With Americans Back on the Road, Is Pep Boys a Good Bet?

Shareholders in Pep Boys have been waiting for a spark to ignite profit growth and a higher market valuation for the company. Could a rise in miles driven by Americans be just what the doctor ordered?

Jul 24, 2014 at 4:07PM


Source:  Pep Boys-Manny, Moe & Jack

Shareholders in auto parts retailer Pep Boys-Manny, Moe & Jack (NYSE:PBY) have been waiting for the company to find a little "pep" in its business after suffering while its stock price has increased very little over the past five years. Pep Boys has anecdotally been hurt by the costs of competing in both the service and retail segments of the auto parts business. This strategy has placed the company at a disadvantage to more efficient and profitable retail-only competitors, like Advance Auto Parts (NYSE:AAP) and Autozone (NYSE:AZO).

On the upside, though, management seems to have acknowledged the company's deficiencies. It recently launched a new strategy, known as Road Ahead, which includes a more customer-friendly store layout and greater capabilities in the online world. In addition, the company should be able to get positive traction from a return to growth in miles driven by Americans, which was up an estimated 0.6% in 2013, as this trend could lead to greater service revenue for Pep Boys. So is it time to bet on Pep Boys?

What's the value?
Pep Boys is one of the major players in the retail auto parts business, operating a network of nearly 800 stores around the country. The company has historically focused on both the service and retail sides of the business, a strategy that theoretically should provide cross-selling opportunities and thus improve the profitability of the overall enterprise.  Unfortunately, Pep Boys has been negatively affected because its customers have delayed service for their cars, ostensibly due to constrained budgets, and this trend has led to lower store productivity and operating profitability.

In its latest fiscal year, it was another tough campaign for Pep Boys, highlighted by a 1.2% top-line decline that was primarily a function of lower comparable-store sales for its retail operations. While the company enjoyed positive comparable-store sales for its service operation, it was hurt because of higher overhead costs for its growing store base, including its small-format service and tire business.Consequently, Pep Boys generated a slight down-tick in its adjusted operating profitability, which negatively affected its cash flow and its ability to deliver on its new operating strategy.

A glimmer of hope, sort of
Of course, the question for investors is whether Pep Boys can levitate itself onto a higher profit growth trajectory in the foreseeable future, thereby providing the impetus for an improved market valuation. On that score, investors have a glimmer of hope based on the company's performance in its latest fiscal quarter, as its adjusted operating profitability jumped thanks to the gross margin of its service operation improving significantly. Strong sales growth in Pep Boys' online segment, a focal point of its Road Ahead strategy, also helped matters.

That being said, Pep Boys is still struggling a bit in its retail operation, which posted another comparable-store sales decline for the latest period. Undoubtedly, that negative performance directly reflects rising competition from Pep Boys' growth-oriented competitors, including Advance Auto Parts.

The company has been a model of consistent profit growth over the past few years thanks to its focus on back-office efficiency and ability to increase the productivity of its store base, which partly came about because it added commercial delivery services to a growing number of its stores. The net result for Advance Auto Parts has been a continuation of solid operating profitability at 10.2% in its latest fiscal year, far above Pep Boys' level. More importantly, the company has continued to generate a similarly solid level of operating cash flow which has provided it with the flexibility to engage in activities that enhance shareholder value, highlighted by its recent purchase of the owner of the Carquest and Worldpac brands.

Meanwhile, Autozone has also been generating solid operating profit growth over the past few years, courtesy of a seemingly unending string of comparable-store sales gains. Like Advance Auto Parts, Autozone has been adding commercial sales capabilities to a larger subset of its store base, 76% at last count, which has generally improved its store productivity and kept its operating margin at a relatively high level. The biggest beneficiary of the company's favorable financial performance has been its shareholders, who have been rewarded with a rising share price thanks to strong cash flow that has facilitated a steady dose of share repurchases.

The bottom line
Pep Boys' overall business has shown a little pep in 2014, highlighted by better than expected profitability in its latest fiscal quarter. However, the company still needs to find a way to improve its razor-thin operating profit margin, a metric that badly trails those of its larger retail competitors and limits its ability to reinvest in its business. Until then, investors should probably keep this turnaround story on the shelf.

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Robert Hanley has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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