LKQ Corp. and Keystone Automotive: Alternative Battles OEM Auto Parts

Includes: KEYS-OLD, LKQ
by: Jerry Marks

In a decision that could have far-reaching implications in the realm of intellectual property, the justices on Monday unanimously overturned an appellate court's decision, ruling that the test for determining whether an invention is "obvious"--and thus not patentable--is too rigid. In other words, the court said that there needs to be a fairly high standard for patentability.

- Brian Wingfield, "Getting a Patent Just Got Harder", April 30, 2007

LKQ Corp. and Keystone, what is the need? And overcoming limitations
LKQ Corp. (LKQX) fills a really important need. They are becoming a "one stop shop" for alternative parts in the $30 (some call it $40) billion collision and repair industry (labor and parts).

What are alternative parts and why are they so important to the collision industry?

If you get into an accident and need a new bumper for a Ford Focus, you have one of three options: 1) replace it with a new bumper manufactured (branded) by Ford Motor Company (NYSE:F) (referred to as a "new OEM" part), 2) get a generic part made by some manufacturer in Taiwan (for example), or 3) get a bumper from the junkyard (referred to as a "recycled" part).

Options 2 and 3 are alternative parts (generic and recycled parts). LKQ Corp began with recycled facilities, but over the last few years has expanded its product offering to generic and even some remanufactured/refurbished parts. Keystone, the only other real national distributor in the alternative parts arena focuses strictly on generic and remanufactured/refurbished parts.

It is estimated that alternative parts can cost anywhere from 25% to 50% less than "new oem" parts. Although some people will debate the cost savings you can get from generic parts, especially if the part doesn't fit correctly. Something like $7 out of every $10 in parts purchased in the collision and repair industry are "new oem" parts.

LKQ's CEO Joseph Holsten brought up on the company's first quarter conference call (Thursday) that some industry studies suggest alternative parts are gaining share "by about a percentage point a year." Meaning, if $7.10 out of every $10 in collision repair purchases consisted of "new oem" parts, the next year new oem parts purchases would be $7.00 out of every $10, and the next year they would be $6.90, etc.

I think measuring collision parts demand (the "market") is difficult. But directionally, I think Mr. Holsten's assessment of the industry is pretty accurate. And I think more alternative parts (generic and recycled) being used in collision and repair work helps lower overall collision repair costs (which hopefully we will agree is a good thing).

However, there are three main things I see limiting the use of generic and recycled parts: 1) new vehicle manufacturers (like Ford), that want people to continue buying "new oem" parts, 2) Availability of suitable, like kind quality LKQ parts, and 3) acceptance of alternative parts within the collision shop.

So today, I wanted to address the 3 limitations to filling this need, and why I think some things are changing with the limitations.

Limitation #1: New vehicle manufacturers (like Ford) want people to buy "new oem" parts
Over the last 6 - 7 months I have shared my concerns with you about Ford Motor Company (and other organizations) suing generic parts manufacturers and even distributors like Keystone (KEYS-OLD) and LKQ for patent infringement.

Ford even won a ruling in December with the International Trade Commission [ITC] against folks like Keystone where "seven of ten design patents directed to parts for the Ford F-150 truck were enforceable and infringed." And this raised an even bigger concern. What if other automakers begin to patent and protect simple parts and sue the distributors of generic parts?

Over the long run, I have argued that automakers should be more concerned about residual values. And so forcing the use of more costly new oem parts (versus alternative parts) in collision repair jobs can hurt residual values.

Of course there are legitimate concerns about the quality of some alternative parts. But this should be addressed with even better standards and certifications (there are some with CAPA right now), something that becomes rather difficult when the automakers and generic parts distributors are "at war" (for lack of a better expression). When all of this began, in my first piece on the topic I titled it: "I encourage cooperation versus confrontation." My opinion has not changed.

Now in today's opening quote I provided a summary of a ruling the Supreme Court made Monday that basically makes it tougher for "obvious" products to be patented. The article was written by Forbes journalist Brian Wingfield. Here are a few more details from the article.

"In his opinion, Justice Anthony Kennedy disagreed. 'Throughout this court's engagement with question of obviousness, our cases have set forth an expansive and flexible approach inconsistent with the way the Court of Appeals applied its ... test here,' he wrote. If just any common-sense invention is able to receive a patent, he deduced, 'patents might stifle, rather than promote, the progress of useful arts.'

