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Pep Boys Manny Moe & Jack (NYSE:PBY)

Q2 2012 Earnings Call

September 5, 2012 8:30 a.m. ET

Executives

Sanjay Sood - VP, Chief Accounting Officer, and Controller

Mike Odell - President and CEO

Scott Webb - EVP, Merchandising, Supply Chain, and Digital Operations

Brian Zuckerman - SVP, General Counsel, and Secretary

Analysts

Bret Jordan - BB&T Capital Markets

Simeon Gutman - Credit Suisse

Ronald Bookbinder - Benchmark Company

John Evans - Edmunds White Partners

Operator

Greetings, and welcome to the Pep Boys Manny Moe & Jack second quarter 2012 earnings conference call. [Operator instructions.] It is now my pleasure to introduce your host, Sanjay Sood, vice president, chief accounting officer, and controller. Thank you Mr. Sood. You may now begin.

Sanjay Sood

Good morning, and thank you for participating in Pep Boys’ second quarter earnings conference call. On the call with me today are Mike Odell, president and chief executive officer, and Scott Webb, executive vice president, merchandising, supply chain, and digital operations.

The format of the call is similar to our previous calls. First, Mike will provide opening comments regarding our results and our strategic priorities, then I will review the financial performance, balance sheet, and cash flows for the second quarter. We’ll then turn the call over to the operator to moderate a question and answer session and the call will end promptly at 9:30 a.m. this morning.

Before we begin, I would 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 FD. In compliance with these regulations, we are webcasting the conference call on www.investorcalendar.com. For anyone on the webcast who does not have the financial statements, you can access them on our website, www.pepboys.com.

I will now turn the call over to Mike Odell, our president and chief executive officer.

Mike Odell

Good morning. Thank you for joining us today. As you can tell from our press release, we’ve been quite busy this summer. The bright spot is our strategically important service business, which grew 3.8% on a comparable store basis during the second quarter, and an impressive 7.8% in customer count.

Our maintenance business was particularly strong. However, the mix shift toward oil changes did lead to a lower average ticket and a lower margin rate. Tires were up 6.7% with a strong performance in July. Our repair business has remained consistently steady with a low single digit comp.

For the foreseeable future, we expect vehicle complexity to continue to increase. Therefore, we are focused on our competitive advantage with the skill level of our technicians to perform the medium and heavy work that folks just can’t do themselves.

In the meantime, we have also been evolving our pricing and online strategies to make it easy for customers to choose us to do it for them. And our biggest lever is to continue to improve how we engage and care for our customers.

As we discussed on our last earnings call, and as you have seen in our competitors earnings releases since then, the rate of sales in the industry has been decelerating. July was a much better month for us, allowing us to achieve flat comparable store sales overall for the second quarter. I do caution, however, that tire sales were sluggish again in August and we expect the environment for tire sales to continue to be choppy this year.

Obviously our termination of the potential deal to go private back in May significantly and positively impacted our second quarter and year to date results. The impact was a net $43 million of pretax, non-operating income. As we also previewed on our last earnings call, we experienced a decline in operating profit for the quarter due to tighter margins in our service business, higher marketing spend, and new store operating expenses. Sanjay will walk you through the details in a few minutes.

Our retail business has been challenging and declined 3.8% on a comparable store basis, driven by declining customer count, partially offset by a higher average ticket. Retail margins improved 120 basis points leading to a slight increase in retail margin dollars, but there was not much difference in the performance of parts versus accessories, but as in service, performance was stronger in the warmer weather climates.

In the big picture, industry fundamentals remain sold over the long term and mixed in the short term. The demand for maintenance and repair are consistent with the primary driver being miles driven. The recent spike in gas prices could create a short term headwind. Our primary external challenge is consumer spending relative to discretionary and deferrable purchases.

Industry response to this short term challenge has squeezed tire margins for the past 19 months. Tire margins declined over 300 basis points year over year, continuing the trend that started in January of ’11. We continue to take sales price increases where the market allows it, but we are not going to raise prices at the expense of market share in this fragmented and competitive marketplace. We have been working with our supplier partners who are seeing lower production input costs, and expect to improve tire margin rates in the back half of the year.

