2023-10-11 16:46:42 ET
Summary
- State Farm Insurance's policy change regarding aftermarket parts could have a significant impact on LKQ Corporation's financial performance.
- State Farm's decision to accept aftermarket parts may lead to increased business for national multi-shop operators, potentially benefiting LKQ Corporation.
- LKQ Corporation's upcoming financial results and guidance might provide more insight into the potential effects of State Farm's policy change and other developments.
Although I have never found myself interested in the companies that make automobiles, I have found myself intrigued by different aspects of the automotive industry. One segment of the market that I have come to appreciate over the years is the aftermarket parts space. The fact of the matter is that the average driver is keeping their vehicle longer than they did in the past. And that shift in consumer behavior has led to greater demand for aftermarket parts. Because although vehicles might be on the road longer, the longer they are on the road, the more the issues will arise.
For anybody interested in this space, one company that deserves attention is LKQ Corporation ( LKQ ). Management describes the enterprise as a global distributor of vehicle products, with those products including replacement parts, components, and systems that are used in the repair and maintenance of vehicles. They also produce and sell specialty products and accessories for vehicles as well. In the past, I have found myself bullish regarding the company, pointing to its fundamental performance and how cheap shares were, as reasons why investors would consider owning stock in it. But now the firm has another catalyst that can help to propel financial performance higher. And while we do not yet know the full impact this will have, it's something that investors should be aware of for when the business reports financial results in the coming weeks.
A big catalyst of unknown impact
On Oct. 10, news broke that State Farm Insurance has finally decided to change a rather old policy regarding non-OEM, or more commonly known as aftermarket, parts. Decades ago, the insurance behemoth had no problem if vehicles that required repairs used aftermarket parts. For those who don't know, aftermarket parts are similar to OEM parts in terms of how they work. But they're produced by a different company and the fact that they are not brand name means that they are often cheaper than the OEM parts they are chosen to replace. But back in 1999, the insurance company decided to temporarily suspend the acceptance of these parts in vehicle repair estimates.
That temporary suspension lasted for the most part until the present day. There have been times, such as in December of last year, where the company reintroduced the use of some aftermarket parts such as bumper covers, head lamps, and tail lamps. But this newest memo, which will be effective starting on Oct. 16, represents the first true rollback of this on a massive scale. There are still some uncertainties associated with this policy, such as how the company will handle parts that have been decertified after they have been put on vehicles, and which parts it will not accept. For instance, the memo did specify that exterior parts that bear the OEM or vehicle name or logo on them cannot be replaced using aftermarket parts.
While this may not sound like a big change, it likely will have a measurable impact on the long-term financial performance of companies like LKQ Corporation. I say this because State Farm is a truly massive player in the automotive insurance space. In 2022, the 10 largest car insurance companies in the US accounted for 77% of the car insurance market. At the top of the list was State Farm with a market share of 16.8%. GEICO came in the second at 14.1% while Progressive ( PGR ) was third at 13.8%.
Because State Farm is not a publicly-traded company, we don't have all that much in the way of details on it. But we do know that, between auto insurance, homeowners’ insurance, life insurance, business insurance, and health insurance, it boasts around 91 million policies and accounts that it services across the country. It handles 26,000 claims per day, on average. And we also know that the company is not exactly in the best of shape at this time. You see, despite being the largest player in its market, State Farm had a truly awful 2022. The company generated a net loss of $8.7 billion that year off of $46.6 billion in premiums that were earned. This compares to the $722 million loss generated in 2021 from the $42.2 billion in premiums earned that year.
The management team at State Farm attributed these to auto insurance underwriting losses thanks to "rapidly increasing claims severity and significant additions to prior accident year incurred claims." There's also the fact that supply chain issues and inflationary pressures resulting from supply chain issues resulted in costs rising for insurance companies across the board. In fact, that's why the company implemented a limited rollback of its non-OEM parts policy in December of last year.
As for LKQ Corporation, we don't know yet what size impact this will have on the company. We do know that it should largely impact two of the company's operating segments. The first of these is its largest, known as the Wholesale – North America segment. Last year, this unit of the company accounted for $4.56 billion, or 35.6%, of the firm’s overall revenue. It also accounted for $852 million, or 49.6%, of its EBITDA. The other segment likely to see some positive impact is the Specialty segment, which accounted for $1.79 billion, or 14%, of sales and for $199 million, or 11.6%, of EBITDA.
