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Hypermarkets And Super Centers Industry: Costco Stands Taller

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By: Bob Cramer
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The hypermarkets and super centers industry is led by three key players – Walmart (WMT), Target (TGT) and Costco (COST), and together, they account for more than 99% of industry revenues in the US. Walmart and Target’s stock prices have gone up around 25% over the last five years ending September 2013, while Costco’s stock has gone up 78% over the same period. The industry’s annual revenues are estimated to grow by 4-4.5% over the next three years.

Major Players

Walmart

Walmart’s stores include Discount Stores, Supercenters, Neighborhood Markets and Sam’s Club warehouses of different sizes. The company contributes almost 73% of the total revenues generated by the industry. Walmart’s customer base has an average yearly household income of $35,000, the lowest of the three main players.

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Target

Target runs its discount stores under the name, Super Target. These contribute around 11% to the total revenues generated by the hypermarkets and super centers industry. Super Targets have an average store size of 150,000 square feet. Target’s primary customers have an average yearly household income of $50,000.

Costco

Costco is a chain of warehouse stores which contribute around 15% of the total revenues generated by the hypermarkets and super centers industry. The average size of its warehouses (143,000 square feet) is even smaller than that of Target  but Costco’s customer base has an average yearly household income of $80,000.

Costco Maintains Highest Revenue Growth Amongst Peers

Costco achieved the highest annual revenue growth of 9% over the last five years compared to 4.4% for Walmart and 3% for Target. Its comparable store sales (comps) grew at an annual rate of 8% over the last three years compared to 0.6% for Walmart and 2.6% for Target.

Costco’s growth can be directly attributed to better customer service. Consumers today seek not just discounts but better service as well. Costco pays its employees twice as much as what Walmart and Target pay their employees. This motivates Costco’s employees and subsequently translates into better customer service.

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Target Maintains Higher Gross Margins

Target has higher gross margins of 31% compared to 24.9% for Walmart and 12.4% for Costco. Private label brands contribute 33% to Target’s revenues compared to 18% for Walmart and 18% for Costco, and this is one of the primary factors behind Target having the highest gross margins in the industry.

Walmart has higher gross margins compared to Costco because of its 73% market share, which helps it negotiate better deals with vendors, and reap the benefits of economies of scale.

Walmart and Target Losing Market Share to Costco

Walmart and Target have been losing market share to Costco since 2009. Walmart and Target’s share of the total revenues in the hypermarkets and super centers industry decreased by around 1-2 percentage points from 2009 to 2012, while Costco’s share increased by 2.5 ppts over the same period.

Although the change in market shares of these three players seems very small, the trend still presents a possible threat to Walmart and Target in the long run.

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Walmart has Low, but Sustainable Growth:

Even though Costco has higher revenue growth, Walmart still maintains its position as the least risky stock among its peers; it has a low beta of 0.36. Average annual change in Walmart and Target’s revenue growth over last three years has been 1.4 percentage points compared to Costco’s 4.3 ppts. Walmart also tends to perform better compared to its peers during recessions. Its dominant market share acts as a cushion and lets it maintain margins during periods of financial crisis. At the same time, the ‘every day low price’ strategy also helps it increase market share in times of slow economic growth. This is why Walmart’s operating margins dropped just 2.8 percentage points to 5.65% during t the 2008 recession, while Target and Costco saw operating margins fall 18.5ppts and 7.7ppts respectively.

Costco underperformed Walmart during the 2008 recession by around 15% (from June 2008 to August 2009.)

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In a gradual shift away from its Supercenters, Walmart plans to expand its Neighborhood Markets by 75% over the next year. Neighborhood Markets* would not only allow Walmart to provide its customers with a better shopping experience compared to traditional Supercenters, but will also help Walmart attract customers living in urban areas.

In addition to that, higher pricing at Neighborhood Markets compared to other Walmart stores will also help Walmart expand its gross margins. On the other hand, Target and Costco continue to focus on Super Targets and warehouses respectively.

*Neighborhood Markets are stores with an average size of 38,000 square feet, i.e. approximately one-fifth the size of Supercenters. These stores are located near urban centers and have higher pricing compared to other Walmart stores.

Valuation:

Costco is currently trading at a higher forward P/E multiple of 24x compared to 14x for both Walmart and Target due to higher revenue growth over the last four years.

