To this day, whenever I hear the tune "looking for love" I think of Mr. Murphy's "Wookin' Pa Nub" skit. But as I listened to the replay of the Pep Boys conference call, the song "Wookin' Pa Nub" (in all the wrong places) just kept ringing in my ears.
All of us on Wall Street look for a "story." And the story that seems to be emerging with Pep Boys (PBY), is that the company is finally making headway in its struggling service bays. Specifically, as you may have seen last week when the company reported earnings, the gross profit margins in the company's service bays improved to 21.8% in the fourth quarter versus 16.4% in the prior year period.
In other words, if you took your car into Pep Boys for repairs and spent $100 (let's say on an oil change, a tire rotation, and a new headlight), after Pep Boys had paid for the parts as well as paying the dude (or dudette) that actually did the repairs, Pep made $21.80 (before indirect operating expenses like advertising, electricity, and administrative stuff like accounting). Last year, in theory, for the same parts and work, Pep Boys only made $16.40 on every vehicle it fixed in its service bays.
To boot, the company just hired a new CEO (Jeff Rachor) who has some 20+ years of experience in the automotive industry, most of the time (by default of his positions) ultimately being where "the buck stopped" as far as who was responsible for performance out of the car dealership service bays. Who better than Mr. Rachor to really get the gross margins in Pep Boys service bays back on track?
And you could sense this "story" emerging on the conference call. As a number of different questions in various forms and fashions focused on what the margin potential of service bays really could be. Frankly, I think investors are wookin' pa nub.
Understanding the service repair business and business model
To begin, I think it is important to understand how the service repair business model works. My vehicle breaks down, or some error light begins flashing on my vehicle's computer. If my vehicle is one, two, sometimes (nowadays) even up to five or six years old, I almost immediately take it to the dealer because chances are the problem is covered by the warranty. When it starts getting up to the 4 - 7+ year old vehicles, I start taking it elsewhere (because it just doesn't seem "cost competitive" to take it to the dealer and chances are I am not even the original owner who bought it from the dealer since American's turn over their vehicle every four years).
Auto parts retailers and even "jobbers" (the folks that sell parts to these independent repair shops that primarily cater to these older vehicle customers) refer to the 7+ year old vehicle market as the "sweet spot." AutoZone has even coined these vehicles as "our kind of vehicles" or (OKVs).
If you remember my note on March 8, 2007 I said that Safecarguide and the US Department of Transportation say about half of all registered vehicles are over 8 years old. And roughly a third of them are 10 years old or older (with an average vehicle life span of 13 years).
And using more recent data, R. L. Polk and Company (one of the leading automotive intelligence groups in collecting and interpreting data), issued a press release in February 2007 saying that nearly 36 out of every 100 vehicles are 11 years or older. So it seems like there is a pretty big market for these older vehicles.
I have to admit, I am not sure how useful and relevant the data tends to be when we are trying to determine the size of various segments of the automotive aftermarket. For example, while Polk indicates nearly 36 out of every 100 vehicles are 11 years or older, they also say that only 5 out of 100 vehicles are "scrapped" every year. Think about this for a second. If at age 10 or 11 I am more than a third of the vehicle population, and then I am done (on average) at age 13, shouldn't the scrappage rate spike up to something like 30+ at some point?
Instead, the number of vehicles being scrapped (as reported in the Polk press release) hasn't changed by more than one or two vehicles (out of every 100) from 5 over the last 16 years. Now, in part this mystery can be explained (I suspect) because the actual lifespan of the vehicle continues to increase. So, for example, next year the average age of the vehicle might be 13.5 years old, and in a few years 14 or 15 years old. But it still seems like a pretty big disparity. I wonder if (for example) the roughly 29 out of every 100 vehicles that went through Copart's auctions (a leading salvage auction company) ending up in international markets that we heard them talk about on their 2Q07 conference call last week in some way skews this calculation?
And that brings me to another confusing aspect about the industry data. Last August I talked about how if you took the Automotive Aftermarket Industry Association [AAIA] and census bureau data you find that only about 6% of the vehicle repair outlets in the United States are at car dealerships, but they account for about 40% of all of the revenues in the industry. Now I understand this does not take into account the number of service bays (i.e. 30 bays at a Mercedes dealership versus maybe 2 at a Jiffy Lube). But if the vast majority of the "work" on vehicles are done when they get older (as most industry studies seem to suggest), why are car dealers (who tend to service the younger vehicles) commanding such a big percent of the market with so few outlets?
