Both Costco (COST 0.26%) and Dollar Tree (DLTR 1.74%) have benefited from shifts in consumer buying patterns, and both appeal to shoppers looking for value. But the two companies have different business models. While Dollar Tree sells products with a price point of $1 and its Family Dollar stores sell products at $10 and under, Costco sells high-quality goods at a very wide range of prices to its members.
One of these consumer discretionary companies is a better longer-term investment because of its positioning in retail and its growth strategies. Once the pandemic subsides and people revert to normal buying patterns, there is one company that is more insulated from the intense competition in the retail space.
Costco's business model is differentiated and consumer-centric: It offers high-quality products at low markups. When people shop at Costco, they know they are getting some of the best prices relative to quality. While Costco's merchandise sales are at lower margins, its membership fees are at much higher margins.
Costco's loyal member base helps to drive stability in its revenue and earnings. The company's North American membership renewal rates remained near record highs over the last two earnings quarters, at around 91%. The company also saw total paid households up to 59.1 million at the end of the first quarter (ended Nov. 22 ), compared to 58.1 million at the end of the fourth quarter.
Set for long-term growth
Costco has seen steady revenue growth over the last five years: 2.2% in 2016, 8.7% in 2017, 9.7% in 2018, 7.9% in 2019, and 9.2% in 2020. More recently, Costco reported a January monthly sales increase of 17.9% year over year, with comparable sales up 15.7% (excluding gas prices and foreign exchange). This is up from December's (five weeks ended Jan. 3) comparable sales increase of 10.7% versus consensus expectations of 9.5%.
The company is relatively insulated from competition from large e-commerce players like Amazon, which are seeing faster revenue expansion. Costco offers very good value and a large selection of quality, in-house branded products, mostly in the groceries and household goods categories. The company caps its markups at 14% for non-Costco brands and 15% for its in-house brands, much lower than the typical 25%-50% markup of typical retailers. Costco also offers gas and pharmaceutical products that drive additional store traffic. The warehouse retailer's strong value proposition combined with the loyalty of its members gives it a larger moat compared to the average retail company.
Costco has room to expand in e-commerce, which is growing but is only about 7% of Costco's total business (excluding third-party sales from vendors like Instacart). In the first quarter, Costco's e-commerce segment saw revenue increasing 86.4%, indicating more opportunity in the future. Costco's March 2020 purchase of Innovel, a delivery and installation company, should help drive its e-commerce sales of home goods. Innovel specializes in items like appliances and furniture.
Discount retailer Dollar Tree has benefited in 2020 as shoppers stocked up on groceries and household staples. While people always like discounts, the recent virus-driven recession has pushed people to favor discount stores. These factors drove a 28.7% increase year over year in earnings per share during Dollar Tree's latest third-quarter earnings (ended Oct. 31), following the second quarter's 44.7% increase .
While the pandemic-driven sales boost will ease as normalcy returns, Dollar Tree's earnings growth will likely slow. Consensus analyst projections are forecasting a 17% increase in full-year fiscal 2020 earnings and an 11% increase in 2021. However, Dollar Tree has initiatives that could help it exceed these future estimates.
New initiatives to increase profitability
Management's been sprucing up its Family Dollar segment, which was 46.5% of total company sales in the third quarter (ended Oct. 31) over the past several years. The plan includes closing underperforming stores, renovating existing stores, and converting some stores into Dollar Tree units. During fiscal year 2019 (ended Feb. 1, 2020 ), Dollar Tree closed over 400 Family Dollar stores and converted 200 Family Dollar stores into Dollar Trees. More recently, Dollar Tree upgraded 371 Family Dollar stores in the third quarter.
Dollar Tree has seen results from its plans to improve sales at Family Dollar: During the first nine months of 2020, Family Dollar's operating margin improved to 5%, up from 2% a year ago. During the third quarter, the segment's net sales increased by 7.5% year over year. Further improvements are being made, with e-commerce launched for familydollar.com during the third quarter, providing added convenience.
Another initiative toward future earnings growth is Dollar Tree Plus! (began in mid-2019), a merchandising update that offers additional products at slightly higher prices points, mostly between $3 and $5. The higher-priced merchandise should help lift margins in the future. "Our customers are buying these products and sales of our multi-price items continue to grow. In fact, we are seeing that when multi-price items are included in the basket, the average transaction value is approximately twice the size," noted CEO Michael Witynski on the third quarter earnings call. Dollar Tree has plans to add Dollar Tree Plus! to about 500 of its stores in 2021.
While both of these retailers are appealing in the current environment, I like Costco more for its bigger moat and unique value proposition for both investors and customers. Costco's membership model gives it a relatively sticky customer base and subjects it to less competition than Dollar Tree. Therefore, Costco is the better investment for its greater stability and growth prospects in various economic environments.