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PEP BOYS MANNY MOE & JACK - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) OVERVIEW The following discussion and analysis explains the results of operations for the first quarter of fiscal 2014 and 2013 and significant developments affecting our financial condition as of May 3, 2014. This discussion and analysis should be read in conjunction with the consolidated interim financial statements and the notes to such consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q, and the consolidated financial statements and the notes to such financial statements included in Item 8, "Financial Statements and Supplementary Data" of our Annual Report on Form 10-K for the fiscal year ended February 1, 2014. Introduction The Pep Boys-Manny, Moe & Jack and subsidiaries (the "Company") has been the best place to shop and care for your car since it began operations in 1921. Approximately 19,000 associates are focused on delivering the best customer service in the automotive aftermarket to our customers across our nearly 800 locations throughout the United States and Puerto Rico and on-line at pepboys.com. Pep Boys satisfies all of a customer's automotive needs through our unique offering of service, tires, parts and accessories. Our stores are organized into a hub and spoke network consisting of Supercenters and Service & Tire Centers. Supercenters average approximately 20,000 square feet and combine do-it-for-me service labor, installed merchandise and tire offerings ("DIFM") with do-it-yourself parts and accessories ("DIY"). Most of our Supercenters also have a commercial sales program that delivers parts, tires and equipment to automotive repair shops and dealers. Service & Tire Centers, which average approximately 5,000 square feet, provide DIFM services in neighborhood locations that are conveniently located where our customers live or work. Service & Tire Centers are designed to capture market share and leverage our existing Supercenters and support infrastructure. We also operate a handful of legacy DIY only Pep Express stores. In the first quarter of fiscal 2014, we opened two Service & Tire Centers and converted one Supercenter to a Service & Tire Center. We also closed three Service & Tire Centers. As of May 3, 2014, we operated 567 Supercenters, 225 Service & Tire Centers and six Pep Express stores located in 35 states and Puerto Rico. EXECUTIVE SUMMARY Net earnings for the first quarter of 2014 were $1.6 million, or $0.03 per share, as compared to $3.9 million, or $0.07 per share, reported for the first quarter of 2013. The prior year period net earnings included a $3.8 million tax benefit due to state hiring credits. Earnings from continuing operations before income taxes and discontinued operations increased by $2.5 million to $2.7 million in the first quarter of 2014 as compared to $0.2 million in the first quarter of 2013. This improvement was primarily due to higher total gross margin and increased sales, partially offset by higher selling, general and administrative expenses. Total revenues increased for the first quarter of 2014 by 0.5%, or $2.6 million, as compared to the first quarter of 2013 due to the contribution from our non-comparable store locations, partially offset by a 1.4% decrease in comparable store sales. This decrease in comparable store sales (sales generated by locations in operation during the same period of the prior year) was comprised of a 3.2% increase in comparable store service revenues offset by a 2.8% decrease in comparable store merchandise sales. We believe that the industry fundamentals of increasing vehicle complexity and customer preference for DIFM remain solid over the long-term resulting in consistent demand for maintenance and repair services. Consistent with this long-term trend, we have adopted a long-term strategy of growing our automotive service business, while maintaining our DIY customer base by offering, in our Supercenters and online at pepboys.com, the newest and broadest product assortment in the automotive aftermarket. In the short-term, however, various factors within the economy affect both our customers and our industry, including the impact of the recent recession, continued high underemployment and the restoration of payroll taxes back to previous levels. Another macroeconomic factor affecting our customers and our industry is gasoline prices. Gasoline prices have not only increased to historical highs in recent years, but have also experienced significant spikes in prices during each year. We believe that these gasoline price trends challenge our customers' spending relative to discretionary and deferrable purchases. In addition, gasoline prices impact miles driven which, in turn, impact sales of our services and non-discretionary products. For the first three months of calendar 2014, miles driven declined by 0.6%. Given the nature of these macroeconomic factors, we cannot predict whether or for how long these trends may continue, nor can we predict to what degree these trends will affect us in the future. Our primary response to fluctuations in customer demand is to adjust our product assortment, store staffing and advertising messages. We work continuously to make it easy for customers to choose us to do it for them and to expand our online efforts to make Pep Boys the most convenient place to shop for all of their automotive needs. As