Dismal Economy Propels Auto Parts Retailers: Is Pep Boys Last to Follow?

A bad economy is good for the retail auto parts sector. Consumers are not buying new cars, but instead are attempting to extend the lives of their old cars. This necessitates more maintenance, as vehicle "wear and tear" starts to take its toll.

The sector's main players are running on all eight cylinders. Both AutoZone (AZO) and O'Reilly Automotive (ORLY) are selling at all time highs, while Advance Auto Parts (AAP) is about 17% from its high- quite an accomplishment, considering the fact that the overall markets have lost nearly 50% this past year. In other words, this group's relative strength is off the charts. The only one late to the party is Pep Boys (PBY), and it is so late, it has already "turned out the lights", as its shares are trading near historical lows. Talk about one extreme to another!

Sales momentum and gross margin health: AAP's first quarter results were stellar, its comparable sales increased 3%, coupled with a 140 basis improvement in gross profit margin from 47.1% to 48.5%. Wall Street was so impressed, it promptly rewarded it with a 16% jump in its share price. ORLY's results were even better: comparable store sales rose 4%, while gross profit margin expanded 150 basis point to 46.25%. Sales were up a whopping 84%, thanks to last year's acquisition of CSK Auto. ORLY's impressive report, hiked its shares up 18% in a single trading session.

The dog of the group: PBY is the dog, and don't forget to add the fleas. This undisputed fact makes it a perfect candidate for those wishing to invest in this sector without buying at all time highs. The beauty of it is: you can still purchase this stock at an all time low, even though its sector is on fire. You just have to have the risk tolerance to do so. Higher risk presents higher returns.

Translation: PBY offers by far the most opportunity for improvement within the sector. Its gross profit margin, at a mere 24.7%, stands at about ½ its competitors. In an effort not to skew gross margins, it is relevant to point out that PBY is the only auto parts retailer that includes its store labor costs in computing its gross profit margin. As a consequence, PBY's SG&A costs of 25.8% are much lower than its peers, since its labor component is absent from its SG&A calculation. (AZO, ORLY and AAP average a 38% SG&A burden).

ORLY's stock gained about $700 million in market cap in just one day. That staggering figure represents more than four times the entire $161 million market cap of PBY. ORLY's market cap of $4.5 billion is nearly 28 times greater, yet PBY's sales are just 33% less than ORLY's. PBY owns a real estate portfolio worth over $1 billion (ORLY owns no real estate). PBY has a current dividend yield of almost 9% and offers service through its 5800 service bays. ORLY does not offer service or pay a dividend. ORLY is selling at 3 times book value, while PBY is selling at about 1/3 of book.

Why are PBY's shares so low? Simple: the market is spooked due to its inability to generate a profit as well as its $320 million pile of long term debt. I think the fear is overblown, if things were that bad, PBY would not continue paying its 27 cent annual cash dividend, nor would a consortium of banks agree to offer the company a new $300 million credit line, which closed last month. The point is, how else are you supposed to buy low, unless the stock you intend to purchase is wildly out of favor? PBY fits this category to a tee.

PBY's expectations are low: next month, Manny, Moe and Jack are expected to report 4th Quarter earnings. Analysts are forecasting a 11 % sales decrease to $460 million, compared to $518 million reported in the similar period last year. PBY is expected to show an improvement on the earnings side, with a 12 cent loss versus a 39 cent loss. These forecasts could be too low, as PBY's CEO, indicated expectations of a profitable new year.

Could Management be "catching on" to the old Wall Street game of under promising in order to over deliver? Only time will tell, but patience is certainly a virtue when it comes to holding on to these shares. PBY's recent $20 million cost cut announcement, as well as its strategy to increase sales by compensating employees based on their performance, appear to be paramount actions on their road back to profitability.

The stock is cheap at this juncture, and warrants a second look, as it could either rally from an operational improvement standpoint or as a takeover play. The lower the company's share price falls, the more vulnerable it becomes as an acquisition target.

Bottom line: PBY is seriously undervalued in relation to its peers. The market seems to be pricing the stock based on a chapter 11 outcome. There is no doubt that this scenario makes the company worth more "dead than alive" at this juncture. The last time the shares were this low, back in Dec of 2000, they experienced an incredible run-up, climbing more than 700% to $28, in just four years. Could history repeat itself? It often does, and Activist Shareholder Glenhill Advisors seems to be banking on it, as it recently reported doubling its stake to 15%, becoming PBY's single largest shareholder.

