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Summary

  • Find out if Costco or Wal-Mart is a better buy for dividend growth investors.
  • Costco's razor thin margins drive customer growth while membership fees add to the bottom line.
  • Wal-Mart grew e-commerce revenue 27% in the most recent quarter.
  • Wal-Mart has a 40+ year record of consecutive dividend increases.
  • Costco's international same store sales are growing quickly.

Warren Buffett holds both Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST) in his portfolio. Wal-Mart makes up 3.7% of his current portfolio, while Costco makes up 0.5%. Both businesses operate in the competitive discount retailer market. Wal-Mart was founded in 1962 and has grown into the largest retailer in the world with a market capitalization of nearly $250 billion. Costco was founded 21 years later, in 1983. The business has grown rapidly and now operates 658 warehouses throughout the world. Costco is about 1/5 the size of Wal-Mart with a market capitalization of $50 billion.

This article examines Wal-Mart and Costco using the 5 Buy Rules from the 8 Rules of Dividend Investing. The 8 Rules of Dividend Investing identifies high quality businesses trading at fair prices or better prices. The 8 Rules of Dividend Investing works by comparing businesses a long history of dividend payments to each other. This type of comparison creates a quantitative way to determine and rank high quality dividend stocks.

Consecutive Years of Dividend Payments

Costco has paid increasing dividend payments each year since 2004. The company does not meet the first requirement of the 8 Rules of Dividend Investing: 25+ years of dividend payments without a reduction. With that being said, Costco's steady profitable growth is evidence of a strong competitive advantage. The business will be compared to other businesses with a long history of dividend increases in this article to show how it compares.

Wal-Mart has paid increasing dividends for 41 consecutive years. The company's long history of dividend increases shows that it can protect its competitive advantage and grow profitably throughout a range of economic and societal changes.

Why it matters: The Dividend Aristocrats (stocks with 25-plus years of rising dividends) have outperformed the S&P 500 over the last 10 years by 2.88 percentage points per year.
Source: S&P 500 Dividend Aristocrats Factsheet, February 28 2014, page 2

Dividend Yield

  • Wal-Mart has a dividend yield of 2.50%, the 60th highest out of 128
  • Costco has a dividend yield of 1.20%, the 113th highest out of 128

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Why it Matters: Stocks with higher dividend yields have historically outperformed stocks with lower dividend yields. The highest-yielding quintile of stocks outperformed the lowest-yielding quintile by 1.76 percentage points per year from 1928 to 2013.
Source: Dividends: A Review of Historical Returns

Payout Ratio

  • Wal-Mart has a payout ratio of 39.83%, the 43rd lowest out of 128
  • Costco has a payout ratio of 31.77%, the 22nd lowest out of 128

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Why it Matters: High-yield, low-payout ratio stocks outperformed high-yield, high-payout ratio stocks by 8.2 percentage points per year from 1990 to 2006.
Source: High Yield, Low Payout by Barefoot, Patel, & Yao, page 3

Long-Term Growth Rate

The long-term growth rate of each business is calculated as the lesser of the 10-year per share growth in either dividends or revenue.

  • Wal-Mart has a growth rate of 8.23%, the 20th highest out of 128
  • Costco has a growth rate of 8.96%, the 12th highest out of 128

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Why it Matters: Growing dividend stocks have outperformed stocks with unchanging dividends by 2.4 percentage points per year from 1972 to 2013.
Source: Rising Dividends Fund, Oppenheimer, page 4

Long-Term Volatility

Long-term volatility for each business is calculated as the 10-year price standard deviation.

  • Wal-Mart has a standard deviation of 19.14%, the 10th lowest out of 128
  • Costco has a standard deviation of 23.34%, the 37th lowest out of 128

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Why it Matters: The S&P Low Volatility index outperformed the S&P 500 by 2 percentage points per year for the 20-year period ending September 30th, 2011.
Source: Low & Slow Could Win the Race, page 3

Wal-Mart's Current Events & Growth Prospects

Wal-Mart's plan to push growth forward is to focus on what made the company great. Focus on customers and technology to drive prices lower. Walmart's CEO Doug McMillon reiterated these points at the company's annual shareholder meeting:

First, we will be a customer-driven company. We've always said the customer is our boss and we'll make decisions based on how we can serve them better. Second, we will invest in our people. As we change and grow, it will be our associates who will make the difference. Finally, we need to be at the forefront of innovation and technology. We will lead with urgency to get ahead of change.