a result, sales from service appointments made 10 -------------------------------------------------------------------------------- Table of Contents online, tires purchased online and installed in our service bays and products purchased online for pick up or home delivery grew to 4% of total sales in the first quarter of fiscal 2014 as compared to 2.3% in the corresponding period of the prior year. In addition, we are testing a new market concept that we call the "Road Ahead". Designed around the shopping habits of our target customer segments, this concept enhances the entire store - our people, the product assortment, its exterior and interior look and feel and the marketing programs - to learn how we can be successful in attracting more of these target customers and earn a greater share of their annual spend in the automotive aftermarket. Our Road Ahead strategy also allows us to use our retail business to drive the service business with free professional battery and wiper installations. RESULTS OF OPERATIONS The following discussion explains the material changes in our results of operations. Analysis of Statement of Operations Thirteen weeks ended May 3, 2014 vs. Thirteen weeks ended May 4, 2013 The following table presents for the periods indicated certain items in the consolidated statements of operations and comprehensive income as a percentage of total revenues (except as otherwise provided) and the percentage change in dollar amounts of such items compared to the indicated prior period. Percentage of Total Revenues Percentage Change May 3, 2014 May 4, 2013 Favorable Thirteen weeks ended (Fiscal 2014) (Fiscal 2013) (Unfavorable) Merchandise sales 76.5 % 77.8 % (1.3 )% Service revenue (1) 23.5 22.2 6.6 Total revenues 100.0 100.0 0.5 Costs of merchandise sales (2) 69.2 (3) 71.2 (3) 4.0 Costs of service revenue (2) 95.1 (3) 98.7 (3) (2.7 ) Total costs of revenues 75.3 77.3 2.1 Gross profit from merchandise sales 30.8 (3) 28.8 (3) 5.5 Gross profit from service revenue 4.9 (3) 1.3 (3) 305.1 Total gross profit 24.7 22.7 9.3 Selling, general and administrative expenses 23.6 22.1 (7.5 ) Net loss from dispositions of assets - - 91.4 Operating profit 1.1 0.7 71.7 Other income 0.1 0.1 16.7 Interest expense 0.7 0.7 (2.8 ) Earnings from continuing operations before income taxes 0.5 - 1,128.6 Income tax expense (benefit) 39.5 (4) N/M (4) (128.8 ) Earnings from continuing operations 0.3 0.7 (58.4 ) Discontinued operations, net of tax - - 55.4 Net earnings 0.3 0.7 (58.4 ) -------------------------------------------------------------------------------- (1) Service revenue consists of the labor charge for installing merchandise or maintaining or repairing vehicles, excluding the sale of any installed parts or materials. (2) Costs of merchandise sales include the cost of products sold, purchasing, warehousing and store occupancy costs. Costs of service revenue include service center payroll and related employee benefits and service center occupancy costs. Occupancy costs include utilities, rents, real estate and property taxes, repairs and maintenance and depreciation and amortization expenses. (3) As a percentage of related sales or revenue, as applicable. (4) As a percentage of earnings from continuing operations before income taxes. The percentage for the first quarter of 2013 is not meaningful. Total revenue for the first quarter of 2014 increased by $2.6 million, or 0.5%, to $538.8 million from $536.2 million for the first quarter of 2013. While our total revenues are favorably impacted by the opening of new stores, a new store is not added to our comparable store sales until it reaches its 13th month of operation. Comparable store sales for the first quarter of 2014 decreased by 1.4% as compared to the first quarter of 2013. This decrease in comparable store sales consisted of a 3.2% increase in comparable store service revenue offset by a decrease of 2.8% in comparable store merchandise sales. 11 -------------------------------------------------------------------------------- Table of Contents Customer online purchases that are picked up at our stores are included in our comparable store sales calculation. Customer online purchases that are delivered to customers' homes are not included in our comparable store sales, and are immaterial to our total sales and comparable store sales. Total merchandise sales decreased 1.3%, or $5.2 million, to $411.9 million in the first quarter of fiscal 2014, compared to $417.2 million during the prior year quarter. Comparable store merchandise sales decreased by 2.8%, or $11.5 million, primarily due to lower comparable store transaction counts partially offset by higher average revenue per transaction. The decrease was comprised of a 4.0% decrease in merchandise sold through our service business (primarily tires, chemicals and filters) and a 1.9% decrease in merchandise sold through our retail business (primarily oil, chemicals and filters). Non-comparable stores contributed an additional $6.2 million of merchandise sales during the quarter. Total service revenue increased 6.6%, or $7.9 million, to $126.9 million in the first quarter of 2014 from $119.0 million during the prior year quarter. Comparable store service revenue increased by 3.2%, or $3.8 million, primarily due to higher average revenue per transaction, partially offset by a slight decline in transaction counts. Non-comparable stores contributed an additional $4.1 million of service revenue during the quarter. In our retail business, we believe that the difficult macroeconomic conditions continued to impact our customers and led to the comparable store transaction counts decline of 5.0%. The increase in the average revenue per transaction of 3.1% resulted from higher selling prices. In our service business, we believe that the decline in comparable store transaction counts of 0.6% was also due to the difficult macroeconomic conditions as the decline was concentrated in our higher cost repair work (brakes and alignments) which was mostly offset by an increase in lower cost maintenance work (oil changes). Service average revenue per transaction declined by 0.4%. Total gross profit increased by $11.3 million, or 9.3%, to $133.1 million in the first quarter of 2014 from $121.8 million in the first quarter of 2013. Total gross profit margin increased to 24.7% for the first quarter of 2014 from 22.7% for the first quarter of 2013. Excluding the impairment charge of $1.2 million in each of the first quarter of 2014 and 2013, total gross profit margin increased by 200 basis points to 24.9% for fiscal 2014 from 22.9% in fiscal 2013. This increase in total gross profit margin was primarily due to higher product gross margins of 240 basis points (increased merchandise margins of 100 basis points combined with a sales shift to higher margin service revenues), partially offset by higher payroll and related costs of 30 basis points. Gross profit from merchandise sales increased by $6.6 million, or 5.5%, to $126.9 million for the first quarter of 2014 from $120.3 million in the first quarter of 2013. Gross profit margin from merchandise sales increased to 30.8% for the first quarter of 2014 from 28.8% for the first quarter of 2013. Excluding the impairment charge of $0.2 million in each of the first quarter of 2014 and 2013, gross profit margin from merchandise sales increased by 200 basis points to 30.9% for fiscal 2014 from 28.9% in fiscal 2013. The increase in gross profit margin was primarily due to higher product gross margins of 210 basis points. The improvement over the prior year was primarily due to improved product margins in brakes, oil, chemicals and filters. Gross profit from service revenue increased by $4.8 million, or 305.1%, to $6.3 million in the first quarter of 2014 from $1.5 million in the first quarter of 2013. Gross profit margin from service revenue increased to 4.9% for the first quarter of 2014 from 1.3% for the first quarter of 2013. In accordance with GAAP, service revenue is limited to labor sales (excludes any revenue from installed parts and materials) and costs of service revenue includes the fully loaded service center payroll and related employee benefits, and service center occupancy costs (rent, utilities and building maintenance). Excluding the impairment charge of $1.0 million in each of the first quarter of 2014 and 2013, gross profit margin from service revenue increased by 350 basis points to 5.7% for fiscal 2014 from 2.2% in fiscal 2013. The increase in service revenue gross profit margin was primarily due to the leveraging effect of higher sales on the fixed component of payroll and related costs and occupancy costs. Selling, general and administrative expenses as a percentage of total revenues increased to 23.6% for the first quarter of 2014 from 22.1% for the first quarter of 2013. Selling, general and administrative expenses increased $8.9 million, or 7.5%, to $127.1 million in the first quarter of 2014 from $118.2 million in the prior year quarter primarily due to the establishment of a litigation accrual of $4.0 million, higher media expense of $3.3 million, and higher employee costs of $1.0 million. Interest expense for the first quarter of 2014 was $3.8 million, an increase of $0.1 million compared to the $3.7 million reported for the first quarter of 2013. Our income tax expense for the first quarter of 2014 was $1.1 million, or an effective rate of 39.5%, as compared to a benefit of $3.7 million in the first quarter of 2013. The prior year included a $3.8 million tax benefit due to the recognition of state hiring credits. The annual rate depends on a number of factors, including the jurisdiction in which operating profit is earned and the timing and nature of discrete items. 12 -------------------------------------------------------------------------------- Table of Contents As a result of the foregoing, we reported net earnings of $1.6 million in the first quarter of 2014 as compared to net earnings of $3.9 million in the prior year quarter. Our basic and diluted earnings per share were $0.03 for the first quarter of 2014 as compared to $0.07 for the first quarter of 2013. INDUSTRY COMPARISON We operate in the U.S. automotive aftermarket, which has two general lines of business: (1) the Service business, defined as Do-It-For-Me (service labor, installed merchandise and tires) and (2) the Retail business, defined as Do-It-Yourself (retail merchandise) and commercial. Generally, specialized automotive retailers focus on either the Service or Retail area of the business. We believe that operation in both the Service and Retail areas differentiates us from our competitors. Although we manage our store performance at a store level in the aggregate, we believe that the following presentation, which includes the reclassification of revenue from merchandise that we install in