Because of the Supreme Court's ruling, the U.S. Patent Office will now be charged with applying the higher standard toward patents. Any patents that were granted under the appeals court's relatively low bar for receiving a patent will stand--however, they are subject to the Supreme Court's standard if challenged."

Hopefully Monday's ruling by the Supreme Court provides an even greater incentive for the new vehicle manufacturers to work with distributors and manufacturers in establishing better standards for replacement collision parts. Investors appropriately cheered on the ruling by pushing Keystone's stock 7% higher and LKQ's stock up 2%.

"Our legal department says it seems more related to software issues" explained Mark Spears (LKQ's CFO) when I asked him about the ruling yesterday. I agree, but clearly it makes it more difficult for people to patent any "common-sense invention" (like a bumper). And I just don't understand why automakers would want to focus on the collision parts replacement business anyway.

It seems to me an automakers mission is to design and build great personal transportation products. They have clearly learned to leave it up to dealers to sell the products. I was there when Bill Ford addressed thousands of dealers at the National Auto Dealers Association [NADA] Convention in San Francisco back in 2002 and said to them: "we tried to do what you guys do (be an auto retailer), and found we're not good at it."

So the only reason why a company engages in something outside of its core competency (like manufacture or distribute collision replacement parts versus design and build) is because they need to ensure high quality replacement parts are available. But if there are other organizations similarly trying to ensure high quality parts are available (helping to preserve your company's brand image), it is beyond me why cooperation is not in everyone's best interest. I think the automakers might even consider offering "private label" products to these distributors.

Sometimes when groups get so caught up in the profit metrics, they forget what they are really trying to accomplish (which I think ultimately determines long term returns). I hope the Supreme Court ruling helps snap the automakers back to focusing on what is really important; providing exciting personal transportation products.

And right now for Ford specifically, it seems the only way they are going to build these exciting personal transportation products is by creating "One Ford" as I discussed in a previous note several weeks ago after listening to their new CEO (Alan Mulally) speak at the Morgan Stanley Conference in New York. Not by trying to become the leading replacement bumper manufacturer and distributor.

Limitation #2: Availability of suitable like kind quality parts
Repair shops price from cost. Meaning they pay $50 for the bumper, they mark it up $50, and make a 50% margin. If the price is $60, maybe they mark it up $60, and still make a 50% profit margin. It is the insurance companies that press the shops so hard to try to use alternative parts.

But in general, the shops only care about two things: doing the job right the first time, and doing it as quickly as possible (the goal is to get 10 "billable hours" in an 8 hour work day). Having to call around and hunt for the part therefore is not part of the equation, and instead is something the shop must do to appease the insurance companies.

Something like half of the time a collision repair shop calls for a recycled part they find the junkyard (sorry recycled facility) does not have the part. "Obviously our out of stock rates are lower than the industry average" explained Mark Spears on LKQ's conference call Thursday.

I think the ability to invest in inventory management systems and be able to look at all of the products available throughout all LKQ facilities in the region allows LKQ's sales force to say "yes" more often when asked if they have the recycled part. Also being able to look on the screen and say, "no sorry we don't have a recycled Chevy Malibu tail light, but we have a generic part," I think also improves the availability issue. And Keystone has been investing in things like "cross docking" that can help them say "yes" more often when the body shops call looking for generic parts.

But there is something emerging that I did not anticipate, and that is the ability to offer alternative parts that previously were not considered part of the market. Take for example LKQ's recent acquisition of Northern Lights, a head and tail light refurbishing company out of Grand Rapids, Michigan. When LKQ would buy a vehicle, they would chop it up for the parts that are primarily used: bumpers, door panels, maybe a hood, etc. But I think a lot of lights would simply get scrapped. Similarly Northern Lights needed a steady stream of light cores (the "raw material") in order to grow its refurbishing business.

Now LKQ is beginning to send their light cores to Grand Rapids, and these lights can appear in the company's inventory (on the computer screen when someone calls looking for a light). "Northern Light's is averaging 75 (refurbished) lights a day, but by the end of the second quarter they should be up to 200 a day" said Joseph Holsten (LKQ's CEO) on the company's conference call Thursday. LKQ is doing something similar with their Transwheel acquisition, where they are refurbishing wheels.

So parts that were once a lot more difficult to come by as refurbished, now all of a sudden are becoming more available. Or another way of saying this, it is allowing LKQ to use more of the vehicle, expanding the overall alternative market potential.

Are there other areas of the vehicle this can be done with? "We are always looking for opportunities to get more value out of every vehicle we buy or broaden our product line we offer our customers. So our Antenna is up, but there is nothing on the near term horizon." Joseph Holsten answered in response to a question about this on LKQ's conference call.

Limitation #3: Acceptance of alternative parts within the collision shop
Like I said, most collision shops are more concerned with getting a high quality part (so the job can be done right the first time), and getting the part in an expedient manner (so they can get the job done quickly). Hunting for alternative parts does not help with either of these two objectives, and so the inclination right from the start is to order a new oem part.

But the growth of insurance company direct repair programs (which is something like more than one out of every two collision repairs) are what encourage the shops to try to use more alternative parts. Usually an insurance company tells the shop they need to use a certain % of alternative parts to remain in the direct repair program and therefore benefit from the insurance company telling people about the shop when they get into an accident. Insurance companies don't like the term "steer" customers to the shops, but that is essentially what happens. And I don't see what is wrong with the insurance companies steering customers to shops they think will do a better job at a lower cost for their customers.

In this regard, LKQ has developed an electronic "last look" program for insurance carriers to help them make sure alternative parts were not an option before the shops order new oem parts. The last look program is being used by 3 insurance carriers in certain markets, and LKQ management said on the call that a 4th carrier is reviewing the program.

But once again, something even bigger than what I initially considered is likely to evolve in the coming years. On LKQ's first quarter conference call, management said they are also piloting the technology with a body shop chain to make it easier for the shop to buy all their alternative parts directly from LKQ.

At first I just shrugged the comment off. However, the more I thought about it, the more I have come to the conclusion that this could open the door for folks like LKQ (and probably Keystone as well) to offer certified repair programs. What do I mean by a certified repair program? Just imagine LKQ or Keystone "Certified Collision Centers" down the road.

For those of you that read me regularly, you know I think the NAPA Auto Care Centers (now with 13,000 shops signed up), and O'Reilly certified repair programs (now with 1,700 shops signed up) are going to help drive business to parts "jobbers" (folks that run automotive parts out to the repair shops).

Under the NAPA and O'Reilly (NASDAQ:ORLY) programs, these jobbers similarly offer things like electronic ordering, as well as a national warranty program, rebates, training, and in NAPA's case even the opportunity to brand your store a "NAPA Auto Care Center."

For independent service repair chains that are observing an ever increasing competitive environment, this type of support is becoming incredibly helpful and almost necessary for the independent shop to survive. It almost becomes competitive with the support and systems franchise organizations like Midas or Jiffy Lube offer. And of course in return, a certain % of parts are purchased from O'Reilly or NAPA.

NAPA and O'Reilly deal with general repair shops (for the most part). LKQ and Keystone on the other hand focus on collision and repair (body shops). But all of them are jobbers (delivering parts to repair shops versus a "retail sale" of someone walking in off the street).

And if LKQ is now piloting providing electronic look up/ordering technology (actually the technology comes from a third party vendor) to these collision repair shops. Doesn't it seem like the next logical step is for folks like LKQ to begin offering similar Auto Care Center or Certified Repair Shop programs for the collision shops like you see NAPA and O'Reilly offering in the general repair shop market?

And in return for LKQ offering systems and support, the collision shops will have to buy a certain % of parts through LKQ. And if LKQ moves in this direction, you can bet Keystone won't be far behind (if they aren't already moving in this direction).

But maybe I should explain why this is so critical. The Romans-Group has a white paper available on their website discussing multiple location collision repair operators (MLOs).

And what the white paper found was that there are roughly 57 independent and dealership MLOs with more than $20 million in annual revenues. The paper estimates that while these 57 organizations only account for 2.1% of the estimated 45,000 collision repair facilities in the United States, they process about 9% of the insurance and customer pay collision repair revenue.

Here again, you probably need to be a little careful with industry data. But directionally I think the Romans-Group is correct. Oh and incidentally, the Romans-Group ranks AutoNation (NYSE:AN) as the third largest collision MLO in America, Sonic (NYSE:SAH) #6, Group 1 (NYSE:GPI) #7, United Auto Group (NYSEARCA:UAG) #9, and Asbury (NYSE:ABG) #10.

Collision and repair probably accounts for $1 or so out of every $10 in service and parts profits at these public dealerships. And since service and parts account for roughly half (ok $4 out of every $10) of gross profits at the public dealership groups, I think collision shops and the collision repair market in general is something we in the investment community often overlook and underestimate in terms of its importance to auto retail.

But I don't think the collision market is something being overlooked by the players themselves. "We are looking at our 28 collision and repair centers. There is some inconsistency in performance and they are deep diving into that." Randy Callison, Group 1's Senior Vice President of Operations said last week on the company's first quarter when asked about the company's new fixed (service repair) operations team and where they hope to get improvements.

The bottom line is that the MLOs (multiple location operators) are likely to become a bigger force in the collision market in the years to come. And the insurance companies are likely to demand more (service levels, alternative parts usage, etc.), from collision shops.

And just like how NAPA and O'Reilly have identified and spotted a need to help independent repair shops compete in the market (as the owners focus on the repairs and benefit from better systems and processes being offered by NAPA and O'Reilly). Over time, I think we will see a similar relationship evolve with collision and repair jobbers like LKQ and Keystone (providing these systems and support to the collision shops).

So where you once had a shop almost opposed to using alternative parts because they viewed it as a nuisance and something they were only doing to appease the insurance companies. The shops over time are likely to see alternative parts jobbers as important (if not critical) partners in helping them survive. And from that cultural shift, where the use of alternative parts goes from being a nuisance to the fabric of an independent body shops survival, now all of a sudden alternative parts usage can really take off.

As a result I am becoming a little more optimistic about the outlook for alternative parts usage (over the long term). I still worry about automaker resistance, but when I look at all three barriers to alternative parts usage, I see favorable things happening.

LKQ 1Q07 Results
LKQ reported first quarter results on Thursday April 26 so I am sure you have seen several notes regurgitating the figures. The point of earnings season (and reporting periodic results) is simply to help measure how effective a company is in filling the need, and the returns they are generating from the fulfillment of that need.

For the most part I was highly encouraged with LKQ's results for January, February and March of 2007 (first quarter). But there was one area/metric that I think merits attention and that is on the employee productivity front.

Specifically, I figure LKQ sold about $52,300 worth of stuff (alternative parts) per employee. After you subtract out what it cost the company to get the part (either purchased from some overseas manufacturer or dismantled at one of the company's recycle yards), you end up with a gross profit (so sales price minus cost of the part) of roughly $23,800 per employee.

And after you consider expenses (like rent for the facilities and warehouses, distribution/shipping costs, and all of the selling general and administrative expenses), each of LKQ's roughly 4,500 employees made the shareholders some $6,060 in operating income (per employee) over the last three months.

Now LKQ ended 2005 with roughly 3,370 employees. So if I assume the company had a similar number of employees at the end of the first three months of 2006 (recognizing this is only a best guesstimate), I end up with the company selling about $57,000 worth of alternative parts (stuff) per employee in the first quarter of 2006, generating $26,200 in gross profits per employee, and ultimately making about $6,040 in operating income per employee. In other words over the last 12 months employee productivity has eroded.

Now if I go all the way back to the end of 2003 and look at the 1,800 employees the company ended with. And do the same analysis on the first quarter of 2004, I end up with average sales per employee of $55,600, gross profit per employee of $26,100, and $5,500 in operating income per employee.

I'm not too concerned about the lower gross per employee because of the company's smelter operations. And as you can see over a longer term perspective (going back to the first quarter of 2004), the general trend is clearly for higher sales and operating profits per employee at LKQ.

I suspect the decline in operating profit per employee in the first quarter of 2007 versus the first quarter of 2006 is due to the company acquiring and investing in the appropriate infrastructure for future growth. But it is a metric that merits watching in the future.

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LKQX 1-yr chart