Tire and related merchandise sales account for 17% of our total sales and 36% of service and tire center sales. With our full service capability and great price position, Pep Boys is in a very good position to succeed in service over the long haul as the industry slowly consolidates. Margins in other product categories have remained stable overall except for some mix shift.

Since the announcement that we would not be going private, we have worked to establish our team for our next phase. We had a good team in place to restore Pep Boys to profitability. We needed to make some changes to become great with our customers and achieve a higher level of profitability.

Tom Carey joined us last month as chief customer officer. He is now responsible for guiding our customer experience strategies and tactics as well as leading the development and execution of our marketing strategies. I am very excited to add Tom to our team. He is customer-focused, creative, energetic, and a strong marketer.

Our number one objective is to earn the trust of our customers every day, and the creation of the chief customer officer position is to ensure that all of our actions company-wide are focused on, and consistent with, that objective.

Dave Stern joins us next week as chief financial officer. He will oversee our finance function as well as technology and corporate development. Dave has great breadth and depth of experience, and I really appreciate his operational focus from a financial perspective. Dave is willing and able to get his hands dirty to drive performance, and will be a great contributor to our operational, merchandising, marketing, and customer analytics.

Yesterday we also announced the departure of Bill Shull. We have made great strides over the past five years with our store appearance and store discipline. Our customer service has improved also. But we don’t feel like we stand out, and our number one strategy and objective is to earn the trust of our customers every day.

We have reorganized our store leadership under Sean Chidsey in the west and Terry Winslow in the east, and Brian Hoppy now heads our store operations support team. All three are seasoned leaders with Pep Boys, so we are in good hands while we conduct the search for a new leader for overall store operations that has a proven track record in delivering world class customer service. People make the difference, and we need to continue to improve.

While I appreciate the team that turned Pep Boys around to make us profitable and growing again, we need to continue to evolve to be the automotive solutions provider of choice and to produce the financial returns you want and we expect of ourselves.

We have taken a hard look throughout our company over the past year and have been making the necessary moves to continue to improve our performance. We have a great strategic position in service regardless of the economic situation, while our competitive advantage in our retail business is more reliant upon discretionary purchases of appearance and performance products.

Turning to strategic initiatives, I will start with new store growth. We expect to open 40 stores this year and are targeting 4-5% annual growth in service bays for the foreseeable future. Most of the service bay growth will come in the form of service and tire centers in existing markets. Service and tire centers, as you know, average 6 service bays, but can range from 4 to 8.

We will also open new supercenters focused in locations where tires and parts are needed to support new service and tire centers. New supercenters have 6 to 7 service bays as compared to 9-11 in traditional supercenters. Store density is important to our economic model, but equally important it makes us convenient to customers.

We will continue to be opportunistic with acquisitions based on their fit with our store location model targets. New stores are focused in markets where we have greater density because the returns are better in those markets, and our new store mix is shifting two build to suits and conversions based on the potential customer opportunities.

Speaking of convenient to customers, buy online pick up in store went live late in the second quarter. Buy online ship to home will go live near the end of this quarter and we are working on expanding service online. Online appointment scheduling has been a big hit with customers. We know customers like to research tires online, so we want to allow customers to price more of their services just like they do their products. We have the best pricing among national and regional service providers, but we intend to make pricing more transparent for customers and convert their research into appointments.

Now that our second quarter earnings have been released, we will begin to market our debt refinancing. Our intent is to reduce our long term debt by approximately $100 million, settle our interest rate swap, extend our maturities, and reduce our overall interest expense. Pro forma for this proposed transaction as of the end of the third quarter we would expect to have approximately $75 million of cash remaining on hand, plus $180 million of availability under our revolver for operations, the settlement of our pension liability, and the flexibility for accelerated growth, and/or to return capital to our shareholders.

