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The Pep Boys – Manny, Moe & Jack (NYSE:PBY)

Q3 2007 Earnings Call

November 28, 2007 8:30 am ET

Executives

Harry Yanowitz – CFO

Jeffrey Rachor – President, CEO

Analysts

Matthew Fassler - Goldman Sachs

Tony Cristello - BB&T Capital Markets

Scot Ciccarelli - RBC Capital Markets

Jeff Glazier - Morgan Joseph

Cid Wilson - Kevin Dann & Partners

Operator

Greetings and welcome to the Pep Boys third quarter 2007 conference call. (Operator Instructions) It is now my pleasure to introduce your host Mr. Harry Yanowitz, Chief Financial Officer. Thank you Mr. Yanowitz, you may begin.

Harry Yanowitz

Good morning, and thank you for joining us as we discuss Pep Boys third quarter financial results for fiscal 2007. I’m Harry Yanowitz our Chief Financial, with me today are Jeff Rachor our President and Chief Executive Officer and Bernie McElroy, Vice President and Chief Accounting Officer.

The format of today’s call is as follows; first, Jeff will provide opening comments, I will do a briefer than usual review of our third quarter and then Jeff will devote the bulk of our time today to provide an overview of our five year strategic plan. Following this presentation the three of us will be available to answer any of your questions.

Before we begin I’d like to remind everyone that this conference call is governed by the language at the bottom of our press release concerning forward looking statements as well as SEC regulation updates. In compliance with these regulations we are web casting the conference call on www.investorcalendar.com for anybody on the web cast who does not have the financial statements you can access them at our website www.pepboys.com.

I’d like to now turn the conference call over to Jeff Rachor our President and CEO.

Jeff Rachor

Thank you Harry, good morning. This is Jeff Rachor, President and CEO of Pep Boys Manny Moe & Jack. Thank you for joining us this morning. We recognize the importance of the investment community and appreciate each of your spending the time to learn more about our enterprise and where we are headed.

Before we get started, I think that it is worth acknowledging that we recognize that Pep Boys historic performance and business model has clearly not met the company’s expectations or the expectations of our shareholders. Since my arrival at the company we have begun to put the pieces in place to turn our enterprise towards a much brighter and more prosperous future. I’ve worked alongside of our leadership team to gain insight into the unique challenges represented by the Pep Boys business model. Together we have executed a number of tactical initiatives to target improved performance and to reveal the root causes of many of Pep Boys historic challenges. These efforts are already making a difference and in many ways are supporting the organization in moving forward in the midst of increasingly difficult economic headwinds.

I’m excited to share with you today the results of our efforts and a strategy to move us forward. One important milestone for our company that I would like to highlight is that this is the first quarterly discussion where I can say that we have the executive team in place that will carry us toward the future and I can confidently point to our leadership as a strong industry focused team with the capability to make a tremendous difference at Pep Boys. In fact, they already have.

Let me reintroduce an important member of our team and let Harry share with you our third quarter 2007 earnings results.

Harry Yanowitz

Thank you Jeff, and thanks for joining us this morning for an abbreviated review of Pep Boys third quarter 2007 earnings results ease of comparison we provided a supplemental line of business information page as the last sheet of our press release that presents the performance for the quarter including a pro forma for our restructuring. I will refer to this information in my remarks this morning.

We reported a net loss of $0.42 per share after a $0.50 per share restructuring charge this quarter. Before that charge we reported substantial operating improvements supported by continuing improvements in our service business and reduced SG&A costs. Importantly for us, in a difficult macro environment we saw a positive 4.5% comp up against a positive 4.8% in last years quarter three in our service business and a gross profit rate improvement in our service center operations of some 380 bips.

Again, we think that outside of the restructuring, we have stabilized our overall financial performance, started to move that financial performance ahead and are now in a position to start pushing ahead on our new strategic plan.

The restructuring charge we announced this morning largely reflects the merchandising changes Jeff will speak to in our strategic plan reflecting the costs of substantially narrowing our merchandise focus down to a more productive core automotive offering. As we will discuss in more detail, we believe that this will provide a clearer message of our after market focus to customers and employees alike, allow for a stronger merchandise mix of those products and be more productive for us at the net line in the long run.

We simply did not think it was feasible to accomplish this one sku at a time dribbling the cost out over years, so we have undertaken a substantial sell down effort that we plan to complete over the next couple of quarters.

In addition, we have reflected certain legal reserves, the cost of previously announced executive severance and the benefit of a gain on a life insurance policy from a previous officer of the company. In addition, today we closed 31 low productivity stores and expect to report associated store closing costs of $0.22 per share in Q4. Combined we expect those two programs to help our long term profitability and to generate approximately $65 million in additional working capital to be deployed to higher and better uses.

