Pep Boys: Staggering Potential for Improvement

Pep Boys (PBY) does not stand up too well with its competitors from an earnings perspective, but maybe that's a good thing, as it creates the potential for mammoth progress to unfold. The last time the shares were at these depressed levels, they promptly rallied almost 500% to the $30 vicinity. Will history repeat itself? It often does, and this time around the company is leaner and meaner, so instead of a five banger, a possible ten banger could be in the cards.

The Competition: The O'Reilly Group (ORLY), Auto Zone (AZO) and Advance Auto Parts (AAP) are PBY's main rivals. They have an average PE multiple of 16, and a gross profit margin of 47.6%, which is a shocking 2300 basis points higher than PBY's gross margin of only 24.6%. Manny, Moe and Jack's SG&A cost is surprisingly superior to its competitors' at only 24.6% (quite coincidental that its SG&A costs and gross profit margin are exactly the same) of sales versus a 35%  average. If PBY was just able to increase its gross profit margin 40% (1000 basis points) to 34.6%, its earnings would nearly vault to $4 a share, and with a peer multiple of 16, a possible share price of $64.

PBY stands out in the crowd:  It is the lone auto parts retailer that owns the real estate on most of its locations. Its cash dividend yields 4.2% versus .60% for Advanced Auto Parts (AZO and ORLY do not pay a dividend). It is the only company that offers service to install the parts they sell. Its price to sales ratio is an astounding .16, compared to AZO's 1.38, ORLY's 1.49 and AAP's .82 calculation. The company is selling at only .68 of book value compared to AZO at 19 times, AAP at 3.9 and ORLY at 1.49 of its shareholders' equity.

Cash and Debt: PBY has increased its cash and decreased its debt through its ongoing real estate sale lease back program. It now carries $56 million in cash and $330 million in debt. Its debt load is lower than AZO's $2 billion position or AAP's $600 million of borrowings, but is higher than ORLY's long term debt of $75 million. PBY's cash position is somewhat lower than the group's average of $72 million. The company also has a $100 million stock buyback program in effect, with about $50 million remaining for future purchases.

Dead Cat bounce: I was surprised to see that the shares didn't even experience a "dead cat" bounce despite dropping 35% last week. I expect that last week's disappointing .3% drop in US Retail Sales didn't help matters, but I am stunned that the shorts haven't started covering to book profits or that bargain hunters have not entered the picture.

Analysts take: Goldman Sachs's Matthew Fassler trimmed his 2008 earnings estimates by .05 as well as his one year price target from $9 to $8; however at today's price, Fassler's opinion still translates into a substantial 33% return on investment. David Schick of Stifel Nicolaus was more upbeat, stressing, "we continue to believe that Pep Boys is pursuing the right initiatives to better position  the company long term, and has added experienced senior management members in the last year. Their focus on automotive service offers their best chance for success." The analysts have overall ratcheted down their expectations, but that only makes it easier for PBY to ultimately "beat" estimates in the future.

Liquidation scenario: If PBY decided to sell off all its assets, pay off its liabilities and subsequently distribute the remaining proceeds among shareholders, the result could be pleasantly surprising. The balance sheet indicates that the company has $56 million in cash, $28 million in account receivables and $36 million in prepaid expenses. Current assets also list $560 million of merchandise inventory. If you add these items up and subtract 50% from the inventory amount (allowing for a closer resemblance to market value), their sum is $400 million. Adding an additional $1 billion for what the real estate is expected to fetch and you are left with a $1.4 billion war chest before liabilities.

The liabilities that must then be paid off are: Accounts payable of $228 million, Accrued expenses of $257 million, long term debt off $335 million and other long term liabilities of $66 million, totaling $888 million. If you take the expected proceeds of $1.4 billion and subtract anticipated payouts of $888 billion, you are left with $512 million to distribute between 52 million shares, equating to $9.84 per share, or a substantial 60% premium to the current share price. I realize that this liquidation analysis is somewhat crude and saddled with "rough estimates" but its main intention is to draw attention to the company's confounding undervaluation.

Bottom line: I thought for sure, the shares would have experienced at least a bounce last week, though I was woefully wrong. I still like the stock, but wouldn't try and pick a bottom at this juncture, as supply still seems to be overwhelming demand. I think it is imperative to see a capitulation and a intraday trading reversal to occur before a prime buying opportunity arises. It makes more sense to wait for the shares to change course and begin an uptrend before buying more. A stop buy order placed at a trigger price of $7.11 seems the logical approach. You have to pay more, but the added cost, is well worth having the trend on your side.

Disclosure: Long PBY.

Comments

[TheGMan:]

Shoddy management practices, hires the lowest people on the totem pole (I worked there), worst product lines in the sector. Sure its got potential, but so does every car in the junk yard. Get out from behind your computer and go visit some of thier stores. Then visit every other auto parts retailer. PBY does everything wrong.

2008 Sep 26 05:43 PM