Welcome to The Pep Boys second quarter 2008 conference call. (Operator Instructions) It is now my pleasure to introduce your host Ray Arthur, Chief Financial Officer for Pep Boys.
On the call with me today are Mike Odell, Interim Chief Executive Officer of the company, Scott Webb, SVP Merchandising and Marketing, and our Controller, Sanjay Sood.
The format of the call is similar to those done by Pep Boys in the past. First Mike will provide opening comments regarding our results and priorities then I will review the second quarter and first half 2008 financial performance, balance sheet and cash flows. We’ll then turn the call over to the Operator to moderate a question and answer session. The call will end at 9:30 Eastern Time.
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 FD. In compliance with these regulations, we are web casting the conference call on investorcalendar.com. For anyone on the webcast who does not have the financial statements, you can access them on our website at PepBoys.com.
I will now turn the call over to Mike Odell, our Interim Chief Executive Officer.
As you’ve seen we reported net income of $5.4 million for the second quarter 2008 and $10.1 million year to date as compared to $4.2 million and $7.4 million for the same periods last year. We are pleased with our progress on our strategic priorities but we are disappointed with our sales. In service, tires and maintenance have been stable categories for us but repair work has been challenging. We have seen customers repair only what is necessary to safely operate their vehicles rather than to improve its performance or to restore their vehicles to new like condition.
Execution of drive up service continues to improve as have our customer service scores but we know that we are not yet the customer focus company that we aspire to be. We also feel the effects of fewer miles driven. In commercial we have experienced a saleable shift in profitability due to our focus on parts in addition to tires, commodities, and equipment sales.
We added four commercial operations in the second quarter and we’ll add 15 more in the second half of 2008 to end the year with commercial operations in 428 of our 562 stores. We have improved both or staffing and in stock to drive this business segment.
In retail our updated DIY parts categories have been fairly stable but accessories and personalization categories sales have been much softer than we planned and updates of these categories are still in progress.
Our biggest declines have been in the categories that we de-emphasized which are largely discretionary big ticket categories that are most susceptible to the effects of current economic conditions. Ray will walk you through the financial details including unusual items in a few minutes but first I’d like to share with you our progress on our strategic priorities.
We are in the midst of our business transformation to become a profitable customer focused automotive business. I’ll organize my comments today around leadership, merchandise mix, marketing mix and store operation.
Regarding leadership, most recently we announced the addition of Bill Shull as our Senior Vice President of store operations. Bill assumes the majority of my former Chief Operating Officer responsibilities, most importantly daily leadership of our store team. Bill will spend most of his time in our stores leading our service, retail, and commercial team members in their role to make Pep Boys the automotive solutions provider of choice for value oriented customers.
Bill’s deep automotive experience, passion and energy, coupled with his senior operating roles in other consultative retail environments make him especially qualified to lead our stores. Bill is a motivator and a store operator and his charge is to continue to drive the development of a store culture that develops our people, focuses on our customers and drives sales with intensity.
The other officer change this quarter is the addition of Bryan Hoppe, Vice President of Loss Prevention. Bryan also has deep automotive experience and brings a fresh store oriented perspective to help us improve our gross margin controls relative to shrink, point of sale activity and reverse logistics.
Regarding merchandising mix, this year we have devoted significant store labor to our sales floor transformation without incremental expense. This has been a huge undertaking and we remain on track to complete the sales floor moves by the start of the fourth quarter. Our stores now look like tires, parts and full service automotive centers consistent with our customers expectations. I want to personally thank each and every associate that continues to assist in this effort.
While this work needs to be done for the long term we recognize that it may have impacted our recent performance. Now our store team focus is on serving customers and selling complete solutions. In fact, we launch our Do It Right sales program in our stores this quarter to drive that focus.
Scott Webb and his team continue to update our merchandise assortments using our new category management approach. As we update our categories we continue to see positive trends. More importantly we are reestablishing ourselves as the dominant solutions provider for the automotive after market customers. We updated 31 categories this past quarter and are planning another 61 during the remainder of the year which we do not expect to be as disruptive as some of the large scale adjacency moves that we have made during the first eight months of the year.
