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Investment Ideas McDonald’s and its 267% rally get no respect from Wall Street

Pedestrians pass a McDonald's Corp. restaurant on 42nd Street in Times Square in New York, N.Y., on Oct. 20, 2013.

Michael Nagle/Bloomberg

McDonald's is having a moment.

Actually, it's been having one for a while. Analysts may find no shortage of things to fret about - from rising labour costs to lousy consumer feedback on the quality of the food - but investors love McDonald's Corp. Okay, there was that seven-quarter U.S. sales slump that took the blush off the share price. It ended last year, though, after Steve Easterbrook became chief executive officer, and overall the stock has climbed 267 per cent in the past decade. (The S&P 500 Index, by comparison, has gone up 58 per cent.)

"McDonald's has its challenges, but they're resilient," said Bob Goldin, vice chairman at industry researcher Technomic Inc. Even he, a fan of sorts, can reel off what he calls the headwinds coming at the giant, among them increasingly nutrition-conscious Americans who might not be tempted by Big Macs and their 28 grams of fat.

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Mr. Easterbook's introduction of all-day Egg McMuffins in October at most domestic locations helped yank the company out of its recent funk. There was a 5.7-per-cent boost in fourth-quarter sales at established U.S. restaurants, the biggest gain since 2012. Global profit climbed 10 per cent. The stock is trading at a 38-per-cent premium to the Standard & Poor's 500 Index on a price-to-earnings basis, a nice switch from the 3.2-per-cent discount early last year.

The CEO has made tweaks big and small since he took the helm of the world's largest restaurant chain in March 2015. He slimmed down the corporate staff, revamped drive-thru ordering to make it more efficient and tackled the flabby hamburger-bun issue by requiring they be toasted longer. Some stores are experimenting with touch-screen menus. The goal is to stem, then reverse, the slide in traffic. Guest counts, as they're called in the business, have been falling for three years, dropping 3 per cent in the U.S. in 2015.

The challenge will be to sustain the breakfast buzz long enough for Easterbrook's team to address all the nagging issues and follow through on innovations like the create-your-own-burger endeavor. "They want to keep that going over a consistent, long period," said Jack Russo, an analyst at Edward Jones. "There's no easy fix on that."

For some customers, the novelty of hashbrowns at 1 p.m. will wear off. And competitors are elbowing in, with Dunkin' Donuts, for example, overhauling its menu boards to emphasize its all-day breakfast fare. McDonald's is aiming to keep up the pace with new items; restaurants in the south will soon be offering McGriddles breakfast sandwiches at all hours. Round-the-clock hotcakes and Egg McMuffins debuted in Australia a few months ago and may show up in other countries, according to McDonald's spokeswoman Becca Hary.

Even if the breakfast glow fades, the company is hardly in danger of a meltdown, no matter some analysts' worries. (More of them have sell or hold recommendations out on the stock than buy ratings, an unusual ratio for a company that's posted such outsize equity returns.) McDonald's continues to add restaurants. The dividend keeps growing, with data compiled by Bloomberg showing a 4.8-per-cent uptick over the past year. And the stock rose 26 per cent in 2015, outpacing gains at Yum! Brands Inc. and Wendy's Co. "People are flocking to safety," Mr. Goldin said. "It's looked at as kind of a low-risk investment."

Of course, to stay that way, it'll have to draw more customers. "The trick is to find right price and the right products that stimulate enough traffic and sales and doesn't hurt you too badly" if some diners trade down to cheap items, said David Palmer, an analyst at RBC Capital Markets. Now's the time to get that right because "the company has re-established some momentum."

McDonald's knows it needs to appeal to Americans' appetite for healthier, environmentally friendly fare. The chain also has a less than stellar reputation in its limited-service burger-chain universe: It scored lowest in quality, trailing Wendy's, Burger King and Jack in the Box Inc., in a 2015 consumer survey by WD Partners and Nation's Restaurant News.

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The company has committed to cleaner ingredients, though change will be slow because of its massive size: 36,500 restaurants in more than 100 countries. Serving only cage-free eggs at U.S. and Canadian stores will take a decade, while putting only chicken raised without certain antibiotics on the menu will take two years.

"Their biggest challenge is really being able to resonate with the consumer on fresh and quality, and all the things that the millennials want," said BTIG analyst Peter Saleh.

Labour costs are a thornier issue. McDonald's has been feeling some pay-cost pain in the U.S. The profit margin at U.S. restaurants narrowed to 15.1 per cent last year, from 17.4 per cent in 2014, and the company cited higher wage and benefit expenses.

At the beginning of this year, 14 states raised their minimum rates, and lawmakers in California just made a deal to hike the most populous state's hourly minimum to $15 by 2022. McDonald's increased pay by $1 for employees of its 1,400 corporate-owned locations last year, putting pressure on franchisees to follow.

"Labour costs are going to rise and they're either going to have to suck it up or pass it along," Mr. Goldin said, "and my sense is they'll do a little bit of both."

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