Our forecasted new store growth of 4-5% new service bays per year and maintenance capex is expected to be funded fully from our cash flow from operations. We will also continue to improve our payables to inventory ratio, which is now at 58% of inventories as compared to 54% at year end and 50% at the same time last year. This has allowed us to continue to invest in inventory coverage to drive sales while positively impacting cash flow.

Our number one strategy remains to earn the trust of our customers every day. It is the foundation of our business, and I thank our 19,000 associates for their daily commitment to our customers. But we also need to continue to improve and that is what is driving our changes.

This is a simple business even though the work can be challenging and the knowledge requirements are significant. We engage with, and care for, our customers, and with that comes customer and personal satisfaction followed by sales and profits.

I will now turn the call over to Sanjay Sood, our corporate controller, to review our financial statements.

Sanjay Sood

Thanks Mike. This morning I will review our results on a GAAP basis, as well as a line of business format. Please see the last page of our press release for line of business format financial information. I’ll also review relevant balance sheet and cash flow data.

On a GAAP basis, net earnings for the second quarter of 2012 were $33 million, or earnings per share of $0.61, compared to $13.9 million, or earnings per share of $0.26 in the prior year second quarter.

The current year second quarter includes, on a pre-tax basis, settlement proceeds from the termination of the proposed merger, net of related costs, of $43 million. This item is shown separately on the face of the income statement, below operating profit.

The second quarter also includes, on a pre-tax basis, a $0.7 million charge for severance costs from a reduction in force at our store support center. The prior year included, on a pre-tax basis, a $0.4 million asset impairment charge, $1 million of acquisition-related expenses, and a $3.4 million benefit from the release of state tax valuation allowances.

Second quarter of 2012 total sales increased by $3.1 million, or 0.6%, to $525.7 million from $522.6 million in the prior year, driven primarily by our store growth. Total comparable store sales are flat for the quarter and were comprised of a 0.9% decrease in merchandise sales offset by a 3.1% increase in service revenue.

The decrease in comparable store merchandise sales was driven primarily by lower comparable store customer counts, partially offset by a higher average transaction amount per customer. The increase in comparable store service revenue was due to higher customer counts, offset by a decrease in the average transaction amount per customer. I’ll address the drivers for these during the LOB format review.

Total gross profit dollars for the second quarter of 2012 decreased by $4.6 million to $130.6 million from $135.2 million for the same period in the prior year. Gross profit, which is fully loaded with occupancy costs, warehousing, and service payroll, decreased to 24.8% of sales as compared to 25.9% in the prior year quarter.

This decrease was primarily due to shift in sales mix to lower margin tires and oil change services, combined with decreased tire margin rates due to cost increases exceeding retail price increases. This impacted the margin rate by approximately 70 basis points. In addition, we had higher occupancy and payroll and related expenses as a percentage of total sales, which impacted margins by another 35 basis points.

The new service and tire centers have a higher concentration of their sales in lower margin tires and higher rent and payroll costs as a percentage of total sales. While the new service and tire centers have a negative impact on total gross profit margin, they were accretive to gross profit dollars in both years.

Selling, general, and administrative expenses as a percentage of total revenues were 21.7% for both periods. SG&A expenses increased by $1 million, or 0.9%, to $114.3 million from $113.3 million in the prior year quarter due to higher media expense of $3.5 million, higher store payroll expense of $1.2 million, and severance costs for a reduction in force at our store support center of $0.7 million, which were partially offset by lower acquisition and merger costs of $2.2 million, lower credit card transaction fees of $1.7 million, and lower store support center payroll expenses of $0.7 million. SG&A expense benefited from the reclassification of first quarter merger costs to merger termination fees net, which are shown separately on the face of the income statement.

Net earnings for the year to date period improved to $34.1 million, or earnings of $0.63 per share, versus net earnings of $26.3 million, or $0.49 per share, for the same period last year. The 2012 results include, on a pre-tax basis, merger termination fees net of related expenses of $43 million, and a $0.7 million charge for severance costs. The 2011 results include, on a pre-tax basis, a $400,000 asset impairment charge, $1.3 million of acquisition-related expenses, and a $3.4 million benefit from the release of state tax valuation allowances.