We are extending our hard parts assortment not just in our stores but throughout our supply chain. Last quarter we mentioned that we had launched two super hubs that provide same day delivery of hard to find late model parts to stores in the surrounding area. We are launching six more super hubs during the remainder of this year.
Super hubs carry approximately 10,000 more parts than average stores and supports service, retail and commercial sales. In addition, our ND DC which carries 10,000 more parts than the super hubs is preparing to provide next day parts delivery to our stores chain wide. By the end of this quarter customers will be able to look up tires and parts, pricing and availability on PepBoys.com.
Regarding marketing mix, in past years as Pep Boys added non-automotive merchandise the media plan also shifted to become print based in order to inform customers about new merchandise and related promotional offerings. As we have shifted our merchandise mix back to core automotive this year we have reduced the page count of our print ads and narrowed their distribution around our stores.
Last year we also invested significantly in national TV ads to drive tire promotions. While these efforts drove sales the payback was unsatisfactory given the cost and our store density. Around Memorial Day when we last ran national TV ads we did not get a return from advertising this promotion in the current economic environment. Accordingly we did not repeat the national TV ads over the course of the summer. While we are unhappy with our reduced sales our objective is to build a profitable, sustainable business model.
As an alternative to national TV we have been testing local radio ads in three markets with promotional messaging. This month two of these test markets will switch to branding messages with promotional tag lines. In one of the markets we will add local TV to the radio spots.
Our vision for Pep Boys is to take our industry leading position in automotive services and accessories and become the automotive solutions provider of choice for value oriented customers. We have been working with our advertising agency, the Zimmerman Group, to refine this vision into a clear brand positioning. This positioning addresses the fact that while 85% of the people in our markets know our name only 15% of them know that we provide service and even a smaller percentage know that we are a full service provider.
Our new marketing message lets folks know about the breadth of services that we offer. You can see and hear the TV and radio commercials on our website under press releases. The branding message is that Pep Boys does everything for less. The context is that whenever a warning light goes on in your vehicle you need to bring your car or truck into Pep Boys, America’s only Tires, Parts and Full Service Center. We have also tested this message with DIY customers and found it to be just as compelling to them as it is with service customers. When the light comes on just come in. Pep Boys does everything for less.
Regarding store operations, we have also implemented a number of changes in our stores this year including training and development programs to build our expertise, drive up service to show care for our customers, a new service point of sales system as well as margin and expense controls. We constantly evaluate the pace and sequence of change and while we work hard to avoid distractions we also know that we need to move quickly to improve our customer experience and to further simplify our operating model.
Fast, expert customer service is important to retail, commercial, and service customers. We continue to push hard on improving the expertise of our people, in stock and store presentation, staffing and scheduling and creating a customer focus culture.
In summary, we are on a mission to become the automotive solutions provider of choice for value oriented customers and we are pleased with our progress but not yet with our results. I’ll now turn this call over to Ray who will walk you through our results.
This morning I will review our results on a GAAP as well as line of business basis. Please see the last page of our press release for a line of business format statement. I will also review relevant balance sheet and cash flow data.
On a GAAP basis net earnings from continuing operations for the second quarter 2008 rose to $5.8 million or $0.11 per share versus $3.9 million or $0.07 per share for the same period last year. The results reflect significantly reduced interest expense resulting from debt repayments paid with the proceeds from sale lease back transactions, net earnings from continuing operations also benefit from increased gains on the sale of assets resulting from sale lease back transactions and the sale of excess properties.
In addition, income tax expense benefited from the recognition of a $2.2 million deferred tax asset resulting from a June 2007 state tax law change. These benefits were offset by a $9 million reduction in operating profit that was driven by reduced sales but softened by reduced SG&A.
Net earnings from continuing operations for the first half of 2008 rose to $11 million or $0.21 per share versus $7 million or $0.13 per share for the same period last year. The results reflect significantly reduced interest expense, increased gains on the sale of assets and reduced SG&A offset by the impact of reduced sales. In addition, income tax expense was favorably impacted by recognition of a $2.2 million deferred tax assets resulting from a June 2007 state tax law change.