To recap from the adjusted LOB summary, reflecting less emphasis in some discounting in our non-core products and a more difficult economic environment, we had a negative retail comp of 8.1%. This caused some de-leveraging of fixed costs and reduced our overall gross profit rate for retail. On the other hand, as mentioned above, service comps were up 4.5% and gross profit rates improved due to our variable labor pricing initiatives, better staffing and ongoing stability in that part of the business.

Once again, we saw geographic dispersion in the results of our business. Particularly difficult was in Southern California and Florida and strength in the most densely populated store group the Northeast where for instance we saw service comp of 9% positive.

SG&A costs as adjusted were down $7.8 million from last year in the quarter or approximately 80 bips reflecting our ongoing costs reduction programs and overhead expenses, labor costs and other operating expenses. We expect our efforts on this program to continue. This led to an operating profit improvement of approximately $7 million on an adjusted basis and an adjusted net profit improvement from last year.

Thanks again for walking through this abbreviated review of Q3. Jeff.

Jeff Rachor

Thank you Harry. I think you can see that while the challenges we are facing in the marketplace continue, we are actively preparing our enterprise to move forward. I want to share with you now our strategic vision for Pep Boys, the course we will set to change the trajectory of our enterprise. We believe this approach will provide Pep Boys with the chance to gain a market leading position in the automotive aftermarket. Let me start with some quick context.

The automotive aftermarket is a remarkably dynamic industry and we’ve seen a market that has grown in size by more than 45% in the last decade. It has provided the opportunity for some of our competitors to create substantial presence in communities across the United States and we’ve watched as consumer behavior has begun a transition from a focus on product that supports them in doing it themselves towards a greater demand for do it for me services. As we look at this changing industry, we would like to highlight a number of strengths that we believe Pep Boys uniquely demonstrates in the marketplace and provide some insight into the strategy that we’ve chosen.

We are an organization with a national footprint, national brand awareness, and a distribution and marketing system that supports our ability to go to market across a broad geographic presence. The Pep Boys brand remains extremely strong in the consumer testing that we conducted recently. People know Manny Moe & Jack and they know we are an enterprise that they can count on for their automotive needs.

We have a unique breadth of capabilities in the commercial market to provide hard parts, service, tires, and wheels. This allows us a great deal of flexibility as to how we find and meet the consumer’s needs. Pep Boys continues to maintain a strong balance sheet and liquid capitals structure that provides the resources and flexibility to renovate our enterprise.

Pep Boys potential has also attracted a new leadership team with more than 100 years experience in the automotive aftermarket industry. Our outstanding team comes to us with the experience of having positively impacted many of our automotive competitors. On the other hand, we must identify the factors which suggest that our model must adapt. Consider we have not participated in the 45% growth demonstrated by the aftermarket over the last decade. Our historic performance, store count, revenue, profitability, has remained stagnant over the past decade and has lagged all industry benchmarks. Quite simply, we have not achieved the promise that our enterprise truly represents.

We have allowed our stores to become surrounded in their markets by fierce competitors. Our sole approach as a destination store has not held up well against competitors that also have the capability to build a local additional and conveniently placed store network. Our competitors have gained ground with a more efficient store footprint, smaller than our average super center for both DIY and DIFM.

Let me share with you some additional context that is important in setting the tone for our strategy. Pep Boys has the capability to build its position in the market that now exceeds $175 billion in size. Additionally, we have the opportunity to play across multiple segments within this market, but for the moment I want to focus on the relative size of the Do It For Me versus the Do It Yourself segments.

The Do It For Me market is more than three times the size of the DIY marketplace. This will become our largest priority for growth as it has demonstrated an ongoing growth potential of more than 4 to 5% per year. Increasing vehicle service age and a continued growth in the number of miles the cars are driven continue to move more vehicles into Pep Boys suite spot and drive demand for DIFM services.

Interestingly, the DIFM market also remains highly fragmented with no one competitor owning more than 1.5% of the total market. With a strong starting position, this provides an opportunity for Pep Boys to gain an industry leading position from our already strong $1 billion annual service revenue base. It is important to face the reality that the DIY market has and will continue to add competitive capacity. The DIY segment has the presence of several substantial scale market players all at a time when the industry DIY customer counts are declining.

While the DIY part of our business will remain very important, objectively it does not offer the industry potential that we find in the DIFM environment. Pep Boys will remain a company with many capabilities and we will define ourselves by our ability to meet the broad needs of the automotive aftermarket consumer. We will regain an industry leading position in this market by establishing ourselves as the automotive solutions provider of choice for the value oriented consumer. Our purpose will be committed to serving the needs of our communities for safe, reliable and fun transportation. We are an organization that cares passionately about cars and the people who drive them. Pep Boys associates are car people.

