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LKQ's Shares Remain Attractive

The European integration story continues.

LKQ LKQ is a leading alternative auto-parts distributor with operations in North America and Europe. It distributes includes new aftermarket parts and remanufactured and recycled parts, typically at a discount of up to 50% over original-equipment manufacturer parts. Its ability to source new products from low-cost overseas manufacturers and to obtain parts through salvaging more than 300,000 automobiles annually gives LKQ unparalleled scale of operations. In addition, it has combined extensive distribution networks in North America and Europe with local delivery and strong customer relationships. These elements allow LKQ to offer its repair shop customers significantly higher fulfillment rates than its competitors.

The company reported first-quarter adjusted earnings per share of $0.56, in line with consensus. Revenue of $3.10 billion missed Wall Street estimates by 1%. The performance was solid given numerous headwinds, including weak macroeconomic factors in Europe and unusually low collision activity in North America, which CCC Information Services indicated was down 2.6% year over year.

More central to our thesis is the ongoing progress in Europe, where LKQ continues to consolidate its catalogs and procurement activities. Management indicated that its centralized procurement contributed 50 basis points to its European gross margin improvement, which came principally in the form of supplier rebates. LKQ’s European segment EBITDA continues to trail that of the North American segment by over 500 basis points. We believe management will ultimately bring European margins closer to those of LKQ’s more mature North American segment. As such, we believe the shares are undervalued and maintain our $38 fair value estimate.

Europe is LKQ’s largest and least profitable segment after the Stahlgruber acquisition closed in 2018, so we remain focused on management’s progress in the region. Despite macroeconomic headwinds, the segment’s organic growth of 1.3% was the highest in LKQ’s portfolio. As most of LKQ’s activities in Europe support mechanical repair as opposed to collision, we think any softness in underlying demand is transient, as such repairs can be delayed but not avoided. In the event of a more significant downturn in Europe, the average vehicle age is likely to increase, which could drive mechanical repair volume.

LKQ’s North American segment was a bit more sluggish than we expected as organic revenue fell 1.4% year over year. Management cited an unusually weak collision season and one fewer selling day in the quarter compared with the prior year. Our recent conversations with body shop owners reinforce our opinion that the LKQ value proposition remains strong, however.

LKQ’s larger strategy of expanding the size and scope of its operations and capturing a greater share of its customers’ wallets was evident in the first quarter. Its North American segment increased the number of collision stock-keeping units and the total number of certified parts by 5.8% and 11.6% year over year, respectively. Shortly after the quarter ended, LKQ announced that it was acquiring Elite Electronics for an undisclosed sum. While the acquisition is small, it provides LKQ with valuable technology to address the rapidly growing vehicle diagnostics and calibration marketplace. More important, it will position LKQ to better address the growing vehicle sophistication that could impede reverse engineering of components for the aftermarket.

Cost Advantage Results in Narrow Moat LKQ's narrow economic moat is rooted in its ability to maintain a cost advantage, which is realized through its extensive distribution networks in North America and Europe along with its unique procurement abilities. LKQ maintains over 1,500 locations. From the customer's standpoint, the principal benefits of LKQ's business model include high fulfillment rates, which are 95% compared with approximately 65% for the best competitors, and LKQ's ability to provide a savings of 20%-50% on OEM part prices. For the past 10 years, the company has generated returns on invested capital, including goodwill, averaging 9.3% compared with a weighted average cost of capital of 7.9%. While we forecast average ROICs for the next five years of only 8.7% because of large acquisitions in Europe, we expect ROIC to reach 9.3% by 2023 as LKQ refines its operations outside North America.

The logistics advantage provided by the sophistication of LKQ’s distribution and depth of catalog manifests itself in rapid turnaround time, where parts can be delivered in less than 24 hours. In North America, its distribution system employs tractor-trailers to ship parts across states, if necessary, and local drivers who are familiar with local repair shops. In certain U.K. operations, parts can be transported via a third-party motorcycle fleet for exceptionally rapid delivery. Providing a mix of new aftermarket, recycled, remanufactured, and specialty products across a region allows LKQ to shift inventory between warehouse locations to maximize fulfillment rates and minimize delivery times. In some cases, these parts can include difficult-to-stock items, such as a complete car door.

