Big Mac attack: McDonald's prepares to challenge Subway's dominance.

After 40 years of rapid growth, Subway Restaurants finally may have awakened the sleeping giant.

Last month, McDonald's Corp. began selling Subway-type sandwiches at a handful of U.S. and Canadian locations, and if the concept is successful, the burger giant will likely expand it to more of its stores--thus challenging Subway's control of fully one-third of a $17.3 billion deli sandwich market.

Last year, Subway overtook McDonald's as the largest restaurant group operating in Los Angeles County. This year, it added another 21 local stores to repeat as No. 1 with 416 outlets. McDonald's, meanwhile, fell to third with 348 locations, behind Starbucks Corp. with 366.

"Subway has come a long way in the past five years," said Robert Zarco, one of the nation's top franchise lawyers. "They're essentially hitting competitors like a tidal wave."

While Subway has shown amazing growth for many years--it now has 17,700 U.S. locations, versus 13,000 for McDonald's--it wasn't until 1999 that it became a fast-food phenomenon.

That's when a 425-pound Indiana University student named Jared Fogle became the chain's calling card. Fogle lived eight blocks from a Subway franchise and, after failing on a variety of diets, designed one that involved eating two Subway sandwiches a day--including a bag of chips and a soft drink--for a year.

When his college newspaper published a story about Fogle shedding 245 pounds, Subway executives seized on it, making Fogle the centerpiece of an ad campaign highlighting the chain's low-fat sandwiches. His story fed into emerging concerns about the health effects of traditional fast foods, and sales at Subway took off. Now virtually all fast-food restaurants have added salads and healthier fare.

"Many more people who used to visit McDonald's or Burger King, which are infamous for the high caloric content of their food, are now being diverted to Subway," said Zarco, a partner at Zarco Einhorn & Salkowski in Miami.

Growth pains

In the past, Subway has been criticized--and occasionally sued--by its franchisees for a corporate structure that rewards rapid growth, sometimes at the expense of existing franchise operators.

What distinguishes Subway from other fastfood franchisors is that the parent company, Milford, Conn.-based Doctors Associates Inc., doesn't own any restaurants itself. Royalties flow to the parent based on overall sales, but individual franchisees are not granted exclusive territories, as in other fast-food operations. Stores are often opened nearby to existing locations, cannibalizing sales.

In the 1990s, some franchisees filed lawsuits against Doctors Associates, claiming the company operated like a pyramid scheme.

Zarco said this situation has improved in the past several years, as Doctors Associates tries to minimize the impact of new openings. It formed a committee to decide if locations overlap each other, and existing franchisees get first dibs on new outlets nearby.

Today, Zarco represents franchisees of Blimpie International Inc., Dunkin' Donuts Inc., Burger King Brands Inc., McDonald's and Quiznos, in various litigations against their franchisor parents--but no Subway franchisees.

"I don't think there's a better chain out there that can give me the rate-of-return as this chain," said Paul Gill, who opened his first Subway when he was 22 and now owns 19 outlets--including one at Dodger Stadium and another at Kaiser Hospital on Sunset Boulevard, with a partner, Behzad Cohan.

He still complains about rising rents and higher costs for tomatoes ("Subway start-up costs were more affordable in the old days than they are today") but generally it's cheaper to operate than other fast-food joints. Nothing is cooked except the bread, which means lower energy expense and lower start-up equipment costs. Consumers have responded well to the assembly-line set-up with sandwiches made in front of them.

While turnover in the restaurant industry is high, training isn't too strenuous.

"Anyone can make a sandwich," said Hardy Grewal, who owns 18 Subway franchises in Los Angeles.

Today it costs $150,000 to $175,000 to build a new Subway restaurant, with a franchise fee of $12,000--double what it was a decade ago. (A McDonald's, by contrast, can require an investment of more than $1 million.) Buying an existing restaurant is more expensive; one franchisee recently paid $1 million for a Subway near USC, due to its high volume.

Sales vary by location but Subway franchisees claim they can pay off the initial investment in a year if the location takes in $8,000 to $10,000 in sales per week. Subtracting the cost of rent, employees and products and it's possible to earn a living with just one Subway in a prime location.

Large Subway franchisees who got into the business more than a decade ago claim they are pocketing anywhere from 18 percent to 25 percent of sales as profit.

Franchise structure

Subway contracts with separate companies, known as development agents, which buy the rights to sell franchisee leases in specific territories.

Money flows from the franchisees to development agents to Doctor's Associates, which is responsible for national advertising and computer systems. The more outlets that are opened--Subway has 22,288 restaurants in 78 countries with $6.8 billion in sales--the higher the franchisor's royalties.

Ruth Sender, president and chief executive of Subway development agent OhCal Foods Inc. of Woodland Hills, said agents take a cut of the royalty payments in exchange for maintaining the brand's identity, finding new franchisees and negotiating leases. Royalty fees typical run about 8 percent of each franchisee's total sales.

Earlier this month, Sender held a rally to get Los Angeles franchisees pumped up about working for Subway. Like multilevel marketers Amway Corp. and Herbalife International Inc., Subway encourages franchisees to recruit new people into the business.

"We're their partner, so if they do better sales-wise, we generate more income," she said. "I have the responsibility of people's livelihoods in my hands and I find it extremely rewarding to help them do a better job in their restaurants."

OhCal Foods conducts monthly inspections of every Subway franchise in Los Angeles, checking baking procedures to temperature controls. Sales are tracked electronically so franchisees have no wiggle-room to cheat the development agent or franchisor by lowballing income.

Grewal, who opened a Subway franchise in 1989, said the key to his success was jumping on the Subway bandwagon early. He left a job as an accountant for Mitsubishi Motors Corp. and now owns 18 Subway outlets, with four more on the way. He now owns the Sylmar mini-mall where he opened his first Subway location, and he owns a Holiday Inn franchise in Dallas.

"When I saw what these stores were making, a light went off in my head," Grewal said. "It's not what it used to be in 1989 because wages and rents were so low then. But sales are way, way up."

Bloomberg News contributed to this story.