Short-Term Challenges Pressure LKQ's Performance, but We Remain Optimistic on Long-Term Trends

Equity Analyst

Dawit Woldemariam

LKQ is the top alternative vehicle-parts provider to repair shops in North America and Europe. We believe the company benefits from scale-driven cost advantages in its business. Customers value LKQ’s consistent parts availability across a wide range of products and quick delivery. LKQ helps customers complete repairs faster, improving productivity. We think the company’s strong distribution network will support its ability to keep order fulfillment rates high in both aftermarket and salvage products. 

The company’s strategy focuses on being a one-stop shop for vehicle repair professionals, ranging from salvage products to aftermarket and remanufactured parts. LKQ’s parts are a strong alternative to original equipment manufacturers’ parts, exhibiting high quality in comparison. While insurance companies aren’t usually direct customers, they do have sway over which parts are used in vehicle repairs. LKQ’s alternative parts allows insurance companies to reduce their cost base while also reducing the cycle time for repairs. Historically, the company has used acquisitions to build up its capabilities and footprint, but that has changed over the past few years. LKQ has shifted its focus to integrating its businesses and improving its cost structure, and we believe it will aim to make smaller tuck-in acquisitions as opposed to larger deals. 

We think LKQ is well positioned to compete as electric vehicle adoption increases. The shift to EVs will present new revenue opportunities for the company, in our view. In both hybrid and full-electric vehicles, new parts will be needed to keep vehicles on the road. For example, we expect to see increased demand for battery-related parts and a need for remanufactured or refurbished batteries. 

LKQ has exposure to end markets with attractive tailwinds. We think demand for vehicle repair work will be strong long term, largely due to the high average age of vehicles.

Business Strategy & Outlook

Over the past two decades, LKQ has evolved from an auto salvage business to a comprehensive alternative parts provider, which extends to aftermarket, remanufactured, and refurbished auto parts. As the largest player in the highly fragmented auto-parts industry, LKQ benefits primarily from scale-driven cost advantages over smaller competitors, in our view. LKQ is the largest auto-parts distributor in North America and Europe. We believe smaller local and regional competitors will struggle to win market share in both regions, given LKQ’s strong distribution network, efficient inventory management, and extensive customer service capabilities. We award LKQ a narrow economic moat rating because we expect its competitive positioning will allow it to generate excess returns over the next decade. 

We think LKQ’s high fulfillment rates are driven by its product breadth and consistent product availability. LKQ’s primary customers are collision and mechanical vehicle repair shops, which need auto parts on demand. These customers value LKQ’s ability to maintain optimal inventory levels for a wide range of products. Repair shops usually work under tight time constraints, so finding the desired part when they need it is important to them. We estimate LKQ’s order fulfillment rates for aftermarket products are approximately 95% compared with about 65% for its competitors. In addition, we estimate fulfillment rates for salvage parts are about 75% for LKQ versus roughly 25% for competitors. In our view, this shows that LKQ’s product breadth and extensive customer service capabilities are unmatched by peers. 

We also believe LKQ benefits from cost advantages stemming from global product sourcing and scalable distribution networks. In the aftermarket vertical, LKQ globally sources aftermarket parts from independent manufacturers in Taiwan in addition to the United States. This dynamic helps the company earn higher gross profit margins in comparison with smaller peers. Additionally, we think LKQ’s distribution network is a differentiator. The company operates national distribution centers that help stock branches with popular parts. The distribution network is also flexible enough to shift inventory between LKQ’s facilities to meet demand, utilizing the company’s own fleet of trucks. We believe this allows LKQ to cost-effectively serve its customer base, which requires high product availability. 

We think LKQ’s well-developed salvage procurement system drives its ability to keep costs low. The company sources its recycled vehicles from car auctions. LKQ’s bidders utilize internally developed software to cross-check current inventory levels and average selling prices to determine an optimal bid for vehicles. This prevents the company from overspending on vehicles, driving higher profitability compared with smaller peers. After recycled vehicles are bought at auction, LKQ breaks them down into individual parts, which are then sold to vehicle repair shops. Each year, we estimate LKQ acquires over 300,000 vehicles for its salvage business. We believe LKQ’s procurement process is the best in the industry. The company efficiently catalogs parts and utilizes artificial intelligence to improve its vehicle assessment capabilities. AI technology allows LKQ to catch damage to vehicles that its bidding specialists fail to see.

