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Edited Transcript of LKQ earnings conference call or presentation 25-Jul-19 12:00pm GMT

Q2 2019 LKQ Corp Earnings Call

CHICAGO Jul 27, 2019 (Thomson StreetEvents) -- Edited Transcript of LKQ Corp earnings conference call or presentation Thursday, July 25, 2019 at 12:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Dominick P. Zarcone

LKQ Corporation - President, CEO & Director

* Joseph P. Boutross

LKQ Corporation - VP of IR

* Varun Laroyia

LKQ Corporation - Executive VP & CFO

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Conference Call Participants

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* Bret David Jordan

Jefferies LLC, Research Division - Equity Analyst

* Christopher James Bottiglieri

Wolfe Research, LLC - Research Analyst

* Craig R. Kennison

Robert W. Baird & Co. Incorporated, Research Division - Director of Research Operations and Senior Research Analyst

* Daniel Robert Imbro

Stephens Inc., Research Division - Research Analyst

* Michael Edward Hoffman

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Group Head of Diversified Industrials Research

* Ryan James Merkel

William Blair & Company L.L.C., Research Division - Research Analyst

* Stephanie Benjamin

SunTrust Robinson Humphrey, Inc., Research Division - Associate

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Presentation

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Operator [1]

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Good morning. My name is Jack, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the LKQ Corporation's Second Quarter 2019 Earnings Conference Call. (Operator Instructions)

I'd now like to turn the call over to Joe Boutross, Vice President of Investor Relations. You may begin your conference.

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Joseph P. Boutross, LKQ Corporation - VP of IR [2]

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Thank you, operator. Good morning, everyone, and welcome to LKQ's Second Quarter 2019 Earnings Conference Call. With us today are Nick Zarcone, LKQ's President and Chief Executive Officer; and Varun Laroyia, Executive Vice President and Chief Financial Officer. Please refer to the LKQ website at lkqcorp.com for our earnings release issued this morning as well as the accompanying slide presentation for this call.

Now let me quickly cover the safe harbor. Some of the statements that we make today may be considered forward-looking. These include statements regarding our expectations, beliefs, hopes, intentions or strategies. Actual events or results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors. We assume no obligation to update any forward-looking statements. For more information, please refer to the risk factors discussed in our Form 10-K and subsequent reports filed with the SEC.

During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release and slide presentation. Hopefully, everyone has had a chance to look at our 8-K, which we filed with the SEC earlier today. And as normal, we are planning to file our 10-Q in the next few days.

And with that, I am happy to turn the call over to our CEO, Nick Zarcone.

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Dominick P. Zarcone, LKQ Corporation - President, CEO & Director [3]

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Thank you, Joe, and good morning to everybody on the call. We certainly appreciate your time and attention at this early hour. This morning, I will provide some high-level comments related to our performance in the second quarter, and then Varun will dive into the segments and related financial details before I come back with a few closing remarks.

When taken as a whole, the second quarter of 2019 played out largely as we anticipated when we announced our first quarter results 90 days ago. There were both some clear positive movements and some disappointments, but we are encouraged by the overall result. On the plus side, our North American segment experienced a significant uptick in both gross margin and EBITDA margin, which gives us confidence that our disciplined approach to the market and keen focus on controlling our costs are creating positive outcomes. Also, our global focus on trade working capital management led to significant cash generation, which was well ahead of our 2019 expectations. While there were some positive items related to timing, and we will give a bit back as we move through the remainder of the year, we are ahead of our initial plan from a free cash flow perspective for the first 6 months and we believe we will remain so for the balance of the year.

On the flip side, we knew we had very difficult year-over-year revenue growth comparisons with respect to both our North American and European segments, but the organic revenue growth came in below our tempered expectations. Additionally, there was 1 less working day in Europe in the second quarter this year compared to last, so it's important to focus on the same-day results. There is no doubt that the soft macroeconomic conditions across Europe are weighing on our industry and our revenue comparisons. We are performing better than many of our peers, but organic revenue in Europe was down, and that softness bled through the operating margins.

And finally, by quarter end, scrap prices fell a further 20% from the March 30 levels, which impacted Q2 results and will continue to weigh on our results for the balance of the year.

Now on to the quarter. As noted on Slide 5, revenue for the second quarter of 2019 was $3.25 billion, a 7% increase over the $3.0 billion recorded in the comparable period of 2018. Parts and services organic revenue growth for the second quarter of 2019 declined 2.1% on a reported basis. But when adjusting for the 1 less selling day in Europe, the decline in organic revenue for parts and services was 1.3%.

