Why Carl Icahn's Pep Boys Purchase Is Brilliant

Despite all evidence that Pep Boys (NYSE: PBY) wished to sell itself to Japanese auto parts and repair chain Bridgestone, famed corporate raider Carl Icahn won out in the end. Curiouser still was the price tag: just over $1 billion. True, there is some value in the Pep Boys name, started by the "boys" themselves -- Manny, Moe and Jack -- just under 100 years ago in Philadelphia. But it's going to take more than history to win in the ultra-competitive world of auto repairs. Not only are there scores of national chains vying for Pep Boys' customers -- Monro Muffler Brake (MNRO -1.93%) just to name just one tough competitor -- but there are countless locally owned shops that can get folks' repair jobs done as well. So what is Icahn, who first made a name for himself in the 1980s buyout boom, plotting to do with his newly acquired auto repair chain?

Elusive Profits
As former owners of Pep Boys were no doubt aware, consistent profits have been somewhat elusive:

Data source: S&P Capital IQ

And, it should come as no surprise, in light of the inevitable price competition that occurs in service industries like auto repair shops, that the company has had to invest what little cash has been generated back into the business.

The fact that Pep Boys doesn't frequently find itself in the green is well known: Not only has its hit-or-miss profitability scared off previous potential buyers, but it's spooked other leveraged buyout artists just like Icahn. Back in 2012, after having agreed to buy Pep Boys for $804 million, private equity firm The Gores Group actually called the deal off and paid a $50 million breakup fee after getting a closer look at Pep Boys' books. Not exactly a ringing endorsement of Manny, Moe and Jack's future prospects. It should also be noted that in light of Pep Boys' subsequent results, it appears they were probably right to pay up and walk away. Or were they? 

The question now is not just what Icahn is thinking with his brand new $1 billion prize, but does he actually see something in Pep Boys that The Gores Group missed?

Icahn doesn't even want the auto repair business
While it's always tricky when mere mortals guess at the reasons why a billionaire does anything, we can sure try! After reading through scores of press releases and articles, it seems that the reasons why Icahn outbid rival suitor Bridgestone to snap up Pep Boys, are twofold:

1. Icahn hopes to sell Pep Boy's auto repair business, thus lowering the "purchase price" for what he really wants: the auto parts retail operation.
2. He then wants to merge the remaining part of Pep Boys with Auto Plus, an auto parts distributor he purchased last year, creating a player better able to take on the much larger national auto parts chains. 

So, what could the auto repair business fetch? Pep Boys' auto service revenues came to $490.7 million in fiscal 2015, $457.9 million in fiscal 2014, and $446.8 million in fiscal 2013, or 30.78%, 28.5%, and 27.2% of total revenues, respectively.

Valuing such a business is tricky, as it's decidedly low margin: Pep Boys noted in last year's annual report that service revenues came to $484.4 million, but yielded a gross profit of just $6.3 million. Those aren't exactly numbers that buyers will be lining up to bid for. Granted, maybe costs could be cut and operations merged with a more efficient auto repair service operator. But who are we to guess at the sales price? We can't, and neither can Icahn. However, he  knows is that the operation is worth something -- and it should be enough to drastically reduce his his total outlay for the part of Pep Boys he wanted. 

Monro Muffler, for example, currently trades for 2.23 times last year's total revenues. Such a multiple, assigned to Pep Boys' service operation, nets a very healthy $1.096 billion -- more than Icahn's total purchase price. Do I think he'll get that much? Of course not: Monro is an exceptional operation that generated $62 million in net income in fiscal 2015. The point is that even selling the auto service business at 1 times its 2015 revenue would net Icahn almost half a billion dollars -- not too shabby. 

Granted, I've painted some broad strokes with this analysis. But it is, most probably, at least an approximation of what Icahn is up to. His goal is to not only to sell the service operations, but to then build up the retail parts operation in order to compete effectively with the likes of AutoZone, (AZO -0.75%), the not-associated-with-the-author O'Reilly Automotive (ORLY -0.26%), and AutoNation (AN -1.54%). Make no mistake, it won't be easy -- but it's not impossible. After all, I don't really care which of these retailers sells me new windshield wipers or a car battery -- and you probably don't either. 

AutoZone, O'Reilly Auto, and AutoNation are extremely profitable, and have been rewarded with lofty valuations by investors. This is the reason Icahn is after the retail operations of Pep Boys. That side of its business generated $1.59 billion in sales in fiscal 2015, and produced a gross profit of $469.1 million.

As with the whole of the Pep Boys operation, consistent profits there have been elusive. However, should Icahn steer it to some semblance of the success had by AutoZone or O'Reilly Automotive, he'd make an absolute killing. O'Reilly trades at a respectable 3.03 times LTM revenues, AutoZone trades for 2.03 LTM revenues, and AutoNation (in the wake of a recent sharp plunge) for 0.35 times LTM revenues. This is a fairly wide range, but should Icahn be successful in turning around at least the retail operation of Pep Boys, he stands to make a king's ransom. Valuing Pep Boys at just 1 times parts revenue nets the buyout artist over $1.5 billion -- not a bad day's work, to say the least. 

Foolish takeaway for mere mortals
Most of us can't buy entire companies and sell off parts of them, in the hopes of turning around operations and boosting their value. What we can do is reflect on what Icahn clearly did when analyzing Pep Boys: He focused on the business and what it could become in the long term with the right operational implementation.

The fates of these companies may not rest in our hands, but we can judge determine which ones have managers who are behaving in ways we approve of, based on corporate actions and conference call transcripts, and invest accordingly. That's a philosophy we can all buy.