Will Pep Boys Ever Show Real Growth Again?

By Stephen D. Simpson, CFA | December 05, 2012 AAA

By and large, the U.S. retail world is not forgiving to companies with failed business plans. And yet, Pep Boys (NYSE:PBY) continues to stubbornly hang on. Despite a turnaround process that is going on 15 years now, it's still unclear to me how the company has a leveragable competitive advantage in the auto parts or service market. Although improvement to just sub-optimal levels of performance (relative to industry standards) would likely drive decent gains in the stock, I'm not sure Pep Boys is a stock for any but the most risk-tolerant turnaround investors.

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Can Poor Performance Still Be Called a Surprise?
Expectations were not all that high for Pep Boys going into this quarter, but the company still came up short.

Revenue fell more than 2%, as merchandise sales fell 3% and service sales climbed about 1%. On a comp basis, sales fell almost 3% (-2.7%), with service up slightly (0.2%) and merchandise down 3.5%. Pep Boys also reports adjusted figures based upon how/where the sales are generated, and by this standard service comps were flat (with transactions up 3.4%), while merchandise comps were down more than 5%.

Pep Boys' margins continue to erode. Reported gross margin fell 150 basis points (BPs), with merchandise margins down half a point and service margins dropping five points (and into the red). On an adjusted basis, the company reported that merchandise margins were up 30bp and that service margins were up 40bp. Operating income was down almost three-quarters from last year's level.

SEE: How To Decode A Company's Earnings Report

Some Ideas Just Can't Be Saved
As I said in the intro, Pep Boys has basically been in perpetual turnaround for about 15 years now. Unfortunately, I think the company continues to pursue a strategy that is fundamentally flawed and unfixable - the joint merchandise/service approach.

Pep Boys has never been as good at service as Midas, Meineke or Monro Muffler Brake (Nasdaq:MNRO), though that is admittedly harder to prove now that there are so few publicly traded service companies. At the same time, the company has been out-executed by parts retailers such as AutoZone (NYSE:AZO), Advance Auto Parts (NYSE:AAP) and O'Reilly (Nasdaq:ORLY).

Pep Boys has been actively trying to drive more service traffic, but it's hard to see the benefits so far. By focusing on low-margin transactions such as oil changes, the company is bringing more customers to the stores (transactions were up nicely), but the margins aren't attractive and it doesn't look like offering low-cost servicing as a loss-leader is helping the business. Making matters worse on the service side, retailers such as Wal-Mart (NYSE:WMT), Costco (Nasdaq:COST) and BJ's have stepped up their service offerings through warehouse clubs as an additional perk for members.

On the retailing/merchandising side, I think Pep Boys has several troubling problems. For starters, many of the firm's stores are no longer in highly-desirable locations and they require ongoing capital for improvement/refurbishment. At the same time, they're arguably too big to run efficiently. Not unlike Best Buy (NYSE:BBY), Pep Boys likely finds itself with more in-store space than it can use, and it's not really possible to shrink an existing store. Last but not least, Pep Boys has been slow to really embrace the online sales possibilities for its brand, and I'm not sure a greater focus on this area can really pay substantial dividends anymore.

SEE: Is Online Shopping Killing Brick-And-Mortar?

The Bottom Line
I'm not sure what a retailer can do when it has too many stores in the wrong places and its stores are fundamentally too large for the business. Likewise, even if the company would get out of the service side of the business, I'm not sure it would really help all that much - it would just create more dead selling space. Although retail turnarounds are possible (take a look at Pier 1 (NYSE:PIR)), often they are based on better merchandise assortments, and I don't think Pep Boys' fundamental problem is the merchandise assortment, but rather the very structure of the business.

If Pep Boys could lift its free cash flow (FCF) margins into the low-mid single-digit range, I suppose there's value in these shares. Unfortunately, while I don't think Pep Boys is in any imminent danger of going away, I just don't see how this company is going to close the gap on rivals such as AutoZone, Advance or O'Reilly.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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