Net income was $150 million compared to the $157 million for the same period of 2018. Diluted earnings per share for the second quarter of 2019 was $0.48 as compared to $0.50 for the same period last year. However, the second quarter of 2019 results included a noncash impairment charge of $25 million net of tax. Regarding this impairment charge, as we reported last quarter, we intend to divest a few of our noncore business units over to the next year and thus have recorded the related assets and liabilities as held-for-sale. Each period, we evaluate the recoverability of the carrying value of these assets. In the second quarter, we concluded that the expected recovery will be less than the carrying value, and as a result, we recorded an impairment charge of about $0.08 a share, which is excluded from our calculation of adjusted diluted EPS. On an adjusted basis, net income was $204 million, an increase of 6% compared to the $192 million reported for the same period of 2018. Adjusted diluted earnings per share for the second quarter of 2019 was $0.65 compared to $0.61 for the same period last year, a 7% increase.

With respect to capital allocation, during the quarter, we repurchased approximately 4.4 million shares of our common stock, returning approximately $120 million of capital to our stockholders. Since initiating our plan in late October 2018, the company has repurchased 9.3 million shares for a total of $251 million.

Let's turn to the quarterly segment highlights. As you will note from Slide 7, organic revenue growth for parts and services for our North American segment declined 0.4% in the second quarter of 2019. As anticipated, the PGW Glass business and the airplane recycling operation exhibited a decline in same-day growth while the largest part of our North American segment, that being the automotive salvage and the aftermarket parts operations, exhibited positive same-day growth of approximately 0.7%. While our focus on driving profitable revenue growth has the result of shaving off some low-margin revenue, it has a material positive benefit on our margins.

We continue to perform well in North America especially when you consider that according to CCC, collision and liability-related auto claims were again down 2.6% year-over-year in the second quarter. This softness was nationwide with 40 of the 50 states recording a decline in repairable claims. Additionally, miles driven has slowed with the lower growth coming from increased vehicles and operation versus miles driven per vehicle, and increase in the number of people working from home and the shift towards online shopping.

Despite some macro industry challenges on the top line and facing another tough comparison against the second quarter of 2018, our North America's teams focus on profitable growth drove excellent year-over-year margin improvements. Segment gross margins were 44.1% and EBITDA margins were 14.4%, reflecting improvements of 100 basis points and 130 basis points, respectively, when compared to the second quarter of last year and representing some of the highest levels in the history of the company.

Furthermore, when removing the self-service business, the business unit that experienced the greatest downward impact on margins from the decline in scrap prices, gross margins and EBITDA margins for the rest of our North American segment were up 160 basis points and 190 basis points, respectively. Varun will address this in more detail, but I wanted to highlight the positive results from our margin-enhancement efforts.

We also continue to grow our parts offerings with aftermarket collision SKU offerings and the total number of certified parts available growing 5.4% and 11.5%, respectively, year-over-year in Q2. Related to certified parts, as some of you may be aware, in late June, LKQ received notification from NSF International that it will discontinue its automotive parts certification business and affiliated automotive certification and registration programs effective September 30 of this year. Many parts, which are certified by NSF, are also covered by CAPA, the largest certification body, and we are confident going forward that discontinuation will not have a material impact on our certified parts availability.

Moving to the other side of the Atlantic. Our European segment achieved total parts and services revenue growth of 18% primarily driven by the acquisition of STAHLGRUBER. Organic revenue growth for parts and services in the second quarter of 2019 declined 4.3% on a reported basis and was down 2.8% on a same-day basis, which was below our expectations. As noted by other public companies with European exposure, the softness is an overall industry headwind, not an LKQ-specific issue. Indeed, our performance on a relative basis appears to be fairly strong, which gives us confidence that we are not losing share.

Additionally, the diversification of our geographic footprint in Europe generally reduces the volatility in our segment performance because we are not overly exposed and reliant on any one specific country. While we don't disclose country-by-country detail, I will note that Italy was the softest in terms of organic revenue growth and the Eastern Bloc was the strongest, albeit still below its historically high levels.

