An Expensive Stock Selling Cheaper Alternative Products

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An increasing number of customers are seeking cheaper alternatives to original OEM products to lower repair costs. LKQ (NASDAQ: LKQ), a distributor of alternative repair products to professional repair shops, is a beneficiary of such a trend. However, current valuations for LKQ are expensive at 19.3 times forward P/E and 1.2 times PEG. Is the stock a buy at these levels? Let's check out.

Insurance carriers have increasing say

In the collision repair industry, insurance carriers play an important role in influencing the type of collision products that collision repair shops choose to buy. Many of these repair shops are part of an insurance carrier’s Direct Repair Program (DRP), where insurance carriers refer work to them and have the final say in approving the type of replacement products eligible for reimbursement.

LKQ has provided insurance carriers with various free services, such as quotation services, total loss vehicles disposal, and other claims-related services, in a bid to promote its alternative vehicle collision replacement products. The results of such initiatives have been encouraging. LKQ saw an increase in DRP-based revenue from under 40% of its total revenue in 2008 to slightly more than half of its total fiscal 2012 revenue, according to its most recent investor presentation.

Location still matters

The importance of a distribution network can be illustrated with an example from the banking industry. Banks which operates lesser branches and automated teller machines than other banks usually offer customers higher deposit rates to compensate them for the inconvenience associated with a narrower distribution reach. LKQ has more than 300 facilities located across the U.S. and Canada, enabling it to serve its nationwide repair shop customers effectively and efficiently.

In addition to the huge capital outlay required in building plants and warehouses to replicate a similar distribution network, new entrants and competitors will also have to invest significant time and effort to get zoning approvals and relevant permits for such facilities.

Same quality at lower prices

I recently bought a non-OEM replacement battery for my smartphone at less than half the price of the original OEM battery, which also came with a longer one year warranty. Repair shops have had the same experience as well, discovering that recycled OEM and aftermarket products offered by LKQ are 20%-50% cheaper than its new OEM counterparts and provide similar quality.

The numbers speak for themselves. Alternative products went from owning one-fifth of the mechanical replacement products market to taking up 80% market share in three decades, according to management estimates and data from the Automotive Aftermarket Industry Association.

Peer comparison

LKQ’s peers include automotive aftermarket retailers Advance Auto Parts (NYSE: AAP) and The Pep Boys - Manny, Moe & Jack (NYSE: PBY). Both are shifting away from the lower growth Do-It-Yourself market.

Advance Auto Parts has focused more on the commercial customer, vis-à-vis the Do-It-Yourself customer in recent years, and grew revenue from its commercial segment to 38% of its total fiscal 2012 revenue. It recently completed the acquisition of BWP Distributors, which has a strong commercial focus (85% of revenue) in December 2012, in line with a shift to the Commercial segment. Another growth driver for Advance Auto Parts is geographical expansion. It has strong geographical focus with 90% of its stores located east of the Mississippi, which means that there is a huge opportunity to expand in the opposite direction.

Pep Boys derived slightly more than half of its fiscal 2012 revenue from the Service segment while the Do-It-Yourself segment accounted for less than 40% of revenue. This sales mix with a higher proportion of sales from the Service segment puts The Pep Boys in a good position to benefit from the trend of consumers shifting away from Do-It-Yourself as a result of the increasing complexity of cars. Furthermore, the Service market is perceived as more protected with barriers to entry in the form of high capital outlay and technical expertise.

LKQ is valued at a premium to its peers with a forward P/E of 19.2. In comparison, Advance Auto Parts and The Pep Boys are valued by the market at 14 and 16.6 times forward P/E. Using the PEG ratio shows a slightly different picture, with LKQ valued at a discount to its peers with a PEG of 1.2. Comparatively, Advance Auto Parts and The Pep Boys trade at a similar 1.4 times PEG.

Conclusion

LKQ is a quality company which leverages on its wide distribution network and relationships with insurance carriers to sell its products. Despite being cheap relative to its peers, LKQ is still overvalued on an absolute basis with a PEG of 1.2. I will advise investors to consider buying this stock at a lower entry price.

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Mark Lin has no position in any stocks mentioned. The Motley Fool recommends LKQ. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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