Costco (NASDAQ:COST) and Wal-Mart (NYSE:WMT) are two leading players in discount retail. The two companies have different business models and strategies, and they directly compete against each other for customers' money in a massively big industry. But which one is a better buy for investors in 2015: Costco or Wal-Mart?
A tale of two very different retailers
There are some remarkable differences between Costco and Wal-Mart. To begin, Costco is the pioneer of the warehouse retail business model, meaning that the company makes most of its profits from membership fees as opposed to margins on sales prices. This allows Costco to sell its products for competitively low prices, sometimes even at a loss, which is a major advantage in the industry.
On the other hand, Wal-Mart's Sam's Club division brings in roughly 12% of total company revenues for the company, and it has been a considerable growth driver for the company over the last several years. However, Wal-Mart's competitive strength is mostly based on scale advantages. Wall Street analysts on average forecast more than $500 billion in sales for Wal-Mart during the fiscal year ending in January 2016, making the company the biggest retailer on the planet.
This gargantuan scale allows Wal-Mart to negotiate especially convenient prices and payment conditions with suppliers. Large volumes mean lower fixed costs per unit, as the company spreads fixed costs throughout a sizable amount of items.
Costco: The anti-Wal-Mart
Costco and Wal-Mart have strikingly different company cultures and human resources policies. While Wal-Mart receives a lot of criticism for paying low wages and providing working conditions which leave a lot to be desired, Costco pays salaries which are considerably above the industry average and offers superior opportunities for professional growth.
Higher salaries and other benefits produce higher costs for Costco, but they also mean superior customer service and a happier clientele. Based on the American Customer Satisfaction Index, Costco is the highest ranking company in its industry, with a score of 84. This puts Costco considerably above Sam's Club and its score of 80 in the American Customer Satisfaction Index.
When comparing Wal-Mart against the department and discount stores industry, the company ranks in last place with a customer satisfaction score of 71 versus an industry average of 77. Although Wal-Mart is all about prioritizing cost savings, lower salaries have negative implications on service quality and customer satisfaction, and cheap salaries can be quite expensive when considering the overall impact from a commercial and competitive point of view.
On growth and valuation
Costco has materially outgrown Wal-Mart over the last five years, and there is no reversal in the trend according to the latest financial reports from the two companies. Costco reported an increase of 8% in December comparable-store sales excluding fuel price volatility and currency exchange fluctuations -- quite an impressive performance for a retailer of its size. Wal-Mart does not report monthly sales, but the company announced that total comparable sales excluding fuel rose by a much more moderate 0.5% during the 13-week period ended in October.
On a forward looking basis, Wall Street analysts on average forecast that Costco will increase earnings per share by 10.3% annually over the next five years, while Wal-Mart is expected to deliver an annual growth rate of 5.7% through that period. Yes, these kinds of forecasts are always subject to errors and revisions, however everything strongly suggests that Costco will continue outperforming Wal-Mart by a considerable margin over the years ahead.
One area where Wal-Mart comes well ahead of Costco is valuation. Wal-Mart stock trades at a forward P/E ratio of 16.6, much cheaper than Costco's forward P/E ratio of 24.5. Wal-Mart is also more attractive when it comes to dividends: the stock pays a dividend yield of 2.1%, versus a dividend yield of 1% for Costco.
Being a bigger company and trading at a more convenient valuation, Wal-Mart looks like the way to go for defensive investors who want to keep volatility at bay. On the other hand, Costco beats Wal-Mart when it comes to quality and growth prospects, so chances are Costco stock will deliver higher returns for investors in the years ahead.