Europe has seen many of its economies slowing as evidenced by negative or flat GDP growth and lower new vehicle sales. Discussions with our suppliers and other industry participants have confirmed the downward pressure that poor economic growth across the continent is having on the European parts marketplace. The consensus view is the soft economic conditions have led to an initial deferral of repairs and maintenance. While a near-term headwind, we believe that core automotive maintenance can only be deferred for so long, and the demand will eventually rebound. That said, we anticipate the soft industry conditions will continue through the balance of 2019. We believe our team has done a reasonably good job of reacting to the new revenue paradigm, but the revenue declines have resulted in a deleveraging of our operating expenses and lower margins when compared to the prior year.

Lastly, on Europe, during our Investor Day back in May 2018, we outlined some of the key categories of focus designed to drive the future performance of our European enterprise. There were both some near-term and longer-term activities identified, and we are making good progress on each of these initiatives. Since then, we have also spent considerable time strategizing about how to best optimize the strength of our various businesses in Europe, and to that end, we have engaged with a third-party consulting firm to assist in this ongoing review. Once complete, we will likely settle on an even broader and deeper array of initiatives than those highlighted a year ago.

To be clear, the primary focus of this optimization project is to create an even stronger enterprise and to enhance our already leading competitive position in the markets in which we operate by providing a best-in-class customer experience. To do that across our European platform, we intend to transform a more fully integrated European businesses to operate more as a single entity. The transformation will be designed to allow LKQ Europe to take advantage of its scale and be a more efficient entity. We anticipate most of this analysis will be completed in the next 2 months, and we are currently targeting a call with the investment community in the second week of September so we can share some of the key highlights of the project including the anticipated long-term benefits of the optimization initiatives as well as the related cost required to complete the transition.

Now let's move on to our Specialty segment. During the second quarter, Specialty reported flat total revenue growth with organic revenue growth for parts and services of 0.1% being offset by a negative impact from currencies. Specialty witnessed particular softness in Canada, which accounts for about 10% of the segment's revenue largely related to Canada's weak economy. Additionally, RV parts sales were off slightly due to lower dealer retail sales across all regions. Our Specialty team is laser-focused on spending controls, which will continue to help offset the impact of lower revenue. Despite the softness, light truck and SUV SAAR rates are still running at healthy levels, and the number of RVs on the road are at an all-time high, favorable dynamics for our RV business and our RV replacement part offerings.

Moving on to corporate development. It was a relatively quiet quarter from a corporate development perspective, closing on just 3 smaller transactions including 2 companies in the United States and one regional distributor in Belgium for a total net consideration of $38 million. Our pipeline of opportunities remains quite healthy, and we will continue to acquire businesses that can add value from a customer offering or geographic perspective. Additionally, our development team continues to make solid progress with our assets held-for-sale efforts, and during the quarter, we entered into a definitive agreement to divest a small operation in Europe, which we expect to close in the third quarter.

Finally, during Q2, we opened up 3 branches in Western Europe and one in Eastern Europe while closing 5 underperforming locations including 1 in Western Europe and 4 in Eastern Europe.

And with that, I will now turn the discussion over to Varun who'll run through the details of the segment results and discuss our updated 2019 guidance.

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Varun Laroyia, LKQ Corporation - Executive VP & CFO [4]

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Thanks, Nick, and good morning to everyone joining us on the call. Overall, we feel that the second quarter was a qualified success providing some positive developments in our North America segment and also free cash flow generation while also offering a few areas for improvement. Before diving into the results, let's start with the key financial highlights.

Operating cash flows in the second quarter were $461 million, the highest quarterly amount in the company's history by a factor of more than 2x. Free cash flow from the quarter totaled $413 million or $282 million higher than the same period in 2018. We've talked on the past few calls about our emphasis on cash flow generation, and I want to thank our teams across all 3 segments for their efforts to deliver substantial year-over-year growth. We are raising our full year guidance for free cash flow. More details a little later.

The strong cash flows enabled us to buy 4.4 million units of LKQ stock or approximately $120 million in the quarter. Additionally, we also paid down debt by $220 million in the quarter and in the 6 months through June 30 have paid down $281 million. Returning cash to our shareholders while reducing our net leverage ratio speaks to the strength of our business to generate strong consistent cash flows.

Our North America segment was able to withstand some revenue softness to post its highest segment EBITDA margin percentage since the second quarter of 2017. I want to commend the North America management team for taking a proactive approach to protecting margins to offset inflationary pressures and proactively working to optimize its cost structure. Our Europe and Specialty segments also faced soft revenue, and we are taking actions in both segments to advance our stated strategic objectives and address current market conditions.

