More Pep From Manny, Moe & Jack

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For years, the brothers Manny, Moe, and Jack have toiled away as a hybrid failure in the auto sector. The combination of auto replacement parts store and service center hasn’t worked in years as auto parts focused firms built store after store closer to the Do-It-Yourselfer [DIY] mechanic. That left Pep Boys - Manny Moe & Jack (NYSE: PBY) with an expensive combination of auto parts and service not in demand by either consumer group.

In the auto replacement parts sector the company now competes against much larger competitors in AutoZone (NYSE: AZO), O’Reilly Automotive (NASDAQ: ORLY), and Advance Auto Parts (NYSE: AAP) amongst others. These stocks also command higher multiples considering the better margins, but Pep Boys could be turning the corner and similar revenue multiples would send the stock soaring.

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PBY Price / Sales Ratio TTM data by YCharts

Recent operations updates

Pep Boys is making a push in the auto service segment and saw a 4.2% increase in comparable service revenue. The merchandise segment saw a 0.1% increase in revenue leading to a total comparable sales increase of only 1.0%. The revenue base leans dramatically towards the merchandise sales so the big jump in service revenue had a limited impact.

Net earnings increased for the first quarter to $3.9 million or $0.07 per share versus $1.1 million last year or $0.02 per share. Analysts forecast a sharp increase in earnings to $0.54 this fiscal year, up from $0.32 in fiscal 2013 ended in January.

The key will be whether the company can garner industry gross profit margins of around 50% compared to the 28% generated by Pep Boys in the latest quarter.

New store format catalyst

The company has opened a new store in the Tampa Bay area that could provide a catalyst for the stock. The store concept is more aesthetic appealing with a more inviting exterior and interior look. The store is also more focused on general car products next to the service lounge that places products that are more appealing to consumers without deep car knowledge. In addition, the store has a speed shop that tailors to the car enthusiast or DIYer. The concept includes the 74th speed shop, which is a store within an existing supercenter focused on high end products. The store as well has an auto parts center in the back of the store.

Part of the margin issue is that Pep Boys currently generates substantially less revenue from each existing parts store. Based on rough calculations, the auto parts generate nearly $1.7 million per store while Pep Boys only reaches $1.3 million. Total store revenue is higher due to the service centers, but the margins are so low on each business line that the company doesn't benefit from the combined offerings.

Competitors maxed out valuations

The traditional auto parts suppliers have done tremendously better than Pep Boys over the last decade. Without the service centers, AutoZone and Advance Auto Parts have been able to grow faster by placing the stores closer to the DIYer. Not to mention some disconnect might exist with the consumer on what Pep Boys actually provides. Is it an auto parts store? Is it a service center?

As mentioned above, all these auto parts suppliers trade at much higher multiples of revenue anywhere from 1 to 2 times revenue on a consistent basis over the last decade. AutoZone and O’Reilly Automotive trade at around 2 times revenue, which is roughly 7 times higher than the Pep Boys multiple. Another sign that the hybrid auto aftermarket solution hasn’t worked at driving margins at Pep Boys.

Another interesting point is that all three auto parts chains are considerably larger than Pep Boys. Auto Zone has a revenue base of over $9 billion and a market cap of nearly $15 billion. O’Reilly Automotive has a market cap of $12.3 billion and a revenue base of over $6 billion while even laggard Advance Auto Parts has a market cap of $6 billion with a revenue base of over $6 billion. Pep Boys pales in comparison with a market cap of only $630 million with revenue sliding along at $2.1 billion. The stock could surge 300% to only match the low-end multiple of Advance Auto Parts. Of course, the company needs to vastly improve margins and earnings to see that happen.

Bottom line

While Pep Boys has been an operational disaster over the last decade, the company has the potential catalyst of the new store type and a cheap valuation to propel the stock higher. If the company can turn around operations, it has the ability for substantial gains in order to reach the multiples of other peers in the auto replacement parts sector. Unfortunately, the company has yet to be able to get the hybrid auto service and parts business to work, but the company is showing more pep that investors should watch.

In addition, a stronger Pep Boys could pressure the margins and profits of the auto parts leaders. With all three firms having gross profit margins in the 50% to 52% range, it suggests the market might not presently offer a competitive situation that could be impacted by another strong competitor. The new Pep Boy store concept could be that catalyst so investors in any auto parts stock should keep an eye on the results there.

Mark Holder and Stone Fox Capital Advisors have no positions in any stocks mentioned. The Motley Fool owns shares of O'Reilly Automotive. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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