equipment, small staff) they don't need to match hamburger-joint revenues in order to make an adequate return. Because they don't need to generate big sales, and because they're conceived to encourage repeat business, the shops can be content just to serve working people during the workday, and to cater to a relatively small market area. And finally, because they can be content to serve people in their workplace, and because the absence of cooking makes the shops attractive to commercial landlords leery of grease and odor, they can locate in office towers, where most other chains can't. The result? They're closer than any competitor to their perfect customer, the only customer they think they need.

Is this enough of a market to generate $300,000 per shop in annual sales? The folks at O! Deli think so. Cardin calls the projection "conservative," though the national average for sandwich-shop revenues is about $260,000. The key is the repeat business. Already, O! Deli claims, 60% of its customers return three times a week.

If location is counted on to lure customers, it is counted on even more to lure franchisees. "For one thing," Sanfellipo says, "it is the perfect franchisor response to the constant franchisee question, 'What can you really do for me?' " What O! Deli thinks it can do is get sites and achieve lease terms that few shop owners could capture on their own.

The good fit between O! Deli's concept and the standard granite-and-glass office plaza enables the company's management to pitch the shops to landlords as commercial-property amenities -- the sort of perk that makes buildings more attractive to tenants. Delivering tenants, of course, is the sort of benefit that makes retailers more attractive to landlords.

"I think we offer building managers a lot of advantages," says Cardin. "Our food is simple but high quality. We have the skills and experience to control the operation, to supervise the quality of the service, and to maintain the value of the site."

Most prime office space in desirable markets is managed by giant firms like Trammell Crow Co. that would prefer not to deal with mom and pop, who too often have "questionable finances and questionable business sense," according to Jeff Johnson, northern California leasing manager for Chicago-based JMB Realty Trust.

Johnson has placed one of the first O! Delis in an Oakland, Calif., building run by JMB, one of the nation's largest commercial-property owners. "Of all the different leases we work on, the ground-level food-service lease can be the most difficult. If [O! Deli] makes it easy, if it comes in with professionalism, a strong concept, and strong resources, I think it's going to be attractive to a lot of building owners."

That would make O! Deli attractive to a lot of potential franchisees as well, but for a location-related reason more subtle than high foot traffic or great lease terms: lifestyle. During his research mission at the feet of America's business brokers, Cardin discovered that people loved to buy delis. Why? "Everybody thinks they can run one, you don't need much capital to pick one up, and everybody thinks they can assess the risk -- and know whether a deli will make it or not -- on a gut level. It's a business they understand."

The trouble with most delis, though, as with restaurants, is the schedule. The days are long -- most delis stay open into the evening -- and often include weekends. The hours are legendary for their misery.

But not at O! Deli. The concept and most locations conspire to shut the shops down whenever people aren't in their offices. And Cardin has tried to add other lifestyle sweeteners, too: the concept caters largely to regular customers who enjoy what they're getting, which means they ought to be pleasant to deal with (unlike the customers at a transmission shop); and it requires no specialized employees (increasing personnel flexibility and eliminating any anxious and vulnerable reliance on a few skilled workers). The selling point is simple: O! Deli aims to be fun.

It also, of course, aims to make money. Though the franchise fee of $25,000 is higher than some sandwich shops (Subway charges $7,500 and an 8% royalty, compared with O! Deli's 6%), the total start-up investment of $75,000 to $125,000 is much lower than the price of opening, say, a Burger King, which could run as high as $1 million.

The low entry fee was important to Cardin even before he invented O! Deli. About $100,000, he found, was the price that kept most potential buyers in the game, including those looking to purchase a job. By fitting the concept under that limit, he not only made franchises comparatively easy to sell, but also less risky for franchisees because the units are easier to resell. The small price tag offers other benefits, too. While the standard Burger King produces higher revenues and gross profits, its return on investment doesn't come close to Cardin's projections for O! Deli. Historically, the hamburger chains return about a dollar of sales per year for every dollar invested. An O! Deli franchise that meets the unit forecast of $300,000 in sales can be expected to kick back about $2 in revenue for every dollar put in. A big difference, if Cardin is right.

