Pep Boys: A No Brainer Takeover Target

Pep Boys (PBY) has had its share of problems, and the market has certainly not shown any sympathy in the process, beating the shares down to all time historic lows. The stock is so low, that PBY’s annual cash dividend of 27 cents represents a mindboggling 10% yield. The company, which operates 562 locations, has significant real estate holdings (it just completed selling 22 properties for $77 million in a sale leaseback transaction while retaining 240 properties) and is the only company capable out of the big four (AZO, ORLY, AAP and PBY) of also installing what it sells through 6000 service bays. These service bays' bread and butter are the installation of new tires and brakes, which are nondiscretionary items.

More consolidation in the sector? ORLY scooped up CSK Auto for next to nothing last year when it hit bad times. The deal was pure genius, as it acquired the company through a stock swap requiring it to dish out only $1 per share in cash, while assuming CSK’s debt. Will there be more acquisitions in the auto parts retailing sector? It would not be surprising at all, especially considering the decimated market caps some of the players have experienced.

Enterprise value: EP is a good gauge of what a company would be required to lay out to acquire a competitor, because it takes into consideration how much debt must be assumed, less the company’s cash on hand. PBY’s current market cap is $157 million. If you subtract its cash of $38 million and add its debt of $331 million, an enterprise value of $450 million is computed.

AAP’s buyout scenario: AAP could acquire PBY for about $450 million representing only 15% of its market cap of $2.98 billion, while juicing up its top line by 36% from $5.21 billion to $7.14 billion (by picking up PBY’s annual sales of $1.94 billion). AAP’s debt would increase by about 50% from $653 million to $984 million (it would assume PBY’s debt) and it would incur some dilution, but the deal would certainly be accretive to earnings right out of the gate. AAP’s shares outstanding would swell by about 5% from 95 million shares to 100 million shares.

AZO’s high debt: If AZO acquired PBY, its debt would increase about 15% from $2.27 billion to $2.6 billion. The deal would represent about 6% of AZO’s current market cap of $7.64 billion. AZO’s top line would grow about 29% from $6.57 billion to $8.5 billion in a successful integration scenario. AZO would have to print up an additional 1.1 million shares required to swap to PBY holders, representing a 2% gain from 57 million shares to 58 million shares.

ORLY buying one more time? If ORLY decided to pursue PBY, its debt would rise about 50% from $665 million to $996 million, with the acquisition representing about 12% of its current market cap. ORLY’s sales would increase 41% from $4.69 billion to $6.62 billion. Its outstanding shares would likely increase from 135 million shares to 140 million shares, if a deal with PBY was ultimately consummated.

Why PBY is vulnerable: The stock has reached such low levels, it could be worth more dead than alive at this juncture. This scenario often produces opportunists wishing to exploit the situation. The vultures could be starting to circle. Management has done a poor job communicating its turnaround vision with Wall Street. The company has stressed it seeks to get back to basics by providing better customer service and more relevant inventories, but its quest to acquire 20-30 repair shops is perplexing and contradictory to say the least. Why would management want to take on another project, when they are still unsuccessful getting their own house in order?

Bottom line: PBY has gotten so cheap that many of its competitors could easily pick it up without batting an eye. Furthermore, the company is susceptible to being dismantled by a private equity firm looking to make a fast buck. The company’s financial condition could not be as bad as it seems, as PBY just reported, the closing of a new $300 million credit facility at a reasonable interest rate (LIBOR plus 3%) with a consortium of banks. The syndicate of lenders included B of A, Wells Fargo and Regions Bank. It was a notable accomplishment in light of“very tight credit markets, and the deal surely emphasizes the lenders' continued confidence in Pep Boys.

Comments

[Roger Knights:]

With gas down, people are driving again, but they aren't buying new cars. So PBY's next earnings report (in March I think) should finally be in the black, because sales should improve. If it can continue to bring in cash to buy up its bonds, that should show that it is survivable on its own, and needn't accept a low-ball offer. So I hope it waits awhile until selling.