Disclosure: Long PBY

Comments

[socphd71:]

Why would a company losing money pay a rich dividend? Insiders hold almost 11% of the stock; could that have something to do with the dividend?

You say the gross profit margin is 24.7%; on the Yahoo finance site the ttm profit margin is -0.89%. How do you explain the difference? Don't you think the banks which came up with a $300 million credit line will want to get their money bank (with interest)?

I think the dividend will have to be reduced or eliminated, even if the company becomes profitable.

Feb 22 08:54 PM

[Mark Krieger:]

YHOO Finance's site indication of a -.89% profit , represents operating margin ( profit after Selling, Genral & Administrative costs are taken out). My figure is computed only by taking cost of goods sold from revenues. The $300 million credit line was extended to PBY just last month, and is in addition to the $320 million dollar debt they have already borrowed.The Banks would not be offering a new loan to PBY if they were not confident about being repaid.The dividend is still not an issue, PBY's free cash flow is still high enough to cover it.

Feb 23 08:32 AM

[socphd71:]

Mark, I couldn't help but think about your article this am while I was doing my household. Cramer advocates buying the "best" in a group of similar companies. You've made it quite clear that PBY is the "worst" of the auto parts retailers. Buying the "worst" needs extra persuasive arguments.

I also wondered about the billion $ real estate "portfolio." With residential and commercial real estate prices still falling in many parts of the country, how current is that figure? If you say that they own their stores instead of renting them, then they have all the owner's expenses. This should make it harder for them to close their most unprofitable stores. Their competitors need to re-negotiate with frequently strapped landlords; PBY is stuck with an empty storefront whose taxes still need to be paid.

Feb 23 07:30 PM

[User 367346:]

Mark:

You're dead on about your PBY assessment. This stock is a great buy right now and not just because of the low share price. Their upside is the greatest -- although ORLY has a tremendous opportunity by infusing their commercial sector prowess into the CSK stores -- but because of their balanced approach in DIY and DIFM.

That's why you're observation "Its gross profit margin, at a mere 24.7%, stands at about ½ its competitors...In an effort not to skew gross margins, it is relevant to point out that PBY is the only auto parts retailer that includes its store labor costs in computing its gross profit margin". This needs further explanation: PBY has to add its labor into its GM number because of its mix of business - service work aka DIFM - as this is treated as production sales, not just straight retail & commercial over-the-counter sales as with the other three competitors.

Over the past four years, the revolving door in the executive suite has not helped position them for the opportunities that the market offers them today. That appears to have been remedied. Importantly, they have reinvigorated the “Manny, Moe and Jack” branding as a marketing device. This should pay off for them with baby boomers in their core markets of the northeast and all of California.

All four are positioned for great upside in sales and earnings because of the counter cyclical nature of their biz models. But AZO is seriously over priced. Its comparable sales growth is nearly non-existent and it cannot take much more out of its cost structure without reaching diminishing returns – i.e.: not enough labor to handle the demand (stand in an AutoZone on a Saturday morning and see if you can get waited on in less than 30 minutes) and their inventory position at the store level is weak at best (after standing there for 30 minutes, if you need 6 SKUs for a front axle brake job, its unlikely they’ll have it all on your first visit). Not to mention that AZO does not pay a dividend and most likely never will.

So if you want to invest in retail and you don’t care for the big box guys, these auto retail stocks – while not sexy – show great promise and Pep Boys and O’Reilly should both be fast tickets.

Mar 01 07:10 PM

[Chas Justice:]

Since the Dow >12,000, I have kept my cash position at approx. 77% for the fund. I have been waiting for an opportunity like this since the acquisition of Gateway by ACER. I am not saying that an acquisition is imminent in the short-term. However, short & long-term opportunities are unreal with this stock. In the current climate PBY the highest risk reward potential, for both the short & long term, I have come across in a long time

I am allocating 35-45% of my cash position to this company. I have turned a 17% return in 08', 33% in 07', & 15% in 06'.

Chas Justice
Justice Management Team
Special Situations Desk
[e-mail]

Mar 01 10:30 PM