LKQ Corporation (NASDAQ:LKQ) is a unique but unloved and under-analyzed company operating in the automotive-aftermarket industry. They sell alternative collision parts acquired through disassembling junk cars purchased cheaply during auctions. I was so fascinated after reading their annual report, I wrote an article about them in May and initiated a position almost immediately afterwards.
That article highlighted their business model, their revenue and income growth, opportunities for continuing expansion, and business risks. Since publication, LKW shares have appreciated about 9%, generating about 9% of alpha (S&P 500 as standard) over the same time. This article will analyze the quarterly earnings call, discuss various business tailwinds and headwinds going forward, and provide an updated fair value for shares.
Review Of Quarterly Earnings Call
- Y/Y revenue and net income growth of 7.5% and 14.1%, respectively
- Organic revenue increased 7.5%
- Revenue from acquisitions accounted for 7.8% growth
- Foreign exchange negatively impacted revenues by 7.8%
- FX and low commodity prices negatively impacted EPS by $0.03
- Specialty segment (parts for RV's, trailers, off-roading vehicles) revenues increased 30% Y/Y
- The company acquired PartsChannel, 8 self-service yards, a wholesale salvage operation in Alabama, an aftermarket distributor in Iowa, and made a tender offer for The Coast Distribution System (NYSEMKT:CRV)
Overall revenue growth met analyst expectations and income growth slightly exceeded expectations. This signifies the business is operating efficiently as profits are increasing faster than revenues. Revenue growth was pretty evenly split between organic and acquisitions. As an investor, I'm pleased to see organic growth above 7%. The organic growth indicates LKQ continues to eat away market share from the OEMs for replacement collision parts. Healthy organic growth also means the company doesn't have to rely solely on acquisitions for additional revenue streams.
Foreign exchange rates put a big dent on earnings and revenue, but I'm OK with that. LKQ is now a global business with major operations in the UK and the Low Countries. During the Barrington Investment Conference, LKQ noted the massive opportunity in the rest of Europe and no doubt plans on taking on the collision part-provider champions of each country. As LKQ expands their footprint, we'll see even more earnings impacts due to exchange rate fluctuations. Nevertheless, a global corporation strengthens as it spreads their sales over multiple markets and provides itself with protection in case any one market falters.
Low steel prices also negatively impacted earnings. Part of LKQ's business is crushing and scrapping the metal from junk cars. The company purchased 131,000 "crush-only" cars for the quarter, down 8% from last year. I'm OK with declining revenues from "crush-only" operations as it demonstrates the company's ability to shift operations to more profitable segments during market fluctuations. When scrap prices recover, we'll see LKQ buying and crushing more cars for scrap.
The specialty segment (RV parts) experienced growth of 30% Y/Y. Most of the growth can be attributed to acquisitions, as the company reported organic growth of only 6.6%. LKQ plans to continue expanding the specialty segment through consolidation; they offered $59M to buy out The Coast Distribution System. CRV is the leading North American distributor of replacement parts, supplies, and accessories for RVs. SA contributor Alexander Valtsev is critical of the acquisition (and many other LKQ acquisitions) in his recent article citing an unjustified premium offered for the company. CRV's gross margins are the lowest among peers at 17.7%, their 5-yr revenue growth rate has only been 4.3%, and their EBITDA growth rate has been less than 1%. LKQ couldn't comment on the deal during their earnings call because the deal hasn't been finalized; I'll try to justify the deal below.
A major part of LKQ's strategy has always been to consolidate its industry through acquisitions. They've acquired 70 businesses in the past three years alone, so they're very experienced in the process. They look to acquire companies with attractive synergies and allow them to enter new markets. For instance, this quarter LKQ acquired 8 self-service yards in California from Ecology Auto Parts. California was underserved before this deal. Now, LKQ can supply California customers in a more timely fashion. CEO Wagman is very clear when he says, "…in the vehicle parts business the distributor that has the part readily available, and can get it to the customer on time, wins the sale."
As the market leader, LKQ achieves economies of scale that competitors can't. When asked about the acquisition of PartChannel and their low margins, CEO Wagman displayed confidence in LKQ's ability to raise them.
As for the CRV acquisition, I can offer a few explanations for the premium offered. First, LKQ entered the specialty segment with the acquisition of Keystone Specialty in 2014. The addition of CRV will build momentum in the segment by increasing economies of scale and expanding the distribution network. Second, CRV has paltry gross margins (the lowest among peers, according to Mr. Valtsev). LKQ undoubtedly plans on raising them and thereby transferring the increased margin directly to the bottom line. I believe the EBITDA margin Valtsev used for his FCF analysis are too pessimistic for what LKQ can deliver.
Tailwinds And Headwinds
Gas prices continue to plunge. Last year, the national average was $3.51 per gallon through May; this year, the national average through May was only $2.41. Gas prices are known to influence driver behavior. Very simply, miles driven are inversely correlated with the price of gas. The 12-month moving average for miles driven is the highest it's been since 1990. This increase of miles driven creates more opportunities for wrecks. Car wrecks are great for LKQ. They sell collision parts to fix wrecked cars but they also purchase wrecked cars for salvage parts. It's a double bonus.
Low gas prices also decrease distribution costs. LKQ has thousands of trucks on the road every day, guzzling gas. LKQ and other companies with large distribution expenses are enjoying the cheap gas while it's here.
For mechanical breakdowns, the OEM warranty typically handles all issues for the first three years, so LKQ can't benefit when a new car breaks down. Unfortunately, new car sales are on the rise. The number of new cars on the road has increased from 10 million in 2009 to 17 million in 2014. If consumers continue opting for new cars instead of holding on to their clunkers, sales will be negatively impacted.
Additional headwinds included foreign exchange rates and low scrap prices, as discussed earlier.
What is the fair value of LKQ shares now?
In my original article, I used a Benjamin-Graham analysis to calculate a fair value of shares to be $36. I'll use the same formula to update the fair value.
Value = EPS x ( 8.5 + 2g ) x 4.4 / AA
Trailing EPS increased from $1.26 to $1.31. I'll keep my original earnings growth rate "g" estimate at 9% despite this quarter's increase of 14% and the 5 year average of ~25%. The 20yr-AA corporate bond rate is 4.02%. Using the updated numbers, the intrinsic value is exactly $38, representing upside of about 21%.
I'll restate what I said in my original article, "LKQ may be a junk company, but it offers good growth and good value for a good price."
Disclosure: I am/we are long LKQ.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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