PEP BOYS-MANNY MOE & JACK PBY
August 11, 2010 - 10:41pm EST by
skimmer610
2010 2011
Price: 9.08 EPS $0.52 $0.65
Shares Out. (in M): 53 P/E 17.3x 14.1x
Market Cap (in $M): 481 P/FCF 6.5x 6.0x
Net Debt (in $M): 219 EBIT 74 86
TEV ($): 700 TEV/EBIT 9.4x 8.1x

Sign up for free guest access to view investment idea with a 45 days delay.

Description

Summary:

At current levels, an investment in Pep Boys (PBY) presents a compelling risk reward profile.

Downside protection is provided by hard asset value. Tangible book value for PBY stands at $8.60 per share, a number which is likely understated due to the age of many properties on PBY's books. Insofar as PBY is cash flow positive and has neither near term nor onerous debt maturities, there appears little risk to the hard asset value. I believe the company could be liquidated today for a price very near, and quite likely above, TBV/share. Further downside protection is afforded by the undemanding valuation levels at which PBY currently trades - sub-6x 2010 rent-adjusted EV / EBITDAR and north of a 15% FCF yield to equity assuming maintenance CapEx levels. While PBY is not yet a high quality business, it does operate in a high quality and recession resilient industry. Peer multiples and operating metrics demonstrate that.

Upside will be a function of PBY's continued operational improvement. Since 2007, PBY had been working to transform the company's store footprint and operations. Currently, PBY generates gross margins 2,140 bps lower than its peer group average, and EBIT and EBITDAR margins 891 bps lower than its peer group average. In addition to severe margin underperformance, PBY also trades at substantially lower multiples of revenue, EBITDA, and EBITDAR than its peers.  Assuming that PBY simply trades in line with its peers on an EBITDAR multiple, but giving them no credit for operational improvement leading to margin expansion, PBY is a double from current levels. Additionally, by improving its working capital metrics PBY should be able to reduce net debt by $1-$3/share.

Recently, PBY has seen some material insider buying by a number of key executives. Additionally, an activist hedge fund recently made public a presentation urging private equity firms to explore an LBO transaction of PBY.

 
Capital Structure     Valuation - Fiscal Year ends January 2007 2008 2009 2010 2011
Share price  $      9.08   Revenue  $  2,144.7  $  1,927.8  $  1,910.9  $  1,988.2  $  2,099.0
Diluted shares outstanding 52.9   EV / Revenue 0.33x 0.36x 0.37x 0.35x 0.33x
Market cap  $    480.6   Adjusted EV / Revenue 0.61x 0.68x 0.68x 0.65x 0.62x
Cash and CE          87.8   EBIT  $      28.5  $       (7.0)  $      57.1  $      74.3  $      86.0
Debt        307.0   EBIT margin 1.3% NA 3.0% 3.7% 4.1%
Net debt        219.2   EV / EBIT 24.55x NA 12.25x 9.42x 8.13x
Enterprise value  $    699.8   EBITDA  $    109.5  $      66.2  $    127.7  $    147.1  $    158.9
      EBITDA margin 5.1% 3.4% 6.7% 7.4% 7.6%
FY 2010 lease expense  $      75.3   EV / EBITDA 6.39x 10.57x 5.48x 4.76x 4.40x
Capitalization multiple 8.0x   EBITDAR  $    178.8  $    143.3  $    202.9  $    222.4  $    234.2
Capitalized operating lease  $    602.1   EV / EBITDAR 7.28x 9.08x 6.42x 5.85x 5.56x
      Actual FCF  $      19.0  $        2.0  $      45.0  $      21.8  $      25.5
Adjusted EV  $  1,302.0   FCF yield 4.0% 0.4% 9.4% 4.5% 5.3%
      Maintenance FCF  $      42.2  $      16.7  $      65.7  $      74.3  $      80.5
Tangible book value  $    455.0   FCF yield 8.8% 3.5% 13.7% 15.5% 16.8%
TBV/ share  $      8.60              
P / TBV 1.06x              
 

Business Overview:

 

Formed in 1921, Pep Boys is a leading automotive retail and service chain currently operating 590 stores in 35 states and Puerto Rico. PBY is the only national chain offering automotive service, tires, parts and accessories - i.e. PBY is the only entity that combines automotive after-market retail with a full service center offering. PBY's primary operating unit is the Supercenter format, which service both 'do-it-for-me' (DIFM, which includes service labor, installed merchandise and tired) and 'do-it-yourself' (DIY, or retail) customers. In most Supercenters, PBY also has a commercial sales program that provides commercial credit and prompt delivery of tires, parts and other products to local, regional and national repair shops.

 

Of the 590 store locations operating by PBY as of May 1, 2010, 230 are owned and 360 are leased. At its stores, PBY operates approximately 6,030 service bays. Each service location performs a full range of automotive repair and maintenance services (except body work) and installs tires, hard parts and accessories.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

 

As of year-end January 30, 2010, PBY's 587 stores were split amongst the following formats:

 

  • 1) 562 Supercenters - average 20,700 square feet
  • 2) 24 Service & Tire Centers - average 6,800 square feet
  • 3) 9 non-service/non-tire PBY Express stores - average 9,500 square feet

 

Per the income statement, PBY's sales are split ≈80% merchandise and ≈20% service, with tires alone representing ≈16% of sales:
  FY 2002 FY 2003 FY 2004 FY 2005 FY 2006 FY 2007 FY 2008 FY 2009
                 
Parts and Accessories 64.9% 65.2% 67.8% 69.3% 68.5% 66.6% 65.1% 63.9%
Tires 16.0% 15.8% 14.2% 13.6% 14.1% 15.2% 16.3% 16.4%
Total Merchandise Sales 80.9% 81.0% 82.0% 82.9% 82.6% 81.8% 81.4% 80.3%
Service Labor 19.1% 19.0% 18.0% 17.1% 17.4% 18.2% 18.6% 19.7%
Total Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

 

PBY also provides a breakdown of sales that attributes parts sold as during service installations. Per this breakdown, we see that PBY's revenues are nearly split between pure Retail operations and Service Center oriented operations.