It's hard to imagine that the office Cardin and Sanfellipo share, a walk-up above their San Francisco pilot store, has changed much in the two and a half years since it opened. Unlike their restaurant decor, their literature, or their board of directors, it looks and feels like the start-up that the company remains: cramped, noisy, and littered, with desktops awash in stained coffee cups and mail.

It's equally hard to imagine that the place will look different two years hence. O! Deli will still be a start-up. When the current fiscal year -- its first as a public company -- ends on March 31, the two executives expect to have 20 stores operating and annualized systemwide sales of $6 million. They will again have lost money, though they won't predict how much.

They will predict when they'll turn the corner: at the 50-store level, which may come as early as year end, fiscal 1990. It will be at least fiscal '91 before O! Deli shows a full-year bottom line that's black.

Getting to positive cash flow will have cost the company about $2 million, twice what Cardin anticipated -- a run-up he attributes to increased development and franchise support investment to prepare for swifter-than-expected expansion.

However much the need for it outstripped forecasts, capital was not hard to come by. Cardin has kept away from both venture capital money and bank debt, opting to raise $85,000 by selling 8.5% of the company privately, selling some dividend-paying preferred stock to directors and shareholders for $240,000, taking out a $150,000 Small Business Administration loan, and contributing $150,000 himself.

Last summer, O! Deli collected what will soon be $1.7 million more in cash by going public through a reverse merger with a Denver-registered blind-pool public shell. At root, the deal involved selling 35% of the company to the shell company's investors for the cash. Equally important to Cardin, it enabled O! Deli to become public at enormously reduced cost, both financially and bureaucratically. (O! Deli is traded in the pink sheets.)

Can O! Deli reasonably hope for the kind of rapid future growth its projections call for (500 units by 1993 and 2,000 by '98)? Maybe. Though only 11 stores were operating when Inc. went to press, O! Deli had agreements for 240 more. Fifty-two of these were sold directly, to single-unit franchisees or in territories (such as the deal with a Massachusetts-based, multi-unit Burger King franchisor to build 20 stores in five years). But O! Deli expects quicker growth to come from two other franchise marketing approaches.

The first makes use of joint ventures with "area franchise developers." A New Jersey company, Delimax Corp., has agreed to build 190 O! Delis in New Jersey and Connecticut over 10 years. For these units, Delimax will in effect function as franchisor, performing all the tasks that O! Deli corporate normally does. For taking on that management load, the area-development franchisor gets half the 6% royalties, which are still sent to O! Deli, and half the initial franchise fee for each store. So O! Deli's net is cut 50%, but its management investment drops almost 100%. Similar deals are being discussed with others.

Newer to the company's thinking is the second strategy: re-franchise existing chains that could be effectively repositioned as O! Deli. In some cases, O! Deli may buy a chain outright, then sell locations off individually as franchises -- collecting not only the franchise fee, but whatever profit it can make on the rollover of the business. In other cases, a chain might sell its locations directly to O! Deli franchisees, without O! Deli ever holding title. The franchisees get good value on depreciated facilities and equipment. The seller gets improved odds that the buyers, backed by a franchise system, will stay in business long enough to repay the note he usually has to extend. O! Deli is now negotiating with a 12-unit chain on this sort of deal, in which O! Deli has no financial risk.

If some of these plans sound a note of frenzy in what otherwise seems a fastidiously controlled program, Cardin and Sanfellipo are aware of it. Asked to name the stumbling blocks most likely to trip them, each talked about the pressure to grow. Yet ramping up fast is integral to their strategy. Remember Cardin's Guide: Rarely has the leader been overtaken in a franchise market. If that observation is accurate, some would say O! Deli is already too late to the game. The company's biggest competitor, Subway Sandwiches & Salads, has more than 2,900 units, adding more than 1,000 of them in the past year alone. Subway, Cardin would say, is "one-taste" fare, not exactly O! Deli's style. But that's an awfully fine line to draw.

Expanding too fast, becoming too spread out geographically, and delegating too much management oversight to outside contractors can rapidly give life to age-old franchising woes: loss of control, slippage of quality, deterioration of image. And how fast can O! Deli multiply without straying too far from its carefully honed concept, "selling sandwiches to working people during working hours," and all the site-selection and management-style criteria that strategy entails? Neither of the executives is sure.

