Walmart (WMT) and Costco (COST) have been going toe-to-toe for customers for years. However, there is evidence that one is pushing forward, while the other risks being left behind. Looking at each company’s last earnings report, there are certain key factors that suggest Walmart may have the leg up on its competition. The company’s online efforts are working, it has a chance to become more efficient, and analysts’ expectations for earnings growth look too low.
Though Walmart seems to have several advantages over Costco, what it does not have in the short term is superior in-store results. It’s possible these figures could change over time, yet Walmart investors should still be pleased with what I would call respectable growth.
In the most recent quarter, Walmart’s U.S. comps increased by 2.8%. By point of comparison, Costco’s U.S. adjusted comps increased by 5.5%. The company’s August comp results suggest continued strength, with U.S. comps up 6.4%. If we compare Sam’s Club comps to Costco, the numbers don’t favor Walmart’s division. Sam’s Club’s comps increased at less than half the rate of Costco’s similar operations.
(Source: Walmart Virtual Museum)
Looking at international store locations, Walmart International revenue was up 3.3% in constant currency. Using Costco as our comparison again, the company’s Canada comps increased by just over 5% and Other International increased by 6.9%. The numbers clearly don’t favor Walmart, however they do show growth. Though Walmart stores are a massive part of the retailer’s story, respectable growth should be more than enough as the real growth engine takes over.
$100 billion is just a starting point
Analysts expect Walmart to generate more than $540 billion in revenue next year. With such a huge number, any business it moves into must be massive to move the needle. The company is pushing to take market share in the grocery business, and whether it’s delivery or pickup, the numbers seem to favor Walmart.
In the most recent quarter, Walmart’s online sales increased by 37%. Costco isn’t playing in the same league as Walmart when it comes to e-Commerce, yet it still managed a just under 20% annual growth in e-Commerce last quarter. According to some sources, the online grocery business is expected to take 20% of the total grocery business by 2025. As multiple companies improve their online options, same-day pickup, and takeaway options, consumers are starting to see the benefits of not having to make a trip to the grocery store.
In the U.S. alone, the grocery business is estimated at $641 billion. Given this only represents the domestic opportunity, 20% of this would mean an online grocery market size of more than $100 billion. It would be one thing for Walmart to have one breakout quarter with fast online sales growth, but the company is projecting 35% e-Commerce growth for the entire year.
Costco is planning on expanding its online offerings this year. CFO Richard Galanti said, “We will begin e-Commerce operations in Japan later this summer; and Australia late summer early fall.” This sounds great, as it should give the company more diversity in its online sales. Unfortunately, the company also said, “if somebody wants something in an hour, they’re probably not going to get it from us.” Repeatedly, when analysts asked about same-day pickup or other options, Costco’s management essentially said, “we’ll look at that for the future.”
(Source: Free NextDay Delivery from Walmart.com)
Walmart, on the other hand, already has a significant lead in online sales and plans to continue to leverage its store base. The company said it has 1,100 grocery delivery locations and more than 2,700 pickup locations. In addition, US CEO Greg Foran said, “we remain on pace to reach our year end goal of 1,600 same day grocery delivery stores and 3,100 stores with grocery.” Not to put too fine a point on this, but 1,600 same-day grocery delivery stores is almost triple Costco’s entire store base. On top of this, the company also pointed out in its latest earnings that, “NextDay delivery from Walmart.com now covers about 75% of the U.S. population.”
Walmart wants to make it as convenient as it can for shoppers to do business with the chain. Costco apparently believes that people enjoy spending time wandering around its warehouses. Between the rise of online shopping in general and the convenience of grocery pickup or delivery, Walmart is more than happy to take business from Costco.
Better growth = better margins
Most companies increase earnings in essentially one of two ways: either they sell more stuff, or they spend less to generate sales. The good news for Walmart is it’s doing both. Looking at some numbers, it seems there is a long runway for expense reduction as a percentage of revenue. When examining companies, I tend to watch their SG&A (selling, general & administrative) expenses. These are the costs of staffing, benefits, and the many other expenses beyond the costs related to the goods or services they sell.
This is one place where Walmart can learn a lot from Costco’s business model. The very nature of the Costco store is tons of goods, cheap prices, and relatively few workers. In the company’s last earnings report, it spent just under 10% on SG&A expenses. This is an amazing achievement, as many companies routinely spend 15%, 20%, or more. Where Walmart is concerned, SG&A expenses in the current quarter amounted to 20.6% of total revenue. Walmart may never reach Costco’s level because of their different operating models, but clearly, the retailer can leverage these expenses better in the future.
The road to better expense leverage has been slow but sure over the last three years for Walmart. In Q2 of 2017, the company spent $25.2 billion on SG&A, or 21% of revenue. By Q2 of 2018, Walmart spent $25.9 billion on this line item, also about 21% of revenue. Last quarter’s expense was $26.9 billion and used a slightly smaller amount of total revenue. The point is, Walmart isn’t increasing SG&A at a rapid pace, yet sales growth over the last three years hasn’t exactly been spectacular.
As online sales become a bigger and bigger part of the story, the company doesn’t have to spend quite as much to fulfill these orders. With total revenue increasing by 1.8% annually last quarter and online sales up 37%, if this ratio continues as expected, faster top line growth should be the result. If Walmart can get SG&A to even 18% of total revenue through leverage, last quarter that would have equated to about $23.5 billion, or a savings of more than $3 billion. Even for a massive company like Walmart, $3 billion is still a big number.
Growth and income and a 30% discount
At first, it’s hard to make a case that Walmart stock is a strong value. With a forward P/E ratio approaching 23, and near a 52-week high, the stock could certainly be cheaper. However, considering Costco’s forward P/E is north of 33, Walmart doesn’t look too bad. When it comes to yield, Walmart currently pays investors a 1.8% per year. This level of dividend used up less than 37% of core free cash flow last quarter. Costco pays a yield of 1%, so when it comes to income, Walmart is clearly the better option. It’s true that in the past Costco has paid large special dividends, but these are neither guaranteed nor predictable.
When we look at earning expectations, analysts are calling for 4.6% 5-year EPS growth from Walmart versus 9.1% 5-year EPS growth at Costco. The numbers here aren’t quite as cut and dried as they first seem. First, in the past four quarters, Walmart has beaten expectations each time by an average of 7%. Costco beat expectations twice, missed once, and its average outperformance is 5.5%. In addition, over the past 90 days, analysts have raised Walmart’s 2020 estimates by roughly 2%. By point of comparison, Costco’s estimates are little changed.
The point is, though Walmart is expected to grow at a slower rate, if it continues to beat expectations, the figure should come in higher. With Walmart’s forward P/E ratio 30% cheaper than its peer, the difference in expected growth between the two companies doesn’t seem to warrant Costco’s significantly higher valuation.
If we look at the overall picture, Walmart seems well-positioned for future gains. The company’s store performance could be better, but investors could hardly ask more of its online operations. As online sales continue to climb, they will represent a more significant portion of the company’s overall revenue. Along with increased online sales, Walmart should gain better cost leverage, as it needs less people to service these online orders. As SG&A comes down as a percent of revenue and the top line climbs, earnings and cash flow should improve. Given its current valuation, I would recommend long-term investors dollar cost-average into the shares over several months to take advantage of any dips in the market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.