If successful, the company should evolve into a much more competitive auto service provider while realigning its DIY segment to fuel growth for its DIFM business. Plans include a refocus on core automotive merchandise (larger hard parts assortment, tire and wheel lines and customization products, etc.), optimizing square footage productivity and creating service density through a "hub and spoke" growth model. In addition to the $166 million in sales leasebacks that closed on Nov. 27, Pep Boys announced it was closing 31 underperforming store locations in non-core markets.
Pep Boys' hybrid model has been a difficult one to balance, and as the industry was evolving around it, the company continued to maintain an underutilized service segment, a high mix of non-core inventory and a footprint that created a competitive disadvantage. While some investors might have been looking forward to the balance sheet deleverage from asset sales/sales-leaseback transactions along with margin improvement from internal price and labor initiatives, these changes alone would not have addressed the company's competitive positioning for the future.
While we agree with the strategy, implementing these changes will take time, and we believe investors need to be patient as the next few quarters likely will be challenging. Fourth quarter results will at least be negatively impacted by additional pretax charges of $17 million related to the 31 store closures (not in our estimates). Retail gross margin also should come under additional pressure as the company eliminates its non-core inventory by selling through at cost (estimated $40 million over three quarters).Ultimately, we don't think there was much alternative to the announced strategy, and Pep Boys should become a better competitor with a renewed focus on the service side of the business while simultaneously lessening its dependence on DIY sales. The DIFM segment (4 percent to 5 percent growth) of the automotive aftermarket is growing faster than the DIY side (running flat), and DIFM (including both professional labor and installed parts) is almost four times as large as the DIY side.
Industry fundamentals, such as increasing vehicle complexity and a share shift toward more foreign nameplates, continue to point toward strong DIFM growth for the foreseeable future. However, the DIY segment is witnessing lower traffic levels, which have been, for the most part, offset by higher ticket sales. In addition to more favorable long-term fundamentals, the DIFM segment also offers more opportunity for growth given its more fragmented nature, in our view. That said, the DIY side of the aftermarket is not going away, and Pep Boys could be successful if it learns to run its retail business for cash flow while enhancing parts coverage for its service operations.In the past, Pep Boys tried to be all things to all people, but in today's environment that model simply does not work. In fact, we think it creates uncertainty on the part of its customers, whether DIYers, professional installers or service customers. This won't be an easy fix, but we think opening more stores within existing markets (and closing those underperforming stores) to create density will be a step in the right direction. As far as the "spoke" stores, these shops will require fewer bays (somewhere in the range of four to six for service or six to eight for tires) because the 11-bay structure that Pep Boys currently operates is too inefficient. Staffing becomes problematic — either not having enough certified techs to support demand or having too many qualified techs around without enough jobs to warrant it.
The satellite service centers would focus on light-medium repair and maintenance, tire sales and the referral of heavier repair work back to the hub shops. By utilizing a hub and spoke approach (we estimate the addition of roughly 800 to 1,000 stores over time), Pep Boys should develop much better market penetration and store density, advertising and branding efficiencies, as well as distribution synergies.
In this way, Pep Boys not only would develop a more "neighborhood service shop" image, but also would improve the utilization of its existing 20,000-plus-square-foot supercenters. Over time, these additional spoke service outlets could contribute roughly the same amount of service center revenue that is currently generated from the service operations (labor and installed parts) of Pep Boys' primary supercenters.
We expect these spoke shops to produce annual revenue of approximately $100,000 per service bay, in line with service peers but at a discount to supercenter revenue per bay of roughly $150,000 because the spoke shops will not offer the high ticket major repair services. We estimate that would put annual revenue per spoke shop in the $600,000 to $800,000 range and implies that over the longer term, Pep Boys sees the potential for operating well more than 1,000 spoke locations.
In addition, we think building density (via acquisition) should help improve utilization as more square footage at the supercenter stores can be dedicated to driving service sales at shops requiring lower overhead costs. It will take time for this transition to evolve, but we do think Pep Boys can climb back to the 5 percent to 6 percent EBIT margin (and double digit EBITDA) range, although it may take three to four years to reach it.
BB&T Capital Markets is a full-service investment banking firm that focuses on specific industries, including the Automotive Aftermarket industry. BB&T Capital Markets is a division of Scott & Stringfellow, Inc., NYSE/SIPC. Scott & Stringfellow is a registered broker/dealer subsidiary of BB&T Corporation, the nation's 14th-largest financial holding company with $130.8 billion in assets.
TONY CRISTELLO Senior VP, BB&T Capital Markets Equity Research
Disclosures: BB&T Capital Markets expects to receive or intends to seek compensation for investment banking services from The Pep Boys — Manny, Moe & Jack in the next three months.