Pep Boys has traditionally focused on the maintenance, repair and personalization segments of the automotive aftermarket. We believe that we can extend our automotive aftermarket focus into the ownership segment of the market to generate new opportunities and leverage our core competencies into new areas of the business. This includes opportunities to support consumer needs for used vehicle services or rental vehicles, but more on this later.

We would now like to share with you the goals that our strategy must achieve in pursuing this vision. Our strategy must achieve the following; a narrower automotive aftermarket solutions focus, market density and best in class operating performance.

First we will narrow our merchandising focus to clarify the message to the consumer our team and our suppliers. We will be clear in our choices that we are first and foremost a store to find solutions for their vehicle. Second we must build a greater presence in the markets we serve. Our current store footprint limits marketing, distribution and operating efficiencies. Even more importantly it does not reinforce for the consumers the true convenience of how Pep Boys can solve all of their car problems. Finally, in order to deliver on the opportunity that Pep Boys has, we need to lead our industry in operating effectiveness, that is, best in class performance and execution across measures like customer retention, operating efficiency and talent management.

Let me begin to share with you how we will achieve these goals. First we will lead with the Do It For Me segment; this provides us with the opportunity to target a growth market in which we will demonstrate some clear competitive advantages. Right now, while the revenue from our DIFM business remains lower than our DIY segments, the margins we experience are significantly better. We can use our hard parts capabilities to drive competitive advantages for our service space because as the volume of DIFM increases it contributes to revenue and inventory turns in our other business segments.

Right now more than 30% of our hard parts business serves our own service bays and increasing this volume by driving DIFM revenue represents a substantial opportunity for Pep Boys. While we will emphasize our opportunities in DIFM we will continue to support and improve our retail businesses. Again, the characteristics of the DIFM marketplace also provide us with an opportunity to win a leading position in the marketplace, distinguishing ourselves in a way that creates a sustainable leading market position is a critical element of driving improved returns for shareholders and opportunities for our associates.

Next, we will develop a more robust and dynamic core automotive merchandising program. Many of our efforts in this area are already becoming visible in our stores. Ultimately we are committed to the automotive aftermarket and we must acknowledge that the alternate merchandising and marketing focus on non-core products did not generate a sustainable positive impact. More importantly, we have seen that the added non-core product lines distracted us from an ability to focus on our core product competencies and effectively communicate this capability to our customers.

We are committed to a leading hard parts program that supports our DIFM focus, provides a leading DIY assortment, provides a stronger commercial market potential, and improves our inventory and supply chain capabilities. We will achieve these commitments by reengineering our strategic category management process to enhance hard parts and aftermarket merchandising focus.

We are in the process of executing significant category edits within underperforming non-core categories such as personal transportation, power tools, power equipment and others. Exiting this inventory is a substantial effort. While we are dedicated to doing it prudently, and expeditiously, this initiative will be a painful transition impacting the next several quarters performance as we manage the short term sales and margin implications and rebase the comps.

As I will discuss more on this call, there are a number of areas where our super center format can provide a great opportunity for category focus and we see tires and wheels and personalization as key areas of our go forward focus. The efforts to realign our store level merchandizing will be supported by changes in our inventory management and our marketing strategy and will be led by our automotive centered merchandizing team.

As this transition matures our DIY mix shift will result in higher margins and profitable sales. We will focus our resources on the highest performing opportunities. Over the last few months we embarked on a detailed assessment of each Pep Boys location. The result of this effort is the closure of an initial traunch of sale lease back financing of owned stores generating $166 million in proceeds. We anticipate announcing additional opportunities in the first half of 2008. Today we are also closing 31 low return locations. Our choice to close these stores involved a number of considerations including the appropriateness of the location, market performance and the underlying real estate value. We recognize the dynamic ongoing management of our location portfolio is key. These closings are a result that we will avoid in the future by keeping a close watch on real estate market trends and by seeking relocation opportunities when necessary. Through the inventory edits and these store closures we expect to generate $65 million in additional working capital for the company.

I do not believe that any area of consideration has garnered as much interest as Pep Boys use of the super center format and the related square footage. For our typical store footprint our store size exceeds competitive benchmarks in both our service and retail layouts. There is no question that this additional overhead represents a burden to our organization and we have not yet cracked the code on making it work enough to justify the loss in efficiency.

In a few minutes I will talk to our plans to average down our square footage across the system and in the near term we see it as an absolute priority to improve the ability of our stores to optimize the returns of the existing super center format. New product and service roll outs require discipline and we will execute evaluation, pilots and roll outs through a disciplined products and service portfolio management approach. This philosophy has already provided Pep Boys with the opportunity to test a number of promising ideas.

I want to highlight a number of these concepts for you now. The floor plan demonstrated on this slide actually highlights the feasibility of segmenting approximately 3000 square feet of space that could be re-tasked. We are committed to fixing this problem and have already started a number of pilots to addressing it. In many markets we believe this space can be an outright sublet that lowers our fixed overhead. In addition, this alternative will provide a financial guideline to assess the performance of other alternatives that we are considering.

