Ahan Analytics, LLC

On the same day that BusinessWeek lauded Subway for the success of its discount $5 footlong sandwiches, the National Franchise Association (NFA) sued Burger King Corporation over the legality of requiring franchisees to charge no more than $1 for the Double Cheeseburger. The Subway success story features a pricing strategy built from the bottom where the initiative and innovation of a single franchise owner led the way. The local profit optimization of the franchisees directly support the global profit optimization for Subway as a whole. The unfolding drama at Burger King features a pricing strategy commanded from the top against the expressed desires of the majority of franchisees. The global profit optimization that has convinced management to plow ahead appears to violate the local profit optimization of the majority of franchisees. The dispute has now devolved into a lawsuit filed in the U.S. District Court Southern District of Florida on November 10, 2009. The class action complaint starts with the following introduction:

“This action arises out of a dispute between NFA, on behalf of all owners of franchised Burger King restaurants in the United States (the Franchisees), and Burger King Corporation (BKC) concerning BKC’s actions in compelling the Franchisees to sell a food product known as the BK Double Cheese Burger (DCB) at no more than the maximum price of $1.00, and BKC’s claim that it has the legal right to dictate price points under the respective Franchise Agreements (the Franchise Agreements) previously entered into with the Franchisees – even if those prices are below the Franchisees’ cost and cause them to incur a loss on sale of the product.”

The core of the complaint is as follows:

“The provision of the Franchise Agreement at issue is Section 5, addressing ‘Standards of Uniformity of Operation.’ It provides that ‘BKC shall establish, and cause approved suppliers to the BKC System to reasonably comply with, product, service and equipment specifications.’

While these provisions address standards of uniformity for various operational issues, including menu items, hours, and uniforms, nothing states that BKC has the right to impose mandatory price points for product sold by the Franchisees. The dispute between the parties is triggered by the position recently taken by BKC, contrary to decades of practice, that the general language of Section 5 gives it the power to set prices for its independently owned franchises…Since at least the 1960’s (if not back to the beginning of the BKC franchise system itself), BKC never attempted to unilaterally impose or require a price point for products sold by Franchisees, and did not take the position it had the right to do so under the Franchise Agreements.

After the formation of [the NFA] and a Marketing Advisory Committee in 1989 and shortly thereafter, BKC did not attempt to set, much less enforce, mandatory price points for its franchisees without the agreement of a supermajority of the franchisees.”

Burger King has responded that “the litigation is ‘without merit,’ particularly after an earlier appeals court ruling this year showing the company had a right to require franchise owners to participate in its value menu promotions.”

The legal issues will likely get resolved by determining which contracts are legally binding and what are the conditions for enforcement. I am much more concerned with the strategic and economic issues.

The price cut on the DCB is dramatic; the drop from $2 to $1 positions the DCB below McDonald’s DCB priced at $1.19. The gross margin loss of -10% is significant; the DCB costs on average $1.10 to make. The complaint notes that no other item on the BKC value menu loses money. Based on this loss, franchisees rejected the first proposal in 2008 and rejected it twice by vote this year.

In “$1 deal may boost profits,” the Miami Herald describes an analysis generated by a franchisee that concludes that the $1 DCB is a money-loser:

“…financial models run by one Illinois franchisee and circulated among franchisees across the country suggest that [the $1 DCB] won’t drive enough sales to offset the margin pressure. The franchisee models suggest that the bottom line impact for restaurants would be a loss of between $489 and $930 depending on the percentage of total sales generated by the value menu.”

However, management has its own analysis (and assumptions) showing the $1 DCB is a winner. Again, from the Miami Herald:

“Based on numbers Burger King provided to franchisees, the company projects that the double cheeseburger will lead to a 5-percent increase in restaurant sales. That will translate into an increased bottom line profit of $365 per restaurant based on $105,000 in sales, according to the analysis.”

How could the franchisees and management come to completely different conclusions on the merits of this pricing strategy? Soda and fries make the difference. Soda and fries are higher-margin items. If the cheap DCBs generate extra sales traffic that buys soda and fries, then it is possible to make up the loss in profit from the DCB. In fact, BKC management is relying exactly on this dynamic. The McClatchy-Tribune reported on Nov 13, 2009:

“During an 18-month test, the $1 double cheeseburger had a negative impact on gross profit margin, Burger King said, but restaurants increased gross profit because consumers added high profit items like sodas and fries.”