  FY 2007 FY 2008 FY 2009
       
Retail sales (1)     1,226.2     1,058.0    1,013.3
Service center revenue (2)        911.9        869.8       897.6
Total revenues  $ 2,138.1  $ 1,927.8  $1,910.9
Gross profit from retail sales (3)        277.2        273.3       275.1
Gross profit from service center revenue (4)        209.0        192.2       211.1
Total gross profit  $    486.2  $    465.4  $   486.1
       
Retail sales as % of total 57.3% 54.9% 53.0%
Service center revenue as % of total 42.7% 45.1% 47.0%
       
Gross margins from retail sales 22.6% 25.8% 27.1%
Gross margins from service center revenue 22.9% 22.1% 23.5%
       
(1) Excludes revenues from installed products
(2) Includes revenues from installed products
(3) Gross profit from retail sales includes the cost of products sold, buying, warehousing and store occupancy costs
(4) Gross profit from service center revenue includes the cost of installed products sold, buying, warehousing, serivce center payroll and related employee benefits and service center occupancy costs. Occupancy costs include utilities, rents, real estate and property taxes, repairs and maintenance and depreciation and amortization expenses.

 

Business Transformation:

 

Broadly, there are two reasons why PBY underperforms its peers on a gross margin basis:

 The company's retail stores are too large - The average PBY Supercenter is 20,700 square feet and includes 11 service bays. The average sizes of its competitors stores are:

  • AZO - ≈6,500 square feet
  • ORLY - ≈7,000 square feet
  • AAP - ≈7,000 square feet

PBY has too many stores in too few states - PBY currently operates 590 stores in 38 states and Puerto Rico. Its competitors operate:

  • a. AZO - 4,417 stores in 48 states, Washington DC, Puerto Rico, and Mexico
  • b. ORLY - 3,421 stores in 38 states
  • c. AAP - 3,264 stores in 39 states, Puerto Rico, and the Virgin islands

 

The size of PBY's Supercenters prevents it from stocking the stores efficiently as its competitors can do. Additionally, until changes under current management were made, PBY was a notoriously poor retailer, with ill-planned inventory. Store size also impacts PBY's service business. PBY's Supercenters to not generate sufficient traffic to justify 11 service bays. The underutilized capacity contributes to depressed margins.

 

Presently, the core focus of PBY's transformation is the company's effort to develop a hub and spoke model, which calls for adding smaller neighborhood Service & Tire Centers (spokes) to their existing Supercenter (hubs) store base. The Service & Tire centers are designed to capture market share and leverage PBY's existing Supercenters and support infrastructure (existing inventories, distribution network, operations infrastructure and advertising spend). PBY is targeting a 40 new Service & Tire Centers in fiscal 2010, and 80 in fiscal 2011. In 2009, PBY opened 24 new Service & Tire Centers including ten locations acquired through their purchase of Florida Tire, Inc. The typical Service & Tire Center is full service with approximately six service bays and $1mm in expected sales. PBY Supercenters were built to be destination stores; Service & Tire Centers aim to offer customer convenience, allowing PBY to be close to their customers' home or work.

 

PBY's Service & Tire Centers strategy essentially borrows/steals the MNRO playbook. Insofar as MNRO's business model has proven highly successful, I believe a prudent replication of the plan - supported by PBY's highly recognizable and highly regarded brand name - is quite likely to succeed. Given the increasing age and complexity of cars on the road, resulting in the inability of independently owned garages to make the necessary investments to support such vehicles, PBY's Service & Tire Centers should be able to grow both organically and through consolidation/acquisition.

 

The continued addition of Service & Tire centers should accomplishing two goals:

 

  • 1) In and of themselves, the Service & Tire centers should be profitable ventures with strong IRR's
  • 2) The Service & Tire centers help to solve PBY's density problem, taking advantage of the existing infrastructure that go to support the likely ill-sized Supercenters

 

The Service & Tire centers, therefore, allow PBY to leverage the inventory at its largest square footage stores to support smaller neighborhood stores. As PBY increases store density in markets, the company should achieve leverage not only on a store/local/regional basis, but on the corporate level as well as general overhead and marketing are spread across a more numerous store base.

 

In addition to deploying Service & Tire Centers across all existing markets, PBY is also selectively opening new prototype Supercenters. The new Supercenters are 13,000-14,000 square feet (compared to an average of 20,700 square feet for legacy stores) and feature 6-7 service bays (compared to 11-12 service bays for legacy stores). PBY is opening the new Supercenters where the company has retails gaps and they need a hub for future Service & Tire Centers.

