While the market has impressively bounced back from the COVID-19 outbreak back in March, things are still highly uncertain. We are in a recession right now, and the timing and trajectory of a recovery are still open questions. Research group The Conference Board projects U.S. GDP will fall 7% in 2020, with just a 1% increase in a "recovery" year of 2021. For consumer spending, The Conference Board believes things will be better, but only slightly, with a 6.7% decline in 2020 and a 1.9% recovery in 2021.
If you're a defensive investor afraid of a lingering recession, two strong choices to park your investment dollars may be the consumer staples sector, or better yet, the big, financially strong retailers that offer a wide variety of staples that consumers need in good times and bad. Two such dividend-paying retailers are Target (NYSE: TGT) and Costco (NASDAQ: COST). Of the two, here's why Costco is the more recession-resistant stock.
Costco has a wider moat
When assessing how both Target and Costco would perform in a recession -- especially one caused by a pandemic -- look no further than each company's recent quarter, which ended in early May and therefore had about two months of COVID-19 impact.
At first glance, it may seem that Target had the better COVID-19 quarter. Target experienced same store sales growth of 10.8%, powered by a stunning 141% comp growth in digital sales, where Target has been making big investments over the past few years. That compares with Costco's same store sales growth of 7.8%, excluding the impact of fuel sales and foreign exchange, with e-commerce growth of "only" 66.1%.
However, the bottom lines tell a different story, with Costco's operating income increasing 5% to $1.18 billion, while Target's operating income plunged 58.7%, from $1.14 billion to just $468 million in Q1.
The reason behind the earnings divergence can largely be attributed to both companies' different business models. For Costco, it makes almost no margin on the actual goods that it sells; about 70% of its operating income comes from membership fees, which don't fluctuate with however much of a specific item it sells that month. Costco's business model is geared toward lowering costs as much as possible, which the company then passes on to members in the form of lower prices at near-zero margin. But these lower prices then lure in more customers and membership fees, which enables Costco to lower costs even more, and the cycle starts again.
For Target, the difference between the types of products it sells matters a lot, as does the difference between in-store and digital sales. And while the craziness of the COVID-19 pandemic caused a surge in Target's revenue, the nature of the pandemic also caused Target's gross margin to decline 450 basis points over the prior year. On the conference call with analysts, management explained that Target's torrid growth came from its lowest-margin categories of hardlines, essentials and food and beverage. Meanwhile, demand actually declined, severely, in Target's highest-margin category of apparel, with lower relative growth of another high-margin category of home goods. Meanwhile, the huge shift to digital sales caused a surge in digital fulfillment and supply chain costs, as digital sales are lower-margin than in-store sales.
Target is fiercely competing with other e-commerce and general omnichannel retailers online, which puts pressure on margins. However, since Costco has a more differentiated proposition exclusively around bulk-buying, and is somewhat agnostic as to the mix of products its sells, Costco's earnings are more resilient to the chaotic fluctuations between different types of products, or between in-store versus digital sales.
Costco's international growth prospects are brighter
A second reason that Costco may be the more resilient stock over the long-term is that its differentiated business travels better overseas, whereas Target is mainly confined to the United States. Costco has expanded to many countries over the years, including Canada, Mexico, the U.K., Japan, South Korea, Taiwan, Australia, Spain, Iceland, France, and China.
Of note, Costco just opened its first store in China last year in Shanghai, and the first day drew such a huge crowd that it had to shut down the store. Amid booming signups in China, Costco is currently building a second store in Shanghai, and has plans for a third in the town of Suzhou. Though management said it takes new countries slow and it will take a while to make profits, I don't see any reason Costco can't succeed in China, with its 2 billion citizens, over time. After all, a good bargain is a universal concept.
Meanwhile, Target's more general merchandise strategy is more of a well-worn concept in other countries, and the company has found it difficult to expand. Notably, Target exited the Canadian market in 2015 after it found itself unable to excite shoppers north of the border.
Paying up for quality should pay off
While Costco is the superior recession-resistant stock and appears to have better earnings growth prospects, it is a bit more expensive than Target. Costco has a forward P/E ratio of 35 and a dividend yield of just 0.86%, versus Target's forward P/E of 25 and dividend yield of 2.3%. However, Costco has also issued special dividends to shareholders from time to time, supplementing its regular dividend every few years.
Despite the discount one gets with Target's stock, when looking at the safety of Costco's model and its better prospects for international growth, for me it's definitely the safer retailer for the defensive long-term investor.
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Billy Duberstein has no position in any of the stocks mentioned. His clients may own shares of the companies mentioned. The Motley Fool recommends Costco Wholesale. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.