Now I’ll cover our service center and retail business on a line of business basis for the second quarter of 2012. Our service center business, which includes tires and merchandise sales, as well as service labor revenue generated through our service base, recorded revenue of $274.3 million in the second quarter of 2012, an increase of 5.2% or $13.4 million, over the $260.8 million reported in the same quarter last year.

This improvement was primarily due to comparable store service center revenue, which increased 3.8% on $9.7 million as well as non-comparable locations which contributed an additional $3.7 million in revenues.

The increase in service center comparable store revenues was due to increased customer counts of 7.8%, partially offset by a decrease in the average transaction amount per customer of 3.8%. The increase in customer counts was due to the strength in our maintenance business, led by increased oil change transactions, which have a lower average transaction amount per customer.

Service center revenues also benefited from increased tire sales as a result of retail price increases implemented to offset cost increases. Service center gross profit was $55.9 million, a decrease of 7.9%, or $4.8 million from the $60.7 million recorded in the prior year second quarter. Service center gross profit as a percentage of service center revenue decreased to 20.4% from 23.3% in the same period of the last year.

The decline in the gross profit margin was primarily due to the shift in sales mix to lower margin tires and oil change services, combined with decreased tire margin rates due to cost increases exceeding retail price increases and higher occupancy and payroll and related expenses as a percentage of total sales. The new service and tire centers have a higher concentration of their sales in lower margin tires and have higher rent and payroll costs as a percentage of total sales.

The retail business generated sales of $251.4 million in the second quarter of 2012, a decrease of 4%, or $10.3 million, from the $261.8 million reported for the same period of the prior year. This decline was primarily due to a decrease in comparable store sales of 3.8%, or $10 million, as the result of a decline in customer counts.

The retail business continues to be challenging for us, and [unintelligible] challenge by the tough macroeconomic conditions including high unemployment and high gasoline prices, which tend to depress consumer spending, especially as it relates to our discretionary product categories.

From a gross profit perspective, the retail business reported gross profit of $74.7 million for the second quarter of 2012 versus $74.5 million for the same quarter in the prior year. Retail gross profit as a percentage of retail sales increased to 29.7% from 28.5% in the same quarter last year. The increase in retail gross profit margin was primarily due to lower occupancy costs, primarily lower utilities and depreciation costs in the second quarter of 2012 as compared to the prior year.

As Mike noted, industry fundamentals over the long term remain strong, as increasing vehicle complexity and customer preference for [do it for me] will lead to consistent demand for maintenance and repair services. Also, as we have stated before, we believe the most significant external factor impacting our business is miles driven, as the sales of our services and nondiscretionary products are generally favorably impacted by increase in miles driven.

From January to June 2012, miles driven great an average of 1.1% per month after declining in 2011. However, as previously noted, we believe the tough macroeconomic environment, including the recent spike in gasoline prices in August, will continue to challenge consumer spending relative to discretionary and deferrable purchases.

Our primary response to fluctuations in customer demand is to adjust our service and product assortment, store staffing, and advertising messages. In addition, we continue to make it easy for customers to choose us to do it for them, and to expand our online efforts to make Pep Boys the most convenient place to shop for all of their automotive needs.

I will now discuss some key balance sheet and cash flow data. Cash balances increased by $92.6 million to $150.8 million at the end of the second quarter or $58.2 million at the end of the prior year primarily due to merger termination fees net of related expenses of $43 million, improved working capital as a result of negotiating extended [debt repayment] terms, which more than offset the increase in inventory and lower capital expenditures and other investing activities.

Inventory at the end of the second quarter of 2012 was $626.6 million, an increase of $12.4 million from $614.1 million at the end of last year. The inventory balances in the current year increased primarily due to expanded inventory assortment, including [hard part] categories, seasonal purchases, and increased investment in our new stores.