Last quarter, we disclosed our plans to divest certain low-margin businesses that fall outside of our core operations and geographies. This quarter, we are announcing a restructuring program that we expect to enhance our competitiveness in the current macroeconomic environment. The restructuring program covers all 3 of our reportable segments and advances our efforts to eliminate underperforming assets and cost inefficiencies. With underperforming assets, we intend to close branches and warehouse locations that are not supporting a sufficient return on investment. Our current plan includes approximately 40 locations across the business, both in North America and Europe. We intend to migrate as much of the revenue as possible from these locations to other facilities in the LKQ network, but there will likely be some low-margin revenue loss as a result of the closures. The restructuring charges will include facility closure costs such as lease termination fees and moving expenses to relocate inventory and equipment. Additionally, through this process, we have identified selected personnel reduction that will benefit future periods, but will require upfront severance that will be charged through restructuring. We estimate that the restructuring program will cost approximately $25 million to $30 million over the next year to implement, and will generate savings of a similar amount on a run rate basis.

While this program represents a significant move forward in our plans to improve our competitiveness, we will continue to evaluate our businesses and cost structure to identify further opportunities for simplification and cost efficiency.

Regarding Europe, the restructuring program will aid our efforts to deliver sustainable double-digit segment EBITDA margin. These efforts are part of but do not reflect the entirety of the optimization project that Nick referenced earlier. In conjunction with European margins, I want to highlight that we expect various integration costs such as ERP implementation to have a negative impact on net segment EBITDA margin over the implementation time line. We have incurred some of these costs in the past including in the second quarter, but expect some acceleration as the integration projects ramp up. We think it will be important for investors to understand the nature and amount of these enablement costs and, therefore, we will provide disclosure of the expenses incurred as part of our quarterly reporting cadence.

Now I'll cover our consolidated and segment results. To save myself some words when I refer to net income and diluted EPS, please note that I will be referring to the amounts from continuing operations attributable to LKQ stockholders. In addition, Nick covered the details on net income and earnings per share, so I will not repeat.

Please turn to Slides 12 and 13 of the presentation for a few points on the consolidated second quarter results. The consolidated gross margin percentage increased 10 basis points quarter-over-quarter to 38.4% driven by a 100 basis point improvement in North America. While Europe was flat compared to 2018, as we discussed previously, there is a negative mix impact at the consolidated level as the lower gross margin European segment makes up a larger percentage of the overall results and hence, has a dilutive effect on the consolidated margin. The mix impact will be less impactful going forward now that we've annualized the STAHLGRUBER acquisition.

Our operating expenses increased by 40 basis points quarter-over-quarter with a rise in our European segment. Restructuring and acquisition-related costs were $8 million as a result of ongoing expenses related to acquisition integration activities previously disclosed as well as some initial charges of approximately $5 million from the restructuring initiatives. Interest expense was favorable by $2 million or 6% compared to the second quarter 2018 going to both lower interest rates and lower average debt balances.

Moving to income taxes. Our effective tax rate was 27.1%, which is roughly in line with our full year estimate.

Please turn to Slides 16 for highlights on segment performance starting with North America. Gross margin was 44.1% or 100 basis points higher than last year as I previously mentioned. For the most part, the margin expansion reflects the continued benefits of pricing initiative in both our aftermarket and salvage operations as well as efforts in our glass business to get recognized for the quality of service and the breadth and depth of inventory that we provide and renegotiate underperforming contracts. We had an additional nonrecurring benefit of 25 basis points related to an insurance settlement that was realized in the quarter. The self-service operation was a drag on segment gross margin with a quarter-over-quarter decrease due to scrap pricing. Sequential changes in scrap prices had an unfavorable impact of $2 million for the quarter compared to a positive impact of $4 million in the second quarter of 2018, creating a $6 million year-over-year negative swing.

Operating expenses were unchanged at 30.1% relative to the prior year. Given the pressure on both parts and services and other revenue and the resulting net leverage effect, holding the percentage flat and actually reducing the absolute dollars by $4 million is a very respectable outcome. This quarter is the first quarter without a quarter-over-quarter increase in expense as a percentage of revenue since the third quarter of 2017.

