Forget Costco: Here's a Better Dividend Stock for Passive Income

Costco (COST -0.16%) is an unusually successful retailing business. The warehouse giant has been winning market share for decades thanks to its no-frills, membership-based selling approach that allows it to offer products at rock-bottom prices. Costco routinely beats rivals such as Walmart (NYSE: WMT) in key growth and customer traffic metrics. Its earnings are among the most stable in the industry, too.

Yet Costco isn’t an ideal dividend stock for several reasons, including the fact that management prefers to pay dividends in sporadic lump-sum payments rather than through predictably rising annual ones. There’s a better dividend option available for fans of passive income, and it’s sitting right in Costco’s industry.

Hitting the Target

Target (TGT -1.19%) stock looks attractive after being left out of the recent market rally. Shares declined 15% in the past full year compared to Costco’s 45% surge and the 22% increase in the S&P 500. That’s because the chain has been posting weak growth trends, with comparable-store sales falling 5% in the most recent quarter. Management is predicting that sales will fall at about the same rate for the full 2023 fiscal year. Costco, in contrast, just reported accelerating comps gains for the month of December at 9 %.

Target is making steady progress toward a recovery, though. Inventory has been dropping for more than a year and is now more aligned with the weaker demand it has been seeing in consumer discretionary categories like home furnishings. The Q3 sales result met management’s forecasts as well. Yet investors will still want to watch customer traffic trends over the next few quarters for confirmation that Target is on the rebound.

The good news

The news is more clearly positive around earnings. Target’s Q3 operating profit margin jumped to over 5% of sales, compared with just 1% a year ago, for example. That’s close to its pre-pandemic rate of 6% and is nearly double Costco’s comparable figure.

Cost cuts have been a huge contributor, putting Target in position to boost profitability even further once its sales trends pick back up again. Costco’s margin tends to stay at about 3% of sales, meanwhile, which limits the earnings investors can expect to see even during booming growth periods. That means Target has more flexibility to lift its dividend commitment in the coming years.

Dividend growth

Target stock offers a much higher dividend yield of 3.2% today compared to Costco’s meager 0.6% rate. Income investors will also be impressed with the retailer’s long streak of annual raises. Last year’s increase marked Target’s 52nd consecutive annual raise, putting it among just a handful of retailers in the exclusive club of Dividend Kings. Passive income fans can count on more years of steady growth ahead even as Costco continues to surprise shareholders with its infrequent lump-sum payouts.

Sure, Target’s short-term growth prospects aren’t excellent. But the stock offers a nice balance between rebounding sales potential, strong earnings, and an excellent dividend yield. And the stock’s weak performance this past year has made it cheaper compared with Costco and other peers.

You can own Target for 0.6 times annual sales compared to Walmart’s 0.69 and Costco’s P/S ratio of 1.3 times sales. Income investors should consider taking advantage of that discount before Target’s growth rebound kicks into higher gear in 2024 and beyond.

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