I don't know the answers to these questions. I just want to point out that there are a number of anomalies (irregularities) in the data that make it difficult to determine the true market size/potential in the automotive aftermarket.
Importantly, and in either case, whether my vehicle is 2 years old or twenty, whether I take it to the Mercedes dealership or Jiffy Lube how the repair shop arrives at gross profit is the same; they charged me for labor and the part less what they paid for the labor and the part.
Let me be very clear about how this works. You come in for a brake job. Usually (and this varies widely by the type of job), repair shops keep about $60 - $70 out every $100 in "labor" and $30 - $40 out of every $100 in what they charge for the part (so it averages out to a total gross of $40 - $60 for each job).
Let's simplify the numbers a bit and assume the parts for the brake cost $25, and Chilton's guide or the manufacturer's warranty says it will take the technician one hour (at $25 an hour) to complete the job. So the repair shop owners all in costs are $50. They double the price of the parts, and double the labor hours, and tell the customer it will cost $100, and so the gross profit margin is 50% (meaning the repair shop gets $50 for the $100 they are charging the customer).
An important distinction to make at this point, if the technician completes the job in 45 minutes (instead of the prescribed one hour) the price of the service does not change. And if a technician and shop can do this all day long, well then over the course of 8 hours, the technician can get 10 "billable" hours in an 8 hour work day. This tends to be the goal. The productivity you hear most service repair shops talking about. Getting something like 10 billable hours in an 8 hour workday, or 125% productivity.
Now could I mark up the prices even more, and get a higher gross profit? You bet, but you need to be tracking lost sales then in order to make sure you are not chasing away more business, than what you are gaining by charging above market rates. And you also need to be careful because when you are dealing with warranty or insurance work, as I indicated, the pricing is generally set by things like Chilton's guides and the manufacturers' warranty.
Toward a working expense structure
So why did I walk you through that excruciating level of detail? Well, because there are several important implications you need to take away from understanding how the service repair business works. First of all, Pep Boys is probably fixing older vehicles (7+ years), and the owners probably are not even the original owners.
And did you notice that pricing was generally based on costs? And as a result, the gross profit margin (as a percent of revenues) really isn't what determines a repair shop's profitability.
Now maybe (as management indicated on the conference call) the gross margin as a percent of revenues improved because they stopped so much discounting and "paying up" for labor. But this suggests that they are simply are correcting from a serious misunderstanding about how to approach the business in the first place (meaning you should not have been trying to "discount").
However, I am not convinced Pep Boys has a gross profit problem. Pep Boys has about 6,000 service bays, which means (based on the company's reported $881.3 million in gross profit in the service side of the business), they generated a little less than $150,000 in gross profit dollars per bay ($153k in fiscal 2007, $147k in fiscal 2006). Based on a 53 week year, this works out to roughly $2,900 in gross profits per week, per bay. And on a 6 day workweek, it comes out to about $480 per day, per bay.
Now if I look down the street at a competitor (Monro Muffler), I can find in their annual report (granted their fiscal year ended March 25, 2006 so a slightly different time frame) a store count of 544 service stores and 81 tire stores, with an average of 6 bays at service stores and 7 bays at tire stores, I come up with a total of 3,831 bays. Based on a gross profit of $147.8 million, this works out to roughly $38,583 per bay, or $740 a week.
My point? True, while I have been concerned about Pep Boys ability to mark up the cost of the product like a Monro could (i.e. Monro could buy the brake parts from a NAPA or themselves for $25 and mark up to $50 whereas for Pep's retail side to remain competitive they are stuck charging $25), I actually don't think gross profits are the entire story. As you can see, Pep actually generates a fair amount of gross dollars per bay.
What I don't know, however, is what indirect costs (i.e. support staff/marketing expenses, and fixed expenses like air conditioning and lighting) are incurred to generate these gross dollars. In the case of Monro, the indirect operating costs (we tend to call it selling, general and administrative expenses) were roughly $73 out of every $100 in gross generated in fiscal 2006 and $70 out of every $100 in the first nine months of fiscal 2007.