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However, Costco’s P/E multiple using 2015 consensus EPS is 21x, equal to its historical 5 year average forward P/E. Costco traded at a P/E multiple of 22x even when its earnings growth declined in 2011.

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Dividend Yield:

Costco has a better trailing twelve-month (ttm) dividend yield of 6.7%* compared to Walmart and Target’s 2.4%. Furthermore, Costco had a better total debt to equity ratio of 10% in 2012, compared to 70% for Walmart and 110% for Target.

*Includes $7 special cash dividend

Costco’s lower debt to equity ratio of 10%, and higher dividend coverage of approximately 6.9x reflects its ability to continue increasing dividends in future. The dividend coverage of Walmart is 4.8x while Target’s is 6.1x.

Investment Strategy:

Costco remains a BUY among other industry peers due to high growth potential, resulting from better customer service. It is estimated that Costco will benefit the most from the economic recovery.

Costco’s stock outperformed Walmart and Target by 53% over the five years ending September 2013. It has outperformed Walmart and Target by 8% and 11% respectively YTD.

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However, Costco’s stock tends to underperform Walmart and Target during recessions. This is because Walmart is relatively stable during recessions compared to other industry players and has a low beta of 0.36 (measured against S&P 500 Index). Furthermore, Walmart’s P/E multiple of 12x, calculated using 2015 EPS estimates, is even lower than Walmart’s 5 year low P/E multiple of 12.4x.

There are indications that the US hypermarkets and super centers industry seems to be reaching maturity. The three key industry players’ revenues from the US grew at an annual rate of 3.5% over the last three years, which is far lower than the annual growth of 13.1% in their international revenues over the same period. Therefore, any expectation for revenue growth lies more with the emerging markets, and Walmart has the highest exposure and reach in the international markets.

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Who Has The Best Business Model?

There is no one perfect business model. Costco’s business model of lower discounts and better customer service works well during an economic recovery when consumers are willing and able to buy products at lower discounts. Walmart’s business model of every day lowest prices works well during recessions when consumers want to benefit from higher discounts.

Therefore, the risk of investing in Costco can be hedged with investing in a less risky stock like Walmart. Costco can be bought as a growth stock to benefit from an economic recovery, along with Walmart as a hedge against recessions and maturing US markets. Target remains a riskier stock among all three due to no international exposure and high beta of 0.9.

Comparable Valuation Sheet:

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*Includes a special cash dividend of $7.

Investment Risks:

E-commerce:

E-commerce is a serious threat to brick and mortar businesses. E-commerce sales contribute just 1.5-2.5% to the total sales of Walmart, Target and Costco. The shift from brick and mortar to online retail could eventually allow online retailers like Amazon (AMZN) and eBay (EBAY) to take a leading position in the hypermarkets and super centers industry.

Employee Dissatisfaction:

Employee dissatisfaction is more of a concern for Walmart and Target than it is for Costco. Walmart and Target pay its employees almost half of what Costco pays its employees, resulting in demotivated employees. Walmart and Target will need to improve their customer service or they will keep on losing market share to Costco.

Wage Hike:

To address the expanding levels of income inequality in the US, President Obama proposed to increase the minimum federal wage to $9/hour from $7.25/hour in February 2013. This was followed by a D.C. Council bill in July demanding big retailers earning more than $1 billion in revenues to pay their workers a minimum wage of $12.5. The bill was overridden later in September 2013, and that led to protests by minimum wage earners demanding an increase in their wages.

If the trend continues and Walmart is pushed to increase wages, its costs can substantially rise as it has approximately 1.2 million employees in the US. Walmart relies on its business model of lowest pricing, resulting from low costs. Any substantial increase in wages can push Walmart to increase prices thus compromising its unique selling point and losing an even bigger market share to retailers like Costco.

Conclusion:

Walmart has been better able to withstand the effects of a recession but it is gradually losing share to Costco. Bidness Etc. believes that based on its customer service and better returns from emerging markets going forward, Costco is positioned to continue nibbling away at Walmart’s market share which has a less motivated workforce out of all three players. Costco is also better positioned to capitalize on the economic recovery and Bidness Etc. recommends it as the best buy in this industry.

For further details related to industry please read our detailed article on Hypermarkets and Super Centers

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