Are Activist Investors About to Target Pep Boys?

Manny, Moe, and Jack suffered a surprise loss last quarter, prompting the CEO of Pep Boys to abruptly resign. With the stock losing a quarter of its value in the aftermath, is that the signal activist investors have been waiting for to begin targeting the vehicle repair specialist?

Mario Gabelli is the only one buying the company's stock at the moment, and though he is establishing a sizable position, he hasn't committed to playing an activist role and hasn't issued any demands of management. But if he does flip the switch toward activism, or someone else decides the time is ripe for change, here are the areas of concern most likely to be addressed.

Manny, Moe, and Jack are looking to put more pep in their step. Photo: Flickr user Mike Mozart.

The market Pep Boys targets is evolving. Where previously its customer base was built on do-it-yourselfers, today more do-it-for-mes are coming in.

Pep Boys' retail business saw sales drop 3.7% to $237.5 million in the quarter as comparable-store sales dropped. With chemicals and filters, tuneup products, and oil dropping from the cart, gross profit tumbled 17.5% to $63.6 million. It had to resort to greater promotional activity to get customers in the door, but they weren't spending anyway.

While service center gross profit also fell -- though only 1.5% -- comparable revenue in the segment rose 5.4% as more people got their oil changed and had their brakes done.

The widening gulf between Pep Boys' two operating divisions. Data: Pep Boys quarterly SEC filings.

As a result, Pep Boys has been undergoing a remodeling program that it calls its Road Ahead, a major stylistic redesign away from locations that look like the neighborhood service garage, but a service center with bright lights, clean displays, warm woods, and greater employee interaction.

The company said that of its 571 supercenters in operation as of Sept. 2 -- stores that are typically around 20,000 square feet in size -- 508 will get the new treatment. The remaining 63 might or might not get a remodel, and might just be prime candidates for sale or closure. Problem is, those poorly performing stores aren't necessarily properties anyone else would be interested in, either, so it could make more sense to keep the doors open just to pay the bills.

Your neighborhood coffee shop or an auto service center? Photo: Pep Boys.

Targeting that service-oriented customer just makes more sense.

At $197 billion per year, the auto service industry is four times larger than the $49 billion do-it-yourself market, yet it's still expected to grow faster than DIY (albeit not by much).

Although the declining DIY market got a boost from the recession as more people kept their cars in service longer, it's right to ask just how much the federal "cash for clunkers" program assisted in the acceleration of the segment's decline.

According to a Brookings Institutions evaluation last year, the program that paid people to junk their older autos saw 678,000 cars traded in, boosting sales by some 308,000 autos, almost all of which would have occurred anyway.

The program required the junked cars be up to 25 years old, and the New York Federal Reserve said the average age of traded-in cars was 16 years. Unfortunately for Pep Boys, it says the sweet spot of the auto repair market is in cars that are between 5 years and 13 years old, and since new cars are more complex, more people are turning into do-it-for-mes, or DIFMs.

Thus, it might not be AutoZone , Advance Auto Parts , or O'Reilly Automotive, but rather the car dealers themselves that have found the profits they can make on parts and service too lucrative to pass up.

Ford , for example, opened its 700th Quick Lane Tire & Auto Center earlier this year, service centers offering no-appointment, while-you-wait service for all vehicle makes and models.

Ford is in the fast lane for repairs. Photo: Quick Lane.

According to the carmaker, Quick Lane is one of the fastest-growing service brands, generating $800 million in sales in 2013, helped along in no small part by having sold 1.4 million tires, a 12% increase from the year before and ahead of the industry average.

Chrysler is experimenting with a similar model through its Mopar Express Lanes that are attached to about a third of its 2,400 Chrysler-Jeep-Dodge-Ram dealerships. It noted that dealers with an Express Lane sell far more parts and write many more repair orders than dealerships without it.

Whether what's good for Ford and Chrysler's bottom line is necessarily good for the customer isn't the issue here, but the proliferation of dealer-affiliated service centers as a direct threat to Pep Boys is.

It might be that Pep Boys has warded off activist investors because it has realized the problems it faced and has adopted a program to address them. The company's depressed stock price, though, down 40% from its 52-week high, could represent an opportunity to participate in its recovery, which thus far only Gabelli and his GAMCO Investors seemingly recognize.

Yet of the three largest players in the aftermarket auto parts and service industry, only Pep Boys has been on a steady decline. As the smallest of the three players, its position is most vulnerable -- meaning an activist investor could step in and demand it sell itself to one of its rivals.

As the smallest, weakest player on the block, Pep Boys is in gravest danger of being targeted. Data: Company quarterly SEC filings.

Gabelli has said he might not remain a "completely passive" investor, and since he's paying the piper by establishing a 6.16-million share stake in Pep Boys, or 11.56% of its outstanding shares, he could soon be calling the tune.

Others might soon take a closer look at what this seasoned investor has seen and join him, but it's clear Pep Boys needs to show results soon if it wants to be the master of its future.

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