A Pep Boys sale?

It is a bit too early to discuss how the December quarterly earnings shaped up for our public aftermarket companies. In general, the DIFM side of the business continues to fare better than the DIY. Both the weather and the holiday pressured sales some for O’Reilly Automotive, particularly on the DIY side. It posted a modest 3.3 percent same stor sales (SSS) gain for its December quarter. As we write this in mid-February, we have had only a few companies report and we will add more color in next month’s column. Instead, we wanted to offer some thoughts on Manny Moe and Jack.

Yes, here we go again. It’s not Groundhog Day or a case of déjà vu. The Pep Boys stole the show and now have an offer from The Gores Group to purchase the company for $15 per share (roughly $1 billion in total transaction value). This transaction is roughly 6.4 times our calendar year (CY) 2011 EV/EBITDA (enterprise value/earnings before interest, taxes and amortization) estimate or 5.7 times our CY’12 estimate. While the valuation appears “cheap,” Pep Boys has been shopped many times over the past few years and never received a bid that the board believed to be adequate. In fact, we think the Go-Shop period until March 14 is more a function (and formality) of how the transaction evolved — that is, privately between the two parties rather than a formal sell process. We suspect by the time this article goes to print, a deal is likely to be close to finalized (if not completed).

We do not foresee any strategic buyers that would be interested in Pep Boys, although it’s possible that an international buyer could have some interest similar to when Sumitomo acquired the TBC Corporation in 2005 for purposes of distribution, or when Japan’s Autobacs Seven acquired Strauss Auto (similar model to PBY) out of Chapter 11 in 2007. Considering a play by the retailers such as an O’Reilly for example, it is not likely in our view. The Pep Boys service business would have to be divested and in our opinion, the company simply does not have the compelling turnaround features in its retail operations to make it work (e.g., stores too big, not all stores in great locations).

In our minds, Pep Boys has always been considered for sale, particularly given the very activist board/shareholder involvement associated with the company. While the business model still has its inefficiencies, we believe the strategy to build a “hub and spoke” service model is the right one, albeit one that will take time. Management has cut significant expenses, but the harder choices in terms of closing stores or divesting business and continuing its plans for aggressive consolidation are easier done under the cover that a private company provides. In addition, the tire segment (now at a 20 percent mix) is under pressure, and we suspect that the recent acquisitions the company has made continue to compress gross margins, which may have pressured earnings in Q4 and could pressure overall growth in 2012. Whether Pep Boys can ever achieve high single-digit EBITA will remain to be seen, but it might not be seen in any public filings.