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Better Buy: Costco vs. GameStop

By Leo Sun - Mar 12, 2021 at 8:05AM

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Should investors stick with Costco's reliable growth, or take a chance on GameStop's volatile stock?

Throughout most of the past decade, shares of Costco (COST 1.20%) and GameStop (GME -8.84%) traveled in opposite directions.

Costco impressed investors with its aggressive expansion, sticky memberships, and resilience against e-commerce incursions by the likes of Amazon. Meanwhile, GameStop was often dubbed the "next Blockbuster" as American malls collapsed and digital downloads replaced physical games.

But all that changed this year, when a historic short squeeze propelled GameStop's stock price to record highs. At the same time, interest in Costco waned as investors braced for a slowdown in pandemic-driven shopping.

Growth-oriented investors might still be tempted to chase GameStop, even after it rallied more than 1,200% this year, but is it really a better buy than Costco?

A child draws "buy" and "sell" arrows on a small blackboard.

Image source: Getty Images.

Are GameStop's gains sustainable?

GameStop was already in a precarious position when the pandemic hit. Its revenue fell 22% in 2019, as the anemic growth of its collectibles business failed to offset its tumbling hardware and software sales, and its adjusted net income plunged 91% to $19.1 million.

In the first nine months of 2020, GameStop's revenue plunged 31% year over year to $2.97 billion, with declines across all its businesses, as its adjusted net loss widened from $64.7 million to $229.5 million.

Those numbers look dire, but analysts expect GameStop's revenue to rise 4% in the fourth quarter, which started last November, as Sony and Microsoft's latest consoles hit the market. It also plans to expand its e-commerce business, which generated high-triple-digit-percentage sales growth throughout the pandemic.

A couple plays a video game at home.

Image source: Getty Images.

Analysts expect GameStop's revenue to decline 19% for the full year, but rise 7% in fiscal 2021 after the pandemic passes. They also expect it to post a full-year loss this year, followed by a narrower loss next year.

Based on these expectations and GameStop's current share price of $250, the stock trades at about three times next year's sales. That price-to-sales ratio might seem low, but many brick-and-mortar retailers -- including Costco and Best Buy -- trade at less than one times next year's sales. Brick-and-mortar retailers are usually judged by their price-to-earnings ratios instead, but GameStop's losses make those comparisons impossible.

Furthermore, the two existential challenges for GameStop haven't faded away. First, other big retailers that aren't based in malls, such as Best Buy, are also selling the latest gaming consoles. Second, Sony, Microsoft, and other publishers are encouraging gamers to digitally download games, which generates higher-margin revenue by eliminating physical discs and cutting retailers like GameStop out of the loop.

These secular headwinds, which will likely intensify throughout 2021, still threaten to turn GameStop into the "next Blockbuster" -- despite what the enthusiastic bulls on Reddit might claim.

Should investors be worried about Costco's slowdown?

Costco's business was broadly stable prior to the pandemic. Its revenue rose 8% to $152.7 billion in fiscal 2019, its comps grew 6.1%, and its net income increased 17% to $3.7 billion.

However, the pandemic lit a fire under its business as shoppers stocked up on essential products. Its revenue rose 9% to $166.8 billion in fiscal 2020, its comps increased 9.2%, and its net income also grew 9% to $4 billion.

That acceleration continued in the first half of fiscal 2021. Its revenue increased another 16% year-over-year to $88 billion, its comps increased 15%, and its net income rose 19% to $2.1 billion.

Costco's global membership renewal rate also increased ten basis points year-over-year to 88.5%, and its renewal rate in the U.S. and Canada expanded at the same pace, from 90.9% to 91%.

Those rising renewal rates drive Costco's bottom-line growth, since it generates nearly all of its profits from its membership fees instead of its low-margin product sales. It also ended the second quarter with 804 warehouses worldwide, up from 785 locations a year ago.

Those growth rates are impressive, but analysts expect Costco's revenue to only grow 12% for the full year, and rise just 6% next year. Its earnings are expected to grow 14% this year but increase just 10% next year. Costco's growth is expected to cool off after the pandemic passes.

That slowdown, along with the stock's higher forward P/E ratio of nearly 30, seems to be keeping investors away from the stock. Higher bond yields, which are sparking a rotation from growth stocks to value stocks, could also be keeping investors focused on cheaper "reopening" plays than Costco.

The better pick: Costco

I play plenty of video games, but I can't remember the last time I bought anything from GameStop. But I can easily recall the last time I went to Costco -- and I suspect many investors feel the same way.

GameStop isn't down for the count yet, but the secular headwinds are simply too strong to ignore. Its stock might head higher from here, but I doubt its short-term gains are sustainable.

Therefore, I believe investors who simply stick with Costco will likely generate bigger gains over the next few years than those who chase GameStop's rally today.

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Stocks Mentioned

Costco Wholesale Corporation Stock Quote
Costco Wholesale Corporation
COST
$434.62 (1.20%) $5.14
GameStop Corp. Stock Quote
GameStop Corp.
GME
$87.64 (-8.84%) $-8.49

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