Franchises and Steak n Shake and Sardar Biglari and Real Estate & Retail

New rules rile Steak n Shake franchisees

February 5, 2011

Franchise owners of Steak n Shake restaurants are revolting against parent company Biglari Holdings Inc. just as the chain plans a nationwide expansion fueled by franchising.

Entrepreneurs representing 55 of the chain’s 70 franchised locations have teamed up to challenge a move by the company to impose standardized menus and pricing.

For more than 70 years, Steak n Shake franchise offering documents allowed customization to address varying real estate, product and labor costs and regional customer tastes. But the chain changed course late in 2010, notifying franchisees of a new policy requiring uniform menus, pricing and promotions.

The company sent default notices to several restaurant owners—including the chain’s original franchisee, Stuller Inc. of Illinois, which opened its first Steak n Shake restaurant in 1939 and now owns five locations.

Stuller responded with a federal lawsuit in Illinois that claims the chain is trying to boost its overall sales at the expense of franchisees’ profit margins. Steak n Shake earns royalties from franchisees based on overall sales, not on the profitability of those sales. Stuller says in court filings that implementing the uniform pricing year-round would hit its bottom line by $913,000.

Three other franchisees who own a total of nine restaurants told IBJ that company officials have ignored their concerns, refusing to meet with them or take their calls. The chain now runs its monthly franchise conference call with franchisees on mute.

An updated restaurant design for new locations is making matters worse, they say, since the design has proven inefficient for employees and is laden with cheap kitchen equipment and interior finishes.

Steak n Shake has unveiled plans to add as many as 1,000 units through franchising. It operates about 415 corporate-owned locations. The restaurant operation is based in Indianapolis, while Biglari Holdings has its headquarters in San Antonio.

“I don’t understand how a business that wants to grow through franchising could have such an adversarial relationship with its franchisees,” said Mark Gratkowski, a former director of operations for Steak n Shake who owns three stores in Alabama and Florida. “If we work together, we could fix all of this.”

Franchising focus

Sardar Biglari mug Biglari

Biglari Holdings CEO Sardar Biglari did not respond to interview requests by phone or e-mail. But his 2010 letter to shareholders suggests he understands the importance of franchising.

“Steak n Shake’s future lies in franchising,” wrote Biglari, 33. “It is a fiery growth engine, the kind of business we like to own: one that does not require enormous sums of cash to generate annuity-like cash flow.”

The Steak n Shake brand has the potential for 1,000 stores but it won’t happen without good relationships between franchisees and the corporate office, said Max Olson, a Salt Lake City money manager who follows the company but does not currently own shares.

The bottom line, Olson says, is both sides have to win.

“For franchised restaurants, it’s a balancing act between both uniformity and fostering an entrepreneurial culture,” Olson wrote in an e-mail. “One of the things that made chains like McDonald’s so successful in the past was their willingness to let franchisees experiment with new menu offerings and more efficient procedures. Ray Kroc was very good at striking this balance.”

Eager for innovation

Franchisees have embraced promotions such as 4 meals under $4 and a half-price happy hour for milkshakes, said Gary Reinwald Sr., a former Steak n Shake executive who owns two locations in Knoxville, Tenn., and is president of the newly formed One Voice Franchise Association.

The promotions helped the chain boost a years-long streak of declining same-store sales and post a profit of $28 million in 2010, more than triple that of 2009.

But Steak n Shake—apparently buoyed by its successes—last year unleashed a slew of new promotions and menu offerings that complicated the operation of the restaurants without adding to the bottom line, Reinwald says.

Reinwald hasn’t sold a single Carolina Slaw Dog in either of his restaurants, and the Wisconsin Buttery Burgers aren’t doing much better. Year-round coupons mean fewer customers are paying full price for anything. And the mandate that he sell a sweet tea for 99 cents just makes no sense in a state where all tea is sweet and customers don’t scoff at paying a bit more for such a refreshing beverage.

“Those things aren’t fully vetted—it’s kind of a hip shoot,” Reinwald said. “It used to be you shared best practices and numbers, there was some mutual respect and openness. Boy, now it’s fear and intimidation.”

Gratkowski’s beef with Steak n Shake is that its moves to seize more control of franchise locations and offer a torrent of new discounts are cutting into already thin margins.

