Keystone Shareholders Deserve Much More In LKQ Corp. Buyout

LKQ and Keystone are a great strategic fit and this acquisition is a natural progression of our strategy to expand our presence in the distribution of automotive replacement parts, an industry that we estimate to be over $188 billion in size.

Source: Joseph Holsten, CEO of LKQ Corp., Press release: 07/17/07

LKQ Acquires Keystone: The deal seems too good! (for LKQ)
As you saw yesterday, LKQ Corp (LKQX) announced it was acquiring Keystone (KEYS).

Let me jump to the bottom line: I think the deal is good. Too good!

I think Keystone shareholders deserve more. And therefore Keystone's shareholders should ask for a higher price.

Let me begin with an obvious sign. . .

A Sign: the acquirer went up more than the company being acquired
Usually when an acquisition is announced, the stock price of the company being acquired goes up, while the stock price of the company doing the acquiring goes down.

The reason why this tends to happen is because investors usually worry that the acquirer paid too much for the deal. When combined with integration risk, investor's view the investment merits of the acquirer as less attractive (because the risks have gone up).

Only time tells if the acquiring company's perceived "risky" investment was a good buy or not. But clearly a major acquisition adds integration risk.

The company being acquired, on the other hand, now has someone guaranteeing to pay $X dollars (assuming the deal goes through). And so the price of the company being acquired tends to move within a few percentage points of the announced deal price.

In the case of LKQ acquiring Keystone yesterday, Keystone's stock price appreciated 7% (as the $48 offer represented a 10% premium from Monday's closing price). So pretty much what you would expect (about 3% from the announced acquisition price).

But LKQ's stock was up almost 15%!

In over ten years of doing this, I don't ever recall a time when the company doing the acquiring went up more than the company being acquired. Let alone a 2x percent price appreciation (15% versus Keystone's 7%).

Investors appropriately recognized a good deal when they saw it (for LKQ).

An attractively valued Keystone
To public equity investors alone I think the investment merits of Keystone are attractive (versus the value it brings to a company like LKQ that gets really meaningful synergies).

Even after yesterday's price appreciation, based on what the analysts estimated for Keystone to earn in fiscal 2008 and fiscal 2009 ($2.13 and $2.52), Keystone should generate a 4.5% and 5.4% earnings yield, respectively.

In the past, I have said that Keystone's management (in particular CEO Rick Keister) has really been demonstrating how to maximize underperforming assets.

When you've got some free time you might want to reread my article about Keystone and Gator football.

And I don't think Keystone's management was near complete in maximizing underperforming assets.

On top of that, the growth opportunities have been getting better over the last 6 - 12 months (albeit some lawsuits also increased the risk profile). On one of Keystone's conference calls, Mr. Keister even explained to shareholders that anticipated operating profit margin expansion would likely take a bit longer, because the growth opportunities were greater than they had anticipated, and they therefore wanted to invest in some initiatives.

One growth idea that I have been advocating is the idea of creating a Keystone Certified Repair Shop program for the 25,000 collision repair shop customers Keystone distributes its parts to.

To become a "certified Keystone" shop, I said the program should look very similar to what NAPA and O'Reilly Auto Parts offer general repair shops. Just to clarify a general repair shop would be like a Midas or Bob's repair shop to get a new muffler or brake pad. A collision shop, on the other hand, is where they fix your bumper or paint your car after you have gotten into an accident or something.

I won't walk you through the NAPA Auto Care Center program again. But basically I said Keystone should provide systems and support (technology, mechanic training, etc.), like NAPA Auto Care, and in return the collision shops should agree to buy a certain % of their alternative parts from Keystone. I said LKQ should also pursue something similar to this.

An attractive opportunity for LKQ, but is it fair to Keystone shareholders?
So I hope you can appreciate that above and beyond all of the cost savings management expects to achieve is an even more powerful growth company (story).

Sure, in the generic parts side of the market, it becomes tougher to gain share (because combined LKQ/Keystone probably control 30%+ or so of the generic collision parts market). But you can't think about the market as just generic collision parts, or even all alternative parts (including recycled).

Because roughly $7 out of every $10 in the collision market alone consists of a "new OEM" part. (The Ford bumper versus a generic part from Taiwan).

Not to mention the tens of thousands of general repair shops and millions of do-it-yourselfers that can benefit from a highly efficient, customer friendly "one stop shop" alternative parts distributor.

And just to refresh your memory alternative parts are "generic" (the Taiwan bumper) and recycled (the Ford bumper that came off a car at one of LKQ's junk yards).

The challenge has been shifting the model at the collision shops to use these alternative parts. And until the presence of a national chain existed (like LKQ bursting on the scene over the last 5 - 10 years), it really wasn't very feasible to change the culture.