Property and equipment net declined by $13.7 million to $682.6 million, primarily due to depreciation outpacing capital expenditures. Accounts payable, including a trade payable program, increased to $362.3 million from $328.9 million at the end of fiscal 2011. The AP to inventory ratio increased to 57.8% from 53.6% at the end of the prior year, primarily due to improved vendor payment terms, increased inventory purchases, and and expanded trade payable program.

Total debt net of cash decreased by $93 million from the prior year, primarily due to an increase in cash balances of $92.6 million. We also had $175 million of availability under our revolving credit facility at the end of the second quarter.

We had free cash inflow of $91.6 million in the first six months of 2012 as compared to free cash outflow of $25.6 million in the prior year period. Free cash flow is defined as cash flow from operating activities plus net amounts financed under our trade payable program, which is including cash flows from financing activities, less cash flow from investing activities and dividends.

The current year included net merger settlement proceeds of $43 million while the prior year cash flows included cash paid for acquisitions of $42.8 million and dividend payments of $3.2 million. We spent $26.3 million for capital expenditures in the first six months of 2012, which, in addition to our regularly scheduled facility improvements, included the addition of eight new service and tire centers and one new supercenter.

Prospectively, we have no significant debt maturities until 2013. However, our current intention is to use our cash on hand, together with proceeds from our new debt facility, to retire our term loan and senior subordinated notes, both in advance of their respective 2013 and 2014 maturities. This contemplated refinancing will reduce our overall long term debt by approximately $100 million, extend our maturities, and reduce our overall interest expense, while maintaining flexibility for accelerated growth and returning capital to our shareholders.

We’re also in the process of terminating our pension plan, which has been frozen since December 1996. This process is expected to be completed before the end of fiscal 2012, and in order to do so, the company is required to fully fund the plan on a termination basis and commit to contribute additional assets necessary to do so. The amount is currently estimated to be in the range of $13-18 million, and plan participants will not be impacted by the termination.

We expect capital expenditures to be approximately $60 million in fiscal year 2012. Our fiscal year 2012 capital expenditures include the addition of approximately 40 new locations, the conversion of 15 supercenters into superhubs, and required expenditures for existing stores, offices, and distribution centers. These expenditures are expected to be funded by cash on hand and net cash generated from operating activities. The additional capacity, if needed, exists under our existing line of credit.

I will now turn the call back over to the operator to begin the question and answer session.

Question-and-Answer Session

Operator

Thank you. [Operator instructions.] Our first question is from the line of Bret Jordan of BB&T Capital Markets. Please proceed with your question.

Bret Jordan - BB&T Capital Markets

A couple quick questions here. And one’s on the refinancing. Do you have a feeling for what rates you might be looking at here as you go out in the next couple weeks to repackage that debt?

Brian Zuckerman

We’re likely going to do a term loan D, which will have floating interest rates, so it would likely be LIBOR with a floor, plus two or three points, and we’ll likely swap it out. So somewhere probably in the 6.5% to 7.5% [all in] rate.

Bret Jordan - BB&T Capital Markets

And on operations, the 7.8% traffic increase, I think Mike, in the statements you talked about oil change potentially being a driver there. What did oil changes comp up in the quarter?

Mike Odell

In terms of customer count? It was low double-digits.

Bret Jordan - BB&T Capital Markets

And is that meaningfully changing the demographic of the vehicles you’re seeing? Are you seeing younger cars coming in? Is that changing the customer mix of the people showing up, because you’re driving that?

Mike Odell

I think there’s a couple of pieces to this. We did some things ourselves to drive that in terms of we changed our pricing. You know, over the last couple of years we’ve got off the rebates, which was nice from a profit standpoint but not great from a customer experience. We also removed shop fees from oil changes, which, again, is nice for the profit but it’s a real dissatisfier for customers, on our most frequent transaction. We’ve also simplified the pricing and the step up. We’ve had a lot of customer interest in scheduling their appointments online.

