Cost Pressures Punish LKQ

Here's why investors aren't happy with the auto parts company right now.

Dan Caplinger
Dan Caplinger
Apr 26, 2018 at 10:51AM

LKQ (NASDAQ:LKQ) has found itself an extremely profitable niche in the auto parts and accessories business. By concentrating largely on the specialty and alternative market, LKQ aims to capture higher-margin business that many other parts manufacturers choose not to pursue. That's generally been a winning formula for the company over the long run.

Coming into Thursday's first-quarter financial report, LKQ investors wanted to see continued evidence that its core business would continue to be successful. Yet as other companies in the industrial sector have shown recently, rising costs proved to be an obstacle for LKQ, and the company will have to figure out how to address those potential problems before they have an even bigger impact on its long-term performance.

Assortment of auto parts and accessories, including wheels, radiators, lights, and cleaning products.

Image source: LKQ.

LKQ sees mixed performance

LKQ's first-quarter results reflected the opportunities and challenges that the auto parts specialist has dealt with lately. Revenue soared 16% to $2.72 billion, outpacing the 11% growth rate that most investors were expecting to see and accelerating from previous quarters. However, adjusted income from continuing operations grew at a slower 11% pace to $170.1 million, and the resulting adjusted earnings of $0.55 per share fell short of the consensus forecast among those following the stock for $0.59 per share.

LKQ relied on multiple sources for its revenue growth. Organic revenue growth in parts and services amounted to less than 4%, while acquisitions added almost 7 percentage points to the overall total. Favorable exchange rates provided the balance of 5 percentage points of growth, with the weak dollar having an especially large impact in Europe.

North America was LKQ's strongest region in terms of organic growth, even though its overall 9% growth rate was the weakest among the geographies that the company serves. In Europe, organic sales were higher by just 1.2%, but acquisitions and currency impacts added 25 percentage points more of growth. North American adjusted pre-tax operating income also outperformed Europe's figure, although both sustained extensive margin deterioration.

In the specialty segment, a 12% rise in revenue came almost entirely from the acquisition of Warn Industries. Without the acquisition, organic growth was just 0.3%, but the specialty business saw segment profit climb 18%. Favorable pricing in the scrap market also had a dramatic lift for LKQ's non-parts business.

LKQ had very little acquisition activity during the period, with just a single aftermarket radiator distributor in Tennessee. Five new branches in Europe also contributed to growth.

What's ahead for LKQ?

CEO Dominick Zarcone explained the mixed performance. "Although we faced a few revenue headwinds in Europe and [in] our specialty business, and experienced certain near-term cost pressures in the quarter," Zarcone said, "we are actively addressing the issues." The CEO remains confident that LKQ can get back to sales growth and profit levels consistent with the company's past history.

Yet LKQ did cut its guidance for the coming year based on its early performance. The company now expects organic growth of 4% to 5.5% in 2018, with the top end of the range falling by half a percentage point. Adjusted net income of $685 million to $715 million is $35 million lower than previously forecast, working out to between $2.20 and $2.30 per share. That's $0.10 less than the company's guidance three months ago, and weaker cash flow will also hamper LKQ's ability to make capital expenditures at the rate it had initially intended.

LKQ shareholders weren't happy with the performance, and the stock fell more than 16% shortly after the market opened following the announcement. LKQ needs to figure out what it needs to do to address higher raw material costs if it wants to ensure that its bottom line will grow as strongly as its sales gains would suggest is possible.