Pep Boys' strategic plan gets a thumbs up from industry analysts

After a third quarter decrease in comparable sales and comparable merchandise sales, The Pep Boys — Manny, Moe & Jack have unveiled a long-term strategic plan to rebalance the company's inventory and improve both top and bottom line performance.

The cornerstones of Pep Boys' five-year plan are to refocus on core automotive merchandise, optimize the company's square footage productivity and add incremental service bay density through a "hub and spoke" growth model. The company believes that these initiatives will drive robust revenue and profit growth in each of its lines of business — retail (DIY and commercial) and service centers (labor plus installed merchandise and tires). The principal elements of Pep Boys' long-term strategic plan was communicated in greater detail by Jeff Rachor, president and CEO, on a third quarter earnings call that took place last week.

As part of Pep Boys' plan to refocus on core automotive merchandise, the company will reallocate a larger portion of its inventory investment to core automotive merchandise, including additional tire inventory, a broader parts assortment and more car customization accessories. To rebalance the company's inventory, an aggressive mark down and sell-through program has been launched for certain non-core and unproductive merchandise. The company also is piloting several business development projects aimed at higher return utilization of the excess sales floor capacity present in its existing Supercenters.

"This plan indicates that the company is interested in growing its share of the DIFM market," says Dan Smith, president of Capstone Financial Group. "I think you'll see a lot of these guys as they start to specialize in the DIFM market start shuffling their inventory around to appeal more to the repair shops and local garages, rather than the end consumer."

Tony Cristello, senior vice president of BB&T Capital Markets predicts a bright future for the Pep Boys. "If successful, the company will evolve into a much more competitive auto service provider while realigning its DIY segment to fuel growth for the DIFM business." But Carey cautions that investors will have to be patient and wait for the pay off. "While we agree with the strategy, implementing these changes will take time and investors need to be patient as the next few quarters will likely be challenging for the company."

Pep Boys' growth strategy is centered around a "hub and spoke" model, which calls for adding smaller neighborhood service shops to its existing Supercenter store base in order to further leverage existing inventories, distribution network, operations infrastructure and advertising spend. The company expects to add these new service facilities both through organic growth and opportunistic local acquisitions.

In order to support the investment needed for Pep Boys' revitalization, the company has moved forward with a sale leaseback process for certain existing owned real estate. The first, previously-announced sale leaseback transaction has been completed on 34 stores for gross proceeds of $166.2 million. In addition, the company today closed 31 low-return stores (approximately 5 percent of the store count) located in ancillary markets and locales with changed shopping patterns. The store closures will result in a reduction of approximately 550 store employees (approximately 3 percent of total employees).

"Since joining Pep Boys, I have spoken about the need for transformational change in our business model and a long term strategic plan," says Rachor. "Today is the first of several difficult, but essential steps that we will take towards revitalizing the Pep Boys brand and returning to dominance in the automotive aftermarket. We are confident that these decisions will serve as the foundation for Pep Boys' long-term growth and increased shareholder value."

Cristello adds: "We think the Pep Boys should become a much better competitor and think a renewed focus on the service side of the business is necessary, as is lessening its dependence on DIY sales. It will take time for this transition to evolve, but we think the company can clim back into the 5 percent to 6 percent EBIT margin range within the next three years."

The company also announced the following results for the third quarter ended Nov. 3, 2007. Sales for the quarter were $535,376,000 as compared to the $550,849,000 for the third quarter ended Oct. 28, 2006. Comparable sales decreased 2.9 percent, including a 4.1 percent comparable merchandise sales decrease and a 2.6 percent comparable service revenue increase. In accordance with GAAP, merchandise sales includes merchandise sold through both the company's retail and service center lines of business and service revenue is limited to labor sales. Recategorizing sales into the respective lines of business from which they are generated, comparable retail sales (DIY and commercial) decreased 8.1 percent and comparable service center revenue (labor plus installed merchandise and tires) increased 4.5 percent.

Net loss from continuing operations before cumulative effect of change in accounting principle increased to $21,650,000 ($0.42 per share — basic and diluted) from $10,713,000 ($0.20 per share — basic and diluted).

Sales for the nine months ended Nov. 3, 2007 were $1,640,278,000 as compared to the $1,686,015,000 recorded last year. Comparable sales decreased 2.9 percent, including a 4.1 percent comparable merchandise sales decrease and a 2.6 percent comparable service revenue increase. Recategorizing sales, comparable retail sales decreased 7.3 percent and comparable service center revenue increased 3.4 percent.

Net loss from continuing operations before cumulative effect of change in accounting principle increased to $14,234,000 ($0.27 per share — basic and diluted) from $10,110,000 ($0.19 per share — basic and diluted).

"We were pleased with the continuing improvement of our service center business which yielded a 4.5 percent comparable service center revenue increase and underlying gross profit margin improvement, despite the prevailing difficult macroeconomic environment," says Harry Yanowitz, the company's CFO. "Our cost reduction initiatives also continue to be a highlight, supporting improved overall operating performance. Over the next 12 months, we expect that the inventory rebalancing and the store portfolio reduction will generate working capital proceeds of approximately $65 million. We expect to utilize this working capital together with the proceeds generated from our sale leaseback transactions, the first of which closed today for $166.2 million, to reduce indebtedness and grow the business."

According to Smith, the company's growth plan is a sound one. "Clearly, the Pep Boys is looking for ways to improve earnings, and the company has decided to do so by focusing on a different channel of this industry. From what we can see, that's a good move for them."

For more information about Pep Boys and its long term strategic plan, visit the company's Web site.