So those are the things that we’ve done, that I think are helping us gain share as it relates to oil changes. And I think there’s a couple things going on in the macro. DIY oil change pricing continues to kind of creep up, and I think there’s a smaller gap between a do it yourself oil change right now and a do it for me oil change, which is probably converting some customers that may have started to do it themselves, to say, well, gosh, this is close enough. I’m going to go ahead and pay them to do it for me.

And then the bigger macro, which is a little hard to articulate, but it comes back to the new car sales. And I think it’s an important conversation, because it’s going to be favorable to us over time, even though it creates a headwind in the short term. And I think it’s relevant, because it applies to oil changes, tires, brakes, batteries. Our sweet spot for our service business is cars that are about 5-11 years old. And quite frankly even for us, our retail business is more biased toward younger vehicles than the DIY competitor set.

And what happens is that - again, right now it’s kind of a headwind for tires, brakes, and batteries, but probably helpful for oil changes - is that the first replacement cycle on new cars is our first opportunity to gain a new customer. And for oil changes, that comes pretty quick. And obviously for tires that’s after about three years, and brakes four years, and batteries probably about five.

Because what happens is is that when we had this fall off in the new car sales in ’08, those cars, that fall off, is coming through the bubble, right? But now, as we’ve seen, new car sales increased by about a million or so a year since the fall off. It’s that increase year over year that’s going to favor us, as each of those gets into that replacement cycle. So it’s an initial dip that we’ve experienced. And then it will be beneficial.

And oil changes just goes through the bubble first, because that’s the first thing that customers do for their car outside the dealer network, followed by tires, followed by brakes, followed by batteries. But I think for tires, we’re going to see the benefit of that as an industry next year, where it’s going to be a headwind for the next year or so, and has been a headwind for a couple years.

Bret Jordan - BB&T Capital Markets

I had one quick question on discretionary mix from the retail side of the box. What’s that as a percentage of sales now?

Mike Odell

It’s about a third of our retail business.

Operator

Our next question is from Simeon Gutman of Credit Suisse. Please proceed with your question.

Simeon Gutman - Credit Suisse

Mike, related to that last question, can you tell us what the medium and heavy service mix is today? And then I guess eventually where could that go if we’re starting to put vehicles in the cycle at sort of the beginning stage?

Mike Odell

I don’t have that right in front of me, although we’ve had it in our past presentations. But you know, tires being about 20% of the business, oil change is probably a mid-teens percent of the business. So medium work is over a third of the business, and heavy business I think is less than a quarter, maybe less than 20%. Those are kind of broad numbers off the top of my head. But I think I’m pretty close.

Simeon Gutman - Credit Suisse

But I guess in the near term, as oil changes come in the mix, that could slow a little bit, eventually, the idea that those numbers are going to ramp up into the sweet spot of where your business is?

Mike Odell

Yeah, tires and brakes and then batteries are kind of the next three things that get affected through the cycle.

Simeon Gutman - Credit Suisse

And then on gross profit dollars, sequentially the trend has been improving, and I think the two factors that have been in play for a couple of quarters, the pressure in the tire margins and then the shift over to service and tire centers - can you just talk about both items and maybe when the margin impacts should crest? If there’s any dynamics individually within those that could change? It sounds like this higher trend should slowly get better. I guess the service and tire mix should slowly get better as it’s fully ramped in your model. Just curious when we could see a change or flattening out in the margin and then actually moving from deceleration to acceleration in gross profit dollars.

Mike Odell

We think it’s coming pretty quick here.

Scott Webb

We’re already starting to improvement in our tire margins. We look for continued improvement in the back half. A couple of different dynamics are happening. We’re changing the mix and we’ve been working very hard on changing the mix over the past 12 to 18 months of our supply base. We were heavily leveraged to two key suppliers over the past four or five years, and we’ve diversified our supply base. That affords us stronger margins for ourselves as well as a better value for our customer. We do see input cost moderating and decelerating, which we are working hard with our channel partners, supplier partners, to return some of that value, as well as keeping an eye on price.

Mike Odell

We’re seeing improvement today.

