In this article, I’m going to share my process for analyzing steady-earning businesses like replacement auto parts distributor LKQ Corporation (LKQ) in order to determine its prospects as a long-term investment. The analysis focuses on returns from two main sources: earnings from the business, and sentiment changes regarding the stock. I’ve found these factors are good predictors of future returns and great guides for determining attractive buying and selling prices for stocks.
While business earnings and market sentiment change are the two main factors I use, there are many other minor factors that influence whether or not I actually end up buying a stock. I won’t cover all of those factors in this article, but if any of them jump out at me as noteworthy, then I’ll share my thoughts on those factors as well.
Historical Earnings Cyclicality
The first thing I review whenever I analyze a stock is its historical earnings patterns and how cyclical they are. Adjusted operating earnings are represented by the dark green shaded area in the FAST Graph above. Over the course of the past 20 years, LKQ hasn’t had a single year in which EPS declined. This is extraordinarily rare. In late 2019, I researched over 1,000 stocks in an effort to find businesses with an earnings history like this and I only found about 20 of them (and several of those 20 fell off the list in 2020 because of earnings declines this year). So, based on earnings growth stability, LKQ has been an elite business.
For stocks with modest earnings cyclicality, I perform what I call a “Full-Cycle Analysis,” which uses a full economic cycle’s worth of earnings and price data to estimate a 10-year business earnings CAGR, and a sentiment mean reversion CAGR. (If earnings had been more cyclical, I would have used a different type of analysis.) The goal is to estimate what sort of returns we might expect over the course of the next decade if we purchased the stock today. Let’s calculate those expectations by starting with an examination of market sentiment.
Sentiment Mean Reversion
For the first part of my full cycle analysis, I’m going to estimate what sort of return I would be likely to get if market sentiment for the stock reverted to the mean of the previous cycle. When making this calculation, where one chooses to start and end the cycle is an important consideration because that will affect both the average, full-cycle P/E ratio and the earnings growth rate estimate (though it’s not quite as important for secular growth stocks like LKQ because earnings have gone up every year, even in recessions). I chose to start this cycle in 2011 because 2010 was a 30%+ growth year and I thought that seemed a little too optimistic for current times and was unlikely to repeat. A 2011 start date was more conservative, so I began the cycle there and ran it until the end of 2020 using analysts’ estimates for the last quarter of 2020.
Before I get into the sentiment mean reversion, I want to note the very long multiple compression cycle that LKQ has experienced since 2013, when it’s P/E peaked around a monthly average of 32. I often write bearish articles about stocks that look like LKQ looked back in 2013, warning investors about the low long-term returns they are likely to get when they buy or hold stocks whose valuations are too high. LKQ is now trading at about the same price it peaked at seven years ago even though earnings have grown every single year during this time. I call this movement from a 32 P/E to a 14.5 P/E while the price is basically the same, a multiple compression cycle. Unlike back in 2013, now the P/E is less than half of what it was seven years ago, and the valuation today is much more attractive, which is why I’m writing about the stock today.
In this section, the main question I want to answer is if market sentiment were to revert to the mean from the previous cycle over the course of 10 years, what sort of CAGR it would produce if everything else was held equal. LKQ’s long-term average P/E ratio from the last cycle is 20.35, and using 2020’s estimated earnings of $2.43 per share, combined with today’s price, I get a forward P/E of 14.58. If over the course of 10 years, the 14.58 P/E were to revert to the average P/E of 20.35, it would produce a CAGR of +3.39%.
Current and Historical Earnings Patterns
We previously examined what would happen if market sentiment reverted to the mean. This is entirely determined by the mood of the market and is quite often disconnected, or only loosely connected to the performance of the actual business. In this section, I will examine the actual earnings of the business. The goal here is simple: We want to know how much money we would earn (expressed in the form of a CAGR %) over the course of 10 years if we bought the business at today’s prices and kept all of the earnings for ourselves.
