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TEXT-S&P rates Pep Boys - Manny, Moe & Jack
September 19, 2012 / 7:25 PM / 5 years ago

TEXT-S&P rates Pep Boys - Manny, Moe & Jack

Overview
     -- U.S. automotive parts and service retailer Pep Boys is refinancing its 
existing debt to extend debt maturities and to reduce borrowing costs.
     -- We are assigning a 'BB-' issue-level rating to the company's proposed 
six-year $200 million term loan.
     -- We are also affirming our 'B' corporate credit rating on the company. 
The outlook is negative.
     -- The negative outlook reflects our view that financial ratios may 
weaken to levels indicative of a "highly leveraged" financial risk profile, 
either through continuing weak financial results over the next two quarters or 
through more aggressive financial policies.

Rating Action
On Sept. 19, 2012, Standard & Poor's Ratings Services affirmed its 'B' 
corporate credit rating on Philadelphia-based Pep Boys - Manny, Moe & Jack. 
The outlook is negative.

In addition, we assigned our 'BB-' issue-level rating to the company's 
proposed six-year $200 million term loan. The recovery rating is '1', which 
indicates our expectation of very high (90% to 100%) recovery for creditors in 
the event of a payment default or bankruptcy.

We will withdraw our existing issue-level ratings upon confirmation of 
repayment of existing debt with proposed term loan.

The issue-level rating on Pep Boys' existing senior secured term loan due 2013 
is 'BB-' with a '1' recovery rating, indicating our expectation for very high 
recovery (90%-100%) for lenders in the event of a payment default. The 
issue-level rating on Pep Boys' $200 million senior subordinated notes due 
2014 is 'B' with a '3' recovery rating, indicating our expectation for 
meaningful recovery (50% to 70%) for noteholders in the event of a payment 
default. We will withdraw these ratings on completion of refinancing 
transaction.

Rationale
The ratings on Pep Boys reflect Standard & Poor's analysis that the company's 
business risk profile remains "vulnerable" and its financial risk profile 
remains "aggressive."

Our business risk assessment reflects the company's weak competitive position, 
principally because of its competitively disadvantaged store base. The company 
may be able to improve its competitive position through its service and tire 
center (STC) expansion plan, which would reduce average store size and would 
increase service- and maintenance-related revenue. However, weaker industry 
conditions over a prolonged period could meaningfully disrupt the STC 
expansion plan.

Our financial risk assessment incorporates our expectation for financial 
policies to remain aggressive and our forecast for key financial ratios to 
remain indicative of an aggressive financial risk profile through fiscal 
year-end 2013. Specifically, we forecast operating lease-adjusted debt to 
EBITDA of between 4.7x and 4.8x, funds from operations (FFO) to total debt of 
between 18% and 19%, and EBITDA coverage of interest of between 2.4x and 3.0x 
through fiscal year-end 2013. We note these ratios would worsen to levels 
indicative of a "highly leveraged" financial risk profile if results only 
slightly miss our current forecast, and this is the principal reason for the 
outlook remaining negative.

Standard & Poor's economists believe the risk of another U.S. recession during 
the next 12 months remains at 25%. We expect GDP growth of just 2.1% this year 
and only 1.8% in 2013, consumer spending growth of between 1.9% and 2.2% per 
year through 2013, the unemployment rate remaining at or above 8% through late 
2013, and crude oil (WTI) finishing 2012 at $92 per barrel and finishing 2013 
at $90 per barrel. (See "U.S. Economic Forecast: Keeping The Ball In Play," 
published Aug. 17, 2012, on RatingsDirect.) 

Considering these economic forecast items, our forecast for the company's 
operating performance is as follows:
     -- In fiscal 2012, we forecast revenue growth of less than 2.5%, 
reflecting high-single-digit service center growth and negative retail growth. 
In fiscal 2013, we forecast revenue growth of about 1.5%, driven by 
mid-single-digit service center growth and continued negative retail growth.
     -- In fiscal 2012, we forecast gross margin declines about 50 basis 
points (bps) to 24.2%. Gross margin falls as service center revenue mix 
increases and as it takes time for new STCs to reach full potential. In fiscal 
2013, we forecast gross margin decreases about 10 bps to 24.1%. Gross margin 
stabilizes as more STCs reach full potential.
     -- In fiscal 2012, we forecast selling, general, and administrative 
(SG&A) grows at a faster rate than revenue as the company invests in its STC 
expansion plan and additional initiatives. In fiscal 2013, SG&A grows at a 
lower rate than revenue as the company begins to benefit from some of the 
above-mentioned initiatives.
     -- We forecast capital expenditures remain near $65 million per year in 
both fiscal 2012 and fiscal 2013 as the company continues its STC expansion 
plan. This is below our forecast earlier this year of $80 million, which 
reflects the company's recent plan to slow the pace of new store openings. We 
estimate maintenance capital expenditures are between $40 million and $50 
million per year. Our annual maintenance capital expenditure estimate is based 
on results prior to the STC expansion plan, which started during fiscal 2009.
     -- We forecast free cash flow of about $70 million in fiscal 2012. We 
believe the company will use free cash flow for either incremental store 
expansion beyond our forecast assumptions, dividends, or share repurchases. 
The STC expansion plan may include acquisitions, similar to the Big 10 Tires 
acquisition in May 2011.
     -- We forecast further debt reduction is limited to mandatory 
amortization, which is 1% per year under the proposed $200 million term loan. 
A 50% excess cash flow sweep exists when covenant-calculated lease-adjusted 
leverage is equal to or greater than 5.5x.

