We believe that management is on the right path to transforming Pep Boys over the intermediate to longer term into a successful competitor in the very fragmented professional service aftermarket through a combination of greenfield development activity and acquisitions. Since the beginning of 2010, Pep Boys has aggressively grown its network of “spoke” service and tire centers from just 25 locations to almost 150, including its recent acquisition of Big 10, which added 85 locations in Florida, Georgia and Alabama. And over the balance of the year, management anticipates adding another 25 locations.
To take a very long-term view of the company, we believe that Pep Boys will ultimately need to pair somewhere in the range of five to 10 “spoke” service and tire centers with each of its supercenters —implying a total of 3,000 to 6,000 service units — in order to fully capitalize on improved market density, brand leverage and distribution efficiencies. To put this degree of growth in perspective, it took Monro Muffler more than 10 years to double its store base from the 350 locations it operated in 1999.
In our opinion, this service network build out is critical to the company driving improved productivity and higher returns on capital from its existing asset base, principally its oversized (relative to its peers) supercenter store locations, which will essentially be used as an extensive hub store network. That being said, in the near term, its recently opened service and tire centers will continue to weigh on the company’s overall profitability until these locations gradually mature into higher revenue-producing units.
From a macro perspective, we also remain concerned about the impact of the current challenging operating environment and macro backdrop — in particular, approximately $100 per barrel of oil and nearly $4 per gallon of gasoline — on miles driven and aftermarket demand levels. Historically, fuel expenditures north of 3.5 percent of disposable income have signaled deterioration in aftermarket fundamentals, and we would note that fuel expenditures are currently running at an estimated 4.5 percent of income. Same store sales (SSS) at Pep Boys declined 0.6 percent year over year in the first quarter against a comparison of 1.4 percent in Q1’10, with customer traffic seemingly declining as the quarter progressed.
In particular, the tire segment and discretionary category experienced pronounced weakness in Q1, marking a significant reversal in trend from that seen in recent quarters and signaling to us that the core aftermarket consumer remains in a precarious financial position, and that the recent surge in food and fuel prices is not going unnoticed. With the company facing more challenging comparisons as the year progresses (vs. +1.8 percent, +3.5 percent and +4.3 percent, respectively, in Q2-Q4), we believe that SSS results have the potential to disappoint relative to consensus expectations, barring a substantial reduction in average gasoline prices.
Management maintained its prior multi-year targets of 300 base points of earnings before interest and tax (EBIT) margin expansion, with two thireds of the improvement still expected to come from plugging gross margin leaks. However, with SSS likely to run flattish or slightly negative — and given Pep Boy’s relatively fixed cost structure — and continued margin drag from new service and tire centers, which should experience a slower ramp to sales maturity in the current environment, we expect the majority of these margin gains to be realized on a delayed basis.
With shares down roughly 19 percent since reporting Q1 earnings (vs. a flattish S&P 500), we understand why longer-term investors might find value in Pep Boys at current levels given the opportunities for eventual margin expansion and earnings growth off of a relatively depressed base (FY’10 EBIT margin of 3.8 percent). That said, we believe that recently revised consensus estimates are still too high (FY’11 street at $0.78, BB&T lowered to $0.62; FY’12 street at $1.05, BB&T lowered to $0.75), and valuation on what we view as more realistic earnings assumptions is still too expensive to justify a more constructive rating at this point given the inherent execution risk of what is still a turnaround story.
About BB&T Capital Markets:
BB&T Capital Markets is a full-service investment banking firm that focuses on specific industries, including the Automotive Aftermarket. BB&T Capital Markets is a division of Scott & Stringfellow, LLC, member NYSE/FINRA/SIPC. Scott & Stringfellow is a wholly-owned nonbank subsidiary of BB&T Corporation, one of the nation’s largest financial holding companies with $155 billion in assets. Securities and insurance products or annuities sold, offered or recommended by Scott & Stringfellow are not a deposit, not FDIC insured, not guaranteed by a bank, not insured by any federal agency and may lose value.
Disclosures:
BB&T Capital Markets makes a market in the securities of Monro Muffler Brake, Inc. and The Pep Boys—Manny, Moe & Jack.
BB&T Capital Markets expects to receive or intends to seek compensation for investment banking services from Monro Muffler Brake, Inc. and The Pep Boys—Manny, Moe & Jack in the next three months.
An affiliate of BB&T Capital Markets received compensation from Monro Muffler Brake, Inc. for products or services other than investment banking services during the past 12 months. The analyst or employees of BB&T Capital Markets with the ability to influence the substance of this report know or have reason to know the foregoing facts