There are two main components of this: the first is the earnings yield, and the second is the rate at which the earnings can be expected to grow. Let’s start with the earnings yield. The forward earnings yield is about +6.87%. The way I like to think about this is, if I bought the company’s whole business right now for $100, I would earn $6.87 per year on my investment if earnings remained the same for the next 10 years.
The next step is to estimate the company’s earnings growth during this time period. I do that by figuring out at what rate earnings grew during the last cycle and applying that rate to the next 10 years. This involves calculating the EPS growth rate since 2011, taking into account each year’s EPS growth or decline, and then backing out any share buybacks that occurred over that time period (because reducing shares will increase the EPS due to fewer shares).
Shares outstanding have actually risen during this time-frame so they won’t need to be backed out. Interestingly, shares outstanding have started declining the past couple of years. In my view, this is a pretty bullish capital allocation change, especially since LKQ’s shares have been pretty cheap the past couple of years.
I calculate a cyclically adjusted earnings growth rate of approximately +15.40% over the course of the last cycle. This is very solid earnings growth over this time period. Growth has been a little slower in the past two years, which might explain the low price, but analysts are expecting 12% EPS growth the next two years, so my historical estimate is not that far off from analysts’ expectations.
Next, I’ll apply that growth rate to current earnings, looking forward 10 years in order to get a final 10-year CAGR estimate. The way I think about this is, if I bought LKQ’s whole business for $100, it would pay me back $6.87 plus +15.40% growth the first year, and that amount would grow at +15.40% per year for 10 years after that. I want to know how much money I would have in total at the end of 10 years on my $100 investment, which I calculate to be about $264.15 (including the original $100). When I plug that growth into a CAGR calculator, that translates to a +10.20% 10-year CAGR estimate for the expected business earnings returns.
10-Year, Full-Cycle CAGR Estimate
Potential future returns can come from two main places: market sentiment returns or business earnings returns. If we assume that market sentiment reverts to the mean from the last cycle over the next 10 years for LKQ, it will produce a +3.39% CAGR. If the earnings yield and growth are similar to the last cycle, the company should produce somewhere around a +10.20% 10-year CAGR. If we put the two together, we get an expected 10-year full-cycle CAGR of +13.59% at today’s price.
My Buy/Sell/Hold range for this category of stocks is: above a 12% CAGR is a Buy, below a 4% expected CAGR is a Sell, and in between 4% and 12% is a Hold. Right now, LKQ is above a 12% expected CAGR so that makes it a “Buy” using my basic analysis.
It’s pretty rare to find a stock with metrics like these trading this cheap. This always makes me wonder what it is that I might be missing. So in this section, I’m going to share a few additional factors I often examine to reduce the chances an investment might be a value trap. The first factor is the 3-year revenue growth trend. This factor has probably saved me from the most value traps of any other factor.
I choose the 3-year time-frame because sometimes revenue fluctuates from year to year and typically 3 years is pretty reliable and doesn’t tend to give false positives. I also usually stop the time-frame at the peak before a recession because it’s normal to expect recessionary dips in revenue. In this case, I included the recessionary dip this year because it doesn’t really make a difference. Revenue is still up 20% over the past three years. So, this metric looks fine to me.
Sometimes companies try to boost revenue by making big acquisitions, so I typically avoid the stocks of businesses that have M&A that exceeds 20% of their market cap. If I find this sort of M&A while doing my research, I usually wait at least 4 years before I consider buying the stock. LKQ has had M&A. At the end of 2017, they bought Stalhgruber Gmbh for 1.5 billion euros. We saw a bump in shares outstanding, soon after so the probably issued some shares for this as well. This acquisition was right around that 20% threshold that I use as a cut-off to avoid, but it’s not far over it. LKQ also acquired Pittsburg Glass Works in 2016 for about 635 million dollars, which was smaller, but still significant. We see both purchases reflected in their changes in the debt-to-equity ratio:
We first saw a big bump in the debt-to-equity ratio in 2016, and then another bump in early 2018, but now debt-to-equity is back down to historical levels. I don’t really see anything to be overly concerned about here.