Simeon Gutman - Credit Suisse

And in the tire world, the competitive landscape, are people in the same bucket you are, having had pressure for the past several quarters, now wanting to make money on it? Or do you think there are some people that will stay rational, that will keep a cap on how much pricing can actually move back up?

Mike Odell

There’s kind of two ways it could go, and I’m not sure that either one of them is bad for us in the long term. Tires as a mix of our business is less than it is in the mix of a lot of our competitors. So while tire margin pressure has been hurtful to us, it has to, if I balance the sales, hurt others more. And if tire margins stay tight, that’s not good for us, obviously, in the short term, but it squeezes out, I think, more players over the long term.

And obviously if tire margins - if they squeeze a cost hold or decline while we’re able to hold or continue to raise price, then get the margins back, it maybe doesn’t squeeze out as many competitors, smaller competitors, but it makes everybody healthy. And I think you’ll probably see a little bit of both, but I think there’s enough talk about tire margin pressure in the industry that I think even our suppliers are sensitive to the impact that it’s had on their customers.

Operator

And the next question is from the line of Ronald Bookbinder with the Benchmark Company. Please proceed with your question.

Ronald Bookbinder - Benchmark Company

It appears that you guys are really executing on your strategy to drive the service out of the business, but on the merchandise side, especially on the discretionary items, is your consumer just tapped out? Or can you improve the merchandise to help drive some more sales?

Mike Odell

We need to continue to improve our performance to drive more sales. I wouldn’t say our customers are tapped out. I think a lot of America is stressed financially. You see that, obviously, every time gas prices go up. Things tend to get a little bit softer.

But we do think that our retail business, we have a competitive advantage relative to our appearance and performance products, i.e. those discretionary items. The plans that we’ve been in place is the web world plays into that, where people can go onto the web. We want them to be able to see our full assortment on the web, and then be able to expose that in the store as well.

And as you know we’ve been testing different alternatives relative to speed shop to be able to call out our differentiation relative to our customers. And we’re working on plans to make that a bigger part of our retail business going forward. So the hard part is that our competitive advantage in retail is a more discretionary product, but I don’t think that lasts forever. It’s just been challenging.

And part of the changes we’ve made relative to the management team is we need to do a better job of engaging our customers when they’re on the sales floor. We have a tendency to stay near the parts counter or stay near the service counter, whereas the sweet spot for our retail business is on the sales floor. And we are going to change the culture of the company to get our folks to engage customers to understand what it is that brought them in today, and make sure that they leave with a solution. We need to drive that harder.

Ronald Bookbinder - Benchmark Company

On this tire pricing, are you already seeing improvements in the tire gross margins versus last year? Or do you expect to see that shortly?

Scott Webb

We already are seeing it. We started to see it in the back half of the second quarter, actually late in the second quarter. We continue to enjoy margin improvement, and we expect that that trend continues, barring some unforeseen event.

Ronald Bookbinder - Benchmark Company

So looking at the overall gross margin in the back half of the year, despite the pressure that you’re seeing on the higher margin discretionary items, could we see overall gross margins actually increase?

Mike Odell

That’s our plan.

Operator

Our next question is from the line of John Evans at Edmunds White Partners. Please proceed with your question.

John Evans - Edmunds White Partners

Can you just talk a little bit about your thought process relative to the Chinese tariffs, if they come off? And just what it could potentially do to pricing. If prices start to move down, do you believe there’s a lot of pent up demand on the tire side?

Scott Webb

Well, that’s an interesting one. I think if you poll the CEOs of the tire manufacturers, I think the folks at Bridgestone are sort of agnostic there. They’re not calling the ball either way. The folks at Cooper are saying it’s coming off. The folks at Goodyear or some Sumitomo are saying it’s coming off. I think it’s a mixed bag of opinion. Nobody knows. Certainly the political climate is weighing in. The more conversation between the parties around jobs, the more my gut says that the current administration will be biased to keep it in some fashion or another, as a signal of protecting U.S. jobs, although it didn’t have any true impact on U.S. jobs.

