Costco vs. Home Depot: Which Retail Stock to Buy Now?

As investors, we're always on the lookout for top-performing stocks that can generate strong returns. Two retail giants that have consistently impressed the market are Costco (COST) and Home Depot (HD). But which one is the better buy right now? Let's dive into their recent financial performance, capital allocation strategies, and risks to make an informed decision.

Costco: A Thriving Warehouse Club Operator

Costco's relentless focus on providing consumers with a great shopping experience, low prices, and high-quality merchandise has created a truly wonderful enterprise. This is evident in its stellar financial performance. Costco's diluted earnings per share have climbed at an annualized pace of 13.5% in the past decade, with only one year showing a decline. This resiliency points to the company's ability to perform well regardless of the macroeconomic backdrop.

Costco's membership-based business model provides a high-margin, predictable, and recurring revenue stream. This revenue stream grew 5% year over year in fiscal 2024, totaling $1.1 billion in the third quarter. The company's customer loyalty is high, with a membership renewal rate of 93% in the U.S. and Canada. This loyalty is driven by the value proposition offered by Costco's low prices and treasure-hunt atmosphere.

Costco's scale advantage might be the most important factor in its success, underpinning its economic moat. With net sales totaling almost $250 billion in fiscal 2024, this is the world's third-largest retailer. As a result, Costco has unrivaled bargaining power with suppliers, leading to low costs that are always passed on to shoppers, driving more revenue.

Costco has been a fantastic investment, with shares generating a total return of 746% in the past decade, boosted by occasional special dividends.



Home Depot: A Home Improvement Leader

Home Depot is the clear leader in the massive $1 trillion home improvement sector, with trailing-12-month sales of $155 billion. It's much larger than Lowe's, its key competitor in the industry. This gives Home Depot tremendous scale to better serve both do-it-yourself and professional customers.

Home Depot has been struggling recently, as it reported a 1.3% same-store sales dip in the latest fiscal quarter (Q3 2024 ended Oct. 27), which isn't encouraging for any retail-based enterprise. Management expects the weakness to continue throughout the full fiscal year. However, not all hope is lost. The fact that the median age of a home in the U.S., now around 40 years, has steadily climbed over the years means that there will be greater need to undertake renovations and upgrades. Moreover, the sizable housing inventory shortage discourages moving and encourages spending to fix up current dwellings. This all supports demand for Home Depot's products and services.

Investors will certainly appreciate management's capital allocation policy. In fiscal 2023, the business paid $8.4 billion in dividends and repurchased $8 billion worth of outstanding shares. This is only possible because Home Depot generates huge amounts of free cash flow on a consistent basis.

Home Depot stock has been a big winner, producing a 126% total return in the past five years (as of Dec. 5), besting the S&P 500 index.



Capital Allocation Strategies: Costco vs. Home Depot

Costco's capital allocation strategy is focused on reinvesting in the business to drive growth. The company has a low dividend payout ratio, with dividends representing only a small portion of its earnings. This allows Costco to invest in expanding its warehouse club network, improving its supply chain, and enhancing its digital capabilities. While this strategy has led to strong growth in the past, it may not be as appealing to income-oriented investors or those looking for immediate returns.

Home Depot, on the other hand, has a more aggressive capital allocation strategy that prioritizes returning cash to shareholders. The company has a high dividend payout ratio, with dividends representing a significant portion of its earnings. In fiscal 2023, Home Depot distributed a whopping $16.3 billion to shareholders via dividends and share buybacks. This strategy has led to a higher dividend yield compared to Costco, making Home Depot more appealing to income-oriented investors and those looking for immediate returns.



Risks and Challenges: Costco vs. Home Depot

Costco's primary risks and challenges in the near term include:

1. Valuation Risk: Costco's stock price is near its all-time high, and its P/E ratio is at an elevated level of 54. This high valuation leaves little room for error and may lead to disappointing returns in the near term.
2. Economic Downturn: As a discretionary retailer, Costco's sales and membership growth could be negatively impacted by an economic downturn, as consumers may cut back on spending.
3. Competition: While Costco has a strong brand and membership model, it still faces competition from other warehouse clubs, supermarkets, and online retailers. Amazon, in particular, poses a threat to Costco's market share.

Home Depot's primary risks and challenges in the near term include:

1. Sales Slowdown: Home Depot has been experiencing a sales slowdown, with same-store sales expected to decline by 3% to 4% in the current fiscal year. This is due to consumers pulling back on discretionary spending and delaying home improvement projects.
2. Interest Rate Sensitivity: Home Depot's business is sensitive to interest rates, as higher rates make it more expensive for consumers to finance home improvement projects. If interest rates remain elevated or rise further, this could negatively impact Home Depot's sales.
3. Housing Market Fluctuations: Home Depot's sales are tied to the housing market. If the housing market weakens or enters a recession, demand for home improvement products and services could decrease, negatively impacting Home Depot's sales and earnings.



Conclusion: Which Stock to Buy Now?

Both Costco and Home Depot have their strengths and weaknesses, but Home Depot's more appealing capital allocation strategy and lower valuation make it the better buy right now. While Costco's growth prospects are strong, its high valuation leaves little room for error. Home Depot, on the other hand, offers a more attractive entry point for investors looking for income or immediate returns. However, it's essential to keep an eye on both companies' earnings reports and market trends to make informed investment decisions.

In the end, the best stock to buy right now depends on your investment goals, risk tolerance, and time horizon. Both Costco and Home Depot have proven track records and offer compelling opportunities for investors.