Value Investors Club / LKQ CORP (LKQ)

Description

LKQ $31.50

SO 308

Thesis

LKQ is a secular growth story which should organically compound eps at 10% a year and generate strong

FCF which will be used to continue to build their growing European position and help generate a net mid

teens EPS CAGR. If the business develops as we currently think, eps should grow to around $2.70 to

$2.85 in 2019 from $1.90 in 2017. If it traded at 17x (which would be a discount to the comps) it would

be a $46 to $49 stock. Overall, the business is counter cyclical and likely to maintain or accelerate

organic growth into a recession as it did in 2009/2010. In addition, the businesses where it competes

are largely shielded from new competitive threats like Amazon, as explained below. One should think

about the business as being divided into basically three separate businesses each with its own drivers

and growth characteristics. The largest (roughly 50% of revenue) is the North American business. The

North American business should be thought of as largely a collision repair part distribution business

which consists of using both recycled (salvaged) parts and aftermarket parts (cheaper copies of OEM

parts). Also within this business is a smaller business (about 10% of the segment or 5% of total company

revenue) based on recycled mechanical parts. These are mostly rebuilt engines that are salvaged

(sometimes from cars bought at auction, sometimes just from auto repair shops in their auto body

network) and distributed through the same North American distribution system to many of the same

body shops that get collision parts from LKQ. Within North America, it has a dominant position (20x

larger than the nearest competitor) based on the size and scale of its distribution network that cannot

be replicated. The European business (roughly 35% of the revenue) is based on the sale of aftermarket

mechanical parts (wipers, air filters, belts, etc.) and is not collision related. This is a good business and is

similar to a Genuine Auto Parts in the US, with the difference being that Europe, as a result of a

regulatory shift, is far less penetrated with alternative mechanical parts than the US leaving room for

much faster growth. The last business is a Specialty Parts business (roughly 15% of the revenue). This is

primarily after market accessories for trucks and RV’s (special wheels, winches, trailer hitches, floor

liners, etc.).

LKQ is poised to win market share in both of its primary businesses, albeit for different reasons. In the

US because its clients are basically auto insurance companies that offer a commodity product and are

under constant pressure to lower their costs – LKQ and alternative parts offer a 50% +/- discount to

OEM parts. LKQ, being 20x larger than the next largest competitor, is best positioned to service those

customers and participate in that secular shift as it can offer industry leading fulfillment rates given its

distribution network and the quick turnaround of repairs is a key driver for insurance companies. The

largest auto insurer (State Farm), which has not fully embraced alternative parts for reasons explained in

the later in the memo, is bleeding both market share and losing billions on its auto book to the lower

cost providers like GEICO. This dynamic of auto insurers needing to be low cost providers should

continue to lead to market share gains for alternative parts providers and gives a free call on State Farm

getting back into the space which would create a big step up in demand. In Europe recent EU decisions

have removed barriers OEM’s had tried to impose to prevent the use of mechanical alternative parts

(wipers, belts, filters, etc) which have resulted in alternative parts only having a fraction of the market

share that they do in the US. (roughly 60% vs almost 90%). As a result of the removal of barriers to their

use, alternative parts should enjoy market share gains for many years to come as the consumer is able

to purchase parts at a fraction of the cost of OEM parts without restrictions or potential warranty issues.

This business most closely resembles companies like GPC in the US. With two high quality businesses

well positioned for secular growth you are paying 13x forward eps. Comps which would include GPC,

Monro, O’Reilly, Copart, Kar, even AZO trade at 20x forward on average with lower organic growth

profiles.

From a driver/risk perspective you can also break the business down like this (a fuller explanation

follows):

About 35% is collision related(basically all in North America). Of this about 25% is driver related and

11% is non-driver related. Another 5% is around rebuilding engines (also in North America) and so is a

function of fixing up old cars. About 14% is tied to consumer discretionary purchases and the SAAR (as it

is often for new cars/trucks) – this is the Specialty business. Most of the rest – about 40% is sort of an

MRO business – basic replacement of mechanical parts (wipers, filters, belts). Almost all of this 40% is

the European business, with about 36% coming from Europe and a small 4% or so in North America. The

driver here is the general maintenance of gas power cars (automated or not). It is worth noting, while

electric cars need maintenance, they do not require the same number of parts (less filters, belts, brakes,

etc.). The remainder 6% is basically “other” which is tied to heavy truck, self service, scrap metal (0%

margin) and some other small segments.

