Is This a Buying Opportunity in the Steel Sector?

The steel industry gets metal from two places: mined iron ore and scrap. LKQ Corp  (NASDAQ: LKQ  ) has built a used auto parts business around a scrap business -- and it's been growing fast. After hitting a speed bump in the first quarter, however, investors may have an opportunity to step aboard at a discounted price.

A simple business
Essentially, LKQ runs scrap yards. Old cars and other junk are dropped off and customers rummage through looking for what they need. It's not a complex business, but, according to LKQ and competitor Schnitzer Steel Industries (NASDAQ: SCHN  ) , it is a fragmented one. This provides benefits for larger players.

For example, LKQ has a national footprint. It built that by consummating over 170 acquisitions since its IPO in 1998. It now has over 325 domestic locations, plus a European business with another 171. Schnitzer Steel, which is more focused on scrap metal than auto parts, is still building its presence, but has notable scale on both coasts of the country. It has around 60 used auto parts yards.

(Source: Snowmanradio, via Wikimedia Commons)

The growth of LKQ shows why Schnitzer is getting involved in the parts business. Not only does selling parts increase the money made off of cars that would otherwise be turned into a bulk commodity, but LKQ's top line has grown every year for the past decade, including right through the deep 2007 to 2009 recession.

That growth has been impressive, too. In 2003 LKQ's top line was $425 million; in 2013 revenue was nearly $5.1 billion. Earnings have grown steadily, as well, from $0.12 a share in 2003 to just over a dollar last year.

What's the fuss?
With that kind of a history, it's not surprising that LKQ's shares are up massively from their IPO price. However, they have been weak of late. The reason is two-fold. First, early in the year, a short-seller published a negative report on LKQ questioning its growth prospects and accounting. Second, Chrysler hit the company with a patent infringement lawsuit.

LKQ Chart

LKQ data by YCharts

On the Chrysler front, the company notes the parts in question "represent less than one-tenth of one percent (0.001) of our estimated 2013 total revenue and less than one-half of one-tenth of one percent (0.0005) of our estimated total revenue for all the years since the first patent was granted (2009 through 2013)." Right or wrong, that's not a big issue.

With regard to the short-seller, LKQ came out swinging, with CEO Robert Wagman stating: "Management of LKQ stands firmly behind our Company. I am proud of the honesty and integrity with which we have operated our business and take exception to any claims to the contrary." Of course Wagman pretty much had to say something like that. And if the short-seller is right, LKQ's stock could fall much further.

Opportunity or risk...
In the end, there's no free lunch on Wall Street and you have to take some risks to make money. For risk-averse investors who like the idea of used auto parts, Schnitzer Steel is probably a better way to play the space. The company's core business of metal recycling made up nearly 85% of the top line last year, while auto parts was just about 10%. However, the auto business expanded its store count by 20% last year and is still growing. More important, it allows Schnitzer to get more value from a key scrap input—salvaged cars.

However, if you're a little more aggressive, LKQ's sell-off could be a great time to get into a fast growing scrap yard owner at a discounted price. Top and bottom line results so far suggest there's no reason for concern. And if you need proof of the value LKQ offers customers, look no further than your car door—buying used costs over 40% less. That's a value proposition that's just as hard to ignore as LKQ's over 10% price drop this year.

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