Warren Buffett attracts a lot of attention. As the world's third-richest person and most celebrated investor, thousands try to glean what they can from his thinking processes and track his investments.
While we can't know for sure whether Buffett is about to buy Pep Boys (NYSE: PBY ) -- he hasn't specifically mentioned anything about it to me -- we can discover whether it's the sort of stock that might interest him. Answering that question could also inform whether it's a stock that should interest us.
In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:
- Consistent earnings power.
- Good returns on equity with limited or no debt.
- Management in place.
- Simple, non-techno mumbo jumbo businesses.
Does Pep Boys meet Buffett's standards?
1. Earnings power
Buffett is famous for betting on sure things. For that reason, he likes to see companies with demonstrated earnings stability.
Let's examine Pep Boys' earnings and free cash flow history:
Source: Capital IQ, a division of Standard & Poor's. Free cash flow is adjusted based on author's calculations.
Over the past five years, Pep Boys has had some difficulty producing earnings, though that changed somewhat in 2009 and 2010.
2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt burden, because that will skew your calculations and make the company look much more efficient than it actually is.
Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.
|
Company
|
Debt-to-Equity Ratio
|
Return on Equity (LTM)
|
Return on Equity
(5-Year Average)
|
| Pep Boys |
63% |
8% |
0% |
| Monro Muffler Brake (Nasdaq: MNRO ) |
20% |
18% |
14% |
| LKQ (Nasdaq: LKQX ) |
38% |
13% |
11% |
| O'Reilly Automotive (Nasdaq: ORLY ) |
16% |
14% |
13% |
Source: Capital IQ, a division of Standard & Poor's.
Pep Boys produces modest returns on equity while employing moderate leverage.
3. Management
CEO Michael Odell has been at the job since 2008. Prior to that, he was an executive at Sears for a number of years.
4. Business
Auto repair and parts retail isn't particularly susceptible to technological disruption.
The Foolish conclusion
Regardless of whether Buffett would ever buy Pep Boys, and despite the company's improvement in recent years, we've learned that while it operates in a straightforward industry, it doesn't yet exhibit the quintessential characteristics of a Buffett investment: consistent earnings and high returns on equity with limited debt.
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