Can Pep Boys Gain Some Momentum From Old Man Winter?

Auto-parts retailer Pep Boys has been looking for a spark to reinvigorate its business fortunes, as it continues to revamp its stores under a new customer-focused operating strategy. With the bad weather creating a sales tailwind, is it time for investors to bet on it?

Feb 1, 2014 at 8:30AM

Old Man Winter has been releasing his wrath on the northern states of the U.S., closing schools and turning the roads and byways into pot-hole adventures. While that is bad news for car owners, it is good news for auto-parts retailers like The Pep Boys -- Manny, Moe & Jack (NYSE:PBY), which does a considerable business in the tire-replacement area. 

The company's share price has been fairly listless since an aborted private equity takeover bid in early 2012. However, with a new operating strategy in place, code named Road Ahead, and with the weather drumming up business, is the company worth betting on?

What's the value?
Unlike its primary competitors that focus on selling parts and accessories, Pep Boys generates a roughly equal revenue share from its retail- and service-center units. While the top 10 auto-parts chains have consolidated roughly half of the retail trade, the larger service side of the business is more fragmented, providing growth opportunities for Pep Boys through the capturing of a portion of the roughly 60% market share controlled by small independent shops. 

On the downside, though, Pep Boys' dual-focused operating model requires a larger average store size, 20,000 square feet versus roughly 7,000 square feet for its competitors, which generally limits its footprint to more populated market areas.

In FY 2013, Pep Boys has continued to struggle to find growth, reporting a 0.7% top-line gain that was hurt by negative comparable-store sales. Despite a new store layout that caters to car enthusiasts via designated Speed Shop areas, part of its Road Ahead strategy, the company has had trouble attracting larger volumes of customers to its stores. More importantly, the high support and administration costs required by Pep Boys' focus on two major lines of business has kept its operating margin at an unhealthy sub-2% range.

Biting off more than it can chew
Clearly, Pep Boys is focused on growing its service-center business, as evidenced by its recent purchase of 17 service and tire centers in Southern California, a group that will be folded into the company's own growing chain of service and tire stores. Alongside its supercenters, Pep Boys has been building a network of small stores that provide light vehicle and tire services, but maintain little retail inventory, with the hope of leveraging nearby traditional Pep Boys locations. However, that strategy seems to have little chance of success, given that a growing percentage of its retail stores' customer base is commercial customers, the very people that its service centers are competing against.

Competitor Advance Auto Parts (NYSE:AAP) has noticed the changing mix of customers in its stores, a trend that it attributes to the increasing complexity of vehicles' systems, repairs for which are better left to professional technicians. The company's recent acquisition activity has been meant to strengthen its relationship with its commercial customer base, including its purchase of General Parts International, the No. 1 domestic distributor of import vehicle parts.

Like Pep Boys, Advance Auto Parts has struggled with negative comparable-store sales in FY 2013 due to weak customer volumes among its do-it-yourself (DIY) customer base. Nevertheless, the company was able to power an overall top-line gain, thanks to its acquisition of commercial-focused parts distributor BWP, as well as an organic increase in its store network. It has also used a strong pricing environment for auto parts to maintain solid operating profitability, which has helped fund its acquisition activity.

Meanwhile, fellow competitor O'Reilly Automotive (NASDAQ:ORLY) continues its long-standing focus on the commercial-customer subset, a group that accounted for more than 40% of its total sales in its latest fiscal year. The company's recent expansion of its distribution center network, as well as the installation of a more advanced electronic parts catalog in all of its stores, was primarily designed to quickly and efficiently meet the needs of this important customer group.

Despite the operating challenges of its competitors, it has been just another day at the office for O'Reilly in FY 2013, reporting a 7.1% top-line gain that was aided by a solid 3.9% increase in its comparable-store sales. More importantly, the company's focus on high-touch customer service and long-term customer relationships, preached throughout the company's environs, has allowed it to maintain a healthy level of profitability, providing the financial flexibility to pursue selective acquisitions.

The bottom line
Old Man Winter may give Pep Boys' service sales a nice lift, but the company probably needs a rethink of its dual-business-line strategy, if it hopes to compete against hard-charging, focused competitors like Advance Auto Parts and O'Reilly Automotive. While the company certainly has promise with a national network of stores, it still needs to find a way to turn that promise into higher profits. As such, investors should stay away from this work in process.

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Robert Hanley has no position in any stocks mentioned. The Motley Fool owns shares of O'Reilly Automotive. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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