Wage inflation and higher medical costs continued to negatively impact our operating leverage though the North America team has effectively managed expenses to counteract a portion of the impact. We generated further savings through improve safety performance as seen through a reduction in workers' compensation claims and a favorable variance in bad debt expense from ongoing collection efforts. In total, segment EBITDA from North America was $190 million, up $15 million compared to last year, and as a percentage of revenue was up 130 basis points from the prior year quarter.

We've been talking about North America's margin enhancement efforts over the last year, and the numbers show the progress that we made. A year ago, we disclosed a 130-point decrease in segment EBITDA margin in the period with 7.4% organic parts and services revenue growth. This year, North America recovered the full 130 basis points in margin despite a 40 basis point organic parts and services revenue decline. We're also encouraged by the fact that the North America team still feel that there are additional cost efficiency opportunities available and is working on plans to achieve these savings.

Moving on to the European segment on Slide 19. Gross margin in Europe was 36%, flat to the comparable period of 2018. Centralized procurement yielded a 50 basis point improvement from supplier rebate programs as we continue to benefit from the STAHLGRUBER synergies. With respect to operating expenses, we experienced a 100 basis point increase on a consolidated European basis versus the comparable quarter from a year ago. The quarter-over-quarter sales decline partially attributable to 1 fewer selling day in the quarter had a negative impact on operating leverage given the segment's relatively high cost base primarily with personnel costs. Additionally, there was a 30 basis point headwind associated with the ongoing transformation effort primarily the ERP program and the broader project that Nick referenced. Partially offsetting, we had a 30 basis point decrease going to reduce bad debt expenses as the team focused on collection efforts. European segment EBITDA totaled $116 million, a 5% increase over last year.

As shown on Slide 21, relative to the second quarter of 2018, both the sterling and the euro each weakened by approximately 6% against the U.S. dollar causing a negative effect from translation. This was offset by favorability in transaction gains and losses, netting to an immaterial impact on adjusted EPS for the quarter.

Segment EBITDA as a percentage of revenue was 7.7% for the quarter, down 90 basis points compared to the same period a year ago. As noted earlier, we have taken actions through restructuring programs throughout our European operations, and we continue to believe that we have the best assets in Europe and are positioned to achieve significant integration synergies. As Nick mentioned earlier, we will provide an update to the investment community in September on the European transformation project.

Turning to the Specialty segment on Slide 22. Gross margin declined 130 basis points in the second quarter relative to the comparable period a year ago. Of this amount, 60 basis points related to higher net product costs as our supplier discounts were lower than those realized in the prior year. The balance related primarily to unfavorable product mix.

Operating expenses improved 40 basis points with reductions in personnel and freight costs, more than offsetting higher facility expenses related to warehouse expansion projects that went live after the second quarter 2018. Segment EBITDA for Specialty was $52 million, approximately $4 million down from the second quarter of '18, and as a percentage of revenue, down 90 basis points to 12.7%. The Specialty team is taking cost actions to protect its margins aimed at producing benefits in the second half of 2019.

Let's move on to liquidity and the balance sheet. As presented on Slide 24 and as previously mentioned, you will note that our operating cash flow for the second quarter was $461 million or 152% higher than the second quarter 2018. On previous calls, we've talked about driving working capital improvements, and the team did a phenomenal job this quarter. It was a total team effort as all 3 of our segments contributed with North America and Europe posting significant gains. Our key working capital account, that is trade receivables, inventory and payables, generated cash inflow of $189 million this quarter compared to an outflow of $49 million in the second quarter of 2018. I want to give special mention to the North America team for working with our vendor partners to ensure LKQ received market convention payment terms no different than other large customers, and to the European team for its disciplined purchasing approach in light of soft trading conditions.

As you would expect, I do want to offer a few words of caution on the strong year-to-date cash flows. There will be ups and downs in working capital and cash flows as we move throughout the year based on seasonality and the timing of certain transactions. We will also actively use our liquidity to pursue opportunities that support our business objectives, for example, in funding the restructuring costs and those of our key vendor partners by making selective inventory purchases.

CapEx for the quarter was $48 million resulting in free cash flow for the quarter of $413 million and $537 million on a year-to-date basis.

And finally, moving to Slide 25. As of the 30th of June, we have $376 million of cash resulting in net debt of about $3.7 billion or 2.8x last 12 months EBITDA.

Now I would like to spend a few minutes and provide an update on our annual guidance. Please note that the guidance assumes that scrap prices and foreign exchange rates hold at current levels. And additionally, the guidance continues to assume no material disruptions associated with the United Kingdom's potential exit from the European Union currently scheduled to occur on the 31st of October.

