Costco Wholesale (COST -0.12%) and Target (TGT -0.54%) are two of the best-known retailers in the U.S. And while both companies are popular for offering a variety of goods at low prices, Costco relies on a lower operating margin and higher volumes, while Target usually has a higher operating margin because it sells a larger mix of discretionary products.
Therefore, it's no surprise that Target has been hit harder than Costco by supply chain disruptions and inflation. And Costco's recurring revenue stream from memberships, paired with its customer loyalty, adds another layer of protection amid economic uncertainty.
Here's the case for why both Costco and Target could be worth buying now.
Image source: Getty Images.
Sometimes, history does repeat itself
Howard Smith (Costco): Costco and Target are both proven, successful retailers. But they have different business models, with Target being more of a typical retailer while Costco relies more on a loyal and growing membership base and less on operating margin.
COST Operating Margin (Quarterly) data by YCharts.
While Costco is less profitable by that financial metric, it is more consistent, and that has rewarded shareholders in other ways. Costco's total returns -- including dividends -- have significantly outpaced those of the S&P 500 index as well as Target over the past decade. That primarily comes from excellent management and a culture that takes care of both its shareholders and its employees.
Recent quarterly performance provides a good example. Many retailers, including Costco, have been forced to navigate a difficult economic environment with inflated input costs and fears of a slowdown in consumer spending. For its fiscal 2023 first quarter (ended November 20), net sales rose 8.1% versus the year-ago period. However, net income only grew 3% as expenses increased.
But even in a challenging environment, on the quarterly conference call for investors, management said it was still planning to pay a special dividend to shareholders. Costco last paid a $10-per-share special dividend in November 2020, making it the fourth one in the last nine years. When asked whether another would be coming soon, Costco CFO Richard Galanti called it "probably a question of when, not if" the next special payout would occur.
That confidence comes from a loyal membership base and value proposition that allow the company to periodically raise fees. That growing recurring revenue is emblematic of the consistency that shareholders can expect from an investment in Costco, too.
Target is a better value than Costco
Daniel Foelber (Target): Costco is a classic example of a fantastic company but an overpriced stock. And that's coming from a loyal Costco shopper.
Fans of Costco stock will point to its torrid growth rate as a reason to justify its premium valuation. And there's no denying that what Costco has done in the span of just three years leaves Target in the dust.
COST Revenue (TTM) data by YCharts.
But despite this growth, there's just no reason Costco should be trading at a price-to-earnings (P/E) ratio of 36 and a forward P/E of 34. For context, that means that Costco is a more expensive stock than Apple (NASDAQ: AAPL), Microsoft (NASDAQ: MSFT), Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), and even Tesla (NASDAQ: TSLA).
COST PE Ratio data by YCharts.
To be fair, Target's forward P/E ratio of 29 looks way overpriced as well. But that's because Target's profit has fallen off a cliff in recent quarters as the company grossly underestimated the duration and severity of inflation. Target also mismanaged its inventories and was pressured to offer steep discounts just to move products.
When the stock of an industry-leading company like Target tumbles due to what are likely mostly short-term, self-inflicted missteps and economic woes, it's usually a great time to buy.
The long-term investment thesis for Target hasn't changed one bit. It's still the same reliable blue-chip Dividend King with a 51-year streak of raising its dividend it's always been. With a 2.9% dividend yield, Target offers a compelling incentive for investors to hold the stock for the long term even if the company is in for more pain in 2023.
Costco and Target can benefit investors in different ways
On paper, Costco is a better-run, more consistent company than Target. But investors should take into context its lower ordinary dividend and premium valuation.
Both companies should continue to do well over the long term. And for that reason, the decision on which retail stock to choose likely depends more on personal preference toward growth versus value and income.