Sales for the second quarter were $500 million a $52 million reduction from the $552.1 million reported last year. The 9.4% reduction resulted from operating less stores and a 7.5% comp revenue decline. The comp decline reflects $13.2 million less sales of those non-core merchandise categories that we substantially exited as part of our strategic transformation.
Sales for the first half were $998.1 million a $93.6 million reduction from the $1.92 billion recorded last year. The 8.6% reduction resulted from operating less stores and a 6.6% comp revenue decline. The comp decline reflects $26.1 million less sales of those non-core merchandise categories that we substantially exited as part of our strategic transformation.
Moving on to gross profit, gross profit declined as a percentage of sales to 26.1% and 25.9% for the second quarter and first half of 2008 as compared to 26.9% and 26.5% respectively for the same period a year ago. The decline in gross profit was primarily due to reduced service labor revenue without a commensurate reduction in overall service payroll. The continuation of our clearance program and increased occupancy costs as a percentage of sales due to the reduced sales levels and higher rent resulting from our sale lease back transactions.
Product margin before occupancy costs remain flat year over year. The second quarter and first half of 2008 included sales of clearance product of $2.9 million and $8.4 million respectively at no margin versus sales of the same product categories of $16.1 million and $34.5 million respectively during the same periods last year at a gross margin rate of 30% and 31.7% respectively.
Gross profit dollars for the second quarter and first half of 2008 declined to $130.4 million and $258.4 million respectively from the $148.7 million and $289.3 million recorded during the same periods last year.
Selling, General and Administrative expenses declined to $122.6 million for the second quarter and $241.6 million for the first half of 2008 compared to expenses of $131.8 million and $259 million respectively for the same periods last year. As a percent of sales the expense rate rose to 24.5% for the quarter and 24.2% for the first half of 2008 from 23.9% and 23.7% respectively for the same period last year primarily due to de-leveraging impact of the closed stores, and the comp revenue reduction.
Net gain from disposition of assets increased $4.1 million and $7.2 million for the second quarter and first half of 2008 from the same period last year due to the closed of sale lease back transactions and the sale of excess properties.
Operating profit was $11.9 million and $26.4 million for the second quarter and first half of 2008 compared to $16.9 million and $32.7 million for the same periods last year. The results for the second quarter and first half are primarily the result of comp sales declines, operating fewer stores and the continued clearance program offset by reduced SG&A and gains related to the sale lease back transactions and the sale of excess properties.
Interest expense declined for the quarter and first half of 2008 to $6.5 million and $11.9 million respectively from $12.3 million and $25 million for the same periods last year due to lower debt levels. Income tax expense as a percentage of pre-tax income for the second quarter and first half of 2008 declined to 13.1% and 31% respectively from 37.3% and 38.5% for the same periods last year. The lower rates are primarily due to the recognition of $2.2 million deferred tax asset resulting from a state tax law change in June 2007.
Discontinued operations generated a loss in the second quarter and first half of 2008 of $0.3 million and $0.9 million respectively versus a gain of $0.2 million and $0.4 million for the same periods last year.
In summary, net earnings as a result of the items I just described rose to $5.4 million or $0.10 per share for the second quarter 2008 from $4.2 million or $0.08 per share for the second quarter of 2007. For the first half of 2008 net earnings rose to $10.1 million or $0.19 per share from the $7.4 million or $0.14 per share reported for the first half of 2007.
Now I’ll cover our service center, retail and commercial businesses on a line of business basis for the second quarter and first half of 2008. Our service center business which includes tire and merchandise sales as well as service labor revenue generated through our service base generated revenue of $224.2 million and $448.9 million in the second quarter and first half of 2008 compared to $233.4 million and $461.9 million for the same periods last year.
Comparable service center revenue decreased by 1.9% and 0.6% respectively in the second quarter and first half of 2008 compared to increases of 4.9% and 2.9% in the same periods last year. Service center gross profit declined to $52.1 million and $106.6 million respectively for the second quarter and first half of 2008 compared with $57 million and $108.8 million for the same periods last year.
Gross profit as a percent of revenue declined to 23.2% for the quarter from 24.4% last year. However, first half results increased to 23.8% compared to 23.6% last year. The current quarter performance is primarily due to reduced labor sales volume offset in part by increased margins on installed merchandise. The results were also negatively impacted by significantly reducing TV advertising in 2008 versus 2007.
