Description

For the full write-up: https://www.dropbox.com/s/wjtepep5c759z0u/LKQ%20memo%20Feb%202016.pdf?dl=0

Investment Recommendation 

• View on the stock:  Long. Valuation came to historical low as it is being punished as a "SAAR" story alongside the OEMs and dealers but actually have little OEM-related & pricing / margin risk. Could be a good pair vs. Dealers & OEM. Beat & raise story w/ US organic growth consensus too low + capital deployment in Europe w/ strong hints of success.

• $45 / share vs. $26  as of Mid Feb 2016 the following are 2 year price targets to YE 2017

• Bull-case:  $55 / share (45% IRR, 100% up), 1 pt higher growth than base, ~25-30 bp margin expansion, 2x run-rate Net Debt / EBITDA, multiple expands to 20x PE, 12x EV/EBITDA), similar to 2013-14 level.

• Base-case: $40-45 / share (30% IRR, 60% up), US organic growth accelerates, margin towards 12%, 2x run-rate Net Debt / EBITDA, multiple remain @ 17x PE, 10.6x EV/EBITDA, in-line with historical average.

• Bear-case:  $25 / share (flat), 1.5 pt lower growth than base case, 50 bps margin decrease, 2x run-rate Net Debt / EBITDA, de-rate to 12x PE / 8x EV/EBITDA, in-line w/ crisis / other retailer / distributor.

• Nightmare-case: $20 / share (25% down), organic growth slows towards 3-4%, margin <12%, 1.5x run-rate Net Debt / EBITDA, multiple de-rate to 11x PE / 7x EV/EBITDA, in-line with auto-dealers hist. average.

• All cases assume 50/50 deployment of FCF to acquisition at 9-10x EBITDA / share buyback

• 2.5-to-1 risk-reward, gradual beat & raise melt-up, subject to gap-down upon litigation & accident sentiment.

• Time Horizon: 18-24 months

Summary

• LKQ is a reasonably priced non-OEM autoparts distributor that does not receive enough credit for (1) the upcoming growth acceleration of the 3-8 year addressable fleet size in the US and (2) the long, visible runway of capital allocation in Europe to replicate what they have accomplished here. The first point is very “dealer-thesis 2.0” sounding – whatever propelled the HSD-to-LMD growth in Parts & Services for the auto-dealers is set to mirror itself for LKQ as the 0-5 year-old fleet turns into the 3-8 year fleet, setting a trajectory of 8-10% US CAGR (~2 pts above consensus) over the next 4 years barring any incremental share gain and/or sudden accident frequency decline. The ~5% FCF yield coupled with maintained 2x Net-Debt / EBITDA leverage allows for ~$0.8 – 1 Bn of firepower (~10% of market cap) to be deployed in this fragmented industry with a many-to-many structure. Given that (a) the efficient ramp-up from sub-scale to of-scale can drive compelling IRR of 20%+, ROIC of 10%, and margin expansion of up to 500 bps and (b) LKQ’s historical track record of 170+ acquisitions rolling up the US while maintaining 10%+ ROIC/ROIIC and 15% ROE, deploying cash into Europe where the market penetration of OEM parts is ¼ of the US and LKQ’s share is roughly 1/3 of the US could drive further upside vs. consensus (where most sell-side do not model acquisition / any capital deployment). The 7-8% organic growth + 10% acquisition growth + margin upside offset by dilution, assuming multiples remaining at 18x historical average, should drive 15-17% IRR over the next few years with optionality on operational improvements and scrap metal prices potentially turning around.

• That being said, pricing and margin likely saw their best days as OEM parts manufacturers are getting more aggressive while customers (repair shops) are consolidating (although these should help LKQ gain share), LKQ’s increased size, share, and OEM-exposure would render execution risk higher and downside-upon-crisis greater, and, most damning of all, accident rate is likely to take a 1-way street down and permanently drag top-line growth by 3-4%. All these will point to lower and more volatile out-year organic bottom-line growth -- which means the current multiple of 18-20x forward PE sees great risk of compression towards 14-16x, effectively cutting the IRR in half (8-10% IRR).

• While one can argue LKQ deserves a premium over the next 2-3 years given the extremely favorable tailwind and capital allocation trajectory (~$50+ / share at 20x+ PE), the silver-lining is that the risk of a financial crisis and accident rate decline / driverless cars also increases dramatically. The debate then becomes (1) how short-sighted the market can be, (2) what kind of hedges we should put on, and (3) whether the consensus revision upwards + continuous execution drivers have enough hedged IRR to justify the opportunity cost. My hypothesis is that once SAAR stops going up & general economy shows 1st sign of weakness, the multiple beyond 20x is not likely to be seen.