 

Property:

 

Of PBY's 590 store locations, the company owns 230. Over the past three years, PBY has performed sale-leasebacks on 101 properties for aggregate proceeds of $387.2mm. Implied value per property in these transactions was $3,834,168. Presented below are transactions by year:

 

  • - On November 27, 2007, PBY sold 34 owned properties for net proceeds of $162,918,000 - implied value per property of $4,791,706
  • - During 2008, PBY sold 63 owned properties for net proceeds of $211,470,000 - implied value per property of $3,356,667
  • - During 2009, PBY sold four owned properties for net proceeds of $12,863,000 - implied value per property of $3,215,750

 

Using the average price of the transactions, net value of PBY's remaining owned properties would be $881.9mm. As presented below, the net value of PP&E as reported on PBY's books is only $699.4mm.

Property and equipment 1-May-10
   
Land       204.1
Buildings and improvements       829.0
Furniture, fixtures and equipment       703.0
Construction in progress           1.5
Accumulated deprecation and amortization    (1,038.3)
Property and equipment - net  $    699.4
   
Property and equipment - gross  $ 1,737.7

 

Included in owned property, and in addition to the 230 store locations, are the following properties:

- Five-story, ≈300,000 square foot corporate headquarters in Philadelphia, PA

- ≈60,00 square foot structure in Los Angeles, CA

- ≈4,000 square foot administrative regional offices in Melrose Park, IL and Bayamon, Puerto Rico

The following warehouses;

  • o McDonough, GA - ≈392,000 square feet
  • o Mesquite, TX - ≈244,000 square feet
  • o Plainfield, IN - ≈403,000 square feet
  • o Chester, NY - ≈400,400 square feet

 

Comparison to peers:

 

As the table below presents, for many years PBY's margins have dramatically underperformed its publicly traded peers. The margin delta expanded to its largest levels during CY 2005-2008, but came in slightly during CY 2009.

Based on calendar years 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                       
Gross margins                      
PBY 26.0% 25.6% 28.3% 29.4% 29.0% 27.5% 23.8% 25.2% 25.1% 24.1% 25.6%
MNRO 40.0% 40.3% 40.8% 40.7% 40.8% 40.5% 40.1% 39.9% 39.7% 40.2% 40.9%
AZO 42.1% 41.9% 41.8% 44.6% 46.1% 48.9% 48.9% 49.4% 49.7% 50.1% 50.1%
AAP 36.4% 39.0% 43.9% 44.8% 45.9% 46.5% 47.2% 47.7% 46.6% 47.4% 48.9%
ORLY 43.1% 43.0% 42.8% 42.2% 42.2% 43.2% 43.6% 44.1% 44.4% 45.5% 48.0%
                       
Average - excluding PBY 40.4% 41.0% 42.3% 43.1% 43.8% 44.8% 45.0% 45.3% 45.1% 45.8% 47.0%
PBY delta (bps) -1,437 -1,540 -1,406 -1,370 -1,474 -1,732 -2,113 -2,010 -1,998 -2,166 -2,140
                       
EBIT margins                      
PBY 3.9% 2.8% 4.7% 5.6% 3.8% 3.4% 0.4% 1.1% 1.5% -0.8% 3.0%
MNRO 10.1% 10.2% 9.9% 9.3% 10.5% 10.2% 10.5% 9.3% 8.4% 8.9% 10.7%
AZO 10.5% 11.4% 10.7% 14.5% 16.8% 17.7% 17.1% 17.0% 17.1% 17.2% 17.3%
AAP 2.8% 3.9% 4.6% 7.2% 8.5% 8.7% 9.6% 8.7% 8.6% 8.8% 8.5%
ORLY 10.2% 10.1% 10.4% 10.5% 10.9% 11.1% 12.3% 12.4% 12.1% 9.7% 11.1%
                       
Average - excluding PBY 8.4% 8.9% 8.9% 10.4% 11.7% 11.9% 12.4% 11.8% 11.5% 11.2% 11.9%
PBY delta (bps) -446 -608 -416 -479 -792 -855 -1,195 -1,073 -1,005 -1,192 -891
                       
EBITDA margins                      
PBY 8.0% 6.9% 8.6% 9.4% 7.4% 6.8% 4.0% 5.0% 5.3% 3.0% 6.7%
MNRO 15.9% 16.0% 15.6% 14.2% 15.5% 14.9% 15.4% 14.1% 13.0% 13.2% 14.7%
AZO 13.6% 14.3% 13.4% 16.7% 18.8% 19.6% 19.5% 19.3% 19.7% 19.8% 19.9%
AAP 5.4% 6.9% 7.6% 10.2% 11.4% 11.5% 12.4% 11.8% 11.6% 11.6% 11.3%
ORLY 12.6% 12.9% 13.2% 13.3% 13.7% 14.2% 15.1% 15.2% 15.2% 12.8% 14.1%
                       
Average - excluding PBY 11.9% 12.5% 12.4% 13.6% 14.9% 15.0% 15.6% 15.1% 14.9% 14.4% 15.0%
PBY delta (bps) -390 -557 -381 -427 -743 -830 -1,158 -1,010 -958 -1,135 -834
                       
EBITDAR margins                      
PBY 10.5% 9.6% 11.5% 12.2% 10.4% 9.4% 7.0% 7.6% 8.5% 7.0% 10.6%
MNRO 23.3% 23.6% 22.9% 21.4% 21.6% 20.3% 20.4% 19.1% 18.2% 18.3% 19.2%
AZO 16.0% 16.4% 15.5% 18.6% 20.9% 21.7% 22.1% 21.7% 22.2% 22.4% 22.6%
AAP 10.5% 12.2% 12.9% 14.9% 16.2% 16.2% 17.2% 16.8% 17.0% 17.1% 16.8%
ORLY 14.4% 14.7% 15.5% 15.6% 15.8% 16.5% 17.2% 17.4% 17.4% 16.8% 18.8%
                       
