Our confidence in Costco is not shaken by Walmart’s woes. Here’s why
All retailers are not created equal. While our faith in Walmart (WMT) is shaken after the Club holding cut its full-year profit outlook for the second time in roughly two months, we remain steadfast believers in Costco (COST). Not only does Costco’s membership model and cost-saving ethos make it the right retail stock for this environment — a view echoed Tuesday by analysts at Jefferies — but we think it has the foundation for long-term success, too. Bottom line Resist the temptation to join the rest of the Costco sellers on Tuesday. It’s no surprise Costco and other retailers are getting hit Tuesday on the heels of the negative Walmart news after the closing bell a day earlier. But dumping COST into the weakness is an ill-advised approach. At their lows of the day, Costco shares were down nearly 4%. We recognize Costco could be feeling some of same issues weighing on Walmart’s operations — namely a changing sales mix as must-have items like groceries take up a larger share of consumers’ budgets due to the higher prices that come with decades-high inflation. However, we believe Costco has done a better job than Walmart at navigating the inventory side of the equation. Other key differences exist between the companies, potentially limiting Costco from experiencing the bottom-line erosion that Walmart warned investors about late Monday. We have a 1 rating on Costco, which means it’s a stock we like here. The Club didn’t buy shares Tuesday on the pullback because we already have a sizeable position relative to the rest of the portfolio. WMT vs. COST In Walmart’s case, not only has its shoppers been spending more money on lower-margin things like food, but the big-box retailer also has an inventory glut, especially in apparel. In an attempt to help those excess products sell, Walmart has decided to put items on sale. While those discounts on apparel and other goods benefit the consumer, they dent Walmart’s profitability — that’s how Walmart could both slash its earnings outlook and raise its full-year sales forecast. With inflation raging, people are spending more overall dollars at Walmart, which is just earning considerably less money on those purchases. For Costco, we know from the company’s monthly sales reports that top-line growth remains strong and its sales mix also has shifted somewhat. That’s similar to Walmart. In June, Costco’s food and sundries core comparable sales rose in the mid-teens, compared to low-double-digit gains in May. Nonfood categories, meanwhile, rose by just under 10%, a deceleration from the year-over-year gains recorded in May. An importance difference is the demographics of Walmart shoppers versus Costco. Costco’s members tend to be higher-income individuals compared to the average Walmart customer. And, as we’ve seen with the earnings reports of American Express (AXP) and others, higher-earning consumers have generally been able to better weather the inflationary storm than folks who fall into lower income brackets. Here’s what CEO Craig Jelinek said on the matter a few weeks ago during a rare, exclusive interview on CNBC : “For a lot of people right now, they are in a recession because they are just trying to survive with just buying gas and making their house payments, rent payments. For people with higher income levels, they still have discretionary income to buy goods. We have a tendency to probably have middle- to upper-middle-income members in terms of our customers.” The differences between Walmart and Costco run even deeper, fortifying our view that selling Costco is a mistake here. All of Costco’s stores follow the membership model, and those membership fees are its primary source of profit. It’s part of the secret sauce that enables Costco to offer low prices on products that makes a membership such an attractive proposition all the time — not just when inflation is running at its hottest levels in four decades. Yes, Walmart has membership-only Sam’s Club locations, but the vast majority of the company’s operating income comes from its Walmart U.S. and Walmart International segments. This means Costco’s earnings stream should be more stable than Walmart’s, as long as membership renewal rates don’t fall off a cliff, which seems unlikely. After all, Costco’s renewal rates were at all-time highs domestically and internationally at the end of its third quarter: 92.3% in the U.S. and Canada — and, for the time time, they hit 90% globally. Plus, the elevated gas prices of late make joining Costco look like an even better deal because gas is generally cheaper at Costco’s stations than nearby competitors. Here’s what Jelinek told CNBC about the impact high gas prices has on renewal rates: “Let me put it this way, it doesn’t hurt at all. But, I think, overall our value proposition on everything that we sell continues to help our renewal rate.” Put all these factors together, and we feel much better about Costco’s ability to navigate this challenging period than Walmart. We’re not alone in this thinking. Jefferies note In a note to clients Tuesday, research analysts at the investment bank Jefferies reiterated their buy rating on Costco shares with a $580 price target. That represented 9.5% upside from where the stock closed Monday before Tuesday’s Walmart-related decline. The note follows a visit the analysts made to Costco’s headquarters in Issaquah, Washington. “Our time with the company reinforces our conviction in the name, and COST remains a top pick,” the analysts wrote, adding they were encouraged by “company commentary around gas, inventory, international, and in-store productivity enhancements,” such as self-checkout stations. Remember, for Walmart — and other retailers like Target (TGT) and Gap (GPS) — a glut of inventory has led to markdowns, weighing on profitability. Jefferies thinks Costco is in “relatively well-positioned” here. “COST highlighted that food and sundries and fresh inventories are in good shape, and while there is some excess inventory (such as Holiday merchandise that arrived late from last season), we believe that the business should be able to effectively manage through this dynamic,” they wrote. Higher-than-normal gas prices also factored into Jefferies’ near-term favorable outlook on Costco, telling clients that management indicated gas is a “key traffic driver for the business.” (Jim Cramer’s Charitable Trust is long COST and WMT. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.
