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September 2007

LKQ targets auto recycling facilities in Canada for expansion

Auto recyclers can expect to see the industry consolidate and expand in the United States.

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LKQ Corp., already the largest nationwide provider of recycled vehicle products, is acquiring more competitors and is now targeting Canada for further expansion.

Chicago-based LKQ, with more than 130 facilities in the United States, purchased recycled-parts business Pintendre Autos Inc., near Quebec City, Canada in early July.

"This is our second business acquisition in Canada and it gives us a large parts recycling business in a large population area," said Joe Holsten, president and chief executive officer of LKQ, in a statement announcing the Canadian acquisition.

In June, LKQ announced it acquired a recycled parts business located near Toronto, the company's first entry into Canada. Dominion Auto Recycling, with annual revenue of $9 million, serves the professional repair market in the Toronto market.

Financial terms for both Canadian acquisitions were not released.

"We believe there is an opportunity to continue to acquire Canadian companies in key geographies," said Eric Prouty, an analyst with Canaccord Adams Inc. in Boston.

Prouty said there remains plenty of opportunities for expansion across North America. He said LKQ is looking for geographic as well as product diversification.

"As in many consolidating industries, sellers’ valuation expectations are increasing. We also believe that the industry has become much more mainstream given you have some big national players now – not just mom and pop anymore," he said.

Anthony Cristello, an analyst with BB&T Capital Markets in Richmond, Virginia, also said he sees more room for consolidation across the auto recycling market.

"We think the recent transactions in Canada will afford the company another sizable opportunity for growth in its core recycled parts business," Cristello said.

"While the Canadian market is not as large as the United States market, we still think it presents a very attractive opportunity." He estimated that the Canadian market totals roughly $1 billion, compared to a market of $8 to $10 billion in the United States.

Cristello said that the largest competitors in Canada have annual revenues in the range of $30 to $40 million. He said the Canadian market remains fragmented with roughly 1,100 auto recyclers compared to 6,000 recyclers in the United States.

"The Canadian marketplace presents LKQ with another advantageous venue for consolidation, much like the United States market, where many smaller independents face pressure from a larger competitor that is willing and able to implement product management systems and generate higher fill rates for recycled parts," Cristello said.

The Canadian auto recycling market is a bit different than in the United States, however, Cristello said. In certain Canadian provinces the government owns the insurance companies and dictates how vehicles are repaired. "Interestingly, the utilization rates of recycled parts in Canada appear to be higher, a 20 percent rate versus roughly 13 percent in the United States, which bodes well for LKQ's business," Cristello said.

Cristello said that over time, LKQ could build its share to at least 10 to 20 percent of the Canadian market, totaling potential new revenue of $100 to $200 million.

Cristello said that he does not expect expansion outside of North America.

"With the entrance into Canada, we think the company may continue to focus on gaining scale and synergies in that geographic before leaving North America," Cristello said. But he said that there could be some opportunity for expansion into Mexico.

Soon after the acquisitions in Canada, LKQ announced plans to acquire Pomona, California-based Keystone Automotive Industries Inc. for $811 million in cash. Keystone is a provider of after-market collision replacement parts with 137 facilities in 39 states.

Keystone reported sales of $714 million in the year ended March 31, 2007 and net income of $30 million. "LKQ and Keystone are a great strategic fit and this acquisition is a natural progression of our strategy to expand our presence," Holsten said in a statement.

The LKQ CEO said he expects the acquisition to add to earnings in 2008.

LKQ received a $1 billion secured financing commitment for the acquisition from Deutsche Bank and Lehman Brothers Inc. LKQ expects to complete the acquisition in the fourth quarter of 2007. Robert W. Baird & Co. is the financial advisor for LKQ.

"We remain bullish on LKQ based on the news of the Keystone acquisition. We like the deal, as it combines the largest providers of recycled, generic, and remanufactured parts," said Craig Kennison, an analyst with Robert W. Baird in Milwaukee, Wisconsin, in a research report following the announcement.

Kennison estimated that once the acquisition is complete LKQ and Keystone would have approximately 30 percent market share of the alternative parts market.

"LKQ has created a national footprint, which gives local facilities access to more inventory than local competitors. Despite its current scale advantage, a significant opportunity exists to further expand this network," Kennison wrote in the report.

There is still plenty of room for expansion within the United States, said Cristello, the analyst with BB&T. "If the industry data is correct and there are more than 6,000 recyclers in the United States, then there remains ample growth opportunity," he said.

"We think from a geographic standpoint, LKQ would like to expand and create more density in Southern Florida and across the Mid Atlantic and the West Coast. Those regions clearly represent target markets for the company," Cristello said.

LKQ reported that revenues increased 19.6 percent to $233.3 million during its second quarter ended June 30, 2007, compared to 2006. Net income during the quarter increased 20 percent, totaling $14 million or 25 cents a share, compared with $11.7 million or 21 cents per share for the same quarter in 2006.

To increase revenues and profits, Cristello said LKQ should look for companies that "offer synergies, expand geography and build density within existing markets."

However, Cristello said the acquisition of Keystone by LKQ may slow the pace of LKQ's acquisitions as the company focuses energy on integrating the company.

Despite a possible temporary slowdown in acquisitions, Cristello said the acquisitions place competitive pressure on smaller independents across North America.

"LKQ has made significant investments in technology and it has created an advantage with respect to vehicle procurement and inventory management," he said. Lower product costs and economies of scale also benefit LKQ, Cristello said.