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Norman Barnett

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Salad days

Norm Barnett

 TORONTO (GlobeinvestorGOLD)—One of the reasons for Warren Buffett's enduring popularity as an investment guru is that his advice is often boiled down to a simple idea: invest in what you know. Certainly few things are more familiar than the golden arches of a McDonald's restaurant. Across the globe, the company has more than 30,000 outlets, and with annual profit of about $2-billion (U.S.), its stock is classically blue-chip.

For investors, however, this blue chip has fallen on hard times. Three years ago, the share price was well over $30. By 2002, the stock was beginning to fall, as sales slipped and signs of trouble overseas seemed like an omen of things to come. It closed at $12.38 in March, its three-year low, and currently trades in the $23 range. As is often the case, the market was right. A price war with arch-rival Burger King hurt the McDonald's Corp. bottom line, and improvements to service systems and menu developments in restaurants both failed to stem the negative tide. By the end of that year, the company posted a quarterly loss, its first in 38 years as a public company. Granted, there was still a decent profit to be salvaged over the year, and there was a change at the top, with Jim Cantalupo brought in as CEO. But the damage had been done, and investors continued to shun the stock.

In the meantime, the company did what blue chips are supposed to do, which is pay a dividend. The 2-per-cent yield may not be anything to do cartwheels over, but it goes a long way toward calming antsy investors watching the value of their portfolio slip away. McDonald's also continued to generate plenty of cash and began a program to lower its capital costs. Instead of opening new restaurants, especially overseas, the company renovated existing ones, a cheaper alternative.

Most importantly, the company continued to innovate, something that has been its real hallmark over the years. It cut its losses on menu items that weren't working and went in search of ways to do things cheaper and faster. Waiting times, which had grown longer as people were given flexibility to customize their orders, had to be shortened again too.

All this seems to be paying off. The McDonald's just released July sales and reported a jump of 9.9 per cent. Second-quarter results, reported earlier this month, showed an overall 5.3-per-cent decline in net earnings to $471-million, but many investors seem to be focusing on the fact that sales in the U.S. rose 4.9%. That means about a million more people a day were stopping at a McDonald's than in the same quarter a year earlier. The company is giving much of the credit to new salads on the menu. Many of the customers who come in to buy salads typically used to bypass the restaurants. And when you break the numbers out, orders from those customers tend to be in the $8 range, higher than the $4 or so for other meals. One of the happy byproducts of the salad sales is that they often went to parents who also brought their kids with them. As a result, sales of "happy" meals is up at least 6 per cent in the past few months. The Big Mac, the heart and soul of the McDonald's menu, saw a sales increase of 40 per cent in July.

Andrew Barish, an analyst at Banc of America Securities, rates McDonald's a "buy" with a price target of $26. He says that, like many, he has been pleasantly surprised by the company's changes. "We continue to believe that management is focusing on the right things (existing restaurants and operations) and that the results can continue to surprise on the upside."

The company still has to do something about overseas sales. While the U.S. stores were racking up those great numbers, Europe—its second biggest market—declined 1.2 per cent in the same period. And the Middle East and Asia posted a 6.6-per-cent drop. That may mean McDonald's will focus on core operations and leave global expansion behind for now. U.S. unpopularity alone in some parts of the world may limit what a restaurant chain can accomplish.

A Bear Stearns research report said recently that international sales will bounce back, making the current share price an opportunity to buy into the recovery. It said the expectation is growing that a "significant" dividend increase could be on the horizon. Looking ahead, you can expect more innovation. Possibilities include a system where the burgers come frozen off a conveyer belt and onto grill that doesn't require manual flipping of patties. There could also be new, do-it-yourself order kiosks. They aren't expected to reduce the time between the order and the food being delivered, but they could easily cut counter waiting times. The kiosks could also be placed in the "playland" areas, so parents do have to go up to order the food. And this fall, the company will be introducing more items to a low-price menu and bringing back the immensely popular Monopoly game.

As with many large companies working at resurgence, the process is slow and requires good management, but if the share price is any indicator, investors seem ready to buy back in.

Norm Barnett is a producer at Report on Business Television.

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