We also have tests underway as our preference is to drive revenue through reconfigured merchandising opportunities of core product like tire and wheels store within a store opportunities creating more attractive waiting rooms or developing the space to service the needs of ownership segments like rental services and even moving towards a variety of used car services. Other companies such as Carmax have had success with the sell your car here alternatives. We believe these services can be provided, certainly initially in a pilot mode without significant balance sheet commitments.

From an expansion perspective, the extra square footage can also provide hub distribution opportunities that will support potential satellite stores. We will speak to this further in just a moment.

Our product and service development program includes opportunities to drive utilization within our service space while not a consistent theme throughout our system we would like to offer our service managers additional resources to drive revenue. In fact, we are already preparing to test window tinting, dent removal, windshield repair and used car reconditioning services. We have also identified pilot stores that will support testing car wash services.

As we move to the top of our upside down pyramid we being to focus on the tiers of our strategy that will provide us with the most significant long term outcomes, the first is our commitment to grow the footprint. Growth will provide us with a number of benefits that we see as absolutely vital. It supports a broader distribution of our overhead, drives turns within our parts inventories, takes advantage of market economies, the brand asset and most importantly expand our exposure to the highest margin, least competitive and highest growth sector of the automotive aftermarket.

We see growth occurring through two primary channels. First, through acquisition, the opportunity to rapidly add bays from local and regional store operators that are already servicing customers and converting them to central sourcing, process and marketing systems. Second, we will develop concepts that support green field growth. We anticipate using a smaller service and tire focus model as the footprint. Again, we will pilot these alternatives to develop the financial characteristics we believe they would have if rolled out across the chain. These programs are in early development and will take time to achieve scale but we are confident in the long term growth potential that they represent.

Building a network of DIFM focused facilities can work as a unit with our existing super centers. This hub and spoke structure clearly would support a more local market presence and promote distribution of parts plus leverage marketing, sourcing and operational efficiencies. Market density will be achieved by adding smaller neighborhood DIFM focused facilities in markets where we can leverage our existing super stores as hubs.

We envision 6 to 8 bay neighborhood service centers that will focus on light and medium repair and maintenance on tires on heavy repair referrals and offer light retailing such as impulse items and special order capabilities. We also envision a lean staffing model with a technician management component. The super centers or hubs would serve as our brand flagships offering a full line of maintenance and repair services including heavy DIFM services. The hubs or super centers would carry a deeper inventory of both parts and tires and serve as hub distribution resources providing parts and tire delivery to the spoke service bays. They would also continue to house our commercial business and provide HR and administrative support to the spoke locations.

The second top tier of our strategy is operational excellence. Achieving best in class performance will require a deliberate focus on how we do business and a culture of continuous improvement. Operational excellence is a transformational journey that will require that we reconfigure and realign our people, processes and technology. We have begun this journey through the cost focused initiatives that are working to save more than $90 million across the enterprise by the end of 2008.

To support a focus on our strategy and facilitate the management of our many efforts we will be transitioning improvement and reengineering efforts into focused strategic initiatives. Each initiative will be championed and led by a member of our executive team and we have asked one of our key leaders to step in and establish a core execution capability for our organization to facilitate progress within these areas and to measure our performance against our strategic roadmap.

I want to highlight the transformation we are seeking at Pep Boys by demonstrating the transition in a number of key areas. We will be a company that focuses our merchandise and customer message on our core aftermarket offering and lead with Do It For Me. We will create a hub and spoke network that adds store density to our system and builds exposure in this higher margin more fragmented and faster growing part of the automotive aftermarket.

We will be focused on our core merchandising offerings in the aftermarket. Our stores will be merchandised to meet the needs of their specific local market. Our service teams will focus on providing fast easy expert service across our business. While we do not see commercial driving our future we do see that offering this consistently and with a greater degree of quality we’ll continue to support our business and is key to our hub and spoke strategy.

Tires and wheels will be a focus of our business and an opportunity to enter into longer term relationships with our customers. At the present time, one key element of our business is the amount of investment in acquiring new customers. We will transition ourselves to be a business where our customers will continue their relationship over the life of their vehicle and longer. We also see an opportunity to transform the people, processes and technology of our enterprise to a more disciplined organization that drives consistent execution.

The internet will be a much more important doorway to our business. We will be investing wisely in the training and development of our associates to support our commitment to differentiating ourselves with automotive expertise.

