2023-05-03 12:30:17 ET
Summary
- LKQ is the market leader in providing alternative collision parts for automobiles and trucks in North America, thanks to its economies of scale.
- I believe LKQ's growth outlook remains positive, driven by the aging car PARC and insurers' efforts to cut repair costs by using aftermarket/recycled components rather than OEM components.
- LKQ's valuation is fairly valued at 13.7x NTM PE, but there is a path to decent returns if valuation reverts to its average of 15.5x.
- The risks include the long-term threat of autonomous driving reducing demand for parts, but this is not expected to have a significant effect for at least the next 15-20 years.
Thesis
LKQ Corporation (LKQ) provides alternative collision parts for the repair of automobiles and light, medium, and heavy-duty trucks. I believe LKQ to be the market leader in North America. What sets LKQ apart from rivals is its size, which allows it to take advantage of economies of scale in procurement and stock a wide variety of items that smaller competitors simply cannot match. In particular, LKQ scale makes it possible to take advantage of volume discounts from suppliers, expand into new markets, increase fill rates, and decrease response times compared to rivals. The company has also invested heavily in its technological infrastructure and logistics network, surpassing the resources of its smaller rivals and solidifying its market dominance through technological superiority. However, the valuation appears to fair valued at this point at 13.7x NTM PE. While the upside is pretty decent if it reverts back to its average of 15.5x, I believe it is safer to purchase at a lower valuation.
1Q23 results
Despite a 7.9% increase in organic parts and service revenue, 1Q23 sales were flat at $3.349 billion compared to the same period in the previous year. Gross margin rose to 41.0%, while segment EBITDA margin rose to 13.6%, thanks largely to growth in Wholesale - North America & Europe and partially offsetting declines in Specialty & Self-Service. However with an increase in SG&A as a percentage of sales, GAAP EBIT margin shrank to 10.9%.
Growth outlook
I think LKQ will continue grow thanks to the healthy market demand outlook brought on by the aging car PARC and the limited new vehicle supply, and also thanks to its success in stealing market share from smaller competitors. I would point out that LKQ's scale advantage would continue to snowball, but the incremental difference in scale would manifest in distribution, faster response time, and also sheer financial capacity rather than % discount in procurement (which has a limit). Indeed, 1Q23 results did not disappoint, with organic revenue growing 9.7% y/y in Europe and healthy growth rates in the high single digits to low double digits% across all regions. I believe the growth momentum is strong here, especially as insurers' efforts to rein in rising repair costs by switching to aftermarket/recycled components rather than OEM components is what I anticipate will continue to drive future market share gains and growth. Another driver of growth, would the development in Europe. in the same way that LKQ has aggressively expanded its North American operations to reap the benefits of economies of scale and capitalize on the rising demand for alternative parts, I anticipate that the company will do the same in Europe. If carried out, these would result in healthy earnings growth and long-term growth of the top line. In addition to the positive trend in the top line, the 1LKQ initiative has increased operating leverage, which improved the EBITDA margin in 1Q23.
Weak specialty and self service
Sales of recreational vehicles slowed, which had a significant impact on the Specialty organic sales decline of 13.5%. In light of the expected drop in RV wholesale shipments, I do not anticipate a speedy recovery this year. But it's not all bad news; the impact should decrease as the mix shrinks and other parts of the business expand, at least from a mathematical standpoint.
Valuation
I believe the valuation is fair for LKQ at 13.7x NTM PE using consensus figures, but I do see a path to decent ~14+% returns if valuation were to revert to its average of 15.5x. My recommendation is a hold rating as I believe it is hard to bet on multiple re-rating upwards in this environment. The catalyst I would look out for to bet on valuation re-rating is when fed starts to cut rates, which would trigger an increase in valuation across the board.
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Risks
Market participants believe that autonomous driving poses a long-term threat to LKQ because it will reduce the number of accidents and, consequently, the demand for parts. I agree that this is a potential problem, but I don't think it will have a significant effect on valuation for at least the next 15-20 years. Furthermore, it's not like demand will be zeroed; even in a fully autonomous future, vehicle damages are likely to occur. Perhaps LKQ will fare better than its competitors in a contracting market, as it can easily absorb the market share of any smaller competitors that fail.
Conclusion
LKQ dominance in the alternative collision parts market is primarily due to its economies of scale and technological superiority. Despite the flat sales in 1Q23, LKQ's growth outlook remains positive, particularly in Europe, where I expect the company to replicate its North America's operations to grow and gain share. Overall, LKQ would be a solid investment that has good growth momentum and long-term growth prospects at a cheaper valuation than today.
For further details see:
LKQ Corporation: Valuation Is Fair Today But Business Continues To Be Strong