They'll just keep trying to move the sandwiches. "If you have enough sales," says Cardin, "you can work out the rest."

For an update on this company, see Anatomy of a Start-Up Revisited: Facelift

Research assistance was provided by Leslie Brokaw.


EXECUTIVE SUMMARY

THE COMPANY
The O! Deli Corp., San Francisco
Concept:
A publicly traded, national chain of franchised sandwich shops selling breakfast and lunch items at fast-food prices "to working people during working hours." Differentiated from competitors by location strategy, menu, and quality of management

Projections: Five hundred units by 1993; 2,000 by 1998. Capital based on the units' sales as they begin operations during the year. Systemwide sales of $112 million in 1993, with franchisor revenue of $9.4 million and pretax profits of $2.8 million

Hurdles: Preventing the push for fast growth from leading to poor locations, inadequate controls, diminished quality, and diluted image. Sustaining the concept, even if it limits growth

THE FOUNDER
Frederick A. Cardin, 42
Chairman and CEO
'A Consulting Job for Myself'
The truth, says consultant turned company builder Rick Cardin, is consultants don't invent new solutions, they find the old ones that fit. "You assume every problem you come across has already been dealt with by someone else, so you go see what they've done."

Which is exactly what Cardin did after deciding that becoming a franchisor was the best way to make a business out of creating and selling businesses. For nearly two years, he networked his way through the industry's elite (in the guise of prospective franchisee) and learned everything he could from at least 75 national franchisors. The research led to The O! Deli Corp.

Did it ever trouble him that the neighborhood deli has so steadfastly resisted franchising? Surely sandwiches would have gone the route of hamburgers, chicken, and pizza unless there were some compelling reasons they couldn't. "I think I know the reasons," Cardin says. "Perceived competition; low gross volume; fewer opportunities for vertical integration; and an unglamorous reputation." He adds: "I think our concept deals with them all."


FINANCIALS

O! Deli Projected Annual Operating Statement (per unit)

Sales (operating Monday-Friday, $300,000

@ $2.33/check) 7 a.m.-5 p.m.

Cost of Sales
Product (35% of sales) 105,000

Labor, including management

(20% of sales) 60,000

Labor benefits 12,000

Total cost of sales 177,000

Gross Margin 123,000

Direct Operating Expenses
Advertising 3,000

Utilities, maintenance, supplies, etc. 19,350

Royalties 18,000

Total direct operating expenses 40,350

Administration and General 7,900

Income Before Occupancy/Depreciation/Interest/Tax 74,750

Total occupancy costs 24,000

Income Before Depreciation/ 50,750
Interest/Tax

Profit Before Depreciation/Interest/Tax 17%


Projected Franchise Growth

1988

1983

1998

Units

5

500

2,000

Annualized systemwide sales*

($ millions)

1.5

150

600

*Annualized systemwide sales based on full volume for all stores open at end of fiscal year. For 1988, end of fiscal year is March 31, 1989.


CARDIN'S GUIDE

Or, How to Create Your Own Perfect Franchise

It took almost two years, but eventually Rick Cardin, consultant, delivered to Rick Cardin, client, a four-page, 18-point treatise entitled "Ideal Characteristics of a Franchise Business." Want to invent the perfect fast-growth, born-to-be-big franchise concept? Navigate by these attributes. That's what Cardin did.

Below is just part of the list. "Ideal characteristics" are in bold, followed by how Cardin thinks O! Deli reflects them.

The ideal franchise would be:

* A stable, nonfad concept. "American" sandwiches in a variety of tastes at low prices are "everyday foods," encouraging repeat business -- 60% of O! Deli customers return three times a week.

* Recession proof. People will always eat. Moderate prices always appeal. People buy franchises in good times (they have money) and bad (they need jobs).

* A limited risk. Delis are among the easiest businesses to resell; lots of people feel confident they can run one. An O! Deli is inexpensive enough that there are many potential buyers, including those looking to purchase a job.

