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.

Guide To Oil And Gas Plays: We've got your comprehensive guide to oil and gas shales in North America.

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.

Related Articles
  1. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  2. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  3. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  4. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  5. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
  6. Stock Analysis

    Analyzing Sprint Corp's Return on Equity (ROE) (S)

    Learn about Sprint's return on equity. Find out why its ROE is negative and how asset turnover and financial leverage impact ROE relative to Sprint's peers.
  7. Stock Analysis

    Why Alphabet is the Best of the 'FANGs' for 2016

    Alphabet just impressed the street, but is it the best FANG stock?
  8. Investing News

    A 2016 Outlook: What January 2009 Can Teach Us

    January 2009 and January 2016 were similar from an investment standpoint, but from a forward-looking perspective, they were very different.
  9. Mutual Funds & ETFs

    3 Vanguard Equity Fund Underperformers

    Discover three funds from Vanguard Group that consistently underperform their indexes. Learn how consistent most Vanguard low-fee funds are at matching their indexes.
  10. Investing News

    Alphabet Earnings Beat Expectations (GOOGL, AAPL)

    Alphabet's earnings crush analysts' expectations; now bigger than Apple?
RELATED FAQS
  1. How do dividends affect retained earnings?

    When a company issues a cash dividend to its shareholders, the retained earnings listed on the balance sheet are reduced ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  4. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  5. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  6. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center