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June 21 - Overview -- U.S. auto parts retailer Pep Boys posted weak financial results for the first quarter of fiscal 2012. -- We are affirming our 'B' corporate credit rating on the company and removing it from CreditWatch with negative implications following our review of the planned LBO termination; 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 into late 2012 or through more aggressive financial policies. Rating Action On June 21, 2012, Standard & Poor's Ratings Services affirmed its 'B' corporate credit rating on Philadelphia-based Pep Boys - Manny, Moe & Jack. At the same time, following our review of the planned LBO termination, we removed the company from CreditWatch with negative implications, where it had been placed on Jan. 30, 2012. The outlook is negative. We also affirmed our 'BB-' issue-level rating on the company's senior secured term loan due 2013. The '1' recovery rating on the debt remains unchanged and indicates our expectation for very high (90%-100%) recovery for creditors in the event of a payment default. We also affirmed our 'B' issue-level rating on the company's $200 million senior subordinated notes due 2014. The '3' recovery rating remains unchanged and indicates our expectation for meaningful (50% to 70%) recovery for noteholders in the event of a payment default. 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 of time 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 about 4.7x, funds from operations (FFO) to total debt of about 18%, and EBITDA coverage of interest of about 2.8x 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 negative outlook. Standard & Poor's economists currently place a 20% probability of a recession occurring in the U.S. Additional economic forecast items include GDP growth of 2.0% in 2012 and 2.1% in 2013, consumer spending growth of 2.2% in 2012 and 2.4% in 2013, the unemployment rate remaining around 8%, and crude oil (WTI) ending 2012 and 2013 near $90 per barrel. Considering these economic forecast items, our forecast for the company's operating performance is as follows: -- In fiscal 2012, we forecast revenue growth of slightly less than 3%, 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 negative retail growth. -- In fiscal 2012, we forecast gross margin declines about 70 basis points (bps) to 24%. 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 increases 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) expenses growing 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 prior forecast 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 commenced during fiscal 2009. -- We forecast free cash flow of about $35 million in fiscal 2012. We believe free cash flow will be used 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 debt reduction occurs as the company seeks to refinance its term loan due in 2013 and its senior subordinated notes due in 2014. We expect the refinancing will occur before fiscal year-end 2012, if capital markets conditions permit. We estimate the company will reduce debt by about $100 million through the use of existing cash (including a $50 million merger settlement payment from The Gores Group LLC). Operating performance was below expectations for the first quarter of fiscal 2012. Principal reasons cited by the company for its poor performance included unusually warm weather, which lowered demand for certain weather-related products (e.g., tires, batteries, wipers), operational issues associated with the conversion to the One Team staffing model, and IT issues associated with the company's e-commerce and TreadSmart systems. We believe weaker industry conditions were also a factor. The higher price of unleaded gasoline versus the prior year restricted miles-driven growth, and that growth is a big demand determinant. Also, high unemployment and weak consumer confidence continue to limit demand for non-discretionary products. We forecast second-quarter performance will remain weak, with a return to better results possible in the third and fourth quarters only if the company addresses its operational issues and if industry conditions do not worsen. 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. Its 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, up from 8.5% of total stores in the prior year. We forecast STCs will reach nearly 26% of total stores at fiscal year-end 2012 and over 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 mean time, we believe the company's business risk profile will remain vulnerable. Liquidity We view Pep Boys' liquidity as "adequate." We expect the company's 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 forecast positive net sources over the next 12 months, even if EBITDA declines by 15%. -- The company is not subject to financial maintenance covenants. There is a fixed-charge coverage covenant if revolver availability drops below the greater of $50 million or 17.5% of the borrowing base. -- We believe the company will be able to refinance its upcoming debt maturities. A supporting factor is the company's ownership of about 230 stores. There are currently 126 stores serving as collateral under the company's existing term loan. -- We believe the company has good banking relationships and a satisfactory standing in the capital markets. As of April 28, 2012, we calculate the company had total liquidity of about $289 million, which included revolver availability of about $190 million. The company's average total liquidity over the past eight quarters is about $250 million. Recovery analysis The issue-level rating on Pep Boys' senior secured term loan due 2013 is 'BB-' with a '1' recovery rating, indicating our expectation for very high (90%-100%) recovery for lenders in the event of a payment default. The issue-level rating on the $200 million senior subordinated notes due 2014 is 'B' with a '3' recovery rating, indicating our expectation for meaningful (50% to 70%) recovery for noteholders in the event of a payment default. (For the complete recovery analysis, please see the recovery report on Pep Boys, published on RatingsDirect on Nov. 18, 2011.) 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 into late 2012 or through more aggressive financial policies. We would likely lower the ratings if performance does not improve in the second-half of fiscal 2012, 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 first-quarter fiscal 2012 results, an EBITDA decline of nearly 10% 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 first-quarter fiscal 2012 results, EBITDA growth of about 15% 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 And Off CreditWatch To From Pep Boys-Manny, Moe & Jack Corporate Credit Rating B/Negative/-- B/Watch Neg/-- Senior Secured BB- BB-/Watch Neg Recovery Rating 1 1 Subordinated B B/Watch Neg Recovery Rating 3 3 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.
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