Average - excluding PBY 16.1% 16.7% 16.7% 17.6% 18.6% 18.7% 19.2% 18.8% 18.7% 18.6% 19.3%
PBY delta (bps) -557 -715 -518 -536 -817 -926 -1,222 -1,114 -1,016 -1,159 -873
                       
PBY segment gross margins                      
Merchandise 27.6% 27.3% 29.2% 30.3% 30.1% 28.5% 27.1% 28.8% 28.2% 28.1% 29.4%
Service 19.1% 18.8% 24.5% 25.4% 24.5% 22.8% 7.9% 8.0% 11.2% 7.0% 9.9%

 

 

In addition to severe margin underperformance, PBY also trades at substantially lower multiples of revenue, EBITDA, and EBITDAR than its peers - assuming that PBY simply trades in line with its peers on an EBITDAR multiple, but giving them no credit for operational improvement leading to margin expansion yields a return on investment in PBY of ≈100%:

All on LTM Basis Adjusted EV /  EV /  Adjusted EV / 
Peer Multiples Revenue EBITDA EBITDAR
AZO 1.99x 8.7x 8.6x
ORLY 1.81x 12.1x 7.8x
AAP 1.31x 7.6x 9.3x
MNRO 1.97x 10.9x 10.2x
AVERAGE 1.77x 9.8x 9.0x
PBY 0.68x 5.5x 6.4x
Discount to mean 61.5% 44.2% 28.4%
Implied value of PBY at Average multiples 48.37 19.56 18.83

I do not believe that PBY can achieve margins in line with its peers due to the aforementioned structural disadvantages to PBY's business versus its peers. However, a mid-to-high single digit operating margin (translating into low-double digit EBITDAR margins) is a reasonable goal for the company. Presented below are equity valuations for PBY based on a conservative range of EBIT/EBITDAR margins and a below peer 7.5x Adjusted EV/EBITDAR multiple. 

Revenue  $   2,000.0  $   2,000.0  $   2,000.0  $   2,000.0  $   2,000.0  $   2,000.0
EBIT margin 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%
EBIT  $       90.0  $     100.0  $     110.0  $     120.0  $     130.0  $     140.0
             
Tax rate 39.00% 39.00% 39.00% 39.00% 39.00% 39.00%
NOPAT  $       54.9  $       61.0  $       67.1  $       73.2  $       79.3  $       85.4
D&A  $       75.0  $       75.0  $       75.0  $       75.0  $       75.0  $       75.0
EBITDA  $     165.0  $     175.0  $     185.0  $     195.0  $     205.0  $     215.0
             
Rent expense  $       75.0  $       75.0  $       75.0  $       75.0  $       75.0  $       75.0
EBITDAR  $     240.0  $     250.0  $     260.0  $     270.0  $     280.0  $     290.0
EBITDAR margin 12.00% 12.50% 13.00% 13.50% 14.00% 14.50%
EBITDAR multiple 7.5x 7.5x 7.5x 7.5x 7.5x 7.5x
Adjusted EV  $   1,800.0  $   1,875.0  $   1,950.0  $   2,025.0  $   2,100.0  $   2,175.0
Net debt and capitalized operating leases  $     821.3  $     821.3  $     821.3  $     821.3  $     821.3  $     821.3
Equity value  $     978.7  $   1,053.7  $   1,128.7  $   1,203.7  $   1,278.7  $   1,353.7
Equity value per share  $     18.49  $     19.91  $     21.32  $     22.74  $     24.16  $     25.57

 

PBY operates with an Inventory / Accounts Payable Ratio of 2.57x. Other companies in the auto after market space run with much lower ratios, as historically suppliers in the market have offered generous terms to customers.

 

    Accounts  
  Inventory Payable Ratio
AZO  $ 2,288.4  $ 2,235.8 1.02x
ORLY  $ 1,903.1  $    794.7 2.39x
AAP  $ 1,745.6  $ 1,185.8 1.47x
PBY  $    561.4  $    218.5 2.57x

 

(With regards to ORLY, prior to the CSK acquisition, ORLY was running at ≈2.1x ratio. Management and investors both recognize that ORLY has meaningful opportunity in improvement of its ratio).

 

Assuming PBY can improve its Inventory / Accounts Payable ratio by having its vendors increasingly finance its inventory, PBY can materially reduce net debt.

 

 

Inventory  $    561.4  $    561.4  $    561.4  $   561.4  $   561.4
Accounts Payable  $    218.5  $    268.5  $    318.5  $   368.5  $   418.5
Ratio 2.57x 2.09x 1.76x 1.52x 1.34x
Reduced net debt  $          -   $     50.0  $    100.0  $   150.0  $   200.0
Per share NA  $     0.94  $     1.89  $    2.83  $    3.78

 

Management:

 

Top management at PBY is relatively new and generally well regarded for their efforts to date towards the company's turnaround.

 

CEO - Michael Odell joined PBY in September 2008 as EVP - COO. In April 2008 he was appointed Interim CEO. In September 2008, Odell was named permanent CEO.