But once a national chain did emerge, they (LKQ) could target the real end customer (the insurance companies) and pull in demand at the collision shops (via insurance company direct repair programs). And then LKQ began acquiring generic parts distributors to become a "one stop shop" in alternative parts usage. The opportunities to create a real systemic change in the market have been well documented in this newsletter.

So the combination of LKQ and Keystone (in my mind) creates almost overnight (ok over the next 2 - 3 years) a national one stop shop chain of alternative parts. Something that would likely have taken LKQ another 5 - 10 years on its own.

And this "one stop shop" powerhouse in the alternative parts market I think creates an even more credible force to help transition the market from using "new oem parts" the majority of the time, to a much greater usage rate of these alternative parts.

But let's forget about the incredible growth opportunities a combined LKQ/Keystone can now tackle (well beyond just capturing share of the existing generic and recycled parts markets but expanding and changing the very face of the market itself).

Instead, let us just think about the cost savings management expects. LKQ's management said they should generate $25 - $35 million in cost savings over the next 2 - 3 years ($15 - $20 million in 2008).

The synergies ranged from corporate overlap, some public company costs, freight, duplicate marketing costs, bumper reconditioning, and overlapping facilities and warehousing. In fact, later in the call, CEO Joseph Holsten indicated that the overlapping facilities were a big (material) part of the expected cost savings.

So you should not be surprised to see the 260 facilities (when the company is combined) shrink over the next 2 - 3 years and be replaced with higher revenues and operating income per facility. As a quick reminder, here is what each company's productivity metrics looked like:

click to enlarge

Here again, if you look at how LKQ has improved operating income per employee and per facility by 30% and 19.9% respectively over the last three years, just imagine what they can do by rationalizing all of the Keystone/LKQ aftermarket parts distribution centers?

Altogether LKQ and Keystone have 267 facilities (Keystone has 137, LKQ has 130).

I should also add that during the conference call, LKQ's CEO Joseph Holsten said that LKQ has typically operated at a 300 basis point advantage to Keystone (9.8% versus 6.7% in last fiscal year for each company) and that he would expect those operating margins to pretty much "come together."

On this metric, you end up with a $1.5/$1.6 billion company (in revenues) with operating income of roughly $150 million. So just the Keystone revenues would generate (at LKQ 9.8% margins) about $70 million of that operating income. Or another way to think about this is to consider a 20% reduction in Keystone facilities (to 110), but functioning at LKQ's average operating per facility ($612,429). Either way you come up with close to $70 million in operating income (versus the $48 million Keystone generated in operating income in fiscal 2007).

Before interest, taxes, and integration costs, this works out to roughly an 8.6% return on investment ($70 million in operating income divided by the $811 million LKQ is paying for Keystone).

The reason I am pointing out the return, is because even though it is not much more than LKQ's cost of capital (depending how you measure cost of capital), I think it leaves little risk with the deal. Because what those numbers do not factor in are the revenue opportunities (like I discussed above) that await both companies (particularly as a merged entity).

So I just don't know why Keystone's shareholders would want to basically give away all of the upside potential to the shareholders of LKQ without asking for something in return?

As I said earlier, I don't think the equity markets gave Keystone its rightful value. Now the shareholders are going to accept a mere 10% premium to what equity investors were willing to pay from a company (LKQX) that stands to receive significant economies of scale and benefits from the deal.

It just seems like the Keystone shareholders deserve more (in my opinion).

Don't let market psychology tell you what something is worth.

LKQX-KEYS 1-yr chart:

Comments

[Value Stoxx:]

You make some good points Jerry. Here are some add'l observations. Why a straight cash deal? If the business has great secular legs, why not include some form of equity participation? Why hire a banker that doesn't cover either company? This deal reeks of having been done in a hurry. If you know LKQ's business, you'd know that their core recycling business is in secular decline. That is why they have diversified into aftermarket parts. So as you point out, this was a smart deal for them. I believe the lack of growth in their core business was going to be apparent in the coming quarters which is why they did this. If you know KEYS, you might speculate that their recent string of investments may have led to a few poor quarters of financials. I would not put it past these 2 companies to have consumated this merger as a purely defensive mechanism. Highly dissapointing for KEYS shareholders.

2007 Jul 21 01:06 AM

[mugwumps88:]

Question for Jerry or anyone else who cares to comment ..what would a reasonable formula be for detemining PPS for shareholders of a company that is about to be bought? The company has a great product with tons of growth iminent, which is why a much bigger fish wants to swallow them.

Sales projections for 09 are $136M at least, possibly much higher. Profits margin in the 40% range. Current PPS is $.017. TIA

Mar 20 08:18 PM