• Hence, It could be an interesting pair with the dealers/OEM with 15-17% IRR, downside rerating jump-risk upon accident sentiment or headlines, and secular risk; or hedge should we choose to invest.

• Key Catalysts: Visible acceleration of US organic topline growth, guidance / realization to margin upside thanks to consulting / UK warehouse, entry to other European countries w/ additional disclosure to consolidation roadmap.

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Investment thesis / Highlight

Visible but underappreciated US organic growth acceleration as auto age group enters the sweet spot, aka “dealer thesis 2.0”

• If one follows the auto dealers, one would recall the very clever bull thesis 2 years ago: given the high P&S attachment to 0-5 year-old vehicles (with warranty) and the corresponding high gross profits composition (~40-50% of dealer profit), as SAAR came out of the 2009 recession with a vengeance, the vintage data will suggest strong, unabated, and accelerating 5-10% top-line growth as P&S impact kicks in starting in late 2013.

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• We are currently in the 6-7th inning of that story – but the next chapter spells a similar backdrop for LKQ as the 0-5 cark turn into the 5-10 car park. I believe we are just in the 1st inning of this “dealer thesis 2.0” over next 5 years. Raw SSS organic growth in the US could reach 8-11% circa 2016-2018 and LKQ potentially at 10-13% assuming share gains, well above the 5-7% consensus estimate.

• The sweet spot for cars to use non-OEM parts is between 3 and 8 years old.  In this window, cars are off-warranty and still of high enough value to justify repair.

• Importantly, it is a rather tedious exercise to triangulate an industry figure that ultimately matters to LKQ, namely the total $ amount for Non-OEM parts used on 3-8 year vehicles. Key drivers not only include vehicle ages, but one also has to tie churn, miles traveled, # of claims / crashes per registered vehicle, parts per vehicle, parts pricing, and penetration + usage of non-OEM parts all together logically. Most relies on management’s qualitative commentary and extrapolate 5-7% based on historical data, and, upon checking, no sell-side has performed a top-down build to quantitatively model the growth trajectory despite the availability of data.

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• Assuming # of crashes per mile continue to decline at 3% per annum, we can arrive at a 8% CAGR of total addressable market growth for LKQ (3-8 year vehicle) over the next 4-5 years, with the maximum growth point of ~11% coming in 2017. If we assume no improvement in accident rate, then we are looking at an 11% CAGR with ~14% peak growth in 2017. (See above).

• The punitive accident rate assumption is almost completely offset by increased miles driven, increased aftermarket penetration, and increased SKU / vehicle that requires replacement. Our assumption on no price inflation ever is also debatable and could prove conservative – although the OEMs pricing down keeps be from being aggressive.

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• Notably, LKQ’s organic growth had historically out-paced the 3-8 year car pack growth by 500 bps+ / year. While it likely could be revenue synergy from its acquisitions and increased store count, it is unlikely that SSS will be so negative in a strong backdrop as such – thus rendering the sell-side consensus of 6-8% growth likely too low.

• Please see appendix / model for the detailed build-out. Other assumptions include (1) SAAR stabilizing at ~17.5-18 mm, (2) miles / vehicle stabilize around currently, (3) # of crashes per mile continue to decline at 3% per annum, (4) replaced parts per vehicle growing at 2% per annum, (5) no price inflation in parts, (6) 20-30 bps of increased non-OEM penetration per year, and (7) various other vehicle age group allocation assumptions.

   

Sizable TAM in Europe, proven UK record, and acquisition economics can drive long run-way of high ROIIC growth

• The large, fragmented, and OEM-heavy Europe seems like a good place to soak up LKQ’s $400 mm+ annual FCF at 10%+ ROIC and >20% IRR. While further due diligence on the local markets and regulatory landscape are needed, LKQ’s track record on >170 acquisitions, stable historical ROIC at >10%, and success in UK and Benelux market suggest high visibility of ~15-20%+ topline growth in the region with deals at good returns – most of which is not modeled by consensus.

• There is a good amount to like about Europe: The car parc is similar to that of US, the vehicle age is aging quickly, DIFM market is actually larger but likely caused by high parts prices (as evident by 10+ pts higher composition), non-OEM penetration is very low at about ¼ of US’s level, and LKQ is running at 2% of the market share driving the shift towards non-OEM usage. As far as we know, distributors and salvagers remain regional, and there are no player of national scale similar to LKQ of the US.

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• By purchasing the leading national distributors & branches, converting the distribution from 3-to-2 steps to save margins, driving aftermarket collision parts usage amongst insurers, LKQ should have a very long run-way to penetrate the European market and sustain 20%+ total revenue growth.

• LKQ’s long track record in the US and 2 recent success stories in UK and Netherlands give us some confidence on its execution. The 4Q11 entry in UK via the ECP acquisition saw a more-than doubling of store count over 3 years, with SSS sales consistently above 10% and organic growth still in double-digits; meanwhile 80% of the insurer coverage in UK signed up for aftermarket collision program and alternative parts utilization locally went from 7% to 9%. The 2Q13 entry to the Benelux region via warehouse distributor Sator and subsequent roll-up of local branches, while margin-dilutive for a few quarters due to revenue-dis-synergy amidst 3-to-2 step distribution conversion with 86 branches, is now beginning to see stable MSD organic growth as margin steadily expands. Overall, LKQ’s European business went from non-existent 4 years ago to a $2 Bn operation with ~8%+ organic top-line growth and consistent 10%+ EBITDA margin / 37-38% gross margin. Meanwhile the ROIC / ROIIC remains above 10% and ROE remains above 15%.

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• Importantly, the next-steps for continuous growth is equally visible. Aside from western / southern Europe being completely untouched, LKQ has yet introduced salvage parts in the UK but strongly hinted at it as a “natural extension”. The aftermarkets collision parts push is now about to begin in the Benelux region as the 3-to-2 step transition completes – and the roll-out should be expedited given the existing UK insurer relationship in the region.

• A simple acquisition illustration @ 8.5x EBITDA with 50% debt @ 5%, 250 bps of margin synergy, and 5% revenue synergy points to ~10% run-rate ROIC in 5 years and ~24-25% IRR. Couple this math with the scale advantage mentioned above, a good roll-up roadway is quite visible within the European region.

• The Rhiag-Inter deal recently announced now furthers the company’s entrance into central Europe.

• Consensus mostly does not include acquisitions and let the cash accumulate– whereby we feel like that given the opportunity, the majority of the FCF will be deployed there. We would also note that given management’s record of deploying almost all of its operating cash flow to acquisitions historically, it is highly unlikely that they let the cash pile up as sell-side continuously mis-models.

• Further upside remains in other emerging markets.

Various “self-help” and macro factors could drive margin upside not modelled by sell-side estimates

• LKQ is currently doing ~12% EBITDA margin. Here are several telegraphed but mostly qualitative drivers that could push out-year numbers comfortably above consensus:

• Scrap metal price decline had been a headwind to margins over the past 3 quarters and should persist into 4Q15. The potential trough should remove the headwind given the lag of 30-45 days between purchasing & scrapping.

• Additionally, Manheim used car prices had still been hovering around post-crisis highs despite record SAAR. Perhaps the demand had indeed been robust while supplier had been disciplined. But any crack in the armor should help LKQ’s “other revenue” gross margin further.

• The new UK Tamworth Distribution upgrade is going to cost LKQ ~10 cents / share over the next 2 years but should deliver good run-rate distribution savings. Accretion still under wraps, assuming 20%+ IRR it should be 2-3 cents accretive starting in FY18 (or ~1%+ accretion).

• Alix Partners was brought in in 2Q15 to improve operating efficiency on parts procurement, route optimization, dismantling centers best practice, and sales effectiveness. No disclosures on financial impacts yet but is long called for given the roll-ups. We don’t project margin lift here but could serve as upside surprise.

• On the insurer front, there had been talks about (1) LKQ going direct and by-passing car auctions and (2) State Farm potentially stepping up its aftermarket program further beyond chrome bumpers. The former could further improve margins given the skipped fees and the latter will introduce added volume given State Farm’s 18% share. Progress on both ends seem to be stagnant but could be good optionality one day.

• Other sources of optionality remain even within United States for inorganic growth related to public market, whether it’s Fenix (start-up salvager roll-up), Uni-Select (paint distributor), or GPC’s NAPA Autoparts (might require an activist, size is still a bit big and could be a stretch).

Catalyst

 Visible acceleration of US organic topline growth, guidance / realization to margin upside thanks to consulting / UK warehouse, entry to other European countries w/ additional disclosure to consolidation roadmap.