Again, it's not entirely clear the full impact that we should expect. But there are a couple of different ways in which LKQ Corporation and its investors could benefit from this change. You see, in addition to providing aftermarket collision repair parts for vehicles, LKQ Corporation also helps in the recycling of OEM parts. In 2022, for instance, its Wholesale – North America segment helped in the recycling of 230,000 vehicles that worked out to 4.5 million parts. In addition to already having relationships with major insurance carriers, with 31.8% of this segment dedicated to carrier partners and the remaining 68.2% involving defined supply agreements, the company has partnerships with national multi shop operators. In fact, the top three largest of these firms work with LKQ Corporation, and between 2020 and 2022, their combined market share grew from 16.8% to 20.5%.
If State Farm is now willing to accept aftermarket parts when it comes to repairing existing vehicles, it's more likely, in my opinion, that those vehicles will find their way to companies like Caliber Collision, Gerber Collision & Glass, Service King Collision Repair Centers, and Crash Champions Collision Repair Team. These are some of the national multi shop operators that it has partnered up with. I say that this is more likely because State Farm already has a policy that allows drivers to take their vehicles to any shop that they like. So if they're less likely to run into issues with aftermarket parts, they likely will exercise this option more freely. And any parts that can be recycled or refurbished coming off of these vehicles could find their way to LKQ Corporation as well given the nature of the relationship that it has with these operators.
There are other important items as well
As I mentioned, we do not yet know what the impact of this change will ultimately have on LKQ Corporation. However, management is expected to announce financial results covering the third quarter of the company's 2023 fiscal year before the market opens on Oct. 26. I would be surprised if the company does not make some sort of statement or disclosure regarding this paradigm shift. But obviously, this is not the only important thing that investors should be paying attention to leading up to that time. Investors also should be on the lookout for other developments, such as the financial performance of the company during its most recent quarter.
At present, analysts are forecasting revenue of $3.49 billion. If this comes to fruition, it would represent a rather sizable increase of 12.4% over the $3.10 billion generated the same time last year . Analysts are also forecasting profits per share of $0.94. That would be slightly lower than the $0.95 per share reported the same time last year, resulting in net income dipping from $262 million to $251.5 million. No guidance was given when it came to other profitability metrics. But those should also be looked at. For context, operating cash flow in the third quarter of 2022 came in at $307 million. If we adjust for changes in working capital, we get a slightly lower reading of $304 million. Meanwhile, EBITDA came in at $420 million.
So far this year, financial performance has been rather mixed. As you can see in the chart above, revenue did increase modestly in the first half of this year relative to the same time last year. However, both net income and operating cash flow worsened. Fortunately, if we adjust for changes in working capital, we do get an increase in operating cash flow from $685 million to $698 million. And over the same window of time, EBITDA for the company grew from $915 million to $933 million.
Guidance also will be another hot ticket item. As you can see in the image above, revenue and earnings guidance for 2023 in its entirety is slightly lower than what prior guidance was when management released it earlier this year. With uncertain economic times, as well as strikes in the automotive space, I wouldn't be surprised to see some shift in this guidance in one direction or the other. It's also important to note that this guidance has not taken into consideration the company's recent purchase of Uni-Select that was completed at an enterprise value of $2.1 billion on Aug. 1. Management did say that they would update guidance to account for this. So I would fully expect a rather major change when factoring this in.
Takeaway
These are interesting times for companies like LKQ Corporation. While there's a great deal of uncertainty that could result in some pain, there also exists some interesting opportunities. Because of these reasons, I do believe that the third quarter earnings release will be particularly important for investors to pay attention to. And this is because what's released at that time will probably go a long way toward determining the overall trajectory that shares take. Until that time, I have decided to keep the company rated a "buy." But for those who cannot handle uncertainty and volatility, I could understand the decision to allocate capital elsewhere.
For further details see:
A Big Change For LKQ Corporation Heading Into Q3 Earnings