As Nick noted earlier, the second quarter came in line with our expectations. North America performed well, and we expect Specialty to bounce back in the second half of the year. We see challenges with European economic conditions holding for the remainder of the year. And despite the underlying businesses being resilient, the management team will adapt to the softer market conditions by accelerating the integration and cost efficiency programs in addition to simplifying be carefully evaluating various program that may not deliver benefit in the near term. As mentioned earlier, scrap metal prices has continued to trend down, and the British pound is trending lower based on the ambiguity that continues to rein in the United Kingdom with the new Prime Minister and his very definitive views on Brexit. Given these scenarios, we are trimming our 2019 full year guidance by 2.5% or $0.06 at the midpoint for adjusted EPS while increasing expected free cash flow for the year by $50 million.

Let me run through the updated guidance figures. Organic parts and services revenue growth revised to 50 basis point to 2% for the full year. Diluted EPS on a GAAP basis is updated to a range of $1.73 to $1.81, accounting for the first half activity primarily related to the noncash impairment charge I referenced earlier. Adjusted diluted EPS in the range of $2.30 to $2.38. You will note that at the midpoint of the range, we are down $0.06 per share from a prior guidance. Of this, $0.035 relates to lower scrap prices and FX rates relative to our prior guidance, and the remaining $0.025 largely reflects the net anticipated ongoing softness in Europe in the second half. Cash flows from operations has been increased to a range of $800 million to $875 million, and capital spending is reduced to a range of $225 million to $275 million resulting in a net increase at the midpoint to free cash flow for the full year by $50 million despite the trim in earnings.

In summary, the second quarter had several highlights showing where our actions are bearing fruits such as North America margins and generating strong free cash flow that's funded the ongoing share repurchase program and debt paydown. However, the softer macro conditions in Europe and the volatility in scrap and FX give us pause for thought, and hence we've triggered a cost reduction and efficiency program to adjust to the market conditions. Overall, we remain optimistic about our prospects for the future.

Now I'll turn the call back to Nick for closing remarks.

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Dominick P. Zarcone, LKQ Corporation - President, CEO & Director [5]

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Thank you, Varun, for that excellent financial overview. In closing, I would like to review a few of the key initiatives discussed on previous calls that will continue to be points of focus during the balance of 2019. First, we will integrate and simplify our operating model. Second, we will continue to focus on profitable revenue growth to create sustainable margin expansion. Third, we will drive better levels of cash flows, which in turn will give us the flexibility to maintain a balanced capital allocation strategy. And fourth, we will continue to invest in our future.

As you can see from the second quarter results, these programs and targets are gaining momentum throughout the organization, and the teams are actively working towards achieving their respective goals.

I am proud of the momentum we have created with our second quarter performance and how our team of over 51,000 employees performed amidst various market challenges in both North America and Europe. Importantly, I want to recognize how our leaders across each of our segments have embraced our productivity initiatives and the performance and compensation metrics we have implemented as we progressed through 2019 and beyond. I am confident these factors will create long-term value for our stockholders.

I look forward to having you join our European discussion in September, and we will announce final details as we get closer to that call.

And with that, operator, we are now ready to open the call for questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Daniel Imbro with Stephens Inc.

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Daniel Robert Imbro, Stephens Inc., Research Division - Research Analyst [2]

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I wanted to think about the European margin and actually we're in third of the gross margin line. I think you said gross margins were flat year-over-year despite a 50 bp tailwind from procurement. And we lost some of those issues from Q2 last year. So could you just kind of walk through some of the puts and takes of what's going on in that line? And then as comparison to get more difficult in the back half, how you guys are expecting that gross margin line to trend in Europe?

