Better Buy: Costco vs. Target

Costco Wholesale Corporation (NASDAQ: COST) is known for its commitment to low prices. Millions of customers are willing to pay a membership fee to shop at one of its warehouse stores. A loyal customer base and low prices have been a winning formula that has made Costco one of the most consistently performing companies around.

Target Corporation (NYSE: TGT) has delivered excellent results of late with the backdrop of a healthy consumer spending environment, but over the last 10 years, the stock has underperformed the broader market as the company fell behind Walmart in e-commerce.

Let's take a closer look to find out which stock investors should buy for the long term.

A lower valuation doesn't always translate to superior returns

Over the last decade, Costco has been a much better growth stock than Target. Costco stock is up 483%, beating Target's return of 193%. The outperformance of Costco reflects much superior revenue and earnings growth over the last 10 years compared to Big Red.

Over the last three years, Costco's revenue has increased by 25%, compared to about 5% top-line growth for Target. It's the same story on the bottom line, with Costco's earnings climbing 47% compared to Target's bottom-line growth of just 3%.

However, Costco's higher growth comes at a much steeper price. The membership warehouse store has a reputation for delivering very consistent results every year. Those two qualities -- steady growth and consistency -- mean you have to pay a high forward P/E of 27 to hitch your wagon to the warehouse chain.

On the other side, Target hasn't delivered much growth at all, which is why the stock currently sports a forward P/E of just 12 times next year's earnings.

Keep in mind, Costco stock has always looked expensive. Over the last decade, the shares have fetched a trailing P/E of around 24 or higher in most years. Meanwhile, Target has typically traded for a trailing earnings multiple of about 16 or lower.

Investors may be attracted to Target stock based on its above-average dividend yield of 3.37%. Target stock has generally offered a higher yield than Costco, which currently pays a 1.01% yield. Over the last year, Target has paid out 45% of its earnings in dividends compared to Costco's payout ratio of 28%.

Despite Target's higher yield, investors would have realized a total return on Costco of 653% compared to Target's return of 284%, with dividends reinvested.

All in all, I wouldn't call Target the better buy based on its lower P/E and higher dividend yield.

Recent performance and competitive advantage

The most-watched metric for retailers is comparable-store sales. In the most recent quarter, Costco reported comp sales growth of 5.4% -- or 6.7% excluding changes in gas prices and currency exchange rates. Target's performance was similar, with comp sales up 5.3% in the latest quarter. Those are solid numbers for both companies, which shows that Costco and Target are doing something right to attract shoppers.

E-commerce growth is becoming just as important as comp sales in evaluating retail stocks. Costco saw adjusted online sales rise 25.5% in the last quarter, but Target grew faster, with online sales up 31% during the holiday quarter. However, both companies' online sales growth significantly trails Walmart's e-commerce growth of 43% year over year in the last quarter.

It's tough to argue that Target has a stronger competitive advantage than Costco, especially given that the main draw for shoppers at both Costco and Walmart is grocery. Target has been able to keep traffic up by bringing in specialty apparel brands to lure shoppers through the door. Over the last 18 months, Target has introduced 20 new brands, most notably a recent collaboration with Vineyard Vines. Management reported that the customer response has been "phenomenal."

However, Costco distinguishes itself through old-fashioned cost cutting and low prices. It has a wide moat in acquiring and selling bulk items at rock-bottom prices. Costco is so bent on keeping merchandise prices as low as possible that most of its operating income is generated from membership fees.

On that score, Costco is a winner in getting shoppers to ante up for the privilege of shopping at one of its warehouse stores. In the fiscal second quarter, member renewal rates improved to 88.3%, up from 88% at the end of the fiscal first quarter.

Target has made investing in e-commerce, including various services like order online and pick up in store, a key strategic initiative. It has shown good progress, with online sales growing from $1 billion in 2012 to $5 billion over the last year.

But Target's main categories, including apparel, grocery, beauty, and home furnishings, are highly competitive, and Big Red doesn't have much to distinguish itself over peers. Walmart is way ahead of Target in e-commerce, and I don't see Target catching up anytime soon, especially since Walmart's online business is three times larger and is growing faster.

Because of Costco's cost advantage, it is more insulated from competition from larger rivals like Walmart and than Target is.

Which is the better buy?

Target's low P/E is tempting. I wouldn't be surprised to see the stock outperform in the short term if investors decide Target is worth paying a slightly higher earnings multiple for, based on e-commerce improvements and store traffic.

While I'm not too hot about its high valuation, I believe Costco stock is a better investment for the long term because its business has delivered for shareholders through thick and thin, and the warehouse chain is built on what I see as a durable competitive advantage in keeping prices as low as possible.

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John Mackey, CEO of Whole Foods Market, an AMZN subsidiary, is a member of The Motley Fool's board of directors. John Ballard owns shares of AMZN. The Motley Fool owns shares of and recommends AMZN. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.