Product sourcing will be global and strategic driven by a strong commitment to vendor relationships. Finally, the leadership team will cultivate a culture that is driven by performance and passion for the customer. One of the early accomplishments I’m most proud of and see as absolutely key to Pep Boys future is the strength of our current leadership team. Beyond just the apparent industry experience is a team of professional accomplished leaders who have come to Pep Boys with enthusiasm and commitment. The combination of our new leadership additions with the experience and strength of the leaders who have led Pep Boys through some tough challenges provides our organization with a competitive asset.

Today we have shared with you our vision for Pep Boys future enterprise and given you some insight into our plan to achieve the vision. I want to ask the investment community for your patience as we execute the first difficult steps of this transition over the next several quarters. It took years for Pep Boys to lose its way and the transformation of our business model will take time.

In summary, you can expect the following key elements of our strategy to develop in the next 12 to 18 months. First we’ll lead with DIFM; secondly we will execute substantial inventory edits of non-core and underperforming categories and a renewed commitment to core automotive merchandising and hard parts availability. Next, we are committed to resolving our super center footprint challenge by optimizing our excess square footage. A corporate development capability has been established to test a number of business development concepts including subletting, destination tire and wheel stores, rental centers and used car services.

Finally, we will address store density by initiating a growth strategy focused on a hub and spoke network by adding DIFM focused rooftops through local acquisitions and green field prototype projects. We are committed to becoming the automotive aftermarket solutions provider of choice for the value conscience consumer. I am confident that over the next five years our focus on DIFM and core automotive offerings will ultimately yield a business model that can produce double digit EBITDA margins and create significant shareholder value. It is an honor and a privilege to have this rare opportunity to lead the renaissance of an 86 year old iconic brand like Pep Boys. I am very excited to declare our intentions today as we take the first important steps in this positive transformation.

I want to again thank you for your time and attention today. We look forward to giving you regular updates on our progress in the quarters ahead. At this time we welcome any questions that you might have.

Question-and-Answer Session

Operator

Ladies and Gentlemen we will now be conducting a question and answer session [Operator Instructions]. Our first question comes from Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

My first question, thinking about your decision to pursue the hub and spoke strategy and maybe pursue acquisitions why commit to growing, why commit to capital expenditures or dollars for requisitions when you have significant opportunities to improve the operating profitability of your existing assets?

Jeff Rachor

Matt this is Jeff, good morning. Certainly a valid question I think it is important to note that we do not see our ability to improve our operations within our existing organization as in conflict with our acquisition strategy, in fact, we see it as complimentary as we just articulated I think you can see that there is a clear opportunity in the DIFM market to execute a growth strategy as I have become familiar with the Pep Boys model I’m very impressed with the profitability characteristics of our service business and I’m proud that our team is now demonstrated a couple of strong quarters showing our ability to execute in this arena and I think that it’s clear that the existing business model that Pep Boys has been operating under for the last decade or so has not been able to deliver the returns per shareholders that are consistent with our expectations or the capital markets expectations and we believe that we need to change this business model and that the sooner we get started on moving in that direction that the sooner we’ll be able to deliver the returns per shareholders that are appropriate and we’re confident in our capability on the service side of the business to be able to pursue that growth without being a distraction from the significant operating improvements that are going to be continuing on an ongoing basis.

I think it’s important to note if you look at the configuration of our management team I’ve brought in a very strong team including a COO whose singular focus will be driving the improved performance of our existing operations and that today we have appointed one of our senior leaders as a Senior VP of Corporate Development, Joe Cirelli and he and I will work closely on the acquisition strategy as well as the business development concepts in a way that won’t distract from carrying on with the operational improvement and the operational turnaround that continues to show traction.

Matthew Fassler - Goldman Sachs

I understand the strategic imperative and the strategic opportunities, but from a financial perspective the company has been leveraged, you are starting to come out from under that as you execute these sale lease backs and to repay some of your debt, what kind of financial commitments are we talking about as you pursue that growth strategy?

Harry Yanowitz

I think again it is one foot in front of the other and we need to start making this journey on building out the concept. I think you’ll see us making steps along that way and again the nature of these matters is you have to be opportunistic. In the context of our overall balance sheet building a few rooftops or buying a few rooftops is not material as you start to build scale, they will become more substantial I think in the short run we are certain to have enormous amounts of financial flexibility and we have a great ability to both drive the core assets of our business and again as you noted previously we do have substantial operating cash flow in our base business and we think we can continue to de-lever the business if we were to do anything and then as opportunities present themselves or as we make progress on building out these spokes we’ll start to pull a little bit of capital into that leg of it.

Matthew Fassler - Goldman Sachs

One other quick question, I know you talk about increasing your commitment to the automotive parts business, perhaps some of the footage that you are diverting away from non-core product goes to that, if you think about which customers the footage serves the DIY business has been tough for the industry and very tough for you it seems like would the incremental footage be deployed towards that DIY customer in that instance are you playing to a strength or do you feel that it increases your appeal with that customer or conversely is the footage is going to be somehow deployed to building assortments for DIFM?

