Investor's Business Daily

A Sum More Than Its Parts



Posted 3/20/2008

When you're riding down a highway and see a tow truck carrying away a mangled car, you figure the worthless heap is going to the junkyard.

This tangled mess of steel, parts and wires is worth more than you think. LKQ Corp. (LKQX) buys these battered hulks at auctions and resells the parts, turning them into a lucrative revenue stream.

Chicago-based LKQ has parlayed itself from a niche business that offers cheaper, recycled auto parts, into a fast-track growth player. Its management philosophy of fiscal discipline combined with acquiring related businesses is a recipe for rising profits.

LKQ's fourth-quarter profit soared 78% to 16 cents a share from 9 cents a share in the same quarter a year earlier. Revenue more than doubled to $414.7 million from $204.6 million. Some of that growth was due to its acquisition in 2007 of 12 used auto parts firms, mostly smaller companies except for Keystone Automotive, which it acquired for $810 million.

The Keystone buy was a major purchase, noted Craig Kennison, a senior analyst at Robert W. Baird, based in Milwaukee, Wis. Combining Keystone's supremacy in generic parts with LKQ's dominance in recycled parts creates one-stop shopping for most repair shops. "Shops can make one phone call and get a (parts) delivery from one truck, not two," Kennison said, noting the speed with which orders come in.

Launched in 1998, LKQ went public in October 2003. Initially, it acquired several smaller firms to grow its business and then slowed down to digest them. In 2007, its buying binge included two companies in Canada, broadening its scope beyond the U.S. for the first time. LKQ currently has locations in 42 states.

In 2007, 33% of LKQ's revenue stemmed from recycled parts, 55% from aftermarket and refurbished parts, and 12% from others, which includes melting down parts for aluminum and scrap.

Target Organic Growth

Mark Spears, LKQ's chief financial officer, described the company's strategy for growth as twofold: First was organic growth, ramping up its volume of buying damaged cars to generate more recycled parts, and secondly, through targeted acquisitions. Since LKQ will spend much of 2008 integrating Keystone, it will likely halt acquisitions in the short-term.

CEO Joseph Holsten believes in a very active, hands-on management style. He spends nearly 75% of his time on the road visiting field offices and meeting with regional managers. Holsten likes to say, "You can't manage the business from a desk; you must be out in the field."

"We're a very disciplined company. We set budgets and use them as our game plan," CFO Spears said. Regional managers and regional controllers create a budget, and CEO Holsten performs spot business reviews to make sure financial targets are met.

BusinessWeek noted that the auto parts industry has faced "nearly every problem afflicting American business: union strife, heavy debt, overcapacity, exposure to raging steel and fuel prices, competition from Asia."

But the recycled (also known as alternative parts) and the aftermarkets (generic auto parts not made by major auto manufacturers like General Motors (GM), ) have thrived. Spears explains that insurance companies pay collision repair shops and frequently look for the least costly auto parts, especially in cars four years and older.

Unlike major auto parts makers, Delphi (DPH) and Visteon, (VC) which are dependent on new car sales, LKQ benefits when any car gets into an accident. Hence, if new car sales plunge, LKQ still prospers. Spears added, "We don't manufacture parts like they do; we only distribute parts. We can be more flexible."

LKQ sells to auto repair, collision shops and insurance companies. Insurers demand fast delivery to get their cars out of the shop and keep their auto rental fees (for replacement cars) low. To meet their needs, LKQ focuses on service quality. Analyst Kennison noted, "Trying to keep premiums down, insurance companies are looking to use more generic and recycled parts, just like doctors may recommend generic drugs."

When a car is totaled, most of the engine isn't reused. But sheet metal, bumpers, grills and doors are recycled. "If a car is hit in the back, we're dismantling the front and using the parts that aren't damaged," explained Spears.

LKQ derives its name from the expression "like kind quality," which insurance companies use to describe recycled parts. It plays on the idea of providing parts that are as good as the original in quality.

Gold In Totaled Cars

If a car is totaled in a wreck, the insurance company pays off the insured customer and sells the wrecked cars through auction companies. That's where LKQ comes in.

LKQ, the largest provider of recycled products in the U.S., acquires most of its damaged cars at auctions. "Our gross margin on buying wrecked cars is 45%," Spears said.

Of its 9,000 employees, about 2,400 drive local delivery trucks, 1,200 are in sales, and the rest are in warehouse, refurbishing, dismantling, procurement and administration. About 400 of its employees are union members, but most aren't.

"Aftermarket as a whole has enjoyed seven years of modest growth, mostly about 3% or 4% a year," said Kathleen Schmatz, president of the Automotive Aftermarket Industry Association, based in Bethesda, Md. Alternative parts constitute about 30% of the $16 billion collision replacement parts business in the U.S.

The economy's slowdown can affect the aftermarket industry in two ways. When gasoline prices hit $3.75 per gallon, AAIA research reveals that consumers will cut back on driving, wear out their cars less, delay proper maintenance and buy fewer parts. The good news is that in a recession aftermarket services thrive because people keep their older cars longer, don't buy new cars and buy used parts to save money.

Analyst Kennison says that LKQ is well-positioned because people still drive in a slowing economy. "The fundamental driver is vehicle miles driven, and that should be recession proof," he said.

Schmatz said, "Folks that are economically troubled will try for the lowest possible price." Hence in tough times, used and recycled parts prosper. And that bodes well for LKQ.

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