But it is scheduled to come off on September 26. We’ll see what happens. In terms of if it does come off, I think that it will be a slower ramp than people expect. My sense is that the competitive landscape has run down their inventories. Especially the independents have run down their inventories in anticipation. We have not done that. We are in inventory to serve our customers, not necessarily to hedge. I think that the pricing will likely remain somewhat stable.

Mike Odell

Even beyond that, the tariff, you’ve got the fact that there’s been, over the last several years, starting to come on board now, increased production capacity overseas. And the demand for those tires, in those domestic markets, has been waning. So that should moderate things as well.

Scott Webb

Quite frankly the Chinese car park has just absolutely exploded, and the domestic Chinese demand for tires in their own home country has just gobbled up the production of those Chinese manufacturers to an extent.

John Evans - Edmunds White Partners

And then the one last question I had, just a clarification, did you say that because gas prices started to move up again, you thought that hurt tire sales in August, or that’s what you saw? Is that right?

Scott Webb

Yes, let’s just say that things softened in August at the same time that gas prices started to spike up again.

John Evans - Edmunds White Partners

And then so did you see the competitiveness get more competitive again in August? Because it sounded like it wasn’t like that in July, or started to abate. Or did people just not stay as competitive?

Mike Odell

I think the competitive landscape has been stable. It’s regional. When certain regional players run promotions, we have to be sensitive to that. It obviously happens. East Coast, Northeast players, Southwest players, Central players. And we have to keep our eye on the market at all times.

Operator

Our next question is a follow up from the line of Bret Jordan of BB&T Capital Markets. Please proceed with your question.

Bret Jordan - BB&T Capital Markets

Following up on that tire question, I think you said that tires had a negative year over year gross margin impact of 300 basis points in the quarter, but improved as the quarter progressed. Can you give us a little color, sort of what the rate of improvement was? Did that equate to a 400-basis point negative impact in the first quarter and 100 basis points in the first month of the quarter, and 100 in the end? Or what was the trajectory of improving margin?

Mike Odell

We’re not going to get that full 300 back, you know, with a snap of our fingers.

Bret Jordan - BB&T Capital Markets

Right. And I guess there was also a comment about some regional difference with warm weather climates outperforming some of the cooler weather climates. Is that left over from the lack of winter in some of those northern markets? Or is there something driving regional dispersion that’s different?

Mike Odell

We would suspect that it - because it’s the same whether it’s in service or whether it’s in the retail or even the DIY or the commercial. It’s pretty consistent, so I think that your theory there, that it’s residual from the light winter and to some degree people being able to work on their cars in the winter, and then just a lot less damage to vehicles caused by the winter would be the reason for the difference.

Bret Jordan - BB&T Capital Markets

And then one last question. Scott, you were giving us your opinion on the Chinese tire tariff. Between the Chinese tariff and lower input costs to the manufacturers, what would you see average tire unit prices declining by as we get into the fourth quarter of the year? It doesn’t sound like you think we’re going to get the full benefit of the tariff roll off, but where do you see pricing going between here and the end of the calendar year?

Scott Webb

It all depends on a very irrational market. I mean, Bret, you and I both know this market pretty well. On the retail side, it’s very rational. On the service and tire side, it seems to be very irrational. That’s because of fragmentation. I agree with Mike that the independents and the smaller players have been very stressed. Their financial performances have been very stressed over tire margins.

I would expect that some of them would use this opportunity to recover. If that happens, I think we’ll see very moderate change, if at all, in tire pricing at the sell out. If people try to take advantage of some lower input costs and tariff to gain market share, then it’s anybody’s game. But we’re ready and willing to play. We feel like we’re very strong. I think you can tell by our numbers that we have disclosed today that we’re pleased with our second quarter service performance as well as our tire performance, in light of what other people have been discussing.

Operator

There are no further questions at this time. I will now turn the floor back to management for closing comments.

Mike Odell

Thank you again for your interest in Pep Boys, and just want to let you know that we are excited about our future and hope that you are too. Have a great day.

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