Costco Wholesale Corporation (NASDAQ:COST) and The Home Depot, Inc.(NYSE:HD) have much in common, aside from the obvious fact that each is a retail business. Both firms operate as members of a duopoly, both have economies of scale that provide a strong competitive advantage, and each has a solid balance sheet.
Costco has trounced the S&P 500 over the last five years. During that time frame, the index is up 67% while COST shares soared about 195%. However, it might surprise some to learn that Home Depot stock has outperformed Costco’s over the last ten years. In that time frame, COST shares are up 492% while HD stock has increased by 521%.
Where the two differ, especially in terms of investor’s interest, is in the current valuations, the projected growth rates and the level of profitability of each business.
The Many Manifest Strengths Of Costco
Costco’s primary rivals are BJ’s Wholesale Club Holdings (BJ) and Walmart’s (WMT) Sam’s Club. However, considering BJ’s trailing twelve months revenue is less than $17 billion, while Costco reported sales of over $210 billion, I consider Sam’s Club as Costco’s only true rival.
Those analyzing Costco’s business model often note the firm’s cash conversion cycle. That figure references the number of days needed to convert cash invested in goods into sales. A shorter time frame between the purchase of goods and the time it takes to sell products means less money is tied up in inventory.
Costco’s cash conversion cycle number is currently negative, an astounding metric. By comparison, BJ’s Wholesale turnover time is more than eight days.
Costco’s cash conversion rate is buttressed by the revenue it earns from membership fees. Most of its profit stems from that source, with those fees totaling $4 billion over the trailing 12 months. While membership fees comprise 2% of total sales, they constitute 77% of the company’s bottom line. This provides a degree of transparency when forecasting the firm’s growth and profit profiles.
Costco recently reported 114.8 million memberships, along with a renewal rate of 92%.
The following quote by CEO Craig Jelinek sums up many of the additional advantages the company holds:
Costco is able to offer lower prices and better values by eliminating virtually all the frills and costs historically associated with conventional wholesalers and retailers, including salespeople, fancy buildings, delivery, billing, and accounts receivable. We run a tight operation with extremely low overhead, which enables us to pass dramatic savings to our members.
Costco’s scale, it ranks as the third largest retailer, provides the firm with a competitive cost advantage.
Another source of leverage lies in the fact that the company has less than 4,000 SKUs. In contrast, Target (TGT) carries at least 75,000 SKUs and Walmart around 130,000.
Of those, 8.1% of total SKUs are Costco’s private label products. By sales, the company’s private label (Kirkland) ranks as the largest consumer packaged goods brand in the US. Kirkland constitutes 31% Kirkland Signature’s percentage of Costco sales. Kirkland labeled products are also priced 15% to 20% below branded alternatives.
Combining the firm’s size with a restricted product mix gives Costco bargaining power with suppliers that few can match. Additionally, the average item sold at Costco is marked up by 11%. Contrast this with a 24% markup at Walmart and 35% at Home Depot.
Another mark of the company’s efficiency lies in its sales per square foot. Costco reported over $1,600 in sales per square foot in fiscal 2021. That compares to Sam’s Club’s $920 sales per square foot, Kroger at $765, and Walmart at $560.
This business model generates strong FCF, and that metric has more than tripled in the past decade. The company has increased the number of warehouses from 592 in 2011 to 829 today. Management plans to open 28 additional stores in FY22.
One area of sustained growth could come from China. The company’s first store, opened in Shanghai in 2019, reeled in over 250,000 members within three months. This compares well with the US and Canada’s average 60,000 members per store.
The company currently plans to open a second store in France and its first warehouse in New Zealand.
Home Depot’s Advantages
Like Costco, HD operates in a duopoly, along with Lowe’s (LOW). In the US, 90% of the U.S. population lives within 10 miles of a Home Depot. Consider that HD sells more paint than Sherwin-Williams (SHW), and you understand the company’s place in America’s home improvement culture.