The retail and commercial business generated sales of $275.9 million and $549.2 million for the second quarter and first half of 2008 respectively compared to sales of $318.7 million and $629.8 million for the same period last year. The 2007 second quarter and first half results include sales of $7.2 million and $14.6 million respectively attributable to closed stores that were not operational for any part of 2008. The 2008 second quarter and first half results also reflect a $13.2 million and a $26.1 million reduction in sales of the non-core product sales that we have de-emphasized.
From a gross profit perspective the retail and commercial business reported gross profit of $78.4 million and $151.8 million for the second quarter and first half of 2008 respectively versus $91.8 million and $180.5 million for the same periods last year. The 2007 gross profit amount includes $1.4 million and $3.1 million generated by closed stores not operational in 2008 and $4.9 million and $10.9 million generated from sales of non-core product that we have de-emphasized.
Gross profit as a percentage of sales declined for the second quarter and first half of 2008 due to sales of clearance product at no margin and the de-leveraging impact of reduced sales. Gross margin before occupancy costs for the second quarter and first half of 2008 however increased 140 and 91 basis points as compared to last year.
I’ll now turn to key balance sheet data. As you can see our cash balances have risen significantly from last year end primarily from the proceeds of three sales lease back transactions that we closed this year. During the quarter we settled our master lease obligation and repurchased 29 properties for $117.1 million and to fund this transaction we completed a sale lease back of 22 properties for $76 million and used these proceeds along with $41.1 million of cash on hand.
Inventory at the end of the second quarter was $560.2 million down slightly from the $561.2 million at the end of last year. Inventory levels have remained constant as we have exchanged non-core inventory for increased levels of core automotive merchandise. Property and equipment declined by $21.4 million from year end primarily due to the sale of stores in the sale lease back transactions offset in part by the purchase of stores and distribution centers that were previously part of our synthetic lease facility.
Debt has declined from year end levels by about $64.3 million as we have applied our sale lease back program proceeds to these balances. The deferred gain resulting from the sale lease back transactions has increased from $86.6 million at year end to $173.7 million at the end of the second quarter. As we disclosed previously we continue to believe that we have substantial value in our own real estate. The deferred gains are further evidence to this.
We have sold and leased back 97 properties generating $374.4 million in net proceeds with the result of recognized and deferred gains totaling $198.4 million. We still have 250 owned store properties and four owned distribution centers. We have no immediate plans for additional sale lease back transactions but will continue to evaluate their potential and if favorable we’ll pursue them.
Focusing on cash flow for a moment, we generated $35.3 million in cash flow for the first half of 2008. This is primarily due to the sale lease backs offset by the pay down of debt and the retirement of the synthetic lease obligation. Respectively we have no significant debt maturities until 2013. We expect capital expenditures to remain relatively consistent with prior years and do not see any significant needs of cash other than normal operating cash flow in the near term.
We have begun the process of renewing our revolving credit line and expect to complete this renewal by year end. The line currently has a maximum availability of about $230 million and we do not have any drawings against this facility currently.
With that I’ll close the financial review and turn this over to the operator for Q&A.
(Operator Instructions) Your first question comes from Tony Cristello - BB&T Capital Markets.
Tony Cristello - BB&T Capital Markets
One of the things that stood out in this quarter was on the service side of the business, the labor line. I know that has been something that you and the company have been balancing for some time in terms of master techs and the flat rate and stuff. I’m just wondering when you look at how this quarter played out with the environment and challenges that you appear to be facing is there reason to think that maybe some more staffing adjustments are necessary at this point.
Relative to our flat raters they basically get paid for the work that they do. Even when revenues decline or are not meeting expectations we do not reduce the staffing of our flat raters, it’s an expense adjusts itself. I would tell you that we are always on the look for more qualified technicians and master technicians. Our staffing is consistent with the way it’s been in the past. Turnover is down slightly.
They are the life blood of that work but its really when you look at the decline their productivity has gone down in terms of the work that they produce or that they have to work on relative to the number of people that we have available to do the work.