customer vehicles to service center revenue, shows an accurate comparison against competitors within the two sales arenas. We compete in the Retail area of the business through our retail sales floor and commercial sales business. Our Service Center business competes in the Service area of the industry. The following table presents the revenues and gross profit for each area of the business: Thirteen Weeks Ended May 3, May 4, (Dollar amounts in thousands) 2014 2013 Service Center Revenue (1) $ 293,913 $ 286,978 Retail Sales (2) 244,908 249,195 Total revenues $ 538,821 $ 536,173 Gross profit from Service Center Revenue (3) $ 63,779 $ 51,995 Gross profit from Retail Sales (3) 69,347 69,845 Total gross profit $ 133,126 $ 121,840 -------------------------------------------------------------------------------- (1) Includes revenues from installed products. (2) Excludes revenues from installed products. (3) Gross profit from Service Center Revenue includes the cost of installed products sold, purchasing, warehousing, service center payroll and related employee benefits and service center occupancy costs. Occupancy costs include utilities, rents, real estate and property taxes, repairs and maintenance and depreciation and amortization expenses. Gross profit from Retail Sales includes the cost of products sold, purchasing, warehousing and store occupancy costs. CAPITAL AND LIQUIDITY Our cash requirements arise principally from (1) the purchase of inventory and capital expenditures related to existing and new stores, offices and distribution centers, (2) debt service and (3) contractual obligations. Cash flows realized through the sales of automotive services, tires, parts and accessories are our primary source of liquidity. Net cash provided by operating activities was $11.5 million in the first quarter of 2014, as compared to $9.4 million in the prior year quarter. The $2.1 million increase from the prior year quarter was due to a favorable change in operating assets and liabilities of $2.3 million, slightly offset by decreased net earnings, net of non-cash adjustments of $0.3 million. The change in operating assets and liabilities was primarily due to favorable changes in inventory, net of accounts payable, of $6.6 million and other long term liabilities of $1.1 million, mostly offset by an unfavorable change in accrued expenses and other current assets of $5.4 million. The change in accrued expenses was primarily due to the timing of our Savings Plan (401k) matching contribution. Taking into consideration changes in our trade payable program liability (shown as cash flows from financing activities on the consolidated statements of cash flows), cash used in accounts payable was $4.6 million in the first quarter of fiscal 2014 and $0.1 million in the prior year quarter. The ratio of accounts payable, including our trade payable program, to inventory was 57.6% as of May 3, 2014, 57.4% as of February 1, 2014, and 60.9% as of May 4, 2013. Cash used in investing activities was $14.6 million in the first quarter of 2014 as compared to $11.8 million in the prior year quarter. Capital expenditures were $14.6 million and $12.8 million in the first quarter of 2014 and 2013, respectively. Capital expenditures for the first quarter of 2014, in addition to our regularly scheduled store, distribution center improvements and information technology enhancements, included the addition of two new Service and Tire Centers and the conversion of five stores into our new "Road Ahead" format. Capital expenditures for the first quarter of 2013 included the addition of four new Service & Tire 13 -------------------------------------------------------------------------------- Table of Contents Centers and two new Supercenters. During the first quarter of 2013, we received $1.0 million of previously posted collateral for retained liabilities related to existing insurance programs. Our targeted capital expenditures for fiscal 2014 are $80.0 million, which includes the planned addition of 25 Service and Tire Centers, three Supercenters (two of which are relocations), 25 Speed Shops within existing Supercenters and the conversion of 42 stores to the "Road Ahead" format. These expenditures are expected to be funded by cash on hand and net cash generated from operating activities. Additional capacity, if needed, exists under our existing line of credit. In the first quarter of 2014, cash provided by financing activities was $7.5 million, as compared to cash used in financing activities of $0.7 million in the prior year quarter. The cash provided by financing activities in the first quarter of 2014 was primarily related to net borrowings under our revolving credit facility of $3.5 million and $4.3 million under our trade payable program, as compared to net payments of $0.3 million under the trade payable program in the first quarter of 2013. The trade payable program is funded by various bank participants who have the ability, but not the obligation, to purchase, directly from our vendors, account receivables owed by Pep Boys. As of May 3, 2014 and February 1, 2014, we had an outstanding balance of $134.1 million and $129.8 million, respectively (classified as trade payable program liability on the consolidated balance sheet). We anticipate that cash on hand, cash generated by operating activities, and availability under our existing revolving credit agreement will exceed our expected cash