Second-quarter total revenue of $525 million was nearly $13 million below our 
forecast, largely because service center revenue of $274 million, or 5% 
growth, was below our estimate of $284 million, or 9% growth. Customer counts 
for service centers were up nearly 8%, but average ticket was lower due to 
less complex work being performed. We still believe service center revenue 
growth can reach the high-single-digit percent area for the rest of 2012, but 
this partly depends on the company's ability to generate more complex 
service-related revenue, which remains unproven. Retail revenue of $251 
million, or down nearly 4%, was in line with our expectations, and we continue 
to forecast negative growth from retail for the remainder of 2012. 

Pep Boys has a weak competitive position, principally because of its 
competitively disadvantaged, though improving, store base. The company has 
meaningfully lower sales and profit per square foot relative to automotive 
parts retailer peers, given its excessive store sizes. The company's STC 
expansion plan discussed above has the potential to address this weakness. 
However, we believe it will take considerable time before the full benefits of 
the plan are achieved. Today, STCs account for about 23% of total stores, 
slightly higher than the prior year. We forecast STCs will reach about 25% of 
total stores at fiscal year-end 2012 and about 30% of total stores at fiscal 
year-end 2013. The STC expansion plan performance and potential benefits will 
be clearer toward the end of fiscal 2012 and into fiscal 2013 because it takes 
the average STC about three years to reach maturity. In the meantime, we 
believe the company's business risk profile will remain vulnerable.

Liquidity
We view the company's liquidity as "adequate." We expect cash sources should 
exceed its cash uses over the next 24 months. Our assessment of the company's 
liquidity profile includes the following expectations, assumptions, and 
factors:
     -- We forecast cash sources will exceed cash uses by more than 1.2x over 
the next 12 months, and will remain positive over the next 24 months.
     -- We also forecast positive net sources over the next 12 months, even if 
EBITDA declines by 15%.
     -- The company is not subject to financial maintenance covenants. 
According to the proposed term loan credit agreement, a minimum EBITDA 
covenant applies if liquidity drops below $50 million.
     -- The company has a favorable debt maturity profile, pro forma for the 
refinancing transaction.
     -- We believe the company has good banking relationships and a 
satisfactory standing in the capital markets.

As of July 28, 2012, we calculate total liquidity was $325.9 million, which 
included revolver availability of about $175 million and cash of about $150 
million. Pro forma for the proposed refinancing transaction, we calculate the 
company will have total liquidity of about $160 million. Pep Boys' average 
total liquidity over the past eight quarters is about $270 million. Liquidity 
falls for two reasons: The company is using a portion of its existing cash as 
part of the refinancing transaction and revolver availability is going to be 
reduced for cushion against the minimum EBITDA covenant under the new term 
loan.

Recovery analysis
For the complete recovery analysis, please see the recovery report on Pep 
Boys, to be published on RatingsDirect following this report.

Outlook
The outlook is negative, which reflects our analysis that financial ratios may 
weaken to levels indicative of a "highly leveraged" financial risk profile, 
either through continued weak financial results over the next two quarters or 
through more aggressive financial policies.

We would likely lower the ratings if performance does not improve over the 
next two quarters, which would likely result in financial ratios worsening to 
levels clearly indicative of a highly leveraged financial risk profile, 
including adjusted leverage above 5.5x. Based on second-quarter fiscal 2012 
results and pro forma for the proposed refinancing, an EBITDA decline of 
nearly 15% would be necessary for adjusted leverage to exceed 5.5x. 

We could revise the outlook to stable if it becomes apparent that financial 
ratios can remain clearly within levels indicative of an aggressive financial 
risk profile, including adjusted leverage below 4.5x. Based on second-quarter 
fiscal 2012 results and pro forma for the proposed refinancing, EBITDA growth 
of nearly 10% is necessary for adjusted leverage to decline below 4.5x.

Related Criteria and Research
     -- Corporate Ratings Criteria 2008, published April 15, 2008
     -- Business Risk/Financial Risk Matrix Expanded, May 27, 2009
     -- Methodology and Assumptions: Liquidity Descriptors for Global 
Corporate Issuers, published September 28, 2011
     -- Use of CreditWatch and Outlooks, published Sept. 14, 2009

Ratings List

Ratings Affirmed

Pep Boys-Manny, Moe & Jack
 Corporate Credit Rating                B/Negative/--      

New Ratings

Pep Boys-Manny, Moe & Jack
 Senior Secured                                         
  US$200 mil var/fixed-rate term bank   BB-                
  ln due 2018                     
   Recovery Rating                      1                  

Ratings Affirmed; Recovery Ratings Unchanged

Pep Boys-Manny, Moe & Jack
 Senior Secured                         BB-                
   Recovery Rating                      1                  
 Subordinated                           B                  
   Recovery Rating                      3

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