Time to Panic on Wal-Mart and Target?

Source: Maryland Pride (Wikimedia Commons)

There was a time when Wal-Mart Stores was a surefire winner and Target was an exciting up and comer for investors. In the eyes of many people, these days are long gone. For Wal-Mart, it's the struggling low-end consumer. For Target, it's the data breach and a lack of customer trust. However, these perceptions are focused on the past, and us Fools like to look ahead. 

Warren Buffett's foresight
The Oracle of Omaha hasn't earned his nickname by looking at what happened in the past. Instead, he disregards public opinion and invests by looking ahead with conviction. For instance, he recently added 8.57 million shares to his Wal-Mart position. After this move, Wal-Mart is now his fifth-largest holding.

You might be wondering why Buffett would invest in a company that has suffered five consecutive quarters of U.S. sales declines. Not only does Wal-Mart have to contend with a portion of its customer base getting hit by a cut in food stamp benefits, but it's up against dollar stores and online retailers.

What Buffett realizes is that Wal-Mart isn't a stale business where upper management sits on its hands and watches current trends pass them by. Wal-Mart has great foresight, massive marketing power, and tremendous scale to offer customers low prices. Buffett likely saw Wal-Mart's small-box Neighborhood Market stores moving into populated urban areas and delivering 46 consecutive quarters of comps growth. This includes 4% year-over-year comps growth last quarter -- despite inclement weather. Many retailers blamed severe weather for its poor comps performance last quarter. This wasn't the case for Neighborhood Market.

Neighborhood Market is still in its early growth stages, and it will continue to grow. Wal-Mart also has its younger and smaller Wal-Mart Express stores, which have been received well. On top of these positive trends, groceries now account for 56% of sales for Wal-Mart. Though most food items don't offer high margins, these food items drive repeat traffic to stores, which may then lead to the purchase of higher-margin merchandise. . 

Now you know the likely reasons why Warren Buffett is bullish on Wal-Mart. Perhaps you should get on board as well. But what about Target?

Data breach drama
You're probably sick of hearing about the data breach by now, but try to hang in there because the data breach might present an investment opportunity. Here's an ultra-fast review:

• Dates: Nov. 27 to Dec. 15 
• Payment Card Data Victims: Approximately 40 Million
• Guest Info Data Victims: Approximately 70 Million
• Malware Removed: Dec. 15

This was an enormous breach that led to reduced customer trust. Target attempted to regain that trust by investing $100 million for chip-enabled REDcards and U.S. store-card readers by the first quarter of fiscal-year 2015. Fortunately for Target, comps began to recover in January. But that's not the only positive.

U.S. REDcard penetration 
You have likely been hearing a lot about Target in Canada. This might be the company's biggest area for growth potential, but it's still a small fraction of Target's overall business. The United States is still the key. Therefore, we'll stick to the U.S.

In the fourth quarter, REDcard penetration was 20.9%, up 5.4 percentage points year over year. The REDcard penetration rate slowed after the data breach but still continued to grow. Here's a long-term sample:

Target REDcards allow customers to save 5% on almost every purchase. This leads to increased foot traffic, simply because people like saving money. Therefore, the higher the REDcard penetration, the better.

Comps performance
In regard to long-term comps performance, try not to pay too much attention to the negative numbers in 2013. Despite the data breach happening late in the year, it still had an impact. And keep in mind that Target is going to do everything in its power to drive more traffic to its stores. In other words, it's going to make a stronger effort, and Target will likely be more innovative going forward. It has no other choice. Consider U.S. comps sales growth from 2011 to 2013 (parenthesis indicate a decline): 

Even if you put the data breach to the side and accept the 2013 numbers, the overall long-term numbers are solid. Many retailers suffer bumps in the road and adjust for improvements. Furthermore, there is a positive trend that has remained intact: selling price per unit. This indicates that Target consumers -- primarily Generation X -- have spending power.

What's not shown on that chart is that food and pet supplies have gone from 19% of sales in 2011 to 21% of sales in 2013. This is a positive trend for the reasons given above related to Wal-Mart. 

The Foolish bottom line
Beginning with Wal-Mart, this goes beyond following the money. It's about following the smart money. For Target, the worst of it might not be over yet, but Target has a healthy consumer and trust should rebound. While Target isn't likely to be as safe of an investment as Wal-Mart, long-term upside potential should outweigh long-term downside risk.