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LKQ Corporation (LKQ)’s Potential, and Advance Auto Parts, Inc. (AAP)

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An increasing number of customers are seeking cheaper alternatives to original OEM products to lower repair costs. LKQ Corporation (NASDAQ:LKQ) , a distributor of alternative repair products to professional repair shops, is a beneficiary of such a trend. However, current valuations for LKQ Corporation (NASDAQ: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 Corporation (NASDAQ: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 Corporation (NASDAQ: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 Corporation (NASDAQ: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 Corporation (NASDAQ: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 Corporation (NASDAQ:LKQ)’s peers include automotive aftermarket retailers Advance Auto Parts, Inc. (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, Inc. (NYSE:AAP) 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, Inc. (NYSE:AAP) 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.

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