Tony Cristello - BB&T Capital Markets
If demand right now appears to be, correct me, when you look at your first quarter and then your second quarter. Would you say that some of the weakness was more self induced or did you think that the environment weakened, trends got weaker for you as the quarter progressed?
Relative to service it was more the economic situation that was self induced. The only thing on service that we affected was we affected the marketing, we did not run as many televised tire promotions but that really doesn’t affect the heavy work per se. It’s the heavy work, its engine performance, its air conditioning type work; it’s the type of work that is clearly affected by miles driven.
Also work that people, they’re still going to put the brake pads on to be able to stop their vehicle and they’re still going to make sure that the car starts and runs and change tires when necessary although even that gets delayed. If its purely to enhance performance or to bring it back to new like condition that’s where we’ve seen a pull back from the customers.
Tony Cristello - BB&T Capital Markets
Is there any ability for you to manage the actual labor rate itself? Do you think your pricing or your labor hour rates are in line with competitors or is there some opportunity maybe to bring that up some.
Let me talk a little bit about pricing, obviously we made a number of pricing moves last year and there were some areas where we felt like maybe we got, some areas we had opportunities some areas where we got ahead of ourselves. We’ve actually spent a lot of time this quarter making sure that we’re much more methodical or diligent about our pricing philosophy and service. Our pricing shops include national competitors but now include the local guys as well.
Our objective with our pricing is that we are going to be competitive with our labor rates, which has given us some opportunity and gives us a little bit more opportunity to go up on those labor rates. Because we have our own parts we will be very competitive relative to everyone else even with a mark up on parts from retail to service we’ll still be very competitive on our parts pricing.
We are working all of the pieces to get more margins out of the service business, we’d slowed down on some of that in the second quarter because we just needed to make sure that we were in line with where the competition was moving and did not get ahead of ourselves and make ourselves uncompetitive. We do have a little bit of opportunity there.
Tony Cristello - BB&T Capital Markets
It seems like you’ve pared back significantly on ad spend at least on the TV side and maybe in some other areas. How do you balance that with advertising too little at least from either direct marketing or an exposure and thus having a negative impact on store traffic?
We have not pulled back, when it comes to direct marketing media there are no limits to spending there. We’ve got our customer relation program, rating additional programs; there’s been no pull back on the direct to customer. The pull back has been on the broad based print ads in terms of the size of the ads and the distribution. The one that’s probably been the toughest to swallow is not running as many TV ads for tires.
That’s because we’ve been working on our positioning and because those ads were focused purely on a promotion and purely on one segment of the business its hard with a national spend to get enough lift on a single category even though its our biggest category to get enough lift on a single category for a short duration to make it pay for the national TV.
That’s why, I don’t know if you’ve had a chance yet, I think you’ll think they’re pretty cool when you go to the website to see the TV and radio commercials that we have now which are intended to drive the whole business all the time versus just a segment of the business a portion of the time. I’d love to go big with that as fast as we can we just are trying to be smart about it in terms of doing it in select markets to make sure that the investment is prudent and to understand how quick or slow the payback comes from the branding message before we go bigger. We’re ready to go bigger as we prove it out.
Your next question comes from Emily Shanks – Lehman Brothers.
Emily Shanks – Lehman Brothers
I was hoping you could give us a little bit of color around specific do it yourself and commercial comps on the retail side how it trended during the quarter, what traffic was like. If you can comment at all in terms of you may have seen some kind of activity around the stimulus checks and the possibly trailed off, any color like that.
I think we saw a little bit of benefit from the stimulus checks. We don’t generally talk about the weekly comps coming through but I would say clearly got worse rather than better as we went through the quarter. That’s just a result of the accumulated impact of miles driven continuing to go down. I think it’s the eighth month in row that miles driven have gone down. We’re also continuing to see deferral of repairs because of the economic situation that people are in.
To break out the commercial and retail, while we don’t break them out as segments at our commercial business particularly because of our focus on staffing and parts, in stock on parts has been stable and that the decline is really retail related.
