Keystone Automotive's Success Due To Strong Asset Utilization

I know most earnings notes start out saying company xyz reported earnings per share (eps) of $x.xx blah, blah, blah.

The only thing I'd point out about Keystone's (KEYS) $9.5 million of earned income ($0.57 per share) in the quarter, is that $200,000 of it (a little more than a penny a share) resulted from a favorable tax benefit (as the company adjusts down to a lower than originally expected rate for fiscal 2007).

But when you consider Keystone's earnings were more than a couple million (roughly 30%) higher than what they earned last year in the third fiscal quarter, what's a couple hundred thou?

And, in all fairness, I certainly didn't expect such a strong quarter. I was estimating $0.48. Although in my defense, in part I had lowered my estimate because last earnings conference call management said they were going against "tough earnings comps," which I specifically interpreted in my note: "read analysts take your 3Q numbers down." Clearly, we didn't need to. As an aside I am still in the process of uploading all of my old notes onto the new website. Hopefully this will be completed over the next few weeks.

Beyond that, I'm sure the five or six analyst notes in your inbox this morning do a sufficient job regurgitating what management said on the conference call with respect to why certain profit metrics moved this way or that (this quarter).

So instead, I wanted to begin with a much more important issue. I wanted to apologize to my readers for not congratulating the University of Florida Football team for handily defeating Ohio State (41 - 14) in the Tostitos BCS National Championship game January 8, 2006. I have to admit, having watched both teams play live this year in their respective home stadiums, I was surprised to see such a one sided game. And to be VERY candid, particularly who it turned out to be one sided for.

But the story of the Florida Gators rise (return) to National prominence really began three years ago (2004), when the University of Florida recruited a rising star in the football coaching world; Urban Meyer. First, giving Bowling Green University (his first head coaching gig) and a tiny Mid-American Conference some recognition, and then taking the first "mid major" program (the University of Utah) to a Bowl Championship Series [BCS] game with an undefeated season.

I still remember watching some of the early news reports and interviews of Mr. Meyer as he joined the University of Florida program. Most new coaches emphasize recruiting. And you often hear comments from people like, give him/her a few years to get their team together and you'll start to see some great results. Mr. Meyer's approach seemed very different (and they clearly already had great talent). His emphasis was on "player potential" maximization.

I'm sure every coach talks about player potential maximization, but Mr. Meyer really seems to put it into practice. In one of the early interviews, I recall a player talking about how when Mr. Meyer first came on board, he searched out the players that were known for "getting into trouble," and made them responsible for making sure nothing bad happened at any of the parties.

I don't know how much truth there is to that report. But I do know this; Mr. Meyer focused on leveraging his existing assets, and produced tremendous results. These stories not only make for a heartwarming sports clip (and happy alumni base). They often are the ingredients for some of the most successful investments. It is not always about finding great growth stories. Those are usually a dime a dozen, and you pay a pretty penny for the stock price. Often times the best investments lie in finding under utilized assets (companies). And with the right tweak (usually in leadership) amazing things can happen.

It is this concept that led me to write "the Year of the Underdog?" last year after spending some time with John Rickel (Group 1's newly appointed CFO) and Jeff Rachor (President of Sonic Automotive about his incoming CFO David Cosper) after last year's NADA as I addressed the opportunity of new leadership (at both companies coming from Ford finance) that could help these organizations better utilize their assets.

Sure once you "pull a Rob Gross" (CEO of Monro) and are pretty much maximizing the performance of your assets, then you look to leverage those assets by acquiring other entities that can benefit from your expertise (or in the college football world leveraging your reputation to get quality new recruits). But it begins with maximizing the assets you have. A process a think most of the auto retail industry (across various subsectors) is still undergoing.

But is maximizing your assets the only factor? I wonder what would have happened if Florida (an obvious "warm weather" team) was forced to play Ohio State (a team used to playing in cold weather) in Soldier Field (Chicago, IL, home of the greatest football team on this earth) on January 8, 2007? The results may have been very different.

Nonetheless, it is an external factor Mr. Meyer and the Florida Gators could not control (where the national championship is held). What they could control is maximizing the ability of each and every player. And that is what they seemed to do best (well at least versus any other college team in 2006).

