With all the chaos in Europe, I was searching for an investment in a U.S. domestic company with no international sales, that had not been bid up much in the past month . I also wanted value at some discount to market.
Pep Boys (NYSE:PBY) had been in the headlines recently as its stock fell 22% on May 31, after agreeing to terminate a $15 a share buyout offer from a private equity firm. So I decided to further research this company.
The company was started by four Navy friends who pooled together $800 to open a single auto parts supply store in 1921 Philadelphia. This small business venture is now a multi-billion dollar nationwide retailer and service chain in the automotive aftermarket segment and is known as Pep Boys. Currently, the company has 738 locations across the U.S. and Puerto Rico. According to the GuruFocus summary page for Pep Boys, it has market cap of $490 million, enterprise value of $718 million and price to book of 1.
Pep Boys operates in U.S. automotive aftermarket segment, with two general lines of business:
1) Service business - defined as Do-It-For-Me (service labor, installed merchandise and tires), i.e. Midas (MDS)
2) Retail business - defined as Do-It-Yourself (retail merchandise) and commercial, i.e. Autozone (NYSE:AZO)
Back to the buyout termination story. According to an MSNBC article, Gores Group, a private equity firm, had offered $15 per share for Pep Boys in January, but in early May sought to delay the shareholder meeting to vote on the deal, citing serious deterioration in Pep Boys' business.
On May 29, Pep Boys canceled the shareholder meeting scheduled for the next day, after agreeing to terminate the Gores deal, and said it would receive $50 million from the private equity firm.
On June 6, Pep Boys reported fiscal first-quarter profit fell to $1.1 million, or 2 cents a share, from $12.4 million, or 23 cents, a year ago.
The big news this week was that Mario Gabelli’s Gamco Investors Et, Al disclosed in a June 12, 2012 SEC 13-D/A filing that they now own 7.77% of PEP Boys (4.1 million shares up from the June 1, 2012 filing of 2.8 million).
In a June 11, 2011 Barron’s article, Mario Gabelli provided a brief explanation of why and when he added to his Pep Boys Position. Below are a few keys quotes from the article:
“ …when the arbitrageurs (M&A) dumped the stock, I started buying” (745,510 was disclosed in the 13-D filing of 6/1/2012). The stock got as low as $8.31 on the announcement.
“This was a busted leveraged buyout. Business is not good.”
“Company has $150 million net debt, including a $50 million breakup fee. Its 2011 first-quarter 10-Q gave some insight into the value if its real estate holdings, worth about $700 million.”
“250 million cars on the road in the U.S. They are aging and will again need repair work which can up to a point be deferred. Thinks it could earn 70 cents in 2013 and $1 in 2014."
Let’s Kick the tires and check under the hood of PEP Boys!
Real Estate Assets may be worth $700 million
The company’s real estate holding are as follows:
1) Five-story, approximately 300,000 square foot corporate headquarters at 3111 West Allegheny Avenue Philadelphia, Pennsylvania 19132
2) Approximately 60,000 square foot office building at 1122 W Washington Blvd., Los Angeles, CA
1) McDonough, GA 392,000 sq. ft.
2) Mesquite, TX 244,000 sq. ft.
3) Plainfield, IN 403,000 sq. ft
4) Chester, NY 402,000 sq. ft.
At Jan. 28, 2012, 232 stores are owned by the company. One hundred twenty-six of those stores are collateralized for the Senior Secured Term Loan.
Mario Gabelli stated in the Barron's Article that he thought the property was worth about $700 million. Anyone with access to appraisers can find average per square foot for office and warehouse. The stores are trickier. This clue from Note 8 of the 10-Q for the first quarter of 2011 provided a little insight of what the 232 stores would be worth. New leasebacks could be an avenue for future cash flow tool in the future.
“NOTE 8—SALE-LEASEBACK TRANSACTION
The Company did not execute any sale-leaseback transactions in the first quarter of 2011. During the first quarter of fiscal year 2010, the Company sold one property to an unrelated third party for net proceeds of $1.6 million. Concurrent with this sale, the Company entered into an agreement to lease the property back from the purchaser over a minimum lease term of 15 years. The Company classified this lease as an operating lease. The Company actively uses this property and considers the lease as a normal leaseback. The Company recorded a deferred gain of $0.4 million.”
The aging population case I made with my Has AutoZone Peaked? article on this website explained that the population is aging rapidly and this will be beneficial to Pep Boys, as an aging population will move towards the company’s “Do It for Me” business segment. The company recently boosted their stores in Florida via acquisition and new openings.
Debt Covenant Prevents Buyback of Stock:
I am against buybacks as they typically shield huge stock compensation plans for executives and add little value to shareholders. An article by Kenneth Hackel of CT Capital LLC called Large Share Buybacks Again Prove They Are Misguided on May 27, 2011, can be found online and is worth reading on the subject. The WSJ quoted Pep Boys' CEO Mike Odell the other day stating, “We are planning to pay down debt, settle our interest rate swap and retire our frozen defined benefit pension plan this year with the $100 million in cash and $50 million breakup fee. A debt covenant prevents Pep Boys from buying back shares at this time.” I like execs who use excess funds for the business.
Changes to state inspection going biennially and no safety inspection now common in many states
In New Jersey for example:
"Effective August 1, 2010, the New Jersey Motor Vehicle Commission made changes to the New Jersey Vehicle Inspection Program eliminating the mechanical defects (safety) portion of the inspection process for passenger vehicles. Most passenger vehicles will b e required to b e inspected biennially (every two years) for emissions only. Commercial vehicles and buses will be required to be inspected annually (every year) for safety and the appropriate emissions test. Motorcycles are now exempt from inspection."
Although this was effective almost two years ago, the consumer awareness and it ability to adapt may be part of the reasonfor its first quarter sales decline. So when the typical Pep Boys customer had to ensure brakes, shocks and tires were acceptable at the annual state inspection, now they are able to extend the life of those items until they become un-drivable. In New Jersey, they only inspect emissions and no safety inspection since August 2010. This extended the life cycle of brakes, tire and shocks which are a core of the Pep Boys “Do It for Me" service. There were 36 stores in New jersey or 5% of the total 738 at January 2012.
What happened to first-quarter 2012 earnings?
The chairman Mike Odell in the press release stated, “It has been a challenging start to the year, due to the mild winter weather, restrained customer spending and not clicking on all cylinders in our performance. But we have made the necessary changes and expect to return to year-over-year profit growth in the third and fourth quarters, as we had done for 11 consecutive quarters through the third quarter of 2011.”
First, I usually do not like to hear weather as a cause of an earnings miss. The average customer will do more to make their car safe for harsh winter weather. This would have an impact on the sale and repair of items such as batteries, brakes, tires , wipers and shocks. I just do not see why they did not guide earnings down as January and February were record warm winters in the Northeast. I will be worried if the next quarter has excuses. I give them a pass on this quarter.
Also, another cause may be what I mentioned above: The life cycle of many auto parts and repairs may be extended as many states, eliminated safety inspections leaving the repair decision up to the car owner. Eventually these car owners will have to get their cars fixed.
Pep Boys' current price of $9 is 40% below what the private equity firm was willing to purchase with borrowed money and appears now to be a value play. Although, I would watch second-quarter earning closely to ensure no more excuses for earning misses. Demographics are in the company's favor. Additionally, you will not have to watch the European headlines to keep a close eye on its earnings.
I currently do not own shares but may purchase after the article publish date.
About the author:
• Realized average annualized returns on self managed IRA account of 14% from January 2004 to December 2012 (total return 150+).
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