Earnings Season Sell Signal

We are two and a half months from the end of 2014.

We’ve seen a nasty correction that took stock market down 10% in three weeks, and we are in the middle of third quarter earnings season.

This is the last time we will hear from Corporate America this calendar year. It is vital that we pay attention to what’s happening so we can set up our investment portfolios to be as successful as possible.

And as it happens, there have been a couple revelations so far that could prove extremely valuable to you…

But first things first: In general, earnings have been pretty good so far. Analysts lowered their expectations, as they usually do. And that means companies are set up to do a bit better than expectations, thereby confirming again that there is upside for stock prices.

Truth be told, there probably is. Employment is getting better, lower gasoline prices are putting a little extra cash in people’s pockets, and that correction made valuations look a bit better, too…

However, in today’s economic environment, I think it pays to be aware of what’s wrong rather than simply looking at what’s going right. There are big changes afoot, and the best way to see them is by looking at what’s gone wrong so far this earnings season…

McDonald’s Big Miss

Yesterday, McDonald’s reported $1.07 a share in earnings for the third quarter. Analysts were looking for $1.37 a share.

Yeah, that’s a big miss. But then, McDonald’s has missed earnings estimates in each of the last three quarters, too…

This time a year ago, McDonald’s earned $1.52 a share and had sales of $1.52 billion for the quarter. This year, Q3 sales were just $1.07 billion.

The CEO said: “McDonald’s third-quarter results reflect a significant decline versus a year ago… By all measures, our performance fell short of our expectations.”

I’m not surprised McDonald’s missed earnings again, but I am surprised the company thought it would do better… After all, in August, it posted its worst sales in a decade. For the quarter, same-store sales were down 3.3%, and fewer people went to a McDonald’s.

Now, let’s compare McDonald’s to some of its competitors.

Chipotle (NYSE: CMG) reported a 19.8% gain in same-store sales. Net income was up 56%.

Panera (NASDAQ: PNRA) reports next week, and analysts expect to see that sales grew 8% over last year.

I suppose some analysts will say McDonald’s isn’t executing well. I think it’s something far more problematic than that…

Fewer people are going to McDonald’s. More importantly, fewer young people are going, and parents don’t want to buy Happy Meals for their kids. It’s all because McDonald’s is not healthy, and Americans are starting to value healthy food.

You can see it in the whole farm-to-table movement and the growth of organic foods. The CEO even said on the conference call that if organic food continues to increase in popularity, “we’ll look at it more aggressively.”

And besides, if you want a cheeseburger (and I often do), you can get a fantastic one at Five Guys.

McDonald’s is missing it. The company has failed to brand itself to an entire generation of young Americans. If it can win them over — and that’s a big “if” — it will be a huge task that will take years and be expensive.

McDonald’s still pays a nice dividend. But growth is over. The stock has managed to hold up pretty well, but the price is likely headed lower.

I wouldn’t wait… It’s time to get out of McDonald’s shares and seek a better alternative, like maybe Zoe’s Kitchen (NYSE: ZOES).

Zoe’s is a new chain serving Mediterranean-style food: chicken, hummus, salads, kabobs, etc. It gets food deliveries daily and makes everything in house.

The company is small, with just 150 stores, but it’s growing fast — square-footage is growing 35% a year. Analysts think the company will have 1,500 stores in a few years — 10 times what it has now.

The Coke Problem

In the same way people are swearing off McDonald’s food, people are also drinking less carbonated sugar water. And that’s bad news for Coca-Cola (NYSE: KO).

Coke just reported third quarter earnings, too. And like McDonald’s, revenues missed expectations, and per-share income was down over last year.

Coke’s CEO said soda sales were flat (ha!) and that the 1% growth the company showed was from other beverages (i.e. not soda). Coke has made some moves to expand out of soda, like buying energy drink company Monster.

But for now, the company says it needs to focus on costs. It’s planning to shave $3 billion off of operating costs by 2019. But this is a $180 billion company. And as one S&P Capital analyst put it: “[S]luggish growth (is) expected to continue…”

Coke’s in the same position as McDonald’s: People want better-quality food and beverages. And I don’t see how Coke can make enough of a transition away from soda to support a $180 billion market cap.

Give me Starbucks (NASDAQ: SBUX) any day. It’s a better-run company with sales that are growing — not declining.

Pay Attention

I know earnings season is usually kind of boring, but it pays to pay attention. This is where you learn how the companies you’re invested in are doing.

I’m not one to panic over one quarter’s earnings report. But for Coca-Cola and McDonald’s, these bad third quarter numbers are part of a much broader trend. And it’s time to get out of these stocks, because it’s going to get worse before it gets better.

Until next time,

Until next time,

Briton Ryle

@BritonRyle on Twitter

The Wealth Advisory on Youtube

The Wealth Advisory on Facebook

A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.