In “Burger King’s battle cry: $1 burger,” the Chicago Tribune reports how the local optimization can invalidate the attractiveness of a mandatory $1 DCB promotion:

“John McNelis, president of the real estate division of Mirabile Investment Corp., owner of more than 40 Burger Kings in the Memphis, Tenn., area [states]: “…in some price-sensitive markets, you are just selling a bunch of double cheeseburgers…”

The cheap DCB pricing strategy works if soda and fries are “complementary products” to the DCB. However, if these products are truly complementary, then the more profitable pricing strategy is to make sure that DCB-buyers purchase soda and/or fries by bundling the products into one offering. In other words, customers can only buy the DCB for $1 if they also buy soda and/or fries for a price that generates a profit for the entire bundle. Without this bundle, BKC is using a loss-leader strategy in the hopes that the extra foot traffic will behave in a profitable way.

I suspect that BKC is not bundling the $1 DCB with soda and fries because the bundle would work counter to its efforts to attract increasingly price sensitive customers (high demand elasticity) and would obscure its price positioning versus McDonald’s. Putting the reported analyses aside, I suspect that when BKC runs its global optimization, it finds that it has enough markets with customers who will buy the bundle on its own merits. Absent profits, BKC could still justify the program based on customer retention in the hopes that customers stay loyal to the brand even after the money-losing promotion ends (a much shakier proposition in the highly competitive fast-food category). The franchisees run a series of local optimizations and find too many individual franchisees who lose money to make the program worthwhile as a mandatory offering. Apparently, there are enough of these profit-losing franchises to motivate the lawsuit (according to the class action complaint, about 75% of franchisees belong to the NFA). Indeed, the diversity of markets explains why most discount promotions amongst franchises include the caveat “at participating locations only.” The local optimization typically dominates the global optimization.

Burger King’s August 25th conference call to discuss fiscal fourth quarter 2009 earnings provides additional clues into management’s rationale for implementing a mandatory $1 price point for the DCB (quotes from the transcript provided by Seeking Alpha).

Management describes how it used controlled experiments to measure the potential success of a $1 DCB:

“…we have probably now well over 40 markets in the country that are on $1 Double Cheeseburger and we’ve actually seen a pretty steady check performance…And we’ve really been pleased with what our plans were for check dilution versus what’s really happening in those markets.

…there’s no question that the $1 Double Cheeseburger through its adoption in increasing amounts of markets in the U.S. has helped to improve traffic. So we have seen month-to-month-to-month improvements, a narrowing if you will on our traffic losses nationally and we have certainly seen the markets that have adopted the $1 Double Cheeseburger move into some very strong performance as it relates to traffic.”

Burger King management is eager to reduce losses in traffic. It is probably no surprise to anyone that discounting a burger by 50% will drive increased traffic. There is no indication here that the promotion is actually making money, only that it is losing less money than expected.

Again:

“…we modeled for some GPM [gross profit margin] dilution in the business case for $1 Double Cheeseburger but so far all the test markets have been outperforming in terms of GPM dilution. In other words it has not been as deep as we originally thought. What you really kind of see happening is the effect of this discounting is sort of offsetting the price increases that we’ve taken in the past which would kind of cause for the level check if you will that you’re seeing.”

There is no explanation here that sales of sodas and fries are specifically making up for the profit loss on DCBs. Instead, it seems that price increases on a variety menu items have given BKC the extra cushion it needs to justify using the DCB as a loss-leader. Management does not provide details on these price increases, but, in general, they seem odd given the existing competitive environment and sluggish economy. All together, it seems that traffic is the prime motivator for the promotion – with the assumption that short-term profit-losses will somehow give way to longer-term profit gains.

Finally, it seems competitive pressures are forcing Burger King to take extreme measures:

“…we have to be aggressive on value for the money. There’s no way you can turn on a television set and look at any retail brand in any space and not hear language that talks about price points and value. And we’re no different. Now our value for the money equation also includes talking about a superior tasting product with flame-fresh taste. It includes featuring our superior size versus McDonald’s on our Double Cheeseburger. And yes it’ll continue to pound on the $1 access.”

In the end, BKC’s global optimization is apparently not convincing enough for the franchisees who are presumably more concerned with their individual local optimizations. Certainly, the NFA should not have filed its class action complaint if BKC’s market tests demonstrated comprehensive profit gains from a preponderance of successful local optimizations. A global optimization that delivers average profit gains across the system is insufficient to justify a franchise-wide, mandatory pricing strategy. If this averaging is indeed the true source of the conflict, it is akin to averaging the net worth of Bill Gates and your home town and concluding that your home town would be filled with millionaires if Mr. Gates moved in.

This lawsuit will be fascinating to follow as it could provide additional insights and clarity into BKC’s pricing strategy and the actual data used to justify it.