Buffett, The Wal-Mart Shopper

With the stock in the dumps, it may offer him greater upside than Target

When fans and followers descend on Omaha for the Berkshire Hathaway Inc. (BRKA ) annual meeting on May 5, they'll be eager to hear the homespun business wisdom and folksy investment advice of Chairman Warren Buffett. One thing they probably won't hear during his nearly six-hour Q&A with shareholders: the nitty-gritty on why he likes Wal-Mart Stores Inc. (WMT ) more than rival discounter Target Corp. (TGT )

Buffett, who rarely reveals much about his investment moves in public, started building a big position in Wal-Mart back in 2005, according to filings with the Securities & Exchange Commission. Two years later, Berkshire owns some 19.9 million shares, roughly $960 million worth, making it one of the insurer's largest holdings. Target first popped up in the portfolio about a year ago, a stake some speculate was bought by Berkshire's other bargain hunter, Lou Simpson, chief investment officer at the GEICO car insurance subsidiary. But in the third quarter of 2006, Berkshire held fewer than 1 million shares, and by the end of the year the investment had disappeared from the company's financial reports.

Buffet watchers think price may have been a big factor. Target's stock got whacked in the middle of last year, dropping 17% from its May high to 46 by July. Amid macro concerns that consumers had gotten tighter with their wallets, investors worried that the retailer had spent too much on new distribution centers and had become overly reliant on its credit-card business. But the stock has bounced back to 60. At that price, Target trades for roughly 18.5 times trailing earnings, only modestly less than peers and the Standard & Poor's (MHP ) 500-stock index. "That's a very fine return," says Bill Dreher, a retail analyst for Deutsche Bank (DB ). "[Even] if you hit your return benchmarks sooner than expected, you still have to be true to your own internal valuations."

But for Buffett and others who love to buy brand names at bargain prices, a tarnished Wal-Mart may be a better match. After all, value investors usually show up when a company is facing its darkest days. The stock has been a dog, falling 17%, to 48, over the past five years as sales have slipped and operating costs have ballooned. In 2006 same-store sales in its U.S. operations gained a mere 1.6%, its worst showing ever. As a result, Wal-Mart now sells for 16.6 times earnings, the cheapest it has been in more than a decade. "Right off the bat, we like Wal-Mart's valuation better [than Target's]," says Whitney Tilson, co-portfolio manager of the $22 million Tilson Focus Fund, who counts Wal-Mart among his top 10 stock holdings.

Certainly, Target has the edge in the growth department. With just 1,502 stores, vs. Wal-Mart's 6,930, it still has plenty of room to grow, especially in strong domestic markets such as the mid-Atlantic and New England. To boost traffic in existing stores, Target has been beefing up its assortment of food, electronics, and private-label products. Dreher predicts earnings will rise 14% to 16% a year through 2012. After the stock's recent runup, though, much of those expectations are already baked into the price.

But while many question whether Wal-Mart can get growth going again, contrarians think it has the markings of a turnaround play, a very Buffett-like quality. There's little thought that Wal-Mart will return to its glory days, but those who are bullish figure the company can still be a steady performer. They point to recent moves management is making to get shoppers back in the doors: The big-box retailer has been aggressively remodeling stores, changing its selection in high-margin categories such as consumer electronics, and tweaking the direction of women's apparel. It's also trying to keep a lid on costs by pushing more of its manufacturing offshore, reducing inventory, and reining in store openings. Management plans to increase square footage this year by 7.5%, a slowdown from 2006.

Buffett may also find Wal-Mart's international business appealing. In recent years the Oracle of Omaha has been bearish on the U.S. dollar, figuring the ballooning current-account deficit stateside would favor other countries. But he has been moving away from trading currencies to make that bet, saying it's a pricier strategy these days. Instead, he has been looking to buy companies and stocks that make a significant portion of their money overseas. At last year's annual gathering, Buffett announced a $5 billion purchase of Israeli-based Iscar Metalworking. Berkshire also owns stakes in oil producer PetroChina (PIR ) Co. and British supermarket giant Tesco (TSCDY ) PLC.


Wal-Mart's brand translates better abroad than Target's; the company generates 22% of net sales from its international business, compared with zero for Target. Admittedly, Wal-Mart's results have been mixed. It has a stronghold in Canada, Mexico, and Britain and is also making a play in fast-growing areas such as China, Latin America, and South America. Yet the company had to exit the ultracompetitive South Korean and German markets, where it had a tough time against local players. Still, Buffet may see that exposure largely as a strength. International sales should grow 15% a year, vs. 9% stateside, says Deutsche Bank's Dreher. "The pieces are in place for Wal-Mart to really appreciate," says David Chalupnik, head of equities at First American Funds in Minneapolis, which owns some 2 million shares of Wal-Mart across its retail and institutional portfolios.

Portfolio manager Tilson can't predict exactly when things will click at Wal-Mart, but he figures earnings will hit $4 to $5 a share over the next two to five years. Assigning a multiple of 20 to 25 to those profits—in line with peers today—Tilson calculates the stock could head north of 80.

Of course, Buffett may just be making up for past mistakes. He has long said he regrets not amassing a big stake in Wal-Mart when the stock looked cheap in the 1990s. Back then, he scooped up 5 million shares. But the stock zoomed ahead before he had a chance to take a full position—an "error of omission" that he estimates cost Berkshire as much as $8 billion. With Wal-Mart trading at a lower price-earnings ratio now, Buffett may think the time is right to buy what he calls "the retailing machine of all time."

By Elizabeth Woyke

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