At Wal-Mart, Subway is winning turf war

Subway, the fast-food chain that likes to promote its sandwiches as a healthy alternative to traditional fried and grilled fare, began doing business with the world's largest retailer only three years ago. But from a lone restaurant inside a Wal-Mart in Ozark, Ala., Subway has quickly overtaken McDonald's Corp. as Wal-Mart's primary fast-food concessionaire across the United States.

At one time, McDonald's was the exclusive in-store restaurateur for Wal-Mart. But now Subway, a unit of closely held Doctor's Associates Inc. of Milford, Conn., is in 1,419 Wal-Marts compared with 1,021 McDonald's. So far this year, Subway has opened 105 Wal-Mart locations in the U.S. — more than three times the 34 locations McDonald's opened.

In some ways, Subway's rapid rise at Wal-Mart isn't surprising. The sandwich chain has been expanding at a torrid clip worldwide while McDonald's has been reining in growth, focusing on boosting sales and returns at existing locations. Also, a restaurant inside a Wal-Mart can't operate a drive-through window. That's a big drawback for the hamburger giant, which does about half its business with motorists.

Another major factor, however, may be what's on the menu. Wal-Mart's embrace of Subway comes as it battles an image as a ruthless corporate giant with stingy wages and benefits for employees. Looking to portray itself as a good citizen, Wal-Mart has been tackling greenhouse gases and wasteful packaging. Pitching the virtues of "sustainability," it also has been emphasizing healthier foods at its stores, including organics.

As it struggles to cap rising health care costs, Wal-Mart has singled out employee diets as a concern. Andy Ruben, Wal-Mart's vice president for corporate strategy and sustainability, suggested this spring that "eating healthy meals instead of fast food" might be a good start.

An internal memo leaked in 2005 revealed that the retailer was looking for ways to cut its health care costs without damaging its reputation. It noted that rates of obesity-related heart disease and diabetes were growing faster among its employees than the general public. Among its recommendations were discouraging unhealthy people from working at Wal-Mart and requiring all jobs to include some physical activity, such as cashiers gathering shopping carts in parking lots.

The memo sparked an uproar, and Wal-Mart retreated on the shopping-cart idea. But it has since launched what it calls "personal sustainability projects" for employees to take better care of their bodies and the environment. More than 400,000 of Wal-Mart's 1.3 million U.S. employees are participating in the fast-growing program organized by San Francisco-based Act Now Productions. In addition to recycling more and cutting energy use, workers this year have been resolving to get more exercise and eat better.

Subway franchisee Maurice Novak thinks he's a beneficiary of the program. Six months ago he was invited by Wal-Mart to replace a McDonald's inside a store in Great Falls, Mont., after the hamburger chain let its lease expire. McDonald's cited disappointing sales, but Novak thinks there were other factors at work, too.

"They're trying to push healthier lifestyles — they have a 'green' initiative, a 'sustainability' initiative," Novak says of Wal-Mart. "It made sense to get a Subway in there. The management is thrilled to have us."

As it opens new stores, Wal-Mart hands out lists of prospective locations to both McDonald's and Subway. But the sites on the lists don't overlap, and the two brands aren't allowed to bid against each other for a specific location.

Wal-Mart executives declined to be interviewed for this story. But spokeswoman Linda Blakley said in an e-mail that Wal-Mart picks its in-store restaurant vendors to "align with the customer needs in each market, ... matching customer tastes and preferences with the right restaurant partner."

Elizabeth Rolfe, director of new business development for Subway, contends that one reason the chain is sought out by Wal-Mart is that "they're looking for the healthy alternative." She also noted that, unlike McDonald's, Subway outlets have "no cooking, no frying."

McDonald's rejects the suggestion that it is trailing Subway in the Wal-Mart race because of its food. While McDonald's does occasionally choose to exit less-profitable Wal-Mart locations, it gets "the lion's share of what we ask for" when it comes to leases with Wal-Mart, says Bill Lowery, a McDonald's vice president in charge of business with the retailer.

"As far as food service inside Wal-Mart, we are still their best bet from an economic and any other standpoint," Lowery insists, adding that he is unaware of any situation in which the retailer had asked McDonald's to vacate a store in favor of a rival concessionaire.

While the average full-size, standalone McDonald's grosses about $2.1 million a year, the company says its Wal-Mart restaurants average just $900,000 annually. Subway doesn't disclose its sales, but Technomic Inc., a Chicago restaurant industry consultant, estimates that the typical Subway unit grosses around $400,000 a year. Industry sources say it makes little difference to a Subway's sales whether it's inside a Wal-Mart or not.

"A Subway can make it on fewer dollars," says Dennis Lombardi of WD Partners, a retail and restaurants development firm. By the same token, a McDonald's franchisee may calculate that the investment return from a full-size store is much greater than that from a Wal-Mart satellite unit.

Subway, which has more than 21,000 U.S. stores versus about 13,700 for McDonald's, enjoys an advantage in that its operation can fit into a smaller space than a standard McDonald's. And while they employ relatively small ovens to bake bread, Subways don't use fryers and grills, which require costly ventilation systems and hog more energy.

Both chains have master leases with Wal-Mart, allowing them to be in a store for 10 years. While neither restaurateur will discuss contract terms, "Our rent is based on our sales," says Subway's Rolfe.

Montana Subway franchisee Novak, who has two other stores in Great Falls, says that so far his Wal-Mart location is performing well — "equal to my busiest store." He appreciates the fact that he doesn't have to maintain restrooms, and that security isn't an issue since Wal-Mart takes care of that.

And while he says he's received compliments from many customers, not everyone feels that way. Occasionally, would-be patrons will order french fries.

When told that Subway doesn't serve them, Novak says that some "turn around and walk out."