The razor and the blade
One of the most profitable models for a company is the “razor-and-blade” model. A company sells an expensive item that is seldom replaced — like a razor — and then makes most of its money off that purchase by selling a cheaper component part that costs far less but is replaced much more frequently — like replacement blades. This model doesn’t just work for razors but for items like bicycles (tires and chains), electric toothbrushes, and even mobile devices (every trip to iTunes is a trip to the bank for Apple).
But it also works for big-ticket items…really big-ticket items, like cars and airplanes. Once a Southwest Airlines Co. (NYSE:LUV) or an American Airlines has bought a plane, they’re going to replace seat cushions, headlights, even whole engines before they replace the plane itself. Likewise, when you buy Ford Motor Company (NYSE:F)‘s new 2015 Mustang, you’ll replace that head gasket, the sparkplugs, and the air filter before you’ll trade in the car (well, unless you trade it for the 2.3L 4-cylinder version).
I think Southwest Airlines Co. (NYSE:LUV) and Ford Motor Company (NYSE:F) are best-in-class companies, and I own shares of both. Southwest Airlines Co. (NYSE:LUV) benefits from the lack of pension obligations saddling competitors like American and Delta. Meanwhile, Ford Motor Company (NYSE:F)–alone among the Big Three for not going into bankruptcy during the Great Recession–has just announced that their Focus was the world’s best-selling passenger car in 2012. However, no matter how much either company innovates, sells, or cuts costs, parts in their big machines are going to need to be replaced, which would be great for either company if they controlled the market in said parts. In most cases, though, they don’t.
Mommy, where do gaskets come from?
Gaskets, along with other parts both internal (engine components) and external (car bumpers and airplane wing flaps) are originally designed, developed, and produced by the vehicle’s manufacturer (so, Ford Motor Company (NYSE:F) for Mustangs or Boeing for 787 Dreamliners). These are referred to as “Original Equipment Manufacturers” or “OEMs.” OEMs may give birth to the parts, but once it comes time to replace them, they’re neither the most economical nor, in many cases, the best option.
Let’s say you’re the proud owner of that Ford Mustang I mentioned earlier, and you have an unfortunate rendezvous with a giant Nike soccer ball. Now you need a new hood, water pump, and various other components. A visit to the OEM (read: dealership) is the most expensive option. Luckily for you (and for your insurance company–more on that later), there exist non-OEM manufacturers who create many of these items at a fraction of the price. Also, there are hundreds of people like you who’ve been in accidents that demolished their cars’ rear ends, leaving the front end parts salvageable and in good enough condition to put into your vehicle.
But with dozens of non-OEM partsmakers, and thousands — if not tens of thousands — of salvage yards and recyclers, what’s an investor to do? Well, invest in the biggest and best of the lot, of course, by which I mean LKQ Corporation (NASDAQ:LKQ), which stands for “Like Kind and Quality.” LKQ has been gobbling up smaller companies for years and is now the biggest kid on the block (the engine block, that is) with more than 3 billion dollars in annual sales, compared to mere millions for the majority of its competitors. Looking at it another way, LKQ’s biggest competitor operates three distribution centers. LKQ operates 24.
The best part is, stingy — ahem — frugal insurance companies would rather you bought a cheap LKQ Corporation (NASDAQ:LKQ) part than an expensive OEM part, and they’ve taken notice of LKQ. Several (although nobody’s saying exactly which ones) have designated LKQ Corporation (NASDAQ:LKQ) as their “preferred supplier.”
But airplanes don’t have fenders…or fender benders!
Okay, great for that Mustang, but what about when the lithium-ion battery on my 787 catches fire? I’m not going to be able to hit up the airplane salvage yard! True, but the concept (OEM-versus-third party) still holds in the airline industry (as well as the bicycle industry, the motorcycle industry, and the virtually-every-other-vehicle-you-can-think-of industry). You’re right, though: LKQ doesn’t stock tailfins (well, except for maybe these).
Two LKQs of the airline world are HEICO Corporation (NYSE:HEI) and TransDigm Group Incorporated (NYSE:TDG). TransDigm Group Incorporated (NYSE:TDG) is a bit of a hybrid: they’re the OEM for many airplane components, but they also sell refurbished versions as aftermarket products. HEICO Corporation (NYSE:HEI) sells only aftermarket components.
The ace in the hole for both companies is that all non-OEM airline parts have to be certified by the FAA as being “as good or better than” their OEM equivalent. This means there are very few companies working in this industry. In fact, 75% of TransDigm Group Incorporated (NYSE:TDG)’s sales come from parts for which it is the only supplier! This monopoly equals stability. HEICO Corporation (NYSE:HEI) also has an excellent track record of having its after-market parts approved by the FAA, so its cheaper parts are an equally safe alternative for cash-strapped airlines.
But is it worth it?
Still not convinced? Check out the chart below. I’ve charted the past five year’s stock prices of Ford Motor Company (NYSE:F), Boeing, and Southwest Airlines Co. (NYSE:LUV) alongside the three parts companies (LKQ, TransDigm, and Heico) that I’ve outlined today.
Five-year price growth
The partsmakers — especially TransDigm — are showing remarkable growth compared to their fellows (not surprising, as they’re much smaller). However, even after this growth, Trailing Twelve Month P/E ratios for all three are only in the mid-20s, which I think is reasonable for small companies with excellent “razor-and-blade” revenue models and growth prospects. Cautious investors take note however: all three companies have very high debt ratios, the result of growth through acquisition. In the current climate of low interest rates and taking into account the companies’ many positives, this doesn’t bother me. However, if interest rates rise, debt could be a cause for concern. For now, though, I see a long road/runway ahead for all three.
The article 3 Spare Parts Plays to Rev Up Your Portfolio originally appeared on Fool.com and is written by John Bromels.
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