Jeff Rachor

I think we were pretty clear in our presentation today that most off all we are committed to resolving the square footage return dilemma that this company has been plagued with for some time and we do intend to reallocate some of the space prudently to having a more competitive assortment of our core hard parts and after market product lines we mentioned specifically tires and wheels. We have already tested a store within a store tire and wheel concept in two markets the results were compelling. We are now rolling out that test into 42 more stores so obviously that’s a use of square footage that in my view appeals to both our DIY and DIFM customers because tires are the one thing a DIY customer really can do themselves.

We mentioned in the call today that along with that tire pilot we are also building out waiting room space that we think will differentiate ourselves from some of our DIFM competitors and finally we are in early tests of some business development concepts that are certainly complimentary to our solutions and transportation needs focus in the rental and used vehicle area, very early in those tests but I think it demonstrates our commitment to try and use that space to be more than just a very very large DIY retail box. That has been tried before in this company’s history and again, while we think that in the last few years that we’ve been distracted from providing the appropriate level of service to the core DIY customer and that we can improve our fill rate to the DIY customer and drive some sales growth in that DIY business through returning to focusing on it that we are clearly going to need to find alternative use of that space and as we said today we don’t rule out and outright sublet in some markets and we’ve already got interest in that concept.

Matthew Fassler - Goldman Sachs

Thank you so much.

Operator

Our next question comes from Tony Cristello with BB&T Capital Markets. Please state your question.

Tony Cristello – BB&T Capital Markets

Good morning gentlemen. One question I had was when you look at your 560 stores now, how many smaller spokes do you envision to fully leverage your existing system?

Jeff Rachor

We think that the spoke part of our business could be equal to or greater than the service revenue that we are driving through our existing super center format.

Harry Yanowitz

That obviously would take a considerably larger number of rooftops than we currently are operating service out of now.

Jeff Rachor

We think that building out the markets where we are already have a super center present would yield the ability for us to double our revenue in the DIFM space and when you consider the smaller service focused concept in kind of the $600 thousand to $1 million revenue per rooftop you can do the math to get there, obviously its going to take significant growth in the spoke part of the growth model that we have already articulated.

Tony Cristello – BB&T Capital Markets

I’m assuming that is very much a key component of this strategy and how you view it to ultimately be successful?

Jeff Rachor

We believe as we acknowledged today that we can continue to make significant improvements in our base business. I think this is another quarter that we’ve demonstrated some very encouraging trajectory in terms of the turn around that we are executing operationally in our existing concept and we think that we can continue to show significant improvements in profitability in our existing bays but we believe that to achieve the kind of returns that this asset base and our shareholders expect and deserve that over the next five years executing this strategy to grow our exposure in DIFM through providing these more conveniently located neighborhood service centers is a strategy that will ultimately drive the value creation that we think can reestablish us as a leader and really establish us as a category killer in the DIFM space over a period of time.

Tony Cristello – BB&T Capital Markets

When you look at the accomplishings the growth there, the acquisition environment and sort of the fragmentation of the market with so many independents out there seems like it would be a better route to take over green fielding what’s your thought on that and what is your other thought on the existing opportunities out there from an acquisition standpoint?

Jeff Rachor

I agree with your statement completely, I think it’s our preference to acquire, I think one that it is more expeditious, think there is some values out there when looking at some of the local and regional opportunities it’s a way to jump start the concept and develop some scale that we think will validate our strategy and we really see green fields as being more of a fill in vehicle. For instance, if we were to go into a market and acquire a local player that gave us coverage in two thirds of the given metropolitan area we may come in and do what I characterize as tuck in green field developments so that we could get coverage across an entire market and fully leverage our hub concept.

Tony Cristello – BB&T Capital Markets

One last question as it relates to inventory. How much of your inventory at quarter end represents sort of the non-core inventory you are writing down and I guess what I’m trying to get at is on a percentage basis how much of that then can be used to maybe build additional inventory to serve the service side of the business?

Harry Yanowitz

At the end inventory at the end of the quarter it was about $40 million worth of product that we plan to fully clear after taking affect of the markdown. Again it was about $80 million to start and it’s about $40 million after the restructuring charge that we took. We don’t see that dollar for dollar going back into the hard parts or the core merchandise but we do see select opportunities for taking individual lines and individual product categories updating lines and adding back some of that inventory to categories we think can support all of DIY commercial and support our own bays. Remember, our hard parts inventory, about 30% of it we sell to our own bays. Again, as we broaden out the assortment and invest some of that inventory back, we are supporting three lines of business in that process.

Tony Cristello – BB&T Capital Markets

30% now; is that a number that should be 50% or 75%? What is the right number, what is the right mix there in terms of distributing it into your own bays?

