Wal-Mart Stores (NYSE:WMT) and Costco Wholesale (NASDAQ:COST) may seem like very similar companies on the surface. They both operate in the discount retail space and have large market capitalizations. But there are important differences between them. In short, Wal-Mart and Costco are going in opposite directions. Wal-Mart is really struggling to increase sales, while Costco is firing on all cylinders.
Wal-Mart caters to lower-income consumers. On the other hand, Costco caters to higher-income consumers, through a membership program. The difference in this regard is plain to see in their respective earnings reports over the past year.
The differences have had a distinct bearing on their varying levels of success this year, and the divergence between the two is having an effect on their ability to raise dividends. Here's what income investors need to know.
A tale of two retailers
Wal-Mart's comparable-store sales, a metric that measures sales at locations open at least one year, was flat last quarter. Its Sam's Club segment, which is the direct competitor to Costco's model, posted flat comparable sales last quarter. Overall, Wal-Mart's diluted earnings per share are down 0.4% over the first half of the year.
However, one bright spot in Wal-Mart's last earnings report was the performance of its smaller stores under the Neighborhood Market banner. Comparable sales for the Neighborhood Market concept rose 5% last quarter, and comparable store traffic increased 4%. This represents a compelling growth opportunity for Wal-Mart, as these smaller stores will allow the company to enter urban areas and big cities, areas in which Wal-Mart did not have a pronounced footprint previously. Not surprisingly, this is where the company plans to focus investment this year. Management noted that Wal-Mart opened 22 Neighborhood Market locations last quarter and is on track to open a total of 180-200 new stores this year.
Still, the Neighborhood Market brand represents a fairly small portion of the total business, and the continued struggles of Wal-Mart's Supercenters will weigh on the company for some time. That is why management significantly adjusted its earnings forecast for the full year, to a range of $4.90 to $5.15 per share, down from the previous forecast of $5.10 to $5.45 per share.
That's why Wal-Mart's recent dividend growth has been a disappointment. The last dividend raise was just 2%. This was well below its 12% compound annual growth rate over the past five years.
By contrast, Costco has increased its dividend by strong rates over the past five years, including its 14.5% dividend increase this year. That's because its underlying financial results have been much stronger in recent periods. For example, Costco's U.S. comparable sales increased 6% in its most recently concluded fourth quarter and increased 5% for the full fiscal year. Total companywide comparable sales climbed 4% in fiscal 2014.
That performance allowed Costco to increase its dividend by 14.5% this year. Over the past five years, Costco has increased its payout by 14% compounded annually. Even with these generous increases, Costco still distributes less than one-third of its earnings per share. This is better than Wal-Mart's 40% payout ratio, which will provide even more flexibility for Costco to raise its dividend at higher rates going forward.
The better pick: Costco
Wal-Mart is struggling to increase sales, and it's going to aggressively invest in its new smaller-store concept to reignite growth. Doing so will be a costly effort, hence management's conservative dividend increase this year. Investors should expect future dividend increases to remain below the company's recent five-year average.
Wal-Mart stock has an advantage over Costco stock because of its higher dividend yield: The stock yields 2.5% based on recent closing prices, better than Costco's 1.1%. But that's about where the advantages end. Costco is growing much faster than Wal-Mart. It also carries a lower payout ratio and so should produce significantly higher dividend increases going forward. That's why, even though Wal-Mart's dividend yield is higher now, with enough time Costco's higher dividend growth will make up the difference.
For all these reasons, income investors should pick Costco over Wal-Mart.
Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Costco Wholesale. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.