 

CFO - Raymond Arthur joined PBY in May 2008 when he named CFO of the company.

 

Management has recently made material purchases of PBY stock:

Date Name Postion Shares Price
         
7/2/2010 Scott Webb EVP - Merchandising and Marketing 5,000  $    8.47
7/1/2010 Michael Odell CEO 5,984  $    8.36
7/1/2010 Raymond Arthur CFO 11,800  $    8.40
 

 

Catalysts:

 

  • 1) Continued improvement in results and further evidence that business transformation is succeeding
  • 2) Interest from financial buyer

 

Risks:

 

  • 1) Poor executing or evidence that transformation strategy is flawed
  • 2) Macro issues / stressed consumer

 

 

 

 

 

Catalyst

    sort by    

    Description

    Summary:

    At current levels, an investment in Pep Boys (PBY) presents a compelling risk reward profile.

    Downside protection is provided by hard asset value. Tangible book value for PBY stands at $8.60 per share, a number which is likely understated due to the age of many properties on PBY's books. Insofar as PBY is cash flow positive and has neither near term nor onerous debt maturities, there appears little risk to the hard asset value. I believe the company could be liquidated today for a price very near, and quite likely above, TBV/share. Further downside protection is afforded by the undemanding valuation levels at which PBY currently trades - sub-6x 2010 rent-adjusted EV / EBITDAR and north of a 15% FCF yield to equity assuming maintenance CapEx levels. While PBY is not yet a high quality business, it does operate in a high quality and recession resilient industry. Peer multiples and operating metrics demonstrate that.

    Upside will be a function of PBY's continued operational improvement. Since 2007, PBY had been working to transform the company's store footprint and operations. Currently, PBY generates gross margins 2,140 bps lower than its peer group average, and EBIT and EBITDAR margins 891 bps lower than its peer group average. In addition to severe margin underperformance, PBY also trades at substantially lower multiples of revenue, EBITDA, and EBITDAR than its peers.  Assuming that PBY simply trades in line with its peers on an EBITDAR multiple, but giving them no credit for operational improvement leading to margin expansion, PBY is a double from current levels. Additionally, by improving its working capital metrics PBY should be able to reduce net debt by $1-$3/share.

    Recently, PBY has seen some material insider buying by a number of key executives. Additionally, an activist hedge fund recently made public a presentation urging private equity firms to explore an LBO transaction of PBY.

     
    Capital Structure     Valuation - Fiscal Year ends January 2007 2008 2009 2010 2011
    Share price  $      9.08   Revenue  $  2,144.7  $  1,927.8  $  1,910.9  $  1,988.2  $  2,099.0
    Diluted shares outstanding 52.9   EV / Revenue 0.33x 0.36x 0.37x 0.35x 0.33x
    Market cap  $    480.6   Adjusted EV / Revenue 0.61x 0.68x 0.68x 0.65x 0.62x
    Cash and CE          87.8   EBIT  $      28.5  $       (7.0)  $      57.1  $      74.3  $      86.0
    Debt        307.0   EBIT margin 1.3% NA 3.0% 3.7% 4.1%
    Net debt        219.2   EV / EBIT 24.55x NA 12.25x 9.42x 8.13x
    Enterprise value  $    699.8   EBITDA  $    109.5  $      66.2  $    127.7  $    147.1  $    158.9
          EBITDA margin 5.1% 3.4% 6.7% 7.4% 7.6%
    FY 2010 lease expense  $      75.3   EV / EBITDA 6.39x 10.57x 5.48x 4.76x 4.40x
    Capitalization multiple 8.0x   EBITDAR  $    178.8  $    143.3  $    202.9  $    222.4  $    234.2
    Capitalized operating lease  $    602.1   EV / EBITDAR 7.28x 9.08x 6.42x 5.85x 5.56x
          Actual FCF  $      19.0  $        2.0  $      45.0  $      21.8  $      25.5
    Adjusted EV  $  1,302.0   FCF yield 4.0% 0.4% 9.4% 4.5% 5.3%
          Maintenance FCF  $      42.2  $      16.7  $      65.7  $      74.3  $      80.5
    Tangible book value  $    455.0   FCF yield 8.8% 3.5% 13.7% 15.5% 16.8%
    TBV/ share  $      8.60              
    P / TBV 1.06x              
     

    Business Overview:

     

    Formed in 1921, Pep Boys is a leading automotive retail and service chain currently operating 590 stores in 35 states and Puerto Rico. PBY is the only national chain offering automotive service, tires, parts and accessories - i.e. PBY is the only entity that combines automotive after-market retail with a full service center offering. PBY's primary operating unit is the Supercenter format, which service both 'do-it-for-me' (DIFM, which includes service labor, installed merchandise and tired) and 'do-it-yourself' (DIY, or retail) customers. In most Supercenters, PBY also has a commercial sales program that provides commercial credit and prompt delivery of tires, parts and other products to local, regional and national repair shops.

