Value Investors Club / LKQ Corporation (LKQ CORP (LKQ))

Description

Summary: LKQ’s stock has fallen 32% since announcing Q1’18 results. The principal concern that has persisted since that

release is disappointing North American and European margins. We believe the disappointing performance is primarily

from a confluence of transient factors. We expect to see materially better margins in both segments in 2019. Longer-term,

we believe that the European segment with EBITDA margins at ~8.5% in 2018 is under earning with potential to hit 10%+ by

2020 and 12%+ longer-term. Furthermore, the Company has suffered in recent years from weaker free cash flow

conversion (it is a distributor so FCF is structurally lower than net income as revenue grows due to working capital

investment – however, in 2017/2018 it was below its historical 80% FCF conversion level) due to historical incentives

focused on revenue and EBITDA growth and not ROIC/balance sheet optimization. However, the Board has recently

changed the incentive structure and capital allocation philosophy away from a sole M&A focus to a balanced mix between

M&A and share repurchases, which should drive improving ROICs and FCF conversion in 2019+. The market is heavily

discounting this opportunity because of recent execution missteps as well as softening European economies (specifically

the UK with Brexit and continental Europe broadly but Italy in particular) which could weigh on LKQ’s top-line growth in

2019. As LKQ’s management better executes, we see a path to EPS of $2.90 by 2020 (vs Street of $2.75) and significant re-

rating in the multiple from 10x today back to its 3 year average of 16x-18x. $2.90 EPS x 16.5x P/E = $48 share price or up

86%.

Background: LKQ has three segments: North America (36%), Europe (48%), and Specialty (11%). Additionally, LKQ

generates 5% of sales from scrap steel.

 North America: LKQ is the leading distributor of alternative collision replacement parts. It is ~20x the size its next

closest competitor. The segment generates its revenue principally through Aftermarket Parts (58%) and Recycled

Parts (33%) with the remainder in Self Service Operations (6%) and Heavy Truck (3%).

 Europe: LKQ is the leading distributor of alternative mechanical replacement parts. It is ~3x the size its next closest

competitor in Europe. The segment generates its revenue through the following subsidiaries: Stahlgruber (34% -

Germany), Euro Car Parts (29% - UK), Rhiag (23% - Italy/Switzerland/Eastern Europe) and Sator (14% - Benelux).

 Specialty: LKQ is the leading distributor of specialty vehicle aftermarket products and accessories in North America

serving the following six product segments: truck and off-road; speed and performance; RV; towing; wheels, tires

and performance handling; and miscellaneous.

Investment Thesis / Variant Perception:

 Disappointing North America Margins are Transient: Organic growth in North America of 6.5% in the first nine

months of 2018 is the fastest since 2011 and has exceeded expectations. That has not been the problem. The

problem has been margins which are down ~110bps during that time. The principal problem has been an

inflationary macro environment that has resulted in increased commodity, freight, fuel and labor costs.

Management compounded the headwinds by not being prepared for the stronger than expected organic growth

and being slow to raise prices. Importantly, the weakness in margins has not been a result of a structural change in

the industry or increased competitive pressure.

We believe that LKQ has pricing power to offset these headwinds and is now starting to do so:

o First, LKQ is the dominant provider of collision aftermarket parts. It is 20x the size its next closest

competitor and has greater than 50% market share. It faces no national competitor. In many local

markets, LKQ doesn’t face a significant competitor. In local markets where LKQ does face competition,

LKQ’s scale enables significantly higher fill rates and logistical capabilities to support higher pricing.

o Second, aftermarket parts provide a substantial savings compared to OE parts. Our diligence suggests that

insurance companies and body shops prefer to use an aftermarket part on cars aged 3+ years as long as the

aftermarket part provides a 5%+ savings. We believe there is more than enough room to raise prices by 1%

to offset recent inflationary forces.

We also believe that the OEs will start raising prices themselves. Thus, LKQ will have the opportunity to raise price

without the discount to OEs narrowing. The OEs so far have taken very limited pricing. But, they are facing all the

same inflationary headwinds as LKQ. There is concern that auto parts tariffs from China will negatively impact LKQ.

LKQ however is significantly more insulted than the OEs. The vast majority of LKQ’s aftermarket parts are sourced

from Taiwan (not impacted) with the exception of glass (representing a single digit % of North America sales). By

comparison, the OEs foreign supply chain is principally located in China. The OEs are facing more tariff exposure

than LKQ, which will heighten the OEs need to raise price in 2019. It is significantly easier for the OEs to take pricing

on aftermarket parts than it is to raise prices on new cars. We have confirmed through our VAR that the OEs will

likely raise price on aftermarket parts to offset the higher commodity cost / tariff impact.