North America (about 50% of revenue)

We can think of the North American Business as being broken down as follows:

Endmarket Business Segment

Driving Related Collision 25%

Non-Driving Related Collision 11%

Collision Related 35% North America

Rebuild/Repair 5% North America

Discretionary/SAAR 14% Specialty

MRO 40% Mostly Europe (36% Europe/4% NA)

Other 6%

North America

100%

North America

Recycled Collision 12%

Aftermarket Collision 23%

Total Collision Related 35%

Recycled Mechanincal 5%

Aftermarket Mechanical 4%

Other 6%

Total North America 50%

The collision related business is the largest driver of the North American business. This would include

both recycled parts (which are original OEM parts salvaged from total cars bought at auction) and

aftermarket parts (these are new parts made mostly in Taiwan by non-OEM’s. In terms of drivers, we

have been told that the 35% of the total business (70% of the NA business segment) broadly thought of

as collision related can be broken down further along a rough rule of them that around 70% of such

collision claims come from driver related accidents and 30% from non-driver related damage (deer, hail,

falling trees, floods, etc.). So from a risk of more advanced driver assistance systems (and one day

autonomous driving) only about 70% of that 35% or a net 25% of the overall business is exposed to

having few driver related incidents. This risk is discussed more fully later.

The recycled mechanical piece is mostly rebuilt engines that LKQ collects from salvaged vehicles and

from auto body shops along its distribution network. It then rebuilds the engines and sells them to a

used car owner with a blown engine at a fraction of the cost of a new engine and often at a time when

the car is not worth spending the money on a new engine. LKQ then collects the blown engine and looks

to rebuild it and so on and so on. Just recently, LKQ announced that it was going to do the same thing

for rebuilt transmissions. This is a new business and something worth exploring. Our sense is that this

could be a $300 +/- opportunity over a few years or maybe add 50-70 bps to overall growth for if it

should prove successful. This is not really in our numbers, but is could lead North America to run closer

to the high end of the long term guidance range (4%) or add an incremental $0.10 to eps in a couple of

years. There is also a small piece of aftermarket mechanical sales (coolant, etc), but this is pretty small

and rarely broken out within North America.

The wholesale collision part market is a $15 billion market. Ultimately the big drivers for the business

are a function of collisions (loosely correlated with miles driven but also influenced by weather), the cost

of parts, the number of parts per collision and the market penetration of alternative parts. Currently

alternative parts are about 37% of the parts used for repair while the other 63% come from OEMs. The

value proposition is that alternative parts cost a fraction of what OEM parts cost. The ultimate payor for

collision repairs is the insurance company. Given that auto insurance is largely a commodity business, an

insurance company will care about two things – 1) cost and 2) speed. This plays well for LKQ. As you

can see below, alternative parts are much cheaper and can really lower the cost of doing business for an

auto insurance company:

Driving Related Collision 25%

Non-Driving Related Collision 11%

Collision Related 35%

Interestingly, the largest auto insurer, State Farm, that insures 1 out of every 5 cars in the US does not

use aftermarket parts. This is a result of a lawsuit from several years ago. Even though they won the

suit and have changed their contract to match those of others in the industry (so as to be clear that they

can use aftermarket parts) State Farm has yet to return to using them in a meaningful way. The best

explanation for that seems to be there are lingering challenges to the ruling and perhaps they do not

want to change their stance until those have been removed. It is also worth noting that State Farm does

not advertise its lack of aftermarket part use (something the consumer might like) because it needs to

preserve its ability to return to the market – so they are not getting any benefit from not using such

parts. In the meantime, given the nature of the business they continue to lose billions of dollars on their

auto book and bleed market share to lost cost providers like GEICO and Progressive. Industry leaders

like GEICO and Progressive, perhaps unsurprisingly, have alternative parts use rates in the low 40’s% -

ahead of the industry as a whole. Management thinks the industry could get to the mid 40’s% or so in

terms of penetration up from around 36% today. Certain parts will never be replaced by alternative

parts because they are not in demand enough for an aftermarket part maker to tool up to build or there

are not enough salved parts to keep it in inventory. The back panel of a BMW 7 series is such an

example – its too rarely needed/available. Also, as explained earlier, new cars and old (10+ year) cars

usually do not get alternative parts and those represent about 40% of the car parc. One free call exists

in that it seems likely that at some point – perhaps in the near future – State Farm will reverse course

and return to aftermarket parts like its competitors. Our thinking on the State Farm opportunity is as

follows:

Collisions part industry is a $15Bn industry. State Farm has 18% market share or $2700 if 30% of

that went to recycled parts that would be $810M of which LKQ could capture its pro-rata share

of 60% at a 15% EBITDA margin = $0.17 / share at 20x = $3.37

In addition to low cost, insurance companies care about turn around time. This is because they are

usually paying for a rental car for their customer while the car is being repaired. In addition, long turn

around times upset customers and create switching costs/churn. Here LKQ provides a solution as well.

LKQ is 20x larger then the next competitor. In addition to size, LKQ has invested in and built the largest

and most sophisticated distribution system. As a result, it can get parts to auto body shops within a day

with greater frequency than any competitor as it has the largest inventory and it can move that

inventory around daily depending on need with a logistics system that that links salvage yards,

distribution centers and the customers.

It is worth noting, that management guides this business to grow 2-4% annually. Looking at the growth

drivers – miles driven (loose proxy for collisions over time), cost inflation of OEM parts (alternative parts

are priced as a % of OEM parts so as OEM part prices go up, so do alternative part prices), number of

parts damaged per incident – all of those are LSD+ type numbers. In addition, over time alternative part

penetration has gone up. Most recently this has flatten out, but management points to the negative mix

shift in the age of cars for holding back penetration rates – alternative parts are most often used in cars

3-10 years old (or 3-7 – there is some debate). Older cars get totaled when they crash, not fixed, and

younger cars often do not have alternative parts available yet and insurance companies are more likely

to use OEM parts on new cars. The number of cars within this “sweet spot” of 3-10 year has been

declining for years – since 2009. Starting really in 2018, this pool should begin to grow again which

should help overall penetration rates as you can see below:

If you add up all the drivers behind the business including the shifting age of the car pool – it seems like

you can come up with something much higher than 2-4%. (Miles driven, OEM part price increases,

number of parts damaged per incident, market penetration of alternative parts, shifting age of car parc).

Management claims that the business is of a size and complexity that it is not realistic to think of it

growing much beyond that range and our numbers do not assume it does. But it is worth continuing to

follow this as it can also be a case of being conservative by a new CEO when there is a lot of focus on the

North American organic growth number and it has been decelerating (in part because of the chart

above) – so why set expectations high? In addition to organic growth, management continues to do

tuck-in acquisitions in North America which can be done at 3x-4x EBITDA pro forma for synergies.

Collision is now only 35% of the business and driver related collisions are likely only about 25%, but

there is still a question about this segment of the business as advanced driving safety systems become

more widespread and with the eventual mass introduction of autonomous driving cars.

With regard to advanced active safety and autonomous driving the company makes the following 2

points. First it points to the most recent study by CCC information services about the estimated impact

on the number of collisions from active safety and eventually autonomous driving – the conclusion of

which is that the effect is very mild and takes decades to play out such that it will be hard to see in LKQ

numbers over any investable time frame (see below):

As you can see, CCC estimates the number of collisions will be down only 10% by 2030 – that directly

addresses only 35% of the business (I think the study is on total collisions not just driver related – so I

think it is working off a denominator that includes all collisions).

The second point the company makes is with an illustration of the speed with which new technology

makes it through the car parc – which is a multi decade process historically. Here they show the

penetration of electronic stability control almost 20 years after introduction (introduced in 1995 – by

mercedes, bmw and toyota) with its projected continued penetration rate as an example. ESC was

introduced in 1995 and was one of the first computerized/software accident prevention systems.

Electronic stability control (ESC), also referred to as electronic stability program (ESP) or dynamic

stability control (DSC), is a computerized technology that improves a vehicle's stability by detecting and

reducing loss of traction (skidding). When ESC detects loss of steering control, it automatically applies

the brakes to help "steer" the vehicle where the driver intends to go. Braking is automatically applied to

			2017	2018
Price:	31.00	EPS	0	0
Shares Out. (in M):	308	P/E	0	0
Market Cap (in $M):	9,500	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0	0