Jeff Rachor

That is going to be driven by the DIFM demand. Obviously as we see our revenue mix shift to a higher concentration of DIFM, that is going to increase demand. That percentage of 30% will go up. Also, as we improve our hard parts assortment, we will improve our fill rate; that is the demand that we have on a daily basis for parts in our bays and from our commercial customers. So by refocusing on core merchandise and particularly hard parts, we definitely expect to see sales growth in terms of the number of parts that are distributed through both our own bays and our commercial customers.

To circle back to your inquiry about acquisitions, keep in mind that as we acquire DIFM locations that those are locations that are now buying their parts from competitors or Pep Boys from our commercial businesses and that we immediately, obviously, get 100% of the benefit of their parts purchases, which would be material.

Harry Yanowitz

Yes, just to add in, recall that there are, order of magnitude, about 10,000, six to eight bay shops out there in this country that are in independent hands, so we think there's lots of opportunity. Each of those shops is now selling tires or selling parts and provides, I think, a great opportunity for both the DIFM business as well as to pull through some additional parts as we integrate a piece of that group into our network.

Operator

Your next question comes from Scot Ciccarelli - RBC Capital Markets.

Scot Ciccarelli - RBC Capital Markets

Harry, can you help us understand the inventory writedown? I'm assuming this was an actual markdown of the inventory, but then you talk about continued margin pressure due to inventory transition. Are we talking about selling stuff through at deeply discounted prices or are we talking about additional writedowns? Can you help us understand that a little bit better?

Harry Yanowitz

There are actually two steps of the process. The writedown that we took reflected what we expect to realize for that inventory. The margin pressure I was talking to is we then expect to sell that product at the cost or at the now realizable value over the next quarter or two, perhaps even rolling it into a third quarter. As we sell that product through now it's essentially at zero margin so it will provide some dilution into the overall margins for the retail commercial business.

Scot Ciccarelli - RBC Capital Markets

So a mark-to-market for now and then once you sell-through, additional margin pressure?

Harry Yanowitz

Again, you don't lose money on what you mark it down, but you also don't take any gross profits. It dilutes the rate.

Scot Ciccarelli - RBC Capital Markets

This is a company that has undergone substantial change and disruption over the last couple of years and it has certainly suffered as a result. Do you risk re-stressing the organization as you make all of these changes, because they are pretty big, bold changes that you guys are employing at this point.

Jeff Rachor

Well, I think it's certainly a valid question, but I will tell you that one of the reasons that our performance continues to improve is that we do enjoy much greater stability today in our management and associate ranks than when the company experienced some of that disruption just a couple of years ago. As I tried to communicate earlier, I think that we're very conscious as a leadership team that we need to remain very, very focused on continuing to drive the turnaround improvements in our core business.

Again, I've got a very strong Chief Operating Officer and he has a great team of people around him that are going to be singularly focused on that. We've brought in an outstanding automotive aftermarket merchant with 23 years experience who is going to clearly be able to continue to focus on this renewed commitment to hard parts and core automotive merchandising. I really don't think any of the strategic plan elements are going to distract our team from continuing to focus on the improvements in our core business.

Obviously, the biggest part of our strategy is growth around the DIFM segment. As I stated earlier, when you really dig into the Pep Boys financial model, this is a business that already enjoys very, very favorable profitability characteristics. I think hopefully we are beginning to earn some credibility with the capital markets over the last several quarters on our ability to manage that business and execute more effectively, and so we think we're playing to our strengths by targeting a growth strategy off of our service business, and that we can do that in a way that is not disruptive to the broader organization.

The business development concepts, again as I stated earlier, right now these are very much in a test mode. They will be done in isolated markets and stores in a very controlled environment and we developed an internal capability that can devote their time and energy to moving those initiatives forward and validating them or not; we really don't see them as being a distraction from the broader organization’s goals until they would develop and be validated to where we would see some kind of a scaled rollout across the chain.

I am certainly cognizant that we are strapping on a significant challenge here, but remember, this is a long-term plan. It's a three to five year look. I thought it was important, particularly for our own associates, to articulate a long-term plan, something that everybody could take ownership of and embrace and see not as the idea of the year or the quarter, but as part of a long-term commitment to a transformation in the Pep Boys model that is ultimately going to drive success for all stakeholders.

Scot Ciccarelli - RBC Capital Markets

When did the sale leaseback close?

Harry Yanowitz

Yesterday.

Operator

Your next question comes from Jeff Glazier - Morgan Joseph.

Jeff Glazier - Morgan Joseph

Good morning. Thanks for taking my call. Can you give us an idea of what the impact of the sell down in inventory is going to be on an EPS standpoint? Are we looking at earnings losses over the next few quarters, obviously excluding charges?

Harry Yanowitz

Again, we're going to move expeditiously and aggressively at that so we don't expect this to be a protracted program. Again, part of the reason we took the charge was to support a business plan that sold through that product. A lot of this non-core product does sell well during Christmas; at these new discounted prices, we think it will sell even better. So while you should see some dilution in our margins which I talked to on the call, we don't expect this to go on for an extended period of time. We should be able to give you an update at the end of next quarter as to what the specific impact is going to be and whether this is going to drag into Q1 of next year.

Jeff Glazier - Morgan Joseph

Do you see any other charges in the future other than what you've released today, including the fourth quarter charge?

Harry Yanowitz

Again, the fourth quarter we did announce that the store closure expenses are going to come through in Q4 and that and the selling through of the remainder of product is going to affect our profits into Q4 and Q1, but these are the primary restructurings that we expect for the company at this time.

Jeff Glazier - Morgan Joseph

So no severance for the 500-odd employees?

Harry Yanowitz

That's not material, no.

Jeff Glazier - Morgan Joseph

In terms of the debt levels, would you be able to do an acquisition at this point, or do you need to delever the balance sheet a little bit before you can start adding on to it again?

Harry Yanowitz

Again, just to focus on Jeff's earlier comment. This is a five-year plan, the intention and direction we're going, and again, if we were to buy a five-store chain, that clearly is something that is well within our financial capacity. We have a lot of financial capacity and flexibility about how we operate our business and so again, we're going to have to be opportunistic. If a five-store chain is available we probably will look at it. If it becomes a larger opportunity or a regional chain, we would certainly look at that as well.

Operator

Your next question comes from Cid Wilson - Kevin Dann & Partners.

Cid Wilson - Kevin Dann & Partners

Can you quantify how tire comps performed during the quarter?

Jeff Rachor

Yes, tire comps are positive. We have a very positive trend in terms of our overall tire performance. I think I mentioned that we have piloted now in two markets a store within a store, expanded tire and wheel presence. We were very pleased with the initial results in those pilots and we're now rolling that concept out to 42 additional stores. In fact, those will all be up and running by the end of the year and we expect to continue to drive a positive trend in tire units and tire comps in the quarters ahead.

If you look back just a few quarters ago, we've been able to move from some fairly material negative unit comps back to flat and we're on a positive trajectory and a very, very positive trend and see tires as one of the opportunities we have to get a higher return off of our existing square footage footprint.

The other important thing to note about tires is it's really a great customer procurement vehicle and our data tells us that if a customer buys tires from us, we're going to see them an average of five additional times and so we're going to invest in that part of our business. We think it's very consistent with our new focus on customer relationship management, on database marketing and on customer retention.

Cid Wilson - Kevin Dann & Partners

With regard to some of your comments regarding the extension or at least increase in tire coverage, how does that play out between your national tire brands and your private label?

Jeff Rachor

Well as I think you're aware, we enjoy an outstanding private label business. We're very proud that we really lead in that arena and we're going to continue to stay committed to our private label business. We think that one of the obvious ways to grow our tire business is just to increase the breadth and depth of our private label offering and that's what we've done in our pilots. We have added some select, additional coverage in private label. We think that that's an important branding halo as we try to really reestablish ourselves as an 800-pound gorilla in the tire business and a destination location for our stores.

Cid Wilson - Kevin Dann & Partners

With regard to the store closings, can you give us some further color in terms of what the thinking process was in terms of what were the thresholds that made you decide to close these stores versus others that may have survived and are staying open or at least what was the threshold point?

Harry Yanowitz

Again, without getting too granular, it really revolved around the financial investment we had in those locations as compared to the cash flows that we were generating out of those stores. Again, those stores were essentially breakeven on a P&L basis. They had a modest amount of positive cash flow. We saw that the assets that we had effectively invested in those locations, the combination of the real estate and the inventory carry were substantially worthwhile to bring back and repatriate to the organization.

Cid Wilson - Kevin Dann & Partners

How does this all play out in terms of your relationship with your vendors? Have you had any conversation with your vendors about your plan?

Harry Yanowitz

Again, this is the first forum to set out what the five-year plan of the organization is and certainly we'll have further conversations. Clearly, along the spectrum of our strongest and most important suppliers this is all very good news. We're going to grow business. We're going to be focused on hard parts. We're going to focus on tires and wheels. The constituency of people who benefit by doing business with Pep Boys I think are going to be excited about the prospects of what this is going to bring to them.

Operator

Ladies and gentlemen, our question-and-answer session has now expired. I will turn the conference back over to management for closing comments.

Jeff Rachor

We just want to take this opportunity again to thank you for your interest in the Pep Boys story and again, we look forward to updating you on future quarterly calls as we move forward with this exciting new strategy.

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Source: The Pep Boys – Manny, Moe & Jack Q3 2007 Earnings Call Transcript
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