EUR 850.00 For Business Accounts Only

Morningstar | LKQ Faces Challenges in Europe in 4Q; Lowering FVE to $38 but Shares Still Undervalued

After taking a fresh look at LKQ, we are lowering our fair value estimate to $38 from $47 and maintaining our narrow-moat rating. The change is primarily due to a reduction in our stage II EBI growth estimate to 8% from 10% and a modest change in its revenue growth profile during our explicit five-year forecast. LKQ’s fourth-quarter earnings were in line with Street expectations with revenue matching consensus of $11.9 billion while adjusted EPS of $2.19 was $0.01 below consensus. These results didn’t alter our opinion of LKQ’s prospects. Despite our more modest growth assumptions and fair value estimate reduction, we feel the shares of LKQ are undervalued.

Our recent research has supported our view that usage of alternative automobile parts in repair shops continues to grow. Moreover, we feel that LKQ has the best platform to distribute alternative parts in North America and is making significant progress in Europe. However, there is evidence that North American OEM parts suppliers have ramped up their discounting efforts in recent years to mitigate market share loss, especially for collision parts. We believe this approach will not reverse the trend of alternative parts adoption but rather slow adoption growth. LKQ possesses certain cost advantages, including its ability to source large quantities of salvage parts that neither OEMs nor competing alternative parts suppliers are likely to replicate.

We are favorably impressed with LKQ’s business model that provides an expansive catalog of new aftermarket, recycled, remanufactured, and specialty parts. By giving repair shop customers a wide range of options with price discounts up to 50% when compared with OEM parts, LKQ has become the leading supplier of alternative parts in the regions in which it operates. The price advantage is especially relevant in collision repairs that are primarily paid for by insurance companies, which have developed relationships with LKQ to contain costs and maintain quality.

LKQ’s performance in fourth-quarter 2018 was largely in line with our expectations and consensus despite some softness in Europe. Companywide organic growth was 3.0% year over year, while acquisition growth was 20.1% due principally to the Stahlgruber acquisition. Operating margin, when including goodwill impairment costs, declined in the quarter to 5.5% from 6.8% in the fourth quarter of 2017. Excluding the goodwill charge, which was related to its aviation parts recycler, operating margin was 6.6%. Management provided optimistic guidance for 2019, including companywide organic revenue growth of 2% to 4% and adjusted EPS growth of 7% to 13%.

LKQ has significant consolidation efforts in Europe underway after a string of large acquisitions including Stahlgruber in 2018 and Rhiag in 2016. In the fourth-quarter earnings call, management noted economic challenges in Europe including Brexit concerns and Italy’s slip into recession in the final quarter of 2018. This partially explains the sequential decline in European organic growth in the quarter to 0.3%, from 2.0% and 8.0% in the third and second quarters of the year. We are not overly concerned about larger economic worries as we believe LKQ is likely to benefit from a trade-down effect (buyers purchasing used cars instead of new and delaying vehicle purchases altogether) during recessionary periods. That said, economic disruption is likely to distract management from the significant tasks ahead, which include consolidating 10 catalogs into one or two. We believe that LKQ can provide its European customers unique value in terms of price, selection, and speed of delivery through these efforts. Yet we believe there is some uncertainty in terms of execution as LKQ’s European operations differ significantly from those in the United States. Management, however, appears very confident in its strategy as it opened five new branches in Eastern Europe during the quarter. Our model incorporates the costs associated with streamlining LKQ’s European operations as we anticipate it will take LKQ until 2021 to reach a 10% operating margin that it most recently achieved in 2015.