requirements in fiscal 2014. As of May 3, 2014, we had $37.8 million of cash and cash equivalents on hand, $7.0 million drawn on our revolving credit agreement and maintained undrawn availability on our revolving credit agreement of $147.8 million. Our working capital was $137.2 million and $131.0 million as of May 3, 2014 and February 1, 2014, respectively. Our total debt, net of cash on hand, as a percentage of our net capitalization, was 23.2% and 23.5% as of May 3, 2014 and February 1, 2014, respectively. NEW ACCOUNTING STANDARDS In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, "Revenue from Contracts with Customers." ASU 2014-09 supersedes the revenue recognition requirements in "Topic 605, Revenue Recognition" and requires entities to recognize revenue in a way that depicts the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASU 2014-09 is effective retrospectively for annual or interim reporting periods beginning after December 15, 2016, with early application not permitted. The Company is currently evaluating the new standard, but does not expect the adoption of ASU 2014-09 to have a material impact on the consolidated financial statements. In April 2014, the FASB issued ASU No. 2014-08, "Reporting of Discontinued Operations and Disclosures of Disposals of Components of an Entity." ASU 2014-08 provides a narrower definition of discontinued operations than under existing U.S. GAAP. ASU 2014-08 requires that only a disposal of a component of an entity, or a group of components of an entity, that represents a strategic shift that has, or will have, a major effect on the reporting entity's operations and financial results should be reported in the financial statements as discontinued operations. ASU 2014-08 also provides guidance on the financial statement presentations and disclosures of discontinued operations. ASU 2014-08 is effective prospectively for disposals (or classifications as held for disposal) of components of an entity that occur in annual or interim periods beginning after December 15, 2014. The Company does not expect the adoption of ASU 2014-08 to have a material impact on the consolidated financial statements. In July 2013, the FASB issued ASU No. 2013-11, "Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists". ASU 2013-11 states that an unrecognized tax benefit should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward or a tax credit carryforward, if available at the reporting date under the applicable tax law to settle any additional income taxes that would result from the disallowance of a tax position. If the tax law of the applicable jurisdiction does not require the entity to use, and the entity does not intend to use, the deferred tax asset for such purpose, the unrecognized tax benefit should be presented in the financial statements as a liability. The amendments in this ASU are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The adoption of ASU 2013-11 did not have a material impact on the Company's consolidated financial statements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management's Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments, including those related to customer incentives, product returns and warranty obligations, bad debts, inventories, income taxes, financing operations, restructuring costs, retirement benefits, share-based compensation, risk participation agreements, contingencies and litigation. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. For a detailed discussion of significant accounting policies that may 14 -------------------------------------------------------------------------------- Table of Contents involve a higher degree of judgment or complexity, refer to "Critical Accounting Policies and Estimates" as reported in our Annual Report on Form 10-K for the fiscal year ended February 1, 2014. FORWARD-LOOKING STATEMENTS Certain statements contained herein constitute "forward-looking statements" within the meaning of The Private Securities Litigation Reform Act of 1995. The words "guidance," "expect," "anticipate," "estimates," "targets," "forecasts" and similar expressions are intended to identify such forward-looking statements. Forward-looking statements include management's expectations regarding implementation of its long-term strategic plan, future financial performance, automotive aftermarket trends, levels of competition, business development activities, future capital expenditures, financing sources and availability and the effects of regulation and litigation. Although we believe that the expectations reflected in such forward-looking statements are based on reasonable assumptions, we can give no assurance that our expectations will be achieved. Our actual results may differ materially from the results discussed in the forward-looking statements due to factors beyond our control, including the strength of the national and regional economies, retail and commercial consumers' ability to spend, the health of the various sectors of the automotive aftermarket, the weather in geographical regions with a high concentration of our stores, competitive pricing, the location and number of competitors' stores, product and labor costs and the additional factors described in our filings with the Securities and Exchange Commission (SEC). We assume no obligation to update or supplement forward-looking statements that become untrue because of subsequent events. |