* In a rapidly growing segment of rapidly growing industry. The percentage of restaurant sales captured by franchises has more than doubled since 1970, to more than 43%. Sandwiches are the fastest-growing category of franchised restaurant sales, in percentage terms, yet they still account for only 2% of the total market.

* A cash business. O! Deli has minimal cash needs, inventory requirements, or receivables problems.

* Potentially number one in a national niche. The number-one position is still open for a chain serving a broad line of sandwiches, salads, breakfasts, and desserts at fast-food prices. Rarely has the market-segment leader been overtaken in franchising.

* An enjoyable place to own, manage, or work. Food is fun and interesting; everyone has experience with it. O! Deli is a people business largely catering to regulars who enjoy what they buy. O! Deli's hours -- 7 a.m. to 5 p.m., Monday-Friday -- provide the fun of the restaurant business without its typically exhausting schedule.

* Competitive with major chains from start. O! Deli doesn't seek the suburban corner lot most chains want, and it exploits locations unsuitable for many: small, odd spaces; high-rise offices that won't permit cooking but want food service. O! Deli can market effectively without expensive TV or print ads -- its customers are nearby working people who can be reached directly through coupons and free promotions.

* Proud of its product. O! Deli delivers quality and value in healthy food. Everything about O! Deli says, "We respect our customers."

* Able to generate publicly traded franchises. The history of fast-food franchisees taking a modest number of units public provides O! Deli franchisees with the possibility of earning substantial returns on their equity and effort and of funding rapid unit growth.

* A chance for franchisor to give real value to franchisee. O! Deli can provide many valuable services to individuals in the food business: enhanced appeal to landlords; expertise in commercial lease negotiation; equipment and purchasing discounts; equipment-selection advice; operating and administrative systems; and the combined operational lessons of a number of units.


WHAT THE EXPERTS SAY

COMPETITOR
RON SHAICH

Co-chairman, Au Bon Pain Co., Boston, a bakery cafe selling sandwiches and baked goods at 43 company-owned and-operated and 16 franchised units across the country

I think what O! Deli has done is take a concept that's very interesting and, unfortunately, position the company so the concept won't be allowed to develop. They've guaranteed themselves trouble in three specific ways: by being public; by deciding to franchise and even sub-franchise; and by pushing for such extraordinarily rapid growth.

The public companies that succeed in this business are mature, stable companies, not ones like O! Deli, which I guarantee will change. The market doesn't deal with change particularly positively, so Cardin and his team have put pressure on themselves from the start.

Another pressure they've brought on themselves comes from franchising. I'm basically negative on franchising, but particularly for them -- because it will make altering and controlling their stores more difficult. The food business, no matter how they cut it, is a manufacturing business. It's not about a better concept; it's about 1,000 little details that make the concept work. You succeed or fail depending on how well you can execute at the point of sale -- how well your franchisees can execute.

When you franchise you lose control -- the control you need to change things. And O! Deli is even going into subfranchising, which doubles the risk. Think of it this way: with subfranchisors, you're three levels removed from the customers buying your food. How much control do you think you have?

It's true that franchising is easy to sell, and they have a wonderful story. The question is whether they can deliver. But there will be bumps along the road, and being franchised will make it more difficult to iron out those bumps.

Their growth expectations won't help, either. The wisest people in the food business say you don't grow a company more than 30% to 40% a year. More than that, and you just can't execute. And out of every 100 great concepts, 99 fail because of bad execution.

I'm afraid Cardin is in this to grow a business, not to operate restaurants. And that doesn't work. As an operator, I've seen any number of people try it, and almost all of them fall by the wayside -- because this is ultimately a business of running restaurants.

The probability of their meeting their business plan is minimal.

COMPETITOR

FRED DeLUCA

President and founder, Subway Sandwiches & Salads, Milford, Conn., a franchised sandwich-shop

Last updated: Mar 1, 1989




Register on Inc.com today to get full access to:
All articles  |  Magazine archives | Livestream events | Comments
EMAIL
PASSWORD
EMAIL
FIRST NAME
LAST NAME
EMAIL
PASSWORD

Or sign up using: