Value Investors Club / LKQ CORP (LKQ)

Description

LKQ is a dominant company in a defensive industry - it has 55% share of the North American alternative

auto collision parts distribution industry, and is 3x the size of its next largest competitor in the European

mechanical auto parts distribution industry. After many years of M&A-led growth, LKQ recently began to

shift its focus to integration and optimization. When Covid struck, the company was in the midst of a

multi-year self-help story to significantly improve margins, free cash flow, and returns on capital. Today,

while shelter-in-place orders have clearly had a negative impact on miles driven, the pandemic has also

given the company an opportunity to dig even deeper on cost / asset optimization. The stock remains

down 15% YTD, as the market continues to focus on weak industry demand. In a more typical recession,

miles driven are quite resilient - during the financial crisis, miles driven troughed at -3.9%. If miles driven

can get even close to normalizing over the next year or so, we believe LKQ could potentially earn about

$3.25 on 2022 earnings, implying <10x 2022E P/E and 10% FCF yield. We believe a mid-teens P/E

multiple would be appropriate for the business, implying >50% potential return over the next 18 months

for a highly defensive business.

Company background:

LKQ is made up of three segments: North America (54% of 2019 EBITDA), Europe (34% of 2019 EBITDA),

and Specialty (12% of 2019 EBITDA).

North America: The North American segment primarily deals in the sale and distribution of car parts to

the auto collision repair industry. LKQ specializes in selling non-OEM parts (alternative parts), which can

sell for significant discounts to their OE counterparts. LKQ has about 55% share in the alternative parts

space, and is about 20x the size of its next largest competitor. Its scale provides critical procurement and

distribution advantages, with 95% fill rates vs competition at 65% for aftermarket parts.

The segment should continue to benefit from gradual share gains from OE parts and also smaller

distributors. Alternative parts utilization (APU) in the collision industry still sits at 38%. The top insurers

maintain APU of 50+%, so there is still room for this metric to expand. State Farm will be an important

piece of that puzzle as they are the largest auto insurer with ~18% share, and are finally beginning to

transition to alternative parts from virtually zero utilization.

The segment has a 5-yr organic growth CAGR of 3.5% and posted 13.7% EBITDA margins in 2019. The

segment grew (slightly) through the financial crisis. We expect this business to be a consistent L-MSD

grower in the future, with expanding margins.

Europe: The European segment primarily deals in the sale and distribution of mechanical car parts to

repair technicians and mechanics in Europe. The industry is highly fragmented - LKQ is the largest

European distributor with 7% share, and is 3x the size of its next largest competitor. Similar to the NA

segment, the business benefits from LKQ's scale and its ability to provide nearly any part, usually within

hours.

This segment is relatively similar to the AZO / ORLY / AAP businesses, except with a pure focus on the

DIFM (technician / jobber) market. It is a very defensive industry, as consumers generally need to repair

/ maintain their cars in good times and bad. The US players actually saw accelerating growth through the

financial crisis, as consumers elected to hold and maintain existing cars for longer.

In Europe, the industry remains highly fragmented. We expect LKQ to benefit from both organic and

inorganic consolidation, driven by significant procurement and distribution advantages. These

advantages should strengthen as the segment progresses with its integration plans.

This segment has been the company's problem child for the last few years. Organic growth has

decelerated and margins have contracted from 10% in 2015 to 8% in 2019. The majority of this

contraction was driven by execution issues with the massive T2 distribution center investment in the UK

(we believe about 150bps of margin from 2015-2018 based on 10K disclosures), as well as a mix shift

(both organic and inorganic) to the faster-growing but lower-margin Eastern European business. The

company has finally shifted its focus to integration and optimization, and has pointed to 12%+ margin

potential in the long-term. More on these efforts in the next section.

The segment has a 5-yr organic growth CAGR of 3.5% and 7.8% 2019 EBITDA margins. We believe the

market should be a LSD grower, and that LKQ should be able to take share to drive organic L-MSD

growth. There is opportunity for substantial margin expansion as the company finally integrates its

assets.

Specialty: The leading distributor of specialty parts and accessories in North America for RVs, pick-up

trucks, Jeeps, etc. The segment has 99.9% fill rates, next day coverage, and the largest and deepest

inventory selection in the industry.

The segment has a 5-yr organic growth CAGR of 4.5% and 11.0% 2019 EBITDA margins. While it is the

most cyclical of LKQ's businesses, we have been impressed with its strong performance through the

pandemic (down 1.5% in Q2, with June up DD). We believe the business should be a L-MSD grower

through the cycle.

The turnaround:

Since even before its IPO in 2003, LKQ had been very focused on growing the business through M&A.

This strategy was extremely successful in North America, and the company decided to expand into

Europe in 2011 through the purchase of Euro Car Parts in the UK. LKQ continued its European expansion,

and most recently bought the German leader, Stalhgruber, in 2018. Throughout this acquisition spree,

LKQ did not integrate its European businesses, and we believe hasn't benefited from substantial

synergies. As described in the previous section, the European segment has underperformed due to

execution issues around the T2 distribution center launch, and as the economy in Europe worsened.

The European underperformance, along with some missteps in North America in H1 2018, had attracted

activist interest in the stock. The company mentioned potential activist involvement in the 2018 10K risk

factors for the first time, and ValueAct filed a 13D in September 2019 (currently owns 7.1% of company).

Since early 2019, we have observed significant changes in management tone and focus. Overall, we

believe the company has shifted from a growth at all cost mentality to one of business optimization. The

Board approved a change in management compensation structure in early 2019 to incentivize organic

growth, margins, free cash flow, and returns on invested capital. Previously, management incentives

were aligned with EPS, revenue, and ROE - metrics that favor debt-led M&A rather than organic growth

and business optimization. Management also changed the leadership of the Europe segment, including a

CEO with extensive experience in the European auto aftermarket. From a governance perspective, the

company has added 5 new Board members since 2018, including two CEOs with backgrounds in

European distribution.

In September 2019, LKQ held a Europe segment Analyst Day to update the market on its European

integration plans. The company outlined a plan to expand segment EBITDA margins by ~200bps by 2021,

from ~8% in 2019. Informally, management has targeted 12+% margins in Europe over the long-term.

LKQ also highlighted working capital opportunities to generate over $200m of incremental cash flow

through 2021. In addition to some inventory rationalization, LKQ sees an opportunity to take advantage

of vendor financing programs similar to those that allow AZO / AAP / ORLY to maintain ~100% FCF

conversion.

While there has been no official plan discussed for the North America segment, we believe there are

margin and working capital opportunities in this segment as well. The segment has had essentially flat

margins since 2014, despite solid organic growth, and what should have been accretive M&A. In favor of

growth, LKQ had always provided very lenient payment and return terms for their customers in NA.

Customers were able to return items months after purchase without penalty, which then also increased

the chance that those items got damaged along the way. Additionally, given LKQ’s market share,

superior fill rates, and distribution capabilities, they should have had better pricing power than

exhibited. LKQ started to see some progress in NA margins in 2019 as they began to shift focus to

profitable growth, and introduced tighter payment terms with customers in order to improve working

capital and margins. NA margins expanded to 13.7% in 2019 from 12.7% in 2018, and company free cash

flow conversion of adj net income improved to 110% in 2019 versus a historical average of ~75%. This

progress has continued through 2020 with H1 2020 margins up yoy despite revenue declines associated

with the pandemic.

Covid:

The most obvious impact of the health pandemic has been a dramatic decline in auto travel and miles

driven in each of LKQ's geographies. While there still remains uncertainty on the state of miles driven,

we have been impressed with the company's actions and performance to-date. We also believe the

company will be able to use this crisis to dig even deeper on asset optimization efforts.

LKQ quickly took action to cut $80-90m of costs per month (~$1bn annualized cuts on a business with

~$3.5bn of opex ex-COGS), and dramatically reduced inventory spend. Even with revenues down 17%,

we thought Q2 was a blowout quarter with margins actually up yoy, and FCF generation of nearly $700m

in the quarter (compared to ~$800m in 2019 and a five year average of ~$500m). The company

delevered to 2.2x and highlighted a $2.5bn liquidity position.

Importantly, the company also confirmed it would be able to make $80m of the cost cuts permanent in

North America - worth 150bps of segment margin expansion. In a follow-up call with management, they

confirmed that announced restructuring programs to-date would create $125-150m of permanent cost

cuts (100-125bps of margin). This includes the $80m of cuts in NA, and perhaps 50-60m in Europe

(~100bps segment margin expansion). The cuts in Europe are largely exclusive of the integration plan,

which only encompassed 20-30bps of margin from asset rationalization. Finally, the European

integration proceedings were put back into motion as of July 1 - effectively just a ~3 month delay of the

original plan.

We had always believed that LKQ had a substantial margin opportunity, but after this pandemic, we

have even more confidence that they can achieve their optimization goals, and even exceed our prior

expectations. The permanent cost cuts the company is contemplating relate specifically to facility

closures and the associated headcount and inventory reductions. Demand will be re-routed to other

nearby facilities with some excess capacity, ensuring no impact to revenues. After spending over $3.5bn

in European acquisitions without proper integration, and given a general lack of focus on optimization in

NA, it is not surprising to us that these opportunities exist. Even with the company’s recent shift to

business optimization, much of this restructuring plan would not have been possible in a normal

environment. Because the company had to take such drastic measures to reduce cost through the

pandemic, more difficult decisions and actions like asset rationalization have become more feasible. The

pandemic has clearly enabled LKQ to take an even more rigorous approach to business optimization

than previously contemplated, and the company’s recent outperformance confirms this.

In aggregate, we believe these efforts could potentially lead to over 200bps of margin expansion vs 2019

levels over the next two years, with further opportunity beyond that. We also believe the company's FCF

initiatives can help propel 90+% FCF conversion through at least 2022.

Lastly, LKQ is far more capable from both a capital and operational perspective to weather this

pandemic than its much smaller competitors. In both North America, and especially in Europe, there are

a long tail of small independent distributors with inferior cost and capital structures who will struggle.

We expect the pandemic to accelerate the consolidation of LKQ's industries.

Miles driven:

As LKQ's predominant demand driver, the last key ingredient is the recovery in miles driven. Historically,

miles driven have been very resilient through recessions. During the financial crisis, miles driven

troughed at -3.9%. Clearly, this time is different, but we believe that as the world continues to progress

back to normal, consumers will use their cars again. In fact, we may even see a stickier shift from people

taking mass transit / ride sharing to personal vehicle use. The recent strength in the used car market is

possible evidence of a shift toward personal vehicle ownership during the pandemic: the Manheim used

car pricing index is 9% above its February peak, with several auto dealers / auctions reporting HSD-DD+

used vehicle growth in June.

On its Q2 call, LKQ highlighted varying rates of recovery by geography, generally depending on the

respective state of the pandemic. Encouragingly, miles driven in Germany are essentially back to pre-

Covid levels, and in the Benelux, Italy, and the US, trends have improved to ~90% of pre-Covid levels.

IAA - a salvage auto auction - actually commented on its Q2 call that miles driven at the end of Q2 were

effectively back to pre-Covid levels in the US. This improvement was also evident in LKQ's monthly

financials: June organic revenue was down less than 8% compared to down 30% in April. Management

believes that miles driven should normalize back to 2019 levels at some point in 2021.

Valuation:

Like LKQ, we believe that miles driven and LKQ's demand drivers, will normalize back to 2019 levels at

some point in 2021. Combined with recent cost cuts announced, some progress on the Europe

integration plan, and share repurchases, we believe the company can earn around $3.25 in 2022 - an

11% EPS CAGR vs 2019. This implies a ~12% 2022 EBITDA margin, and the repurchase of about 8% of

weighted-average shares vs current levels.

For illustrative purposes, incorporating 12% EBITDA margins in Europe (the LT goal) on 2022 estimates

would result in $3.70 of EPS. This also translates to 13.5% company EBITDA margins – more consistent

with long-term earnings power potential of the business.

LKQ trades for <10x 2022E earnings and nearly a 10% 2022 FCF yield. This compares to the mechanical

parts retailers trading in the mid-teens on 2022 P/E (ORLY at 19-20x). CPRT, IAA, and BYD CN, collision-

based peers, trade at 24-33x 2022 P/E). The peer group stock performance YTD is down 1% at median,

while LKQ remains down 15% YTD, despite strong performance through Covid.

We believe that as the company continues to execute its plan, and demand continues to normalize,

LKQ's multiple can conservatively re-rate to ~15x NTM P/E. This would be a discount to the auto parts

retailers (ex-ORLY) who trade at 17-18x 2021 P/E. This could drive a 50+% return in less than 18 months.

A further re-rating in line with the retailers would produce a ~100% return.

Potential catalyst / upcoming Investor Day:

On its Q2 earnings call, LKQ announced it would host a virtual Investor Day on September 10. This

should be an opportunity for the management team to provide a deeper update on the status of

demand recovery, an update on the European integration plan, as well as the benefits of the new

restructuring targets recently announced.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Activist involvement increases management accountability/urgency

Progress on Margin initiatives in Europe (and North America)

Upcoming Analyst Day - Sept 10.

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			2020	2021
Price:	31.66	EPS	0	0
Shares Out. (in M):	304	P/E	0	0
Market Cap (in $M):	9,832	P/FCF	0	0
Net Debt (in $M):	2,800	EBIT	0	0
TEV (in $M):	12,632	TEV/EBIT	0	0