The next factor I’d like to check is what I call the “recession P/E ratio”, and how far the stock is currently away from that ratio. To estimate the recession P/E ratio, I typically use FAST Graphs to go back to the last recession and see what the monthly average low P/E was during that time. When I do that for LKQ I get a recession low P/E of 14.24 from the month of November 2008. So, using that P/E the stock is trading right around it’s recession P/E right now, with a P/E of 14.58. At first glance, there isn’t much to worry about here. However, LKQ made a much lower recession P/E during the current recession back in March, when the monthly average P/E that month was 8.60. This is much lower, and about -38.77% below where the stock trades today. In the case of a double-dip in the market, or bad news for the stock, investors should probably expect about a -40% drawdown in the stock price. That’s slightly higher than I would like to see. Most recently, I’ve been using a potential -30% drawdown to recession P/E as my maximum, so, I’m stretching a little bit buying the stock here.
And the last factor I’ll share is what I call the “Shareholder Capital Allocation” factor. Basically, this examines the shareholder yield and compares it to the earnings yield. I usually ignore this factor for businesses whose earnings are growing quickly as LKQ’s have but I think it can add some color in this situation so I want to highlight it. Currently LKQ pays no dividend, and historically, the have made steady share issuances, slowly diluting current shareholders.
From 2004 through the later part of 2018, they diluted current shareholders by half. Most of that occurred before 2008 however, almost certainly because of acquisitions. If I thought this was to going to continue, I would probably avoid the stock.
Since the end of 2018, however, this share dilution stopped, and has now started to turn the other direction, and shares are now being bought back (though not at a particularly fast rate). Since the stock price has suffered during this time and traded at a reasonable value, this change in capital allocation seems prudent to me.
The big picture here is that we have an acquisitive company who is now slowing down acquisitions, paying down debt, and beginning to repurchase stock. The reason I didn’t buy this stock during the March downturn was because of their recent M&A. SA contributor Stanislas Capital wrote a great bearish article titled “LKQ Needs to be Repaired” back in February that I think does an excellent job summing up the dangers of the stock. Perhaps most important is the idea that LKQ because of the high amount of goodwill on their balance sheet may eventually take an impairment charge on some of their acquisitions. This is basically the same concern that kept me out of the stock back in March and it remains a moderate risk.
If I was a reader reading this article, the question I would have is why LKQ is a “buy” now when it wasn’t back in March when the price was much lower? And the main reason I avoided LKQ back then was that I typically avoid stocks that have done big M&A within the past four years. LKQ’s M&A was borderline, bumping up against that 20% market-cap threshold I use as a quick guide when I looked at it. I also noticed the long-term historical uptrend in shares outstanding when I examined the stock last spring and decided to avoid the stock during the March downturn for those reasons, especially if we were going into a big recession, which I expected us to do at the time.
We now have a reversal of the macro backdrop, what are likely to be multiple successful vaccines, governments that have offered more support for their economies than at any time in history, and central banks that have kept interest rates at historic lows. People are itching to travel next year after nearly two years of restricted travel, and many people have cash saved to do so. The medium-term backdrop looks pretty good for LKQ compared to all of the unknowns back in March. Historically, the valuation is cheap for the stock, and if even they experience some headwinds, I think the stock is at least fairly priced, especially relative to the market.
At the portfolio level, I still have about 30% cash, and I’d like to reduce that level given we are likely to have a vaccine for the virus distributed next year. I do think a risk remains that under certain circumstances, like an impairment charge, political or economic surprises, or general economic stagnation, that the stock price could revisit the March 2020 lows. So my strategy here is to take a 1% portfolio weighted position now, and then, if the stock should revisit the March lows, to take another 1% position at that time. (Investors holding less cash than I am might want to wait for a pull-back in the stock, try to get it closer to $28 per share, and build in a little more margin of safety.)
Overall, I think the medium and long-term prospects for the stock are very good, even if they come with certain risks, and I’m a buyer here around $35 per share.
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Disclosure: I am/we are long LKQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.