Company Overview
Pep Boys (PBY) is an automotive aftermarket retailer and service provider. The company operates 767 locations consisting of 571 Supercenters, 190 Service and Tire Centers, and 6 retail stores in 35 states and Puerto Rico.
Differentiation
The automotive retail and service markets are both highly competitive. Big name national companies like AutoZone (AZO) and Advance Auto Parts (AAP), just to name a few, compete with Pep Boys. Add into the market regional chains and independents and the competition looks fierce. Add on top of that dealerships and the industry is downright bloodthirsty. Everyone wants to sell you that brakepad or change your oil for you.
Source: Pep Boys Investor Slides 4/13
Since the industry is so competitive, I felt it necessary in my research to first determine if and how Pep Boys goes about differentiating itself from the rest of the pack. The bottom line- better than most.
You probably recognize most, if not all, of the logos above. The industry is full of strong brands. Branding has been the go-to, dependable strategy for most and has worked quite well in the past. Now, we have an industry full of strong brands, and so it is more important than ever that companies effectively invest in their brands. Pep Boys certainly does just that. I was well aware of what the company is and does before doing any research. The company's old motto and jingle, 'Pep Boys does everything for less,' sometimes infects my dreams. It's that catchy. I know the brand very well and the closest location is 40 miles from where I live. This is a subjective area, but I certainly think the Pep Boys brand is extremely strong relative to the company's small-cap size.
If everyone is branding though, it's almost the same as no one branding. An industry full of companies trying to differentiate themselves in the same way is an industry of ineffective! competitors. So we need something more. Companies need to do something more than just advertising to differentiate themselves. At this point, it might not much matter what action is taken, so long as it is different from what the herd does.
It seems that Pep Boys is taking such action. The three largest automotive parts retailers in the US- AutoZone, Advance Auto Parts, and O'Reilly Automotive (ORLY), operate 4-5 thousand stores each. They have tremendous store bases and brands and solid value propositions in retail, but that's all they do. They sell parts and give advice. Pep Boys was for the longest time solely competing with these giants in the parts market. With less capital and less stores, the company was clearly overmatched. The odds of Pep Boys winning against such large, established, diversified competition was slim to none.
It seems that management has accepted this fact among others and devised a new business strategy that makes much more sense for the company. Pep Boys is now determined to take market share in the service market.
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The red parts of the bar graph above represent the parts of the service and retail markets that will be easiest to take market share from. This part of the market is not supported by strong national brands and doesn't have the resources of a national company. The red in the service market clearly presents more opportunity than in DIY. It's $118B worth of opportunity compared to $27B in DIY. That's in the here and now. But even looking into the future, service has better growth prospects.
Cars are becoming more complicated to fix and, as time goes, by and it's becoming more and more of a necessity to have expensive machines and tools to do service. The baby-boomers that were raised in a time when DIY was more common are aging and becoming less and less capable to do the work themselves. A new generation of car-owners that! for the ! most part, don't have the time or proficiency to do their own service is becoming the new breed of car owner.
Evidence of this trend is everywhere. I do a lot of research in the for-profit education industry. These companies typically only offer programs in career areas expected to grow at a high rate in the next 5-10 years. One of the most common program offerings of these schools is the automotive technician certificate program. I see the commercials all the time for Lincoln Educational Services (LINC) and UTI (UTI) automotive technology programs. I'm sure you've seen them too. If these career-based educators are not only offering the program but devoting advertising dollars exclusively to it, then I'd assume job availability in the industry is expected to grow. Indeed, the US Board of Labor Statistics (BLS) estimates 17% job growth in the 'automotive service technicians and mechanics' category from 2010-2020. That's on par with the national average. The report adds, "Job opportunities for qualified job seekers should be very good." If more and more technicians are being hired, it stands to reason that fewer car-owners are doing work themselves. DIY will be hurt by the trend and service will benefit.
So the economics clearly support Pep Boys' new strategy, but there's more. Think about the financial implications of owning both the parts retail supercenter and the service places around it. The typical shop can only hold a limited variety of parts and tires on site. The small size of most shops doesn't allow enough room for a good selection. A Pep Boys Service & Tire Center can hold approximately 2,000 different SKUs on site. That's pretty typical of any small service center in the US. That's why parts often have to be ordered and cars end up staying in the shop overnight or customers have to come back days later. It's that or they go to AutoZone, Pep Boys, O'Reilly, or Advance Auto Parts and get the parts themselves to bring back to the shop. That involves multiple tri! ps and ca! n be a huge hassle. But the new Pep Boys hub and spoke model of supercenters surrounded by service and tire centers gives the service centers access to an extensive variety of parts. The service center's inventory essentially goes from 2,000 to 28,000 because it is so close (5-15 minutes) from a supporting supercenter. That's a pretty substantial competitive advantage.
I think the hub and spoke network also leverages trust more. Consumers desire a place they can go for all their service and parts needs. They want a place they can trust to take care of them. Once they find that place, they tend to keep coming back. Pep Boys retail locations do display this industry-wide consumer nature. The company's data systems found that customers came back far more often than not. So a sale of a part usually meant another sale of a part. That's why companies often use special deals and discounts- to get first-time customers in the door for their recurring business. Now that Pep Boys will be offering both parts and service, a sale will be larger initially because it will include the part and the service. Even after that, recurring sales will be more often and larger. The company is leveraging trust to maximize what it gets out of customers.
The business model also improves margins and profitability. The service centers will exclusively use Pep Boys parts and tires. Since the service centers will leverage existing assets rather than tying up additional capital with on-site inventory, they will improve the company's returns on those assets, margins, and profitability.
Another point I'd like to mention is capital allocation. Executive management's primary role is to understand the company and allocate capital where it will generate the highest return. The company currently has pretty anemic returns on assets. Service and tire centers, are very profitable though. They typically require about $400K in initial capital and deliver a 15%+ IRR in their first year. For a company making 1-3% ROA in the last few! years, i! t makes tons of sense to allocate capital to the service centers and get the 15%.
The Opportunity
I already showed you the size of the service market and the share that Pep Boys can feasibly take but there's more evidence of the opportunity for growth. In April, the company provided us with a glimpse at the Orlando market as an example of the hub and spoke network. (click to enlarge)
If we look at the US map, there really isn't much red representing service centers. There is definitely plenty of room for expansion which is extremely desirable in retail.(click to enlarge)
The Results
With any big change in business strategy, investors are going to want to see signs that it's working and continues to make sense. In Pep Boys' recent results, we find just that. In Q1, comparable service revenue increased 3.9% vs. a 2.1% drop in comparable retail sales. In fiscal 2012, comparable service sales were .3% positive compared to -4.4% in retail sales. The results really show that service is the trending better and the more profitable direction, confirming the business strategy.
Overall, sales are in the right direction albeit growing very slowly.
(click to enlarge)
I would expect performance to pick up as service! centers ! contribute more and more towards the company's results, but that remains to be seen.
Valuation
I usually value companies by assigning a multiple to FCF. It's somewhat difficult to do so for PBY due to the fact that much of GAAP capex is used to expand, not just maintenance capex. To illustrate that the capex the company uses is more than just maintenance capex, here's the description of capex from the FY12 earnings call:
Fiscal 2012 capital expenditures were $54.7 million compared to $74.7 million in fiscal 2011. 2012 capital expenditures primarily consisted of 20 service tire centers, 6 supercenters, the conversion of 7 supercenters into super hubs, the addition of 17 speed shops within the existing supercenters, information technology enhancements and our eCommerce initiatives and parts catalog enhancements as well as our regular facility improvements.
Just about everything in the above description other than 'regular facility improvements' enhances the company's cash generating ability and hence, is more than just maintenance capex. In the April presentation, the company guided to $60-65M of capex in FY13 and cited that $30-35M of it was maintenance capex, confirming my thoughts that a substantial amount was more than maintenance. So we'll scale down FY12 maintenance capex to half of the reported value as well. That leaves adjusted capex at $27.4M and adjusted non-GAAP FCF for FY12 at $127.3M. Current enterprise value is about $806M. So shares are trading at a multiple of 6.33. In determining what I believe is a fair multiple, I look at future FCF growth. In the past few years, the company's FCF has fluctuated but hasn't really moved enough for me to identify growth or decline. 4 analysts cover the company and the consensus is annual growth of about 14% for the next 5 years.
Source: Yahoo Finance
I find that very optimistic given the lack of growth in the past. We're ! also stil! l in the early stage of the new business strategy. The company hasn't really proven itself a 10%+ grower yet and so I'm not going to assume such a multiple. I do think 8-9% growth is a reasonable expectation though. Assuming a fair multiple of just 8.5, we find the shares to be 25% undervalued. In this market that's beautiful.
I also like to look at relative valuation. The shares trade near a 52 week high now which is concerning.
(click to enlarge)
Despite the margin of safety, investors looking to go long need to protect themselves by buying at some sort of dip, not near 52 week highs. The knowledge of the MOS is helpful in determining whether or not you truly want to go long, but in terms of actually timing your buy, you need to protect yourself from price movements by getting in lower.
Conclusion
Pep Boys is a small-cap differentiating itself in a very competitive environment through its strong brand and what I consider to be an excellent new business model. It appears that the shares trade at least 25% below fair value but shares are near 52 week highs right now, which keeps me from recommending a buy at this very moment. Wait for a move downward before going long.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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