Source: Wal-Mart CEO Outlines Company's Future

In recent years, Wal-Mart has had stocking issues. The company's dogged focus on cost-reduction, coupled with mismanagement left shelves unstocked which results in lost revenue. The company has taken strides to fix its stocking issues.

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Source: Wal-Mart US Jeffries Conference Presentation, slide 4

Wal-Mart's future growth lies with its international division. The company has historically managed to grow international revenues quickly. Over the last 10 years, Wal-Mart has compounded international revenue at 11.1% per year. Wal-Mart's International operations now total nearly 6,500 stores I 26 countries.

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Source: Wal-Mart International Jeffries Conference Presentation, slide 4

Wal-Mart International's first quarter results for the company's fiscal year 2015 where solid if unspectacular. International constant currency sales 3.4% for the first quarter versus the first quarter of last year. Operating income increased 5.3% in the international segment, outpacing sales growth. Wal-Mart is improving operating efficiency internationally as revenues are increasing.

In the US Wal-Mart grew constant currency sales 2.1% for the first quarter. Same-store US sales were down 0.1% due to a small decline in traffic. Sam's Club fared only slightly better, with sales growing less than 1% on a quarter-over-quarter basis.

Source: Wal-Mart First-Quarter Results

Wal-Mart is also attempting to stay competitive with large e-Commerce companies such as Amazon (NASDAQ:AMZN) by investing in e-commerce growth. Wal-Mart saw e-Commerce revenue increase an incredible 27% for the first quarter of the company's fiscal 2014. Wal-Mart plans to offer same day delivery on many e-commerce items. The company has the ability to ship quickly due to its extensive distribution and trucking network.

Source: Wal-Mart First-Quarter Results

Costco's Current Events & Growth Prospects

Costco announced a net sales increase of 7% for the company's third quarter of 2014, as compared to the third quarter of 2013. Growth is being driven by strong same store sales increases. Adjusting for gasoline price deflation and currency changes, same store sales growth is up 6% for the quarter in the US, and 8% internationally.

Source: Costco 3rd Quarter 2014 Results

Costco has expanded internationally with stores in Canada, Mexico, Europe, Asia, and Australia. Strong international growth shows the company's business model and competitive advantage works internationally as well as domestically.

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Source: Costco 3rd Quarter 2014 Presentation

Costco's competitive advantage comes from its pricing advantage. The company's operating margin excluding membership income is under 1%. Costco sells its products just over cost, which drives customers to the store to take advantage of bargains. As Costco's purchasing power increases due to economies of scale, the company passes the savings back to consumers which drives more customers to Costco in a virtuous feedback loop.

Costco bolsters its razor thin margins with membership fees. The company adds over 2% to its operating margin from membership fees. All together, Costco has an operating margin under 3% which is among the lowest in the discount retail business. Generally, low margins show a lack of competitive advantage. In the case of Costco, low margins are the competitive advantage. Excellent deals drives company growth as described by the virtuous feedback loop in the previous paragraph.

Final Thoughts

The 8 Rules of Dividend Investing ranks Wal-Mart as a Top 10 stock due to its strong growth rate, low volatility, and relatively high yield. Costco is not a Sure Dividend stock as it does not have 25+ years of dividend payments without a reduction. If it did, it would rank the 12th highest overall.

Costco clearly has a strong competitive advantage and is a safe investment for dividend growth investors. The downside to investing in Costco today is the company's relatively high P/E ratio of over 26, compared to Wal-Mart's P/E ratio which is under 16.

Source: Wal-Mart Or Costco: Which Discount Retailer Is Best For Dividend Growth?