Jan 22 04:31 PM

[User 342877:]

They are bringing in cash to pay off bonds through sale-leasebacks. Isn't that just off balance sheet financing? Would a competitor want to buy PBY with all the off balance sheet financing through operating leases? As of their last 10-k PBY had 584m in operating leases.

Jan 23 12:12 AM

[Mark Krieger:]

it is not a off balance sheet financing. The real estate is listed on the same balance sheet as the debt. The real estate value is listed on the asset section of the balance sheet at cost less depreciation. Cost does not reflect market value, in fact all of PBY's real estate has appreciated tremendously, but this appreciation is not reflected on the balance sheet. There is about $1 billion of real estate value waiting to be unlocked through additional sale lease backs--the balance sheet shows an entry of $173.1 million under the liability section of the balance sheet--this entry is listed as "deferred gain from asset sales"--it is cleaverly hidden, but it represents the amount PBY has garnered in it monetization of its real estate assets..


On Jan 23 12:12 AM User 342877 wrote:

> They are bringing in cash to pay off bonds through sale-leasebacks.
> Isn't that just off balance sheet financing? Would a competitor want
> to buy PBY with all the off balance sheet financing through operating
> leases? As of their last 10-k PBY had 584m in operating leases.

Jan 23 09:00 AM

[CrR:]

Pep Boys doesn't have the customer service level required to compete with their competitors. Their only advantages over their competitors is that they offer tires and rims and have a much larger retail inventory. They are also competitors of their own installer customers by offering service repairs at the store. Installer customers make up half of O'reilly's revenue. Pep Boys should focus on providing excellent customer service, by having the right parts on the shelf, prompt delivery times, and going the extra mile for every customer. Its the basics that make successful companies successful.

Jan 30 11:30 PM

[Joseph Dubao:]

No auto parts retailer has the market share in terms of customer service. They all have their hits and misses. With a new line of credit, PPY will be around for some time .

Feb 04 01:25 PM

[metroman:]

Having worked for AAP for more than five years and as a customer for ORLY, Pep boys has a hellava long way to go to approach either of these two in service, facility, inventory and attitude. You walk in a store and its dirty, stock out of place or empty shelves, a weird mix of merchandise and not always the helpful/outgoing employees that should define a service business. Maybe if the just turned the DIY part of the stores into a laundromat and just utilized the back areas for the shop to store inventory necessary to operate the service bays. Maybe add a SUBWAY for hungry customers. Just a thought.

Mar 25 04:18 PM

[wb2006:]

I currently work for PBY (3 years) and agree with everything that you said about the lack of cleanliness in the stores and lack of help from the employees. Most stores are now allotted so few hours that they can only afford to keep 1 counter person through the entire day. This has turned customers off and caused them to shop elsewhere (even employee's are beginning to do this as well). The only edge that PBY seems to have is the service bays, and the comments coming from customers are very poor. The service provided by poorly trained individuals is so far below the level that it's not really worth mentioning. I do not know very many people (employee's included) that would trust a PBY service dept to touch their vehicle due to more than one bad experience with the company. Currently the commercial dept is the only dept company wide that is prospering, and they are fighting in the dirt with all the competition. PBY has withheld raises from all store employee's for 2 years now under the guise that they are attempting to return to a profitable company. They have difficulty retaining many employee's and those that are still there (like me) are there for a specified duration due to life changes. It is not a career company. I would not be surprised if another company bought them out similar to CSK experienced.


On Mar 25 04:18 PM metroman wrote:

> Having worked for AAP for more than five years and as a customer
> for ORLY, Pep boys has a hellava long way to go to approach either
> of these two in service, facility, inventory and attitude. You walk
> in a store and its dirty, stock out of place or empty shelves, a
> weird mix of merchandise and not always the helpful/outgoing employees
> that should define a service business. Maybe if the just turned the
> DIY part of the stores into a laundromat and just utilized the back
> areas for the shop to store inventory necessary to operate the service
> bays. Maybe add a SUBWAY for hungry customers. Just a thought.

May 19 07:54 PM