LKQ has historically been very acquisitive, but that changed in 2019. The management team’s roll-up strategy helped LKQ venture into new product verticals and expand its geographical footprint. LKQ moved into selling customers aftermarket, remanufactured, and refurbished auto parts in addition to its salvage products. By expanding its product offering, LKQ has become a one-stop shop for customers. The company has also increased its footprint globally. During its early days, LKQ was solely a North American business, but today it also operates in Europe. The company’s European operations commenced in 2011 and have grown significantly since. Currently, the region generates about $6 billion in annual sales compared with less than $1 billion in 2012.

Acquisitions have been a key reason LKQ has built scale-driven cost advantages in its business. That said, the company’s invested capital base has increased along with the growth in acquisitions over the past decade. Earnings before interest has also grown over the same period, but not at the same pace as invested capital. Adjusted returns on invested capital decreased from approximately 17% in 2015 to about 10% in 2019. During this period, LKQ increased its acquisition activity, which resulted in a larger asset base. Since, the management team has signaled its desire to shift away from its acquisition-heavy strategy, opting to focus more on driving organic growth and cost efficiencies. We believe future acquisitions will more likely be small-tuck-ins as opposed to the large deals of the past. In our view, the pivot in management’s acquisition strategy will push adjusted returns on invested capital past 2015 levels, averaging approximately 20% over the next five years. 

Additionally, we think LKQ is focused on improving its net leverage position (net debt/EBITDA) in the near term. Over the past five years, its net leverage ratio has declined from about 3 times to under 2 times. This resulted in the company reaching investment-grade status. To maintain this level, LKQ will need to focus on improving its cost structure to drive higher EBITDA growth, in our opinion. This will require the company to shift away from making large M&A deals. LKQ did recently acquire Uni-Select, which has pushed its leverage ratio up to 2.3 times. However, we think the company can get its net leverage ratio down under 2 times within 18 months of the deal closing. We also think LKQ’s competitive position is entrenched enough to fend off competition from smaller players. The company’s peers are local and regional players, while LKQ is a national leader. The likelihood of peers winning away market share from LKQ is rather low, in our view. 

We expect LKQ’s Europe business to be on better footing in the next couple of years. The company’s European operations was built up through multiple acquisitions over the past decade. Today, LKQ is the largest distributor of automotive aftermarket parts in Europe. The management team has shifted its focus away from acquiring more businesses in the region to integrating its operations. We believe LKQ will be successful in its efforts to drive cost efficiencies in Europe through its 1 LKQ Europe initiative. Similar to its efforts in North America over the years, we think LKQ will drive procurement costs down by rationalizing its product portfolio. We also think the company can develop efficient and scalable distribution networks to cost-effectively serve its customer base. We forecast EBITDA margins to grow from 9% currently to 10% by 2024.

We do not think LKQ’s narrow economic moat faces any substantial threats from ESG risks. The company has exposure to emission regulation through its fleet operations. LKQ uses its own trucks to move products between facilities. We think LKQ is investing to position itself to win in a zero-emission world. In the United Kingdom and Ireland, the company has launched a six-month pilot for electric trucks. The management team has also expressed its willingness to test fuel-cell trucks in the future. We expect LKQ to be ready for the eventual shift to alternative-power vehicles. Furthermore, we think new emission regulation will likely be introduced gradually over the next decade. This will give LKQ time to invest in next generation products that will aim to reduce emissions.

Narrow

Economic Moat

LKQ Corp. is a distributor of vehicle products and its parts to repair, maintain, and accessorize automobiles. It operates through the following segments: Wholesale-North America, Europe and Specialty. The Wholesale-North America segment includes Glass and Self-Service segments. The company was founded by Donald F. Flynn in February 1998 and is headquartered in Chicago, IL.

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Operational improvements in Europe and strategic initiatives like ESG focus and acquisitions position LKQ for sustainable growth.
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The company's focus on operational efficiency, strategic partnerships, and future growth pillars positions it well for continued success and profitability.
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