“Since the late 1990s e-commerce boom, analysts, investors, and technology purists have been predicting the end of bricks-and-mortar retail. And while the prediction of the bricks-and–mortar format’s end has been greatly exaggerated, the fact is customers continue migrating rapidly from physical stores to online and mobile channels to fulfill their shopping needs.”
Accenture’s Overstored Analysis of 29 top U.S. retailers reveals that total square footage and stores in operation increased by 38 percent and 21 percent in the past five years, respectively, while sales per square foot actually declined 5 percent.
Meanwhile, return on invested capital also declined 25 percent over this period. The evidence is clear that the majority of traditional retailers today are overstored.
The study reveals some eye-opening statistics. Between 2011 and 2014, online sales are expected to grow by 14 percent per year (versus 3 percent for total retail sales). Additionally, mobile commerce sales are expected to grow by a stunning 800 percent through 2015. Since 2000, the percent of American adults with broadband internet access at home has skyrocketed from less than 5 percent to 62 percent, and in 2011, over half of all Americans made purchases online. Importantly, the newest generation of shoppers only knows a world where they can buy in any channel.
Accenture’s work goes on to access the competitive landscape and recommend strategic options for retailers to address structural challenges. From an investment perspective, our options are much simpler. We’ve learned to avoid those retailers that are particularly vulnerable based upon the types of products they offer and the customers they serve.
Of course, there are always exceptions, but many of these businesses are simply deteriorating faster than their ability to generate cash. While they might appear cheap at first glance, declining businesses can get cheaper. Investors would be wise to stay away from most businesses that find themselves on the left-hand side of this chart, competing against significant and rising online competition.
Instead, we believe there are better opportunities to be found in more fragmented markets with limited “internet risk” relative to other retailers. For example, on a recent earnings call, Pep Boys CEO, Michael Odell, explained that, “The economic cycle and the web have created more need and capability for customers to do work themselves, but vehicle complexity limits how much folks can really do themselves. Therefore, we see competitive advantage with the skill level of our technicians to perform the medium and heavy work that folks just can’t do themselves.”
This competitive advantage did not prevent the stock from being chopped in half over the past two months as The Gores Group walked away from its offer to purchase the company for $15 per share. Now trading closer to $9, we think the market and Jim Cramer, have overreacted. As discussed on the call, after eleven consecutive quarters of profit improvement, PBY has taken a temporary step back. But at the end of the day, this is a defensive business trading below 8x next year’s maintenance free cash flow, or slightly more than tangible book value. Management is not out shopping the company to see if another offer is there, but believed $15 was a great price for shareholders. On the bright side, the $50mm breakup fee will be used to further pay down debt, and with additional planned refinancing, better terms would allow for share buybacks and dividends. The balance sheet has been steadily improving over the past few years. Including the receipt of the $50M termination fee, net debt has declined to roughly $147M compared to $516M in 2006. More importantly, net debt to trailing EBITDA has declined from 5x to 1.3x over the same period, even on currently depressed figures.
We believe the company’s real estate portfolio provides investors with a healthy margin of safety. Pep Boys’ most recent real estate appraisal in June 2011 valued the company’s owned real estate at about $690 million. After the stock’s recent decline, PBY’s market capitalization is below $500 million today. We think this is a temporary overreaction and represents a very attractive entry point into a high quality service business with strong brand recognition. It’s unlikely Amazon will find a way to effectively compete with Manny Moe & Jack anytime soon.
Disclosure: At the time of publication, the author was long Pep Boys – Manny, Moe & Jack (PBY), although positions may change at any time.