     

    Of the 590 store locations operating by PBY as of May 1, 2010, 230 are owned and 360 are leased. At its stores, PBY operates approximately 6,030 service bays. Each service location performs a full range of automotive repair and maintenance services (except body work) and installs tires, hard parts and accessories.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

     

    As of year-end January 30, 2010, PBY's 587 stores were split amongst the following formats:

     

    • 1) 562 Supercenters - average 20,700 square feet
    • 2) 24 Service & Tire Centers - average 6,800 square feet
    • 3) 9 non-service/non-tire PBY Express stores - average 9,500 square feet

     

    Per the income statement, PBY's sales are split ≈80% merchandise and ≈20% service, with tires alone representing ≈16% of sales:
      FY 2002 FY 2003 FY 2004 FY 2005 FY 2006 FY 2007 FY 2008 FY 2009
                     
    Parts and Accessories 64.9% 65.2% 67.8% 69.3% 68.5% 66.6% 65.1% 63.9%
    Tires 16.0% 15.8% 14.2% 13.6% 14.1% 15.2% 16.3% 16.4%
    Total Merchandise Sales 80.9% 81.0% 82.0% 82.9% 82.6% 81.8% 81.4% 80.3%
    Service Labor 19.1% 19.0% 18.0% 17.1% 17.4% 18.2% 18.6% 19.7%
    Total Revenue 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

     

    PBY also provides a breakdown of sales that attributes parts sold as during service installations. Per this breakdown, we see that PBY's revenues are nearly split between pure Retail operations and Service Center oriented operations.

      FY 2007 FY 2008 FY 2009
           
    Retail sales (1)     1,226.2     1,058.0    1,013.3
    Service center revenue (2)        911.9        869.8       897.6
    Total revenues  $ 2,138.1  $ 1,927.8  $1,910.9
    Gross profit from retail sales (3)        277.2        273.3       275.1
    Gross profit from service center revenue (4)        209.0        192.2       211.1
    Total gross profit  $    486.2  $    465.4  $   486.1
           
    Retail sales as % of total 57.3% 54.9% 53.0%
    Service center revenue as % of total 42.7% 45.1% 47.0%
           
    Gross margins from retail sales 22.6% 25.8% 27.1%
    Gross margins from service center revenue 22.9% 22.1% 23.5%
           
    (1) Excludes revenues from installed products
    (2) Includes revenues from installed products
    (3) Gross profit from retail sales includes the cost of products sold, buying, warehousing and store occupancy costs
    (4) Gross profit from service center revenue includes the cost of installed products sold, buying, warehousing, serivce center payroll and related employee benefits and service center occupancy costs. Occupancy costs include utilities, rents, real estate and property taxes, repairs and maintenance and depreciation and amortization expenses.

     

    Business Transformation:

     

    Broadly, there are two reasons why PBY underperforms its peers on a gross margin basis:

     The company's retail stores are too large - The average PBY Supercenter is 20,700 square feet and includes 11 service bays. The average sizes of its competitors stores are:

    PBY has too many stores in too few states - PBY currently operates 590 stores in 38 states and Puerto Rico. Its competitors operate:

     

    The size of PBY's Supercenters prevents it from stocking the stores efficiently as its competitors can do. Additionally, until changes under current management were made, PBY was a notoriously poor retailer, with ill-planned inventory. Store size also impacts PBY's service business. PBY's Supercenters to not generate sufficient traffic to justify 11 service bays. The underutilized capacity contributes to depressed margins.

     

    Presently, the core focus of PBY's transformation is the company's effort to develop a hub and spoke model, which calls for adding smaller neighborhood Service & Tire Centers (spokes) to their existing Supercenter (hubs) store base. The Service & Tire centers are designed to capture market share and leverage PBY's existing Supercenters and support infrastructure (existing inventories, distribution network, operations infrastructure and advertising spend). PBY is targeting a 40 new Service & Tire Centers in fiscal 2010, and 80 in fiscal 2011. In 2009, PBY opened 24 new Service & Tire Centers including ten locations acquired through their purchase of Florida Tire, Inc. The typical Service & Tire Center is full service with approximately six service bays and $1mm in expected sales. PBY Supercenters were built to be destination stores; Service & Tire Centers aim to offer customer convenience, allowing PBY to be close to their customers' home or work.

     

    PBY's Service & Tire Centers strategy essentially borrows/steals the MNRO playbook. Insofar as MNRO's business model has proven highly successful, I believe a prudent replication of the plan - supported by PBY's highly recognizable and highly regarded brand name - is quite likely to succeed. Given the increasing age and complexity of cars on the road, resulting in the inability of independently owned garages to make the necessary investments to support such vehicles, PBY's Service & Tire Centers should be able to grow both organically and through consolidation/acquisition.

     

    The continued addition of Service & Tire centers should accomplishing two goals:

     

     

    The Service & Tire centers, therefore, allow PBY to leverage the inventory at its largest square footage stores to support smaller neighborhood stores. As PBY increases store density in markets, the company should achieve leverage not only on a store/local/regional basis, but on the corporate level as well as general overhead and marketing are spread across a more numerous store base.

     

    In addition to deploying Service & Tire Centers across all existing markets, PBY is also selectively opening new prototype Supercenters. The new Supercenters are 13,000-14,000 square feet (compared to an average of 20,700 square feet for legacy stores) and feature 6-7 service bays (compared to 11-12 service bays for legacy stores). PBY is opening the new Supercenters where the company has retails gaps and they need a hub for future Service & Tire Centers.

     

    Property:

     

    Of PBY's 590 store locations, the company owns 230. Over the past three years, PBY has performed sale-leasebacks on 101 properties for aggregate proceeds of $387.2mm. Implied value per property in these transactions was $3,834,168. Presented below are transactions by year:

     

     

    Using the average price of the transactions, net value of PBY's remaining owned properties would be $881.9mm. As presented below, the net value of PP&E as reported on PBY's books is only $699.4mm.

    Property and equipment 1-May-10
       
    Land       204.1
    Buildings and improvements       829.0
    Furniture, fixtures and equipment       703.0
    Construction in progress           1.5
    Accumulated deprecation and amortization    (1,038.3)
    Property and equipment - net  $    699.4
       
    Property and equipment - gross  $ 1,737.7

     

    Included in owned property, and in addition to the 230 store locations, are the following properties:

    - Five-story, ≈300,000 square foot corporate headquarters in Philadelphia, PA

    - ≈60,00 square foot structure in Los Angeles, CA

    - ≈4,000 square foot administrative regional offices in Melrose Park, IL and Bayamon, Puerto Rico

    The following warehouses;

     

    Comparison to peers:

     

    As the table below presents, for many years PBY's margins have dramatically underperformed its publicly traded peers. The margin delta expanded to its largest levels during CY 2005-2008, but came in slightly during CY 2009.

    Based on calendar years 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
                           
    Gross margins                      
    PBY 26.0% 25.6% 28.3% 29.4% 29.0% 27.5% 23.8% 25.2% 25.1% 24.1% 25.6%
    MNRO 40.0% 40.3% 40.8% 40.7% 40.8% 40.5% 40.1% 39.9% 39.7% 40.2% 40.9%
    AZO 42.1% 41.9% 41.8% 44.6% 46.1% 48.9% 48.9% 49.4% 49.7% 50.1% 50.1%
    AAP 36.4% 39.0% 43.9% 44.8% 45.9% 46.5% 47.2% 47.7% 46.6% 47.4% 48.9%
    ORLY 43.1% 43.0% 42.8% 42.2% 42.2% 43.2% 43.6% 44.1% 44.4% 45.5% 48.0%
                           
    Average - excluding PBY 40.4% 41.0% 42.3% 43.1% 43.8% 44.8% 45.0% 45.3% 45.1% 45.8% 47.0%
    PBY delta (bps) -1,437 -1,540 -1,406 -1,370 -1,474 -1,732 -2,113 -2,010 -1,998 -2,166 -2,140
                           
    EBIT margins                      
    PBY 3.9% 2.8% 4.7% 5.6% 3.8% 3.4% 0.4% 1.1% 1.5% -0.8% 3.0%
    MNRO 10.1% 10.2% 9.9% 9.3% 10.5% 10.2% 10.5% 9.3% 8.4% 8.9% 10.7%
    AZO 10.5% 11.4% 10.7% 14.5% 16.8% 17.7% 17.1% 17.0% 17.1% 17.2% 17.3%
    AAP 2.8% 3.9% 4.6% 7.2% 8.5% 8.7% 9.6% 8.7% 8.6% 8.8% 8.5%
    ORLY 10.2% 10.1% 10.4% 10.5% 10.9% 11.1% 12.3% 12.4% 12.1% 9.7% 11.1%
                           
    Average - excluding PBY 8.4% 8.9% 8.9% 10.4% 11.7% 11.9% 12.4% 11.8% 11.5% 11.2% 11.9%
    PBY delta (bps) -446 -608 -416 -479 -792 -855 -1,195 -1,073 -1,005 -1,192 -891
                           
    EBITDA margins                      
    PBY 8.0% 6.9% 8.6% 9.4% 7.4% 6.8% 4.0% 5.0% 5.3% 3.0% 6.7%
    MNRO 15.9% 16.0% 15.6% 14.2% 15.5% 14.9% 15.4% 14.1% 13.0% 13.2% 14.7%
    AZO 13.6% 14.3% 13.4% 16.7% 18.8% 19.6% 19.5% 19.3% 19.7% 19.8% 19.9%
    AAP 5.4% 6.9% 7.6% 10.2% 11.4% 11.5% 12.4% 11.8% 11.6% 11.6% 11.3%
    ORLY 12.6% 12.9% 13.2% 13.3% 13.7% 14.2% 15.1% 15.2% 15.2% 12.8% 14.1%
                           
    Average - excluding PBY 11.9% 12.5% 12.4% 13.6% 14.9% 15.0% 15.6% 15.1% 14.9% 14.4% 15.0%
    PBY delta (bps) -390 -557 -381 -427 -743 -830 -1,158 -1,010 -958 -1,135 -834
                           
    EBITDAR margins                      
    PBY 10.5% 9.6% 11.5% 12.2% 10.4% 9.4% 7.0% 7.6% 8.5% 7.0% 10.6%
    MNRO 23.3% 23.6% 22.9% 21.4% 21.6% 20.3% 20.4% 19.1% 18.2% 18.3% 19.2%
    AZO 16.0% 16.4% 15.5% 18.6% 20.9% 21.7% 22.1% 21.7% 22.2% 22.4% 22.6%
    AAP 10.5% 12.2% 12.9% 14.9% 16.2% 16.2% 17.2% 16.8% 17.0% 17.1% 16.8%
    ORLY 14.4% 14.7% 15.5% 15.6% 15.8% 16.5% 17.2% 17.4% 17.4% 16.8% 18.8%
                           
    Average - excluding PBY 16.1% 16.7% 16.7% 17.6% 18.6% 18.7% 19.2% 18.8% 18.7% 18.6% 19.3%
    PBY delta (bps) -557 -715 -518 -536 -817 -926 -1,222 -1,114 -1,016 -1,159 -873
                           
