Largest-Ever Acquisition Revs Up LKQ's Growth Engine

It was yet another dismal quarterly earnings report from LKQ (LKQ 1.40%). Or at least that's what the market made it look like when it sent LKQ shares lower after the company released its second-quarter earnings on July 26. The stock, though, wasn't hit as hard as after LKQ's first quarter, which could hint that while the company's second-quarter performance wasn't all that great, the market may have some found some bright spots in the report nonetheless.

LKQ results: The raw numbers

The following table provides a snapshot of the key numbers from LKQ's second quarter. Despite solid growth in revenue, a smaller portion of those incremental sales flowed to the company's bottom line. It's not that demand for LKQ's products -- automotive aftermarket and alternative (recycled, refurbished) parts and components -- has slowed down. Costs are to blame for decelerating profits. However, it's a bit different from the first quarter.

Data source: LKQ financials. 

Note that adjusted net income excludes costs such as expenses, gains, and losses related to acquisitions and restructuring, amortization, and tax-related items.

What happened with LKQ this quarter?

By cost pressures, I don't mean only freight and fuel here, as was largely the case in Q1. While these continue to be notable headwinds for the industry, a substantial chunk of LKQ's Q2 costs were related to its Stahlgruber acquisition.

Image source: Getty Images.

LKQ acquired the European aftermarket spare-parts distributor in May for roughly $1.8 billion through mainly debt funding. Acquisition-related expenses and a higher interest outgo were, therefore, greatly responsible for LKQ's low profits in Q2.

On the positive side, the acquisition contributed 12.7 percentage points to LKQ's top-line growth. That also means that the company's organic revenue grew around 7%. That's great as well, but it was an exceptional quarter and growth is likely to decelerate. In fact, LKQ's guidance for the full year confirms this.

What management had to say

CEO Dominick Zarcone was pleased with LKQ's strong organic growth across its North America, Europe, and specialty segments. "This growth reflected a reversal of some of the transitory items noted in our commentary in the first quarter of 2018, as well as better-than-expected performance in each business," he said.

LKQ has largely been an acquisitive company so far, and that's unlikely to change. During its earnings call (here's the full transcript of LKQ's Q2 earnings conference call), Zarcone revealed how he plans to grow the business "through acquisition over the next three to five years." Zarcone further noted that while investors shouldn't expect anything on the scale of the Stahlgruber acquisition in the near term, he wouldn't hesitate to look at something even larger once LKQ's debt comes down. Now that's one area investors would want to watch closely. 

Looking forward

LKQ updated its fiscal 2018 guidance, and here's how it compares with its previous guidance and actual 2017 numbers.

Data source: LKQ financials. 

LKQ's organic growth projection isn't really encouraging, and while acquisitions will drive its sales and profits higher, investors want to see the company unlock greater value from existing businesses. For now, though, LKQ's revised net profit outlook still calls for at least 10% improvement over 2017. 

Despite higher capital spending, largely because of the Stahlgruber acquisition and expansion in North America, LKQ hopes to generate healthy cash from operations, which should drive its free cash flow higher by nearly 20% at the midpoint. 

There's one looming threat, though: a brewing trade war in the United States. Deeper tariffs could force LKQ to jack up product prices to cover costs, but management clarified during the earnings call that LKQ will not earn a profit on "any increases related to cover the tariffs." This risk, along with its muted organic growth estimates, is keeping LKQ's share price in check.