Contrast this with Menard’s, the third largest home improvement retailer. That company has 335 stores in 15 states. The geographic spread of HD translates into multiple advantages, especially when competing for pro customers. Pros constitute about 45% of Home Depot’s sales. This figure is well above that of Lowe’s, with 25% of that firm’s sales coming from pros.
Pros often operate over a relatively broad area, and the ability to pull supplies from different locations is a plus. And like Costco, Home Depot’s scale provides a second competitive advantage; its sheer size provides significant bargaining power with vendors for products and advertising. Inevitably, this translates into greater profitability. Over the last fiscal year, Home Depot’s gross margins beat Lowe’s (33.7% versus 33.1%) as did the company’s profit margins (10.8% versus 8.6%).
Furthermore, the company’s wide geographic span and pricing power undoubtedly contribute to its loyal customer base.
An additional advantage for HD is that much of its merchandise is not ecommerce friendly. A large part of the company’s product lines, think bricks, concrete, lumber, toilets and granite countertops, will never face significant competition from online rivals.
When online sales are practical, HD is dominating the competition.
Home Depot’s online sales also drive additional customer engagement: 50% of the firm’s online orders were fulfilled through the stores in FY21, and over the past two years, sales from the company’s digital platforms increased over 100%.
Many products offered by home improvement retailers are non-discretionary. In fact, Lowe’s CEO claims two-thirds of his company’s sales fall into that category. This places a floor on sales despite inflationary and economic pressures. After all, when a light, toilet, shower, etc are not functioning, most homeowners opt to pay for repairs.
While there is some concern that rising interest rates, inflation, and the spectre of a possible recession could weigh on Home Depot’s prospects, there are also long-term tailwinds to consider. According to a recent study, remodeling activity is likely to remain robust for the foreseeable future.
I mean, the conversations that we have with our Pros. They have basically been multiple weeks and months of backlog, and that continues. So I have not seen any major shift.
Craig Menear, CEO
This is driven in large part by the average age of housing in the US. The median age of homes in every state, with the single exception of Nevada, is at least 30 years, while the median age of homes in 31 states is over 40 years.
Home Depot is also very investor friendly. The company has a five-year dividend growth rate that is over 18%, and HD has a long record of robust share buybacks. Over the last fifteen years, the share count has been more than halved. (The following chart is in millions of shares. HD currently has one billion shares outstanding.)
Management emphasized its continuing focus on shareholder returns during the last earnings call:
Share repurchases, we intend to continue to return excess cash to our shareholders through dividends and share repurchases, and we’ll do that again this year. We have $9.5 billion remaining in our current share authorization program.
Richard McPhail, CFO
Despite its dominance, HD only commands 17% of the US home improvement market share, leaving ample room for growth.
One likely cause for the stock’s malaise of late is the tepid guidance provided during the most recent earnings call. However, this is largely due to the extremely difficult comparison to a record 2021.
Based on this approach and assuming there are no material shifts in demand, we calculate that sales growth and comp sales growth will be slightly positive for fiscal 2022. We expect our 2022 operating margin to be flat to 2021. And we would expect low single-digit percentage growth in diluted earnings per share compared to fiscal 2021.
Richard Mcphail, CFO
Home Depot & Costco Stock: Head To Head Comparisons
The following chart provides forward valuation metrics for COST and HD. They represent analysts’ consensus projections for the next twelve months. The single exception is the PEG ratio, which is over a five-year period. (All data for the charts in this section was gleaned from Seeking Alpha’s Premium service.)
Home Depot has the edge in terms of valuation.
I think it important to note that the forward P/E ratio for Costco is roughly four points higher than its average P/E over the last five years. In contrast, Home Depot’s forward P/E is more than four points below its average P/E ratio over the last five years. Both companies’ five-year PEG ratios are nearly two-tenths of a point higher than the average PEG ratio over the last five years.
The next graph provides analysts’ consensus growth rates for the next two years. The single exception is the EPS CAGR which is a projected over the next three to five years.
Costco is the clear winner with this comparison.
The chart below gives data regarding each companies’ profitability over the trailing twelve months.
Home Depot clearly outperforms Costco in this comparison.
