Pep Boys’ buyer bails out of $1-billion deal

The future of Pep Boys has been cast in serious doubt after a Los Angeles private-equity firm scuttled a $1-billion deal to buy the struggling auto parts retailer.

Gores Group walked away from the acquisition amid worries that Pep Boys’ business was deteriorating. The company posted weak first-quarter results this month, when the deal first began to disintegrate.

Analysts pointed out that the Gores Group’s willingness to pay a $50-million breakup fee without challenging it in court might signal trouble for Pep Boys.

“It might be cheaper to pay a $50-million termination fee than to go through with the buyout,” said Cid Wilson, managing director for U.S. equity research at Princeton Securities Group

in Fort Lee, N.J. “It was clearly an indication that they were having a little bit of buyer’s remorse.”

Investors fled the company’s stock, which plunged $2.20, or 20%, to $8.89 on Wednesday. Gores had agreed to buy the company in January for $15 a share, which was 23% higher than where the stock was trading before the deal was announced.

Pep Boys Chief Executive Mike Odell on Wednesday blamed sluggish sales on “mild winter weather, restrained customer spending [and] delays in implementing new technology.” He said Pep Boys remains “on course” and would continue as a public company.

But analysts fear that business will continue to slump, and that Gores Group probably knew it because it had access to the company’s books.

“Gores Group has better visibility into Pep Boys’ results than anyone,” said David Schick, an analyst at Stifel, Nicolaus & Co.

“While weather was certainly a driver of first-quarter weakness, we now know that Pep Boys’ execution was to blame as well — potentially prompting Gores Group desire to exit the agreement,” he said in a research note.

The deal first began to fall apart in April, when Gores Group tried to slow things down after the first-quarter report, according to filings with the Securities and Exchange Commission. It asked Pep Boys to postpone a shareholder meeting scheduled for Tuesday.

Pep Boys declined to reschedule it, and Gores Group pulled out of the deal. The private-equity group must also reimburse Pep Boys for an undisclosed amount of merger-related expenses.

With the buyout now terminated, Pep Boys plans to use the $100 million in cash it has on hand to pay down debt and refinance certain debts that come due in 2013.

Pep Boys operates 130 stores in California, which have been struggling in recent years to compete against other big rivals such as O’Reilly Automotive Inc., Autozone Inc. and Monro Muffler Brake Inc.

This was the third time in seven years that Pep Boys had tried to find a buyer. It was the first time the company had moved forward with one.

The fact that Pep Boys can’t find a buyer is an indication that its “business model is very challenging,” Wilson said. He points out that the company’s dependence on tire sales to bring customers in the door hurt profits this year because of an industry-wide slump in tire sales.

What’s more, Pep Boys would be reluctant to pass rising tire costs on to their customers, who are already prone to putting off buying new tires in the current economy.

The company decided to “eat the difference, which has an adverse impact on your gross margin,” Wilson said.

Pep Boys’ competitors also have suffered slumps that are due to increasing tire prices and a lack of extreme temperatures this winter, which tend to wear down auto parts, Wilson said.

“I will say that it’s unclear how much of the decline was Pep Boys’ specific mismanagement and how much is part of industry-wide dropoff,” Wilson said.