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I am often critical of investors for reacting to things like ebbs and flows in earnings (due to weather or accident rates or something) and hardly enough when BIG structural issues potentially change the risk profile of an investment (or investments). Yesterday, Keystone Automotive Industries (KEYS) stock dropped 21% and LKQ Corporation’s (LKQX) stock price dropped over 5%.

The impetus for the decline was an announcement by Keystone that seven of ten design patents directed to parts for the Ford (F) F-150 truck were enforceable and infringed Ford's design patents. Keystone is appealing and you can read all the details in the release. Now comments from investors and even conversations with LKQ management prior to the ruling would suggest that today’s reaction in the stock prices is an overreaction. This is a very rare occasion that I actually applaud investors for reacting to a potential shift in the long-term earnings growth potential for these companies.

Don’t get me wrong. Both LKQ and Keystone are ranked in my Elite 5, and so like you, I directly feel today’s pain. It sucks. But my job (the mission of efficient insights) is to help you better understand the investment, not paint a rosey or negative picture (however it suits me). You take the good with the bad, but you never lose sight of the mission (bringing understanding more efficiently).

And so today’s reaction by investors (where there were more sellers than buyers) needs to be respected. Because something has changed with respect to the growth prospects of these two (above mentioned) companies. To simplify the issue, the “story,” so to speak for both LKQ and Keystone has been (and continues to be) the ability for these companies to offer insurance companies (who up until 10 year ago did not really exist as the primary “decision maker” in the procurement of collision and repair parts), with a national footprint and ability to provide alternative (generic and salvage) parts. Alternative and generic parts can be anywhere from 20% to 50% cheaper than “new” original equipment parts. And so these relatively new distributors in the automotive aftermarket, I have argued look to fundamentally change the repair cost the insurance company (and ultimately the customer via insurance premiums) pays to get their vehicle fixed when they get into an accident.

With roughly 70%+ of collision work being done with “new” parts (like a Ford bumper coming from the manufacturers factory or supplier usually called “new OEM” parts) I have argued that these “alternative parts” distributors faced considerable growth and the consumer faced a real benefit as alternative parts gained share from “new OEM” parts. Sadly, Ford Motor Company does not see it this way, is trying to get more involved themselves in providing the parts for collision repairs, and now is fighting (as demonstrated with the ITC ruling) generic parts manufacturers and distributors with the ability to use those parts on the repair of their (Ford branded) vehicles.

Investors will say that patented parts do not represent the majority of parts being sold by generic parts manufacturers and distributors. And that each one would need to be challenged. True, and I should point out that the parts in question represent a tiny fraction (like 1%) of Keystone’s overall parts sales. Today’s announcement is not about what happens to Keystone or LKQ’s earnings this week, this year, or even the next two to three years.

BUT, today’s ruling does potentially change the competitive landscape and growth thesis I laid out above for the next 5, 10 and 20 years. And investors are paying a growth multiple, because I think they similarly see the same potential I do for alternative parts to gain share from new OEM parts. If other manufacturers (like Toyota and General Motors) begin to follow Ford’s lead in patenting and then disputing each generic part, you bet your bottom this creates a competitive threat to these companies ability to grow the share of generic parts (being used in collision repairs) versus new OEM parts.

I don’t like to react to intra quarter fluctuations, particularly given such radical price movements. And so I will wait and see where the price of these stocks settle at the end of the quarter, and as I usually do, make any adjustments at the beginning of the next quarter I deem necessary. The opportunities and potential for LKQ and Keystone are still bright (every industry faces its hurdles and challenges), But make no mistake, I do not fall into the camp of investors that would like to dismiss today’s announcement as a “non event” and the movement in the stock prices as merely over reactions. Something has changed in the risk profile of the investment. I think investors need to understand and appreciate that, and I need to be very clear that right now (because of the ruling) the bias to my 2012 earnings estimates for Keystone and LKQ are at risk and may move lower when I establish the new rankings at the beginning of the new quarter.

Having said that, I will continue to encourage the folks at Ford to re-think this confrontation toward generic auto body parts distributors. Sure, it may help your dealers make a few more bucks in the body shop (or distribution of said parts to body shops in the area). But ultimately it hurts the cost competitiveness of the Ford vehicle. And any other manufacturer on this list that is considering following Ford’s lead, I would ask you to think again. Burdening consumers with higher repair costs ultimately hurts residual values, which I think is one of the most important factors in creating long term customers of a brand. Honda has proven that record high residual values do make a difference in the sale of new vehicles and performance of the auto retail establishment. I hope that auto retailers and manufacturers keep this in mind as the LKQ, Keystone, and Ford confrontation continues.

Source: ITC Rules in Ford's Favor: Risk Profile for Keystone and LKQ Negatively Affected