Emily Shanks – Lehman Brothers
As you look at the trend in service, obviously it’s been comping positive the past few quarters. I think this is the first one that we saw a modest decline. What are the biggest changes or significant drivers that were evident this quarter that swung that to negative territory?
The comments that I just responded to Tony it was the economic environment and then as it related to tires the fact that we did not run the big promotion which again affects top line but bottom line it was favorable to us.
Your next question comes from Jeff Blaeser - Morgan Joseph.
Jeff Blaeser - Morgan Joseph
On the product mix and the disruption that mentioned can you give a little bit more color as to what that disruption was and with 61 new categories coming out why you don’t think that will be an issue going forward.
There are two kinds of updates or moves that take place in the stores. One is if you’ve got a four foot planogram or an eight foot planogram and you’re switching out the items that just becomes disruptive to that category for literally the day that you do that work. It’s fairly minor. That’s what we have ahead of us. What we had behind us was literally the adjacencies in our stores had not been touched for a while and as we exited the non-automotive product we expanded categories from four feet to eight feet, from twelve feet to sixteen feet, etc.
Literally for the first eight months of the year we have been moving whole sections of the store to get make sure that we’re able to expand the categories that are going to drive our business and to get them positioned with logical adjacencies the way the customers shop us. There are two parts to that disruption; actually there are probably three parts disruption. There is the physical move and the effect on the inventory availability to the customer during the move.
The fact that we use our own people to do the work, which we still think it’s the right thing to do. It puts their focus on making the physical moves in the store and perhaps taking it away from the customers the way we’d like to be. Then you’ve got the fact that customers who come to see you on a regular basis they do get a little confused when anything moves. Even if it wasn’t right and logical the way it was before it’s just like in a grocery store when you move something on somebody they start to get a little confused.
Behind us was this wholesale move of literally moving aisles from one end of the store to the other to make sure that we’ve got logical adjacencies in each of our stores. As you walk the stores today, we are still not complete with the updates but as you walk the stores 80%, 90% of the store you can see the difference and then you’ve still got another 10% of the store where you can tell that we have still not updated a category and you’ll see the holes in the floor. The adjacency work is complete.
Jeff Blaeser - Morgan Joseph
On non-core liquidated merchandise how long do you think it will take for the replacement product will take that shelf space away to offset that, do you expect it to offset it completely in sale and margins?
We are in the middle of rolling out our tool program. The tool program is the largest remaining piece of the new merchandise that we intend to put in as a replacement. We finished with the personalization categories as Mike alluded to on this call and previous calls the personalization categories have been a bit softer in this economic environment so we have not seen the full replacement from a sales and gross standpoint out of those categories. We expect that will improve as consumers return to the shelves, so to speak, for those categories, as well, tools we expect great things out of those categories as well.
We still have some other new ideas that we are working through relative to wheels and speed shops and that will be something that we’ll talk about more probably when we get to the next conference call next quarter.
Your next question comes from Peter Benedict – Wachovia.
Peter Benedict - Wachovia
I wanted to clarify the expense associated with the sales for transformation and exchanges etc. That’s not really incremental because you’re using your own people is that the right way to think about it?
Correct and really didn’t give them extra hours to do it. That’s why it’s a distraction to customer service.
Your last question comes from William Keller - FTN Midwest
William Keller - FTN Midwest
To make sure I’m thinking about this correctly, the gain from the disposed assets is that purely the gain relating to what you got for it versus what you paid or is there some of the lower D&A also in that line item?
It’s purely the gain from the immediate gain from sale lease back of about $2.1 million that we had three excess properties that we sold in the quarter was well that resulted in another $2 million of gains.
William Keller - FTN Midwest
The lower D&A we should see in SG&A and then the higher rent is up in.
Cost of sales, correct.
William Keller - FTN Midwest
Should we expect similar numbers going forward or is that more tied to exactly what you do in the quarter as far as the sale lease backs.
It’s tied to the sale lease back transaction as Ray pointed out. We have not decided what we’re going to do with the sale lease back transaction going forward. In terms of actual asset sales or excess property that may continue as we find different players for that.
There are no more questions in the queue at this time.
Thank you very much for participating in the Pep Boys conference call today. I’ll be available should any of you wish to call me separately. Thank you very much.
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