For instance: Gratkowski’s coastal locations require hurricane insurance, an expense that costs him $105,000 over and above what the corporate office covers out of royalty proceeds. So Gratkowski bumped up the price of regular soft drinks, to $1.99 instead of $1.79, to offset the extra expense.

He also used to buy his own paper towels, from Kimberly-Clark, and got the dispensers as part of the deal. Now he has to buy whatever Steak n Shake offers him.

The new agreement requires franchisees buy all supplies from the home office, which also sets menus and pricing for every location. The agreement boosts royalty fees from 9 percent of sales to 10 percent.

Cutting corners

Biglari has bemoaned the slow pace of restaurant franchising over the chain’s history—an average of about one new location per year since Gus Belt founded Steak n Shake in 1939—and has pledged to speed it up with the launch of the new prototype.

The fifth Steak n Shake using the new design opened in December at the South Point Casino in Las Vegas.

“Now, a franchisee can open an efficient, beautiful unit for about $1.5 million,” Biglari wrote in his 2010 letter. “My projection is that revenues emanating from each unit will doubtless surpass the $1.5 million mark, which combined with our current operating margin would yield an attractive return on investment for the franchisee.”

At least one franchisee is unimpressed. The new restaurant design is an inefficient and breakdown-prone mess, said Doug Knipp, who opened one three months ago in Pikeville, Ky.—against his better judgment—after the chain refused to let him build the tried-and-true format.

The fryer has broken down twice. The doors fell off the freezer. The flooring already needs to be replaced, and the cheap dining-room furniture won’t be far behind, he said. And it’s not a contractor issue: Steak n Shake cut too many corners on materials.

“We got a cheaper product to get the price down, but along the way it ended up not being cheaper when you add in all the costs of having to repair it,” said Knipp, who also owns 17 Kentucky Fried Chicken restaurants in Ohio, Kentucky and West Virginia. “They should have built the first one themselves.”

Knipp, who owns two other Steak n Shake restaurants in southern Indiana and another in West Virginia, also takes issue with the lack of operating space for employees. They’re constantly bumping into one another. And there isn’t enough room for product storage.

Knipp said his top line is growing, but he’s nonetheless lost money for 16 months. That’s because food costs have risen from 23 percent of sales to 29 percent, while Steak n Shake-mandated promotions have pushed down the prices he charges.

“I love my brand. I love our heritage. I love the idea of taking Steak n Shake national,” Knipp said. “We’ve got the brand to do it. The main concern we have is there’s no ‘we’. It’s being run like a dictatorship.”

Relationship sours

Relations with the home office soured after Biglari took over in 2008 and began treating franchisees like employees, not partners, Gratkowski said.

Gratkowski was Steak n Shake’s director of operations before he left the then-Indianapolis-based company in 2006, and became a Steak n Shake franchisee in 2007. He spent $4.5 million to acquire land and build three restaurants, in Mobile, Ala. and Pensacola, Fla.

“He has no self-control, and will go ballistic if you push the wrong button,” Gratkowski said of Biglari. “If you don’t do it his way, you’re fired. He really doesn’t care about Steak n Shake any more than it produces cash float for him to invest.”

Biglari has made no secret that his top priority in leading Biglari Holdings is to find lucrative ways to reinvest cash flows from the company’s wholly owned businesses, including Steak n Shake, into other businesses.

He acquired steakhouse chain Western Sizzlin, bought and sold stakes in Advance Auto Parts and Red Robin Gourmet Burgers, and is fighting to take control of a small Michigan insurer.

Biglari’s latest target is a New Jersey company that produces Plus+White toothpaste, Nutra Nail treatments and Bikini Zone shaving products. In a letter to the board of CCA Industries Inc. dated Jan. 24, Biglari notified the company of his intent to nominate himself and partner Philip Cooley as board members.

He’ll likely point to woeful shareholder returns (CCA is trading at roughly the same price as it did in 1993) as he tries to wrest control of the company, a pitch similar to the one he laid out a few years ago for shareholders in Steak n Shake.

Gratkowski can’t understand why Biglari—if he sees franchisees as so important to Steak n Shake’s future—won’t even find time to engage in a dialogue.

“The growth potential through franchising is still unlimited for Steak n Shake,” he said. “We could help if he wasn’t such a jerk.”•

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