 Significant Margin Opportunity in Europe: LKQ had 10.1% EBITDA margins in Europe as recently as 2015. This

year, margins will likely be ~8.5%. Margins in 2018 are being weighed down by two primary issues:

o In Q1’18, LKQ began operating out of a new highly automated DC, known as T2, enabling the closing of two

smaller less efficient (more manual) legacy DCs. T2 was a major logistics initiative involving a complex

software project. It was not ready for primetime when it went fully live. As a result, the company

experienced replenishment / service issues. Fill rates fell from 99%+ to 93%. LKQ immediately increased

headcount to keep the product flowing and implemented promotional programs to maintain customer

relationships. Importantly, there was nothing fundamentally wrong with the DC. A software patch was

installed in April enabling fill rates to return to 99% and a reduction in temporary labor. Given inventory

turns of only ~2x in this industry, Q1 inefficiencies were capitalized into inventory that weren’t recognized

on the P&L until that inventory was sold in Q2 and Q3. Thus, even though the T2 issues from an

operational perspective are behind LKQ, the issue has continued to weigh on reported results.

o LKQ purchased Andrew Page in October 2016. Andrew Page was in receivership and losing money at the

time of acquisition. LKQ spent 15 months working through the UK antitrust process before being granted

approval in January 2018. During this time, LKQ owned the Andrew Page assets but it wasn’t allowed to

integrate them. It wasn’t until July 2018 that Andrew Page’s branch network/distribution was integrated

into T2. By year end 2018, the head office of Andrew Page was to be consolidated and 11 branches sold.

By simply running T2 more efficiently and rationalizing Andrew Page, there is an opportunity to improve margins by

130bps-200bps, enabling LKQ to get to 10% margins by 2020. Longer-term, there is an opportunity to increase

margins by another 250bps – 430bps through procurement, catalogue, logistics and back office initiatives.

Historically, LKQ has run its acquisitions in a decentralized fashion resulting in LKQ not fully taking advantage of its

scale. LKQ completed its largest acquisition in history by purchasing Stahlgruber in Q2’18. Purchasing Stahlgruber

gives LKQ additional scale as well as logistical opportunities by connecting LKQ’s Benelux, Italy, and Central

European assets through Germany and Austria.

Finally, as a sanity check, it is worth benchmarking LKQ’s EBITDA margins to European peers (all of which have less

scale than LKQ):

o GPC / AAG: 10.4% Pre-GPC Synergies, 11.8% Post-GPC Synergies

o Stahlgruber: 7.9% Pre-LKQ Synergies, 9.2% Post-LKQ Synergies

o Autodis: 9.4%

o Mekonomen: 11%

 Tailwinds to North America Revenue:

o LKQ’s Sweet Spot for car age is 3-10 years. A car under 3 years of age is more likely to use an OE part. A car

over the age of 10 years is more likely to be scrapped following a collision. The weak auto SAAR around the

Financial Crisis resulted in a declining / stable Sweet Spot for LKQ in recent years. Going forward, LKQ

should experience a tailwind given stronger auto sales in subsequent years.

o State Farm represents 18% of the auto insurance market. They have been largely absent from using

aftermarket parts since a 1999 lawsuit. State Farm is in the process of finally settling this lawsuit in

December, which we believe will pave the way for State Farm to more aggressively use aftermarket parts –

similar to the competition (overall industry at 37%). State Farm is currently in an unsustainable situation of

losing money and market share due to an uncompetitive cost structure in repairing vehicles.

o LKQ as a national operator has greater market share with Multi Shop Operators (Boyd/Gerber, ABRA,

Service King, Caliber) than independent collision repair locations. Large MSOs have grown from 9% of the

industry in 2006 to 25% of the industry in 2016. As the large MSOs roll up the industry, LKQ gains market

share.

o As cars become more complex, they become more expensive to fix. The average cost of repair has been

rising at ~3% annually.

 Accretive Future Acquisitions (Principally in Europe): LKQ has been built as a rollup of accretive acquisitions in

both North America and Europe. Despite LKQ being ~3x the size of the next closest European operator, LKQ’s

€5.3bn in revenue still represents only ~5% of the European addressable market. Europe is a highly fragmented

market with only two companies meaningfully consolidating the industry in LKQ and GPC. LKQ’s leading platform in

Europe provides it a strategic advantage in future M&A.

 Capital Allocation Inflection: LKQ has not paid out a dividend or repurchased a share in Company history.

Historically, excess cash flow after investing in the business has solely gone towards M&A. Given the recent sell-off

in LKQ’s stock price, LKQ is taking a more balanced approach towards capital allocation going forward. The

Company announced a $500mm share repurchase authorization when it released its Q3’18 results. Historically,

management was compensated principally on absolute revenue and EPS growth. Going forward, incentives are

being changed to place greater emphasis on ROIC, organic revenue growth and margins. The old compensation

structure incentivized M&A and deemphasized FCF conversion. While it is typical for working capital to grow with

sales as a distributor, management has acknowledged that its FCF conversion has been poorer than other

distributors and is committed to working capital improvements in 2019. The new compensation structure will

incentive management to more efficiently monetize current assets and evaluate any potential incremental M&A

against the opportunity to repurchase LKQ shares.

Price Target: If LKQ can restore margins in N. America and get to 10% EBITDA margins in Europe, LKQ can generate $2.90 in

EPS by 2020. As management shows better execution, we expect the multiple to rerate closer to its historical three year

average of 16x – 18x. $3 EPS x 16.5 P/E = $49 or up 76%.

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

Earnings execution, FCF improvement

show sort by

			2019	2020
Price:	26.00	EPS	2.45	2.85
Shares Out. (in M):	319	P/E	10.5x	9.2x
Market Cap (in $M):	8,300	P/FCF	15.0x	10.5x
Net Debt (in $M):	4,025	EBIT	1,060	1,160
TEV (in $M):	12,400	TEV/EBIT	11.7x	10.7x