    PBY segment gross margins                      
    Merchandise 27.6% 27.3% 29.2% 30.3% 30.1% 28.5% 27.1% 28.8% 28.2% 28.1% 29.4%
    Service 19.1% 18.8% 24.5% 25.4% 24.5% 22.8% 7.9% 8.0% 11.2% 7.0% 9.9%

     

     

    In addition to severe margin underperformance, PBY also trades at substantially lower multiples of revenue, EBITDA, and EBITDAR than its peers - assuming that PBY simply trades in line with its peers on an EBITDAR multiple, but giving them no credit for operational improvement leading to margin expansion yields a return on investment in PBY of ≈100%:

    All on LTM Basis Adjusted EV /  EV /  Adjusted EV / 
    Peer Multiples Revenue EBITDA EBITDAR
    AZO 1.99x 8.7x 8.6x
    ORLY 1.81x 12.1x 7.8x
    AAP 1.31x 7.6x 9.3x
    MNRO 1.97x 10.9x 10.2x
    AVERAGE 1.77x 9.8x 9.0x
    PBY 0.68x 5.5x 6.4x
    Discount to mean 61.5% 44.2% 28.4%
    Implied value of PBY at Average multiples 48.37 19.56 18.83

    I do not believe that PBY can achieve margins in line with its peers due to the aforementioned structural disadvantages to PBY's business versus its peers. However, a mid-to-high single digit operating margin (translating into low-double digit EBITDAR margins) is a reasonable goal for the company. Presented below are equity valuations for PBY based on a conservative range of EBIT/EBITDAR margins and a below peer 7.5x Adjusted EV/EBITDAR multiple. 

    Revenue  $   2,000.0  $   2,000.0  $   2,000.0  $   2,000.0  $   2,000.0  $   2,000.0
    EBIT margin 4.50% 5.00% 5.50% 6.00% 6.50% 7.00%
    EBIT  $       90.0  $     100.0  $     110.0  $     120.0  $     130.0  $     140.0
                 
    Tax rate 39.00% 39.00% 39.00% 39.00% 39.00% 39.00%
    NOPAT  $       54.9  $       61.0  $       67.1  $       73.2  $       79.3  $       85.4
    D&A  $       75.0  $       75.0  $       75.0  $       75.0  $       75.0  $       75.0
    EBITDA  $     165.0  $     175.0  $     185.0  $     195.0  $     205.0  $     215.0
                 
    Rent expense  $       75.0  $       75.0  $       75.0  $       75.0  $       75.0  $       75.0
    EBITDAR  $     240.0  $     250.0  $     260.0  $     270.0  $     280.0  $     290.0
    EBITDAR margin 12.00% 12.50% 13.00% 13.50% 14.00% 14.50%
    EBITDAR multiple 7.5x 7.5x 7.5x 7.5x 7.5x 7.5x
    Adjusted EV  $   1,800.0  $   1,875.0  $   1,950.0  $   2,025.0  $   2,100.0  $   2,175.0
    Net debt and capitalized operating leases  $     821.3  $     821.3  $     821.3  $     821.3  $     821.3  $     821.3
    Equity value  $     978.7  $   1,053.7  $   1,128.7  $   1,203.7  $   1,278.7  $   1,353.7
    Equity value per share  $     18.49  $     19.91  $     21.32  $     22.74  $     24.16  $     25.57

     

    PBY operates with an Inventory / Accounts Payable Ratio of 2.57x. Other companies in the auto after market space run with much lower ratios, as historically suppliers in the market have offered generous terms to customers.

     

        Accounts  
      Inventory Payable Ratio
    AZO  $ 2,288.4  $ 2,235.8 1.02x
    ORLY  $ 1,903.1  $    794.7 2.39x
    AAP  $ 1,745.6  $ 1,185.8 1.47x
    PBY  $    561.4  $    218.5 2.57x

     

    (With regards to ORLY, prior to the CSK acquisition, ORLY was running at ≈2.1x ratio. Management and investors both recognize that ORLY has meaningful opportunity in improvement of its ratio).

     

    Assuming PBY can improve its Inventory / Accounts Payable ratio by having its vendors increasingly finance its inventory, PBY can materially reduce net debt.

     

     

    Inventory  $    561.4  $    561.4  $    561.4  $   561.4  $   561.4
    Accounts Payable  $    218.5  $    268.5  $    318.5  $   368.5  $   418.5
    Ratio 2.57x 2.09x 1.76x 1.52x 1.34x
    Reduced net debt  $          -   $     50.0  $    100.0  $   150.0  $   200.0
    Per share NA  $     0.94  $     1.89  $    2.83  $    3.78

     

    Management:

     

    Top management at PBY is relatively new and generally well regarded for their efforts to date towards the company's turnaround.

     

    CEO - Michael Odell joined PBY in September 2008 as EVP - COO. In April 2008 he was appointed Interim CEO. In September 2008, Odell was named permanent CEO.

     

    CFO - Raymond Arthur joined PBY in May 2008 when he named CFO of the company.

     

    Management has recently made material purchases of PBY stock:

    Date Name Postion Shares Price
             
    7/2/2010 Scott Webb EVP - Merchandising and Marketing 5,000  $    8.47
    7/1/2010 Michael Odell CEO 5,984  $    8.36
    7/1/2010 Raymond Arthur CFO 11,800  $    8.40
     

     

    Catalysts:

     

     

    Risks:

     

     

     

     

     

     

    Catalyst

      Back to top