Now, in part, I am probably comparing "apples and oranges" because Monro includes "occupancy" costs (i.e. your lighting and A/C for that area), in the gross. And it is very difficult to "allocate" the indirect (selling, general and administrative) expenses between Pep Boys retail and service operations, so they do not. But when you look at Pep Boys total selling, general and administrative expenses as a percent of total gross profits (retail and service), you come up with the company spending about $96 in selling general and administrative expenses for every $100 in gross profits they make. (Talk about a thin margin!)
This is where the real challenge resides. Appropriately aligning the organizations operating expense structure with the profits that are generated. Now we can go on and on with different theories about ways to improve the company's customer relations management [CRM] systems (so their marketing costs are more effective), maybe change the role of the service writer, and possibly introduce dealership principles like lateral support or Advance Production systems. Even shifting the company's store base more to a variable compensation system (something I've advocated in a number of areas in the automotive aftermarket).
But it begins with thinking about the return on sale as encompassing the entire operating costs associated with the sale, not just the gross. Otherwise, we're just wookin' pa nub.
And finding a purpose: why are we here?
And speaking of wookin' pa nub. Before we can think about the expense structure of the organization, I think Mr. Rachor has an even bigger question to raise to the associates at Pep Boys. Marc Cannon (AutoNation's (AN) Senior Vice President of Corporate Communications) has been calling me the last couple weeks (another refreshing change of events where I am actually now hearing about some of the positive things going on at AutoNation) and keeps asking me if I have something nice to say about Mike Jackson (AutoNation's CEO). So here it goes.
I was told by John Zimmerman (AutoNation's Director of Investor Relations) several years ago that one of the first things Mr. Jackson did when he took charge and began focusing the company on the franchised auto retail business (getting out of businesses like advertising signs, salvage parts and car rental companies), was that he went in front of all of the company's store General Managers (and I presume other execs at the company) and asked a simple question: "why are we here?"
And the reason he raised it, was because the company (and its associates) right there and then needed to decide why they were there. A lot of bright and successful entrepreneurs can run a dealership. So why do they need to be a part of a larger organization? And some of the company's General Managers came to the conclusion (over time) that they did not need to be a part of this larger organization.
But asking this question set the purpose, the direction, if you will for AutoNation (and so many of other large franchised auto retailers) to begin focusing on this idea that there needed to be a reason all of these dealership groups were part of a larger organization. That there is a benefit, an economy of scale that exists from being part this big bad "corporation."
Whether the story is true or not, whether you think AutoNation or any of the other auto retailers are succeeding in this endeavor should be left for another debate, another note. The point is that before any expense structure questions are raised and addressed. Before any successful turnaround can be enacted, a simple question needs to be raised: "why are we here."
I will tell you after studying and watching Pep Boys history, I do not see this clear purpose. In fact, after searching the company's web site and SEC filings multiple times, I still did not find the company's mission statement. The closest thing I found was discussions about the company's history, their vision for an "automotive super center," and the statement that "Throughout its history, one thing has remained unchanged: Pep Boys continues to focus on each customer as if the company had only one store."
So maybe unparalleled customer service is the vision/the mission. Maybe it is this notion of a "one stop shop" (although I don't completely understand that as do-it-yourself, professional parts and vehicles owners needing repairs done are generally distinct segments of the market). But the point is that I think this is where Mr. Rachor's journey (as the new CEO) begins. With this simply little question: "why are we here."
I think Mr. Rachor will need to assess the "lay of the land," if you will, determining the strengths and weaknesses of the organization. And from that establish a vision for who Pep Boys wants to be in the coming years.
And so before we (as investors and industry participants) get excited about any margin potential for the company in the coming years. Before we start running the "flow through to earnings per share from higher gross), I think we need to have some patience as Mr. Rachor gets in and assesses the assets (mostly the people) of Pep Boys and begins to determine a direction, a purpose, if you will for the company.
This is what gets me so excited about the Pep Boys story.
The purpose will no doubt evolve over the years (as it has with the franchised retailers, with a particularly encouraging emphasis on the customer experience). But I think Mr. Rachor's accomplishments of helping to lead, inspire, and focus the employees at Sonic on a real vision, a real mission, is a good a sign as any that he can achieve something similar at Pep Boys. Because it focuses on people maximization, not on any particular product or margin target.
And once a direction is set, therefore, the opportunity becomes far bigger than a few margin percentages. We (as investors and industry participants) should actually have a real (dare I say "growth") story about where the company is headed, and what value the company is bringing.
PBY 1-yr chart: