Description
Pep Boys (PBY), a leading retailer of automotive parts, tires and services, has undergone a successful operational turnaround over the past two years but, impressive as the transformation has been, its full impact on earnings has yet to be felt. Having executed a significant restructuring in 4Q00 (ending 1/01) and having wrung excess costs out of an inefficient operation, PBY has nearly tripled its operating income during the economic downturn and is now well leveraged to a pickup in its top line. While the stock has reflected some of the company's reversal of fortune, at $12.40 it still trades at only 11x 2003e EPS, 5.8x TEV/EBITDA, and a meager 6x PBY's significant and sustainable FCF. In initiating the restructuring in late 2000, management took the proper step of sacrificing near-term growth prospects - virtually no new stores have been opened during this time period - in order to apply its abundant FCF to debt paydown and shore up its balance sheet. This latter goal having been nearly fully achieved, PBY is approaching the point at which it can safely re-invest in its business and, presumably, command a multiple more consistent with renewed growth prospects.
Business. With 629 stores in 36 states, Pep Boys is a leading retailer of automotive parts and tires, as well as service operations. The company has taken a very differentiated approach to the auto parts retailing business, maintaining a much different business model than competitors such as AutoZone (AZO) and Advance Auto Parts (AAP). PBY's stores are mostly comprised of large-scale Supercenters, 11,500 square feet of retail space on average, stocking about 25,000 SKUs, and generally have an on-site service business with 12 service bays (another 9500 Sq. Ft.). While PBY's competitors have shunned the sale of tires as well as the service element, PBY has grown both, believing that, with cars becoming increasingly complex under the hood, the future of the auto parts business lies more in the "Do-It-For-Me" ("DIFM") side than the "Do-It-Yourself" ("DIY") end. Although the tire retailing business in and of itself is an uninspiring one with thinner margins than parts retailing, it is a significant traffic driver to the service side and, when factoring in the associated installation, alignment, etc., is ultimately a higher margin business. In addition to the sale of tires and services, Pep Boys differs from other retailers in its store size (AZO and AAP stores are typically in the 6,000-8,000 Sq. Ft. range) and SKUs (these two competitors generally carry 16k-22k items).
Of PBY's $2.2bb in total sales for FY02 (ending 1/03), parts sales to retail customers should account for about 45%, with another 20% sold to commercial accounts, while service labor equals about 20% of revenues and sale of tires the remaining 15%. The company separates its business into two segments, Merchandise and Service, with the former including Tires. Gross margins in the Merchandise business approximate 30%, while Service is currently running at about 25%. Service is inherently a lower margin business, with higher labor and equipment costs but, the current soft economic environment notwithstanding, generally has better growth prospects. In weaker economic times, the Service end of the business tends to suffer, as car owners defer maintenance spending, as well as the purchase of new tires (whose associated labor revenues are therefore absent). The latest downturn was no exception, and Service comps turned negative early in 2001, only just turning positive in 3Q02. Merchandise comps also showed sharp declines beginning in 4Q00, but had begun to pick up in last year's first half (up about 2.5%), before posting another decline in the third quarter.
Despite the fact that PBY's sales growth the past two years has been unimpressive, the company has managed through the downturn exceptionally well by getting its cost structure in line and its balance sheet in much better shape, and can now turn its attention and resources to driving the top line. As mentioned previously, when sales began to fall off in late 2000, management initiated a Profit Enhancement Plan aimed at rationalizing the business, driving margins and FCF, and debt paydown. The plan worked extremely well, as PBY closed 38 underperforming stores and two distribution centers in 4Q00, reduced store operating hours, and terminated 1500 employees (5% of its workforce). Positive results were immediate: operating margins, which had posted a negative 1.8% in 3Q00, rose to 3.7% the following quarter and have been on the rise ever since (showing 6.5% the past two quarters). In the latest quarter, gross margins for the Merchandise segment reached 30.9%, its highest level in five years and compared to 23.4% two years earlier, while Service gross margins were 26.0% vs. 14.4% two years prior. The latter's performance was especially impressive, as margins rose 270 BPs Yr./Yr. (220 BPs sequentially) on only a 1% comp gain, and should give a strong hint of the segment's inherent operating leverage once business is more robust. In the meantime, with sales growth still generally lacking, EPS has risen from ($0.11) in 2000 to $0.82 in 2001 and an estimated $0.97 this past year; EBITDA has grown during this time from $146.2mm in 2000, to $193.7mm in 2001, and about $207mm in 2002.
Management has stuck to the game plan of generating the FCF and using it to deleverage, despite the temptation of trying to grow the top line with new stores. PBY generated $150mm of FCF in 2001 ($2.88/share), driven by the higher earnings as well as a big source of funds from working capital (bringing it in line with the more streamlined operations) and lower capital spending (as no new stores were opened). Net debt in 2001 declined from $805mm, or 57.5% of total capital, to $653.1mm, or 51.4% of capital (the decline matching the FCF generation). In 2002, PBY is estimated to have generated a further $100mm in FCF (it has done $72mm through the third quarter), or about $1.75/share. The lower FCF in 2002, despite higher earnings, is largely due to a moderate pickup in CapX (PBY did open two Supercenters this year and has invested in new, much more highly advanced operating systems for the stores, to be rolled out during 2003) and less of a benefit from Working Capital. Net debt should end 2002 at $582mm, or 47% of capital. We expect FCF to tick back up next year, with the spending on the new systems behind it and the higher base of earnings; we are looking for $120mm, or a bit more than $2.00/share, which would bring net debt to capital down to slightly less than 40%, the company's stated goal.
We believe that, while this level of FCF is a steady-state level PBY can generate under a low-growth operating plan (equating to a 17% FCF yield), management will at that point look to begin growing the store count once again, as well as potentially pursuing a variety of other avenues of growth. These include Service-only locations, which management believes hold great potential, given PBY's ability to leverage its store base to effectively serve as distribution centers to new service sites. In addition, we believe that PBY can capitalize on the exit of two of the service industry's larger players, Penske (who quit the business after Kmart encountered its problems, as its stores were exclusively tied to Kmart sites) and Montgomery Ward (whose sites were abandoned after its bankruptcy filing). While the Service end of the industry is indeed a difficult one to manage, PBY has done a reasonably good job at it and, we believe, has competitive advantages and value-added over smaller mom & pops in part due to its immense catalogue of SKUs on-site. Other growth opportunities we know management is considering are less-capital intensive and include potential deals with insurance companies to use PBY for vehicle inspection, and deals with towing companies to drive traffic to PBY service locations. Lastly, in the past year, PBY has increased its advertising budget and, more importantly, has better utilized it by diverting more dollars to the more cost-effective radio and print circulars and away from television spots. The company has found it maintains better pricing flexibility when it can target ads market-to-market, rather than running national television spots. Having seen what an effective job AutoZone management has done with its "Get in the Zone" campaign, we believe a renewed focus on advertising (aided by the hiring last fall of a new executive to run its campaign) will help drive the top line as well.
Valuation. As noted previously, at $12.40, PBY trades for modest multiples on virtually all valuation measures. With 52.5mm shares outstanding, PBY's market cap is $650mm (this is not fully diluted, as PBY has a 4.75% convert at $22.40/share which, given the stock price, we currently treat as debt). Net debt, including the convert, ended 3Q02 at $605mm (although, with the 4Q's FCF, we expect this figure to end 2002 at closer to $582mm). So the current TEV is about $1.25bb, or 6x FY02's estimated $207mm in EBITDA. In addition, the company is trading for only 12.5x LTM EPS of $0.99 and 11x the conservative $1.13 we are using for 2003. Our 2003 assumptions include only 1% top line growth, a modest 40 BPs expansion of operating margins to 6.2% (which should be easily attainable, given 3Q02's positive data points for both segments), and lower interest expense due to the continued debt paydown. EBITDA should rise to at least $217mm from $207mm in 2002 and, assuming our estimate of $120mm in FCF for FY03 is applied to further debt paydown, the TEV/EBITDA multiple using today's price and net debt at FY03's year-end would equate to only 5.1x (i.e., $650mm market cap + estimated net debt of $460mm, for a TEV of $1.1bb on $217mm in EBITDA).
We believe a more appropriate TEV/EBITDA multiple for 2003e is 6.5x, which by year-end would equate to about $18/share, or 45% upside from here. Given that other players in the industry are trading in the 8x-9x area, and that PBY's renewed growth prospects should become increasingly clear as we cycle through the year, we feel a 6.5x multiple isn't exactly unreasonable. One further note: our 2003 estimates include top-line growth of only 1%; there is significant positive leverage from higher comp growth, especially if it comes from the Service side of the business, which is more leveraged to an economic pickup. Each 1% of top line growth, all else equal, equates to about 9-10c per share of EPS.
Risks. In addition to the obvious, economic-related risks, we see two company-specific risks worth addressing. First, last week the company announced that PBY's CEO, Mitch Liebovitz, will be retiring sometime in the near future, pending the hiring of his replacement. There are always risks with a change at the top, but we see his retirement as more a function of having largely completed the cost-driven turnaround, and as PBY gets closer to adopting new initiatives to drive top line, we believe new blood with fresh ideas may be a good thing for PBY. Secondly, as mentioned earlier, PBY will be implementing a significant upgrade to its systems at the store level, with its obvious associated risks. However, we believe the benefits of the new system far outweigh the interim risks, as our understanding is that it should increase the stores' productivity dramatically and make for a more seamless operation between the Retail and Service ends of the business.
Summary. During the past two years, PBY has done an excellent job managing through the economic downturn and has nearly completed what we consider to be the first phase and heavy lifting of a large turnaround - that being right-sizing the company and squeezing significant costs out of a once-inefficient business. The full benefits of PBY's efforts should become increasingly clear as it manages the next leg of its transformation, or re-engineering its growth prospects. Part of this effort should, hopefully, be made somewhat easier by a more buoyant economy, but management can do its share as well by orienting the company towards growth through a proper mix of new store openings and sensible, accretive new businesses opportunities afforded by a healthier balance sheet. We feel these opportunities are significant and that, with some sales momentum in the next two years, EPS gains could be meaningfully higher than our conservative estimates reflect.
Catalyst
Continued strong FCF generation through 2003 will put PBY in a position to once again invest in the business to spur top-line growth. Having largely completed its cost-based turnaround, PBY is now well leveraged to a sales pickup and, we believe, EPS may be meaningfully higher than current conservative estimates reflect.