Pep Boys: Manny, Moe and Jack Finally Pep Up

| About: Pep Boys (PBY)
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Saying Pep Boys's (NYSE:PBY) stock has "pepped" up lately, is an understatement. The shares have rocketed almost 77% from their lows, hitting $5.31 per share, before getting caught up in Wednesday's and Thursday's 1000 point Dow down draft. The stock still managed to close at $4.66, a respectable 55% improvement from its previous lows of $3.00. The shares had been so crushed and oversold that a snap back had to be expected. PBY's rally was more than just a dead cat bounce. It had the characteristics of a good old fashioned "short squeeze" as well as some of the attributes related to aggressive bargain hunting.

Analyst upgrades: Analysts seem to be jumping on the bandwagon. Besides last month's Kevin Dann and S&P upgrades, the auto parts retailer received an additional two upgrades, as both Argus Research and Jefferies & Co. issued upgrades. Argus Research notes were so compelling, they need to be highlighted:  

The reason for our rating change is twofold:  First, the stock has fallen so low, that any meaningful turnaround should bring significant gains to the share price. Second, we believe PBY's stock is currently trading near its liquidation value. Even in the event of a default and chapter 11 reorganization, we believe the assets of the corporation would fully cover the share price even after all the creditors are satisfied. Equity is typically wiped out in a bankruptcy, but Pep Boy's appears to be that rare case where the market cap is below even a heavily discounted valuation of net assets.

Buying back debt, not stock: The company purchased back $23.2 million worth of its 7.5% senior subordinated notes (due 2014) in the second quarter. During the third quarter, the financial meltdown caused these notes to get hammered, subsequently selling at more than a 40% discount to face value. It is probable the company is exploiting this situation by buying back these notes in the third quarter as well. Each $1 million worth of bonds purchased will produce almost 1 cent of earnings. The company has not been able to purchase back its own shares due to loan covenants in place, eliminating this ability. It is perplexing why these covenants would allow cash dividends to be paid but prevent share repurchases in the open market. Management should urgently negotiate with its lenders to amend those covenants which prohibit stock repurchases, especially with the share price hovering near 20 year lows.

EPS estimates, streamlining, tax loss carryover and SG&A costs:  The Street is expecting PBY to deliver third quarter revenues of $491 million, and flat earnings. PBY could beat this number if they end up purchasing back some of their senior notes at an anticipated gain. The company has also been in a streamlining mode, eliminating layers of management and reorganizing its field divisions. This reorganization effort, gives directors a smaller region to oversee, as eight divisions were reduced into six. PBY also has a $41 million tax loss carryover to shelter future earnings from income taxes, representing about 75 cents per share of earnings that will not be taxed. Although lately the company has been aiming in the right direction, roadblocks still remain, as management has been ineffective controlling its Selling, General & Administrative costs. PBY's second quarter results showed a 70 basis point increase in this category, from 23.8% to 24.5% of sales. These costs have to be reined in.

Bottom line: My last piece stressed waiting to buy the stock until it crossed the $4 mark. Now that it has, the green light to buy is on. Although a pullback to the low $4s or high $3s is still a possibility, this might be the time to buy more, as the shares provide significantly more upside potential than down side risk. The stock presents a compelling 4:1 risk reward  ratio, meaning you have the potential to profit four times the amount you stand to lose.

Disclosure: Long PBY.