And I think this same principle applies to Keystone. I have liked Keystone (and therefore included the stock in my top ten rankings) for two reasons: 1) because I felt alternative parts (Keystone's business) were poised to gain share from "new OE" parts as insurance company's have gained greater control of the purchase process (with Direct Repair Programs) and therefore move their repair base toward these (alternative) parts, and 2) I felt the recent changes in leadership (Richard Keister becoming CEO in August 2004), and Jeff Gray in March 2006 brought the potential for greater "asset utilization."

Just like where the national football championship is held, I think Keystone's management has very little control on the first part of why I liked the company's earnings growth prospects (alternative parts gaining share from new OE parts). And you have already heard me discuss how I think recent events (like the Ford and MQVP lawsuit) have all combined to change the risk profile of the investment, thus moving it out of the elite 5 (but still keeping it in the top ten), and lowering my 2012 earnings forecast.

And I think Mr. Keister himself appropriately acknowledged on the conference call that the company's dispute with Ford over design patent rights was something that was likely going to continue for the next couple years. The external environment has (potentially) changed. But it is only something time (and the courts) will now resolve. I doubt there is much that can be said or done to change this unfortunate confrontation occurring between the automakers and (generic) aftermarket parts manufacturers and distributors. Although I still wish (for the interest of their consumers and brand residual value) that the automakers consider a more cooperative approach.

However, when we think about the second reason I like Keystone's earnings prospects, I could not be more encouraged. And just like Coach Meyer's Gators, I really think it is coming down to better asset utilization. One of the unique attributes (I suspect) of my model versus the typical brokerage firm earnings forecast (that you may have noticed) is that I have based (in part) my forecast on revenue and profitability per facility.

I bring this up because not a single analyst on the conference call seemed to notice that the number of facilities (now at 136 as reported near the bottom of every earnings press release) has not changed since the second fiscal quarter of 2006 (and remember we are now in Keystone's third quarter of fiscal 2007). And I don't forecast new facility growth (and even then very modestly) until fiscal 2009.

The one thing that did come up on the conference call was acquisition pipeline. Specifically, management was asked if they had noticed "multiples" coming down among smaller aftermarket distributors in the market because of the Ford dispute. Mr. Keister said they hadn't really noticed, and didn't come across as a CEO "on the prowl" for a lot of acquisitions. Don't get me wrong, if the right deal came along that was an appropriate strategic fit, I suspect they would jump at the opportunity. But once again, the focus (and this is what I think the investment banking, sorry I mean analyst community) is really missing, is that Keystone's relatively new management team is focusing on asset maximization. Leveraging (maximizing) the assets the company already has.

It has been the company's investments into cross docks that are helping with "in stock" rates not to mention quality improvements, all of which I think helped contribute to the company's 11% same-store sales results. And the cross dock's are only impacting ~40% of the company's facilities, so there is a lot more "opportunity" to go. And I think we are beginning to see some early signs (of things to come) from the recent addition of CFO Jeff Gray (who came over from Advance Auto Parts). During the conference call, you heard him discuss aspects like "better managing" their vendors, improving the product mix, and reducing damaged parts. All of which should yield higher gross profits down the road.

I also think there is going to be the potential for better cash flow yields, although I have to admit on this front, I think the results were somewhat mixed. True, year over year inventories were up 5% while sales were up 12%. But I was a bit disappointed to see the company's payables as a % of inventories drop to 19% in the third quarter from 27% in the second quarter. Although accrued liabilities (another type of "payable") spiked up nearly $8 million dollars (about a 40% quarter to quarter increase), and so I almost wonder if there was simply some movement "between buckets." Once again, the important things the analysts should have been focused on.

I think in the coming years, you will see Mr. Gray employ a more sophisticated cash management approach, likely working with vendors so both (vendor and Keystone) can benefit from Keystone's more stable financial position and therefore be able to extend out payables (as a % of inventories). But this will likely be a "work in progress" situation, and often times the terms are also negotiated in conjunction with the price, so you have to keep both in mind.

The bottom line? You can't control the external factors (much). But I think Rick Keister has been putting in the infrastructure (albeit at times with some outside "players" like Jeff Gray) to maximize Keystone's assets. And that part (of the investment story) I still like a lot.

Obviously given the better than expected performance (in 3Q), I have taken up my fiscal 2007 estimate to $1.70 from $1.59. My fiscal 2008 estimate goes to $1.98 from $1.93. My 2012 estimate (as you might guess) remains unchanged at $2.66. The basic elements of this new forecast are now available on the website (www.autoretailstocks.com if you click on the KEYS tab on the right hand side of the front page of the website and then open the excel document).

KEYS 1-yr chart: