| 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 (in $M): | 700 | TEV/EBIT | 9.4x | 8.1x | |||
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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:
| 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:
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