Pep Boys Results Dented by Auto Service Shortfall

PHILADELPHIA – They still come to get car batteries, pocket bikes and DVD players. But when it comes to getting their cars fixed, it seems fewer customers are turning to The Pep Boys — Manny Moe & Jack Inc. (PBY).

A second-quarter shortfall in Pep Boys' auto-service revenue has put a big dent in its stock price. Trading recently around $15.75, the shares have fallen about 16 percent since Aug. 11, when the Philadelphia-based company reported lower-than-expected earnings for the three months ended July 31. So far this year, the stock is off about 31 percent.

To some investors, Pep Boys shares look attractive following the sell-off. They say the company's long-term prospects are still good. But a rebound in the shares will depend upon whether the company can fix the problems that led to the service weakness, including poor staffing, advertising and tepid market conditions.

"I'm looking at it right now as a potential buy at these levels again," said Rodney Hathaway, co-manager of the Heartland Value Plus fund (search) in Milwaukee, which sold its Pep Boys stake in April after getting a hefty return on the stock in the previous year.

But for the stock to recover, Hathaway said: "It's going to be a question of execution now by the management, whether or not they can get that service side of the business back on track."

Pep Boys has faced some challenges in recent years, including sagging sales growth and intense competition from Autozone Inc. (AZO) and Advance Auto Parts Inc. (AAP). The company brought in Lawrence Stevenson as chief executive in May 2003 to help turn things around.

Stevenson decided to close 33 stores and lay off about 860 employees in a restructuring designed to save $11 million a year.

The company now has about 595 stores in 36 states and Puerto Rico, and 22,000 employees. Also, Pep Boys began looking for ways to maximize the use of floor space in its stores, which are generally larger than rivals.

Pep Boys began to stock stores with nontraditional products such as pocket bikes (search), which are miniature motorcycles and are the fad of the summer. These non-automotive products have been a solid source of Pep Boys' retail sales growth. Pep Boys has begun remodeling stores, too.

Pep Boys says its retail initiatives are working. In the second quarter, retail sales at stores open at least a year, or same-store sales, rose 16.7 percent.

"It's a retail renewal strategy," said Advest analyst Derrick Irwin. "They're thinking very hard on what they're selling on the retail side of the box, how they're selling it, and dramatically remodeling stores."

But in focusing on products, Pep Boys may have neglected its service business, which contributes about 40 percent of overall revenue, including merchandise installed during service visits.

In the second quarter, same-store service sales fell 5.3 percent. Service sales include labor plus installed merchandise and tires.

Overall, Pep Boys' second-quarter sales rose to $593.4 million from $556 million a year earlier. Earnings were $14.6 million, or 23 cents a share, reversing a year-earlier loss of $13.6 million, or 26 cents a share.

Excluding one-time items, the latest quarterly earnings of 29 cents a share fell short of analysts expectations of 37 cents a share, according to Thomson First Call.

President George Babich told analysts in August that some stores were understaffed, causing prospective customers to take their cars elsewhere. Also, Pep Boys has shifted its advertising campaign to focus more on retail sales.

Finally, weak market conditions have hurt not only Pep Boys, but also other auto service firms.

Pep Boys said mild weather has been a factor, as cars don't need as much service during such conditions.

Pep Boys is taking steps to fix the service business. It has begun selling brand-name tires, in addition to its store brand, which it hopes will bring in more customers.

Also, the company shuffled management, assigning direct responsibility for operations to Babich, who remains president but is no longer chief financial officer.

Stevenson said he wanted Babich to focus on jump-starting the service business.

Pep Boys will also try to hire better-qualified service technicians and improve training, and speed up plans to expand advertising.

Irwin of Advest believes Pep Boys' long-term growth prospects are "very much intact." He said the company stumbled in trying to execute a complex turnaround.

He rates the stock at "buy," though he did lower his price target to $20 from $32 after the second-quarter earnings report.