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Varun Laroyia, LKQ Corporation - Executive VP & CFO [3]

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Absolutely, Daniel, and thank you for are calling in at this early hour. Yes, should we think about our European gross margin, it was flat indeed, so you actually read that correct. We really think about it in terms of while we did get the centralized procurement benefit with the organic decline coming through, there is pressure on margins, right? And so as you think about other competitors also there, the one area where they go through to be able to kind of sustain the revenue side is on the margin piece of it. So margin did come under some pressure as a result of that. Nothing more, nothing less. We've always have those competitors out there. But clearly, with a fallen market as such, that's really where folks end up in trying to give value to their customers. So there was some pressure from that perspective. I think if you step back and think about it while the headline number would suggest that the European segment EBITDA margins declined by, call it, 90 basis points year-over-year, put this entirety into context as you think about the fact that a year ago, Europe delivered an 8.3% organic growth number. This year, the reported number is negative 4.3%, that's a 12.5 percentage point swing. And as you think about the fixed cost structure largely, more so in the European space, that's the kind of deleverage that ends up coming through. And even if we were to be able to hold flat, for example, rather than negative 4.3%, if it were flat and you were to run the math, the SG&A or the OpEx expenses would actually decline by 100 basis points with all other things being similar. So think about the deleverage that takes place in a market that is shrinking. And it doesn't just show up in the gross margin line, it actually shows up in multiple lines in terms of not being able to get the operating leverage.

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Operator [4]

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Craig Kennison with Baird.

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Craig R. Kennison, Robert W. Baird & Co. Incorporated, Research Division - Director of Research Operations and Senior Research Analyst [5]

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Yes. I'm sure there'll be more questions on Europe, but I wanted to shift to North America in the collision business. How do you explain that soft collision trend? And to what extent is the total loss rate, which appears to be climbing resulting in fewer repairs and really just fewer opportunities for LKQ?

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Dominick P. Zarcone, LKQ Corporation - President, CEO & Director [6]

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This is Nick. Thanks for your question. We have a very deep and ongoing relationship with CCC. We get a lot of data from them on a quarterly basis. And when we sat with them a couple of weeks ago, we asked them point blank their perspective as to the decline in repairable claims in particular because that's really what drives our business. In general, they indicated that the winter of 2019 was a bit milder than '18, and that has an impact of reducing collision volume, if you will. And there is no doubt that on April 1, the beginning of the second quarter, right, the collision repair shops have less backlog, if you will, in 2019 than they did on April 1, 2018. You're absolutely right, total loss rates have continued, nudged their way upward just a bit. And on the margin, that takes a few cars out of the repair shops and puts them into the salvage auctions, which is not a bad thing for us because we have more cars to purchase.

Total loss rates for the June 2018 to May 2019 time period was 19.3%, that compares to 18.7% for the June '17 to May '18 time period. So up just about 0.5 percentage point or so. Miles driven has really started to flatten out from May '18 to April '19, up only 0.6% compared to the May '17 to April '18 time period. And most of those miles, the increase is in fleets as opposed to personal miles. The -- what I would call the accident-prone portion of the population, think about our teenagers out there and maybe some of the very elderly, they are not in the fleet segment. And so that they believe and we believe is having perhaps a slight impact as well.

So the good news on a longer-term basis is that the number of cars in the sweet spot is up, and APU continues to shift upward very slowly but it does shift up a bit. And we believe, quite frankly, that accounts for the positive spread between our organic growth and actually the negative repairable claims growth. Then lastly, obviously, we were measuring against the 7% comp in Q2 of last year, and those comps get a little bit easier in Q3 and then much easier in Q4.

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Operator [7]

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Michael Hoffman with Stifel.

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Michael Edward Hoffman, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Group Head of Diversified Industrials Research [8]

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I'm going to change gears completely and talk about cash. Looking at the revised guidance, am I thinking about the second half correctly if I take the midpoint of the net income and the free cash flow, it would suggest that you do about $300 million of net income helped by about $180 million of D&A and then offsetting that? Some of the other things in the cash flow statements stay unchanged other than working capital. That's the comment you made, Varun, is there's about $140 million or $150 million walk back of working capital in the second half and that puts you at the midpoint of your cash flow from ops?

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Varun Laroyia, LKQ Corporation - Executive VP & CFO [9]

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Yes, Michael. So yes, this is Varun. And yes, I think the mechanics that you're utilizing in your model from a free cash flow or an OCF perspective are appropriate. And I think if you also kind of look back into the -- take '17 and '18, 2 prior years, we typically do have an outflow on trade working capital in the second half versus the first half. So in terms of different ways to look at it, clearly with the slight trim of $20 million, $25 million on the -- at the midpoint for adjusted net income, don't also forget that with the restructuring program that we've called, that also takes us back. So I would not think that the usage on a working capital perspective is about $140 million, $150 million. I think just take into account the lower earnings, plus also the restructuring that we've called out that will be utilized in cash and then just in terms of the first half, second half use of trade working capital. