Pep Boys Still Driving to Nowhere

NEW YORK (TheStreet) -- It's true in life and it's true in business. The first step in fixing a problem is admitting that there is one. I think struggling retailer/auto services giant Pep Boys (PBY) has reached that point, if it hasn't completely driven past it.

As I've discussed recently, if management is not careful, this company many not have enough gas to hang a U-turn and reverse course.

While Pep Boys has made some decent operational progress, investors are getting frustrated and wondering if the business model can still work. After so many long battles with failed improvement attempts, Pep Boys just needs to admit what the numbers already say: the model can't work.

There's no longer a point to hanging on to a failing business plan, which is causing investors plenty of headaches, while prolonging the company's recovery.

What Does Pep Boys Want To Be?

That's a question management has yet to answer clearly. Although expectations have been low for some time, the company continues to miss its targets. However, it seems that the focus is beginning to shift more to a services business and less on retail. I'm just not convinced that it's for the better.

The company's third-quarter results showed evidence for this, including a 2% revenue decline that also highlighted much fundamental and operational concerns. For instance, it is clear that merchandise, which fell last quarter by 3%, is a major problem.

Pep Boys, with rivals such as Advance Auto Parts ( AAP) and AutoZone ( AZO), can seem to get comps going in the right direction, as evident by the 2.7% year-over-year decline. Plus, merchandise revenue also fell 3.5% on a comp basis.

However, competition from traditional auto parts rivals is only part of the problem. There is also the likes of Wal-Mart ( WMT), which has been eating away not only at Pep Boys' merchandise business, but also its services revenue. Although Pep Boys did ok in its response, as services traffic grew, I just don't think it was the right move.

Although the company managed to increase Q3 service revenue by 1%, which also grew 0.2% on a comp basis, margin on the service business, which includes low-service oil changes, is not enough to have the sort of impact to make services a worthwhile focus -- and it showed.

Gross margin continue to erode, including a Q3 drop of 150 basis points. Even though the company deserves credit for service revenue growth, service margin still managed to drop by five points. This is despite the fact that customers have responded well with higher transactions.

An argument can be made that the higher traffic actually hurt. Here too, Wal-Mart, which has an auto services business of its own, is undercutting Pep Boys' margins. And from a profitability standpoint, it doesn't appear as if management has an suitable answer. So does Pep Boys want to be a service-oriented business or a retail business? The "joint model" is still not working - not to the extent that it does for AutoZone and Advance Auto Parts.

Expectations for the Fourth Quarter

According to Yahoo! ( YHOO), Pep Boys will announce fourth-quarter and full-year fiscal 2012 earnings on Tuesday. It's worth noting that the company has yet to confirm this. Here again, this brings up concern about the company's management and direction, which also suggests there's no enthusiasm about what the report may say. For that matter, the Street isn't expecting much.

Average estimates for full-year revenue is at $2.07 billion, which would represent 0.2% year-over-year growth, or roughly flat from the $2.06 billion posted a year ago. The company is expected to report earnings of 31 cents a share, which would be a year-over-year decline of 42% from earnings per share of 54 cents. These are not exactly breath-taking numbers.

Absent some clear fundamental changes, it's hard to see a silver lining with Pep Boys, especially since this turnaround story has been going on now for 15 years. Management must still address the fact that its stores are often considered to be in "undesirable locations" and are inefficiently operated from the standpoint that the store seems to have more space than is utilized.

Bottom Line

All of that said, the effort it would take for Pep Boys to fix itself is not impossible. However, it may require "getting worse" before the things get better.

Management should consider exiting the services business and focus solely on the retail end. Unfortunately, this would create additional "unusable space," which is already a concern. Thus, the "getting worse" part.

Suffice it to say, there are much better investment opportunities out there. And even for more risk-tolerant investors, this is not a stock bet on, especially since the valuation is already trading at almost twice that of Auto Zone and Advance Auto Parts.

At the time of publication, the author held no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Richard Saintvilus is a private investor with an information technology and engineering background and the founder and producer of the investor Web site Saint's Sense. He has been investing and trading for over 15 years. He employs conservative strategies in assessing equities and appraising value while minimizing downside risk. His decisions are based in part on management, growth prospects, return on equity and price-to-earnings as well as macroeconomic factors. He is an investor who seeks opportunities whether on the long or short side and believes in changing positions as information changes.

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