Financial Strength And Dividend
Both companies own the bulk of their properties. Consequently, COST and HD weather economic downturns better than most retailers.
At the end of FY21, COST owned the land and buildings for 644 of its 795 warehouses. Most of the remaining stores were owned but were on leased land.
HD owns approximately 90% of its stores, including those on leased land.
Costco holds $12.3 billion in cash and investments as opposed to approximately $6.7 billion in long-term debt.
HD has $2.34 billion in cash and investments with nearly $33.6 billion in long-term debt.
Both companies have solid investment grade ratings from the credit agencies.
As previously noted, Home Depot has a very robust stock buyback program. Costco’s shares outstanding have remained fairly constant for over a decade.
Costco has a current yield of 0.74%. The payout ratio is a hair over 26%, and the five-year dividend growth rate is 12.07%. During the last earnings call, the CFO hinted that management is considering paying a special dividend.
Home Depot’s yield stands at 2.69%. The payout ratio is a bit above 44%, and the five-year dividend growth rate is 18.27%.
Despite Costco having a stronger balance sheet, I have to give HD the edge. The larger yield and management’s focus on stock buybacks should place the firm near the top of lists of shareholder friendly companies.
What Is The Forecast For COST And HD Stock?
Costco currently trades for $485.70 per share. The average 12-month price target of the analysts rating the stock is $582.88. The average price target of the 12 analysts that rated the stock following the last earnings report is $611.75.
The latter price target is a 26% gain from the current share price.
Home Depot currently trades for $290.05 per share. The average 12-month price target of the analysts rating the stock is $387.95. The average price target of the 15 analysts that rated the stock following the last earnings report is $373.60.
The most recent consensus price target is roughly 29% above the prevailing share price.
I give HD a lead here. In addition to the more favorable consensus estimates, I remind readers that Home Depot’s forward P/E is approximately four points below that company’s average P/E ratio over the last five years, while Costco’s is roughly four points higher than its historic P/E.
Is Costco Or Home Depot Stock A Better Buy?
Investors view some companies as so strong that they command premium valuations. Costco ranks in that elite group. However, this downturn in the markets serves as a stark reminder that even the best companies can be overvalued.
Costco’s sales grew nearly 13% over the last year, while net income increased 17%. However, the share price has jumped over 30%. The question is, was the stock undervalued twelve months ago, or has the share price outpaced the company’s growth?
With inflation raging, and a fear that a recession is at hand, it is reasonable to assume that many consumers will turn to Costco for relief. This paradigm might have been borne out by the company’s announcement last Wednesday that comparable store sales have surged.
On that day, Costco reported same store sales, excluding changes in gasoline prices and forex, increased by 8.7%. This was despite this year’s April retail month having one less shopping day due to the calendar shift for Easter.
Is this a harbinger of things to come? Will inflation result in a surge in Costco’s membership numbers as consumers search for a means to escape higher prices?
If so, will those same consumers pare back on shopping trips to Home Depot?
As noted in this article, about two-thirds of HD’s sales are derived from non-discretionary items. Furthermore, the long-term outlook for the home improvement business remains intact.
Even so, as I always endeavor to provide a balanced perspective for investors, while visits to Home Depot were up in the first two months of this year compared to pre-pandemic 2019, they are below 2019 levels for March and April.
That is food for thought.
As to which company presents the best investment, I must opt for Home Depot.
I rate HD higher due to its valuation and profitability, as outlined in the charts above. As one who is largely a dividend growth investor, I also favor Home Depot due to its significantly higher yield. I also note that HD shares trades at a P/E ratio that is 17.56x, versus the S&P 500 P/E multiple of nearly 20.
While I readily admit that Costco is an outstanding company, I nonetheless rate it a HOLD at this valuation.
I also rate Home Depot as a HOLD, as I do not consider its valuation to be desirable at this juncture.
I will add that I am willing to invest in either company if I consider the shares to be trading a fair valuation. This comes from one who nearly always seeks to invest at bargain basement levels, and is testimony to my perception that both firms are exceptional investments over the long haul.