While LKQ offers e-commerce, its call centers receive over 1 million calls per week. Often these inquiries are from individual repair shop customers who are time-pressed to complete a job that may be stalled by lack of a single part. Many of these repair shop owners are older--in their 50s and 60s--and impatient, desiring to speak to a representative immediately instead of using an e-commerce alternative. This nuance would make it difficult for an online-centric alternative to capture significant market share in the near term. It is a tremendous benefit for repair shop owners to have the ability to contact a large, single distributor with a deep catalog instead of juggling myriad smaller suppliers. This enables larger entities with strong customer service capabilities, such as LKQ, to capture greater market share over time.

Having a large network and customer base has enabled LKQ to embark on Big Data and predictive modeling initiatives. In some regions, it is using data analytics to drive weather-related stocking and sales. It is also using data science to provide a better understanding of price elasticity and customer purchasing behavior. The greater volume of data it collects through improvement of these systems, along with its underlying growth, enhances the value of this information, enabling LKQ to improve further its cost advantage and margins.

The large scale of LKQ’s procurement of salvage vehicles further bolsters its moat. Approximately 4 million cars become available for LKQ to bid on annually. Only 8% of these can be absorbed by LKQ. Because much of the bidding for these vehicles has transitioned to an online format, many of LKQ’s bidders are using photos and vehicle specifications compared against the company’s current and anticipated parts needs provided by internally developed technology integrated into its salvage enterprise resource planning system. This software provides bidding guidance, including an estimated maximum bid and hints for areas requiring closer evaluation, such as impact damage to the engine compartment. By establishing an operations center in Bangalore, India, LKQ was able to offshore a significant portion of its online bidding activity, allowing it to further reduce costs.

Environmental matters related to LKQ’s auto salvage yards and self-service locations enhance the company’s moat. In many cases, these facilities can be difficult to create on greenfield spaces due to requisite government permits and local opposition. The separation of hazardous materials, recycling of fluids, cleanup of accidental spills, and companywide environmental risk avoidance require expertise based on institutional knowledge gained over decades. On the flip side, the establishment of a larger, more sophisticated entity may present a bigger target for litigation and government fines than the small and medium-size businesses acquired. Yet, we believe the professionalism and legal acumen maintained under a larger corporate structure outweigh the risks.

As it has grown in scale and scope, LKQ has strengthened its relationships with automobile insurance carriers in North America, as these entities pay for most collision repairs in the region. Insurance carriers are not the direct customers of LKQ, as the auto repair shops purchase the parts, but LKQ provides insurance companies a range of free services, such as the review of repair estimates, direct quotations to adjusters, and participation in aftermarket quality-assurance programs. As a result of its significant growth, LKQ has become the largest acquirer of total-loss vehicles sold by insurance carriers, further solidifying its relationships with these entities.

Acquisitions Bring Risk LKQ's acquisition model is inherently risky. Individual deals can incur unique costs, present delays, and distract management from running existing businesses. LKQ has been fortunate in that it has not suffered from major deal hiccups of which we are aware. Future deals are expected but are likely to be smaller and less risky than the $1.4 billion acquisition of Stahlgruber in 2018 or the $1.1 billion acquisition of Rhiag in 2015.

The most pressing issue now is LKQ’s integration and streamlining of its operations in Europe, where it is now the largest distributor of aftermarket automotive parts. After the acquisition of Stahlgruber, LKQ has 10 parts catalogs in Europe that it is trying to consolidate into one or two. The consolidation is a very complicated process, as the catalogs are very detailed and incorporate 3D images of the parts along with installation instructions. Further complicating matters is the constant influx of new parts that must be added to the underlying databases. LKQ has a history of managing disparate operations in North America, but European efforts present new problems because there are 13 languages and 10 currencies in LKQ Europe. As Europe is now the largest revenue-generating segment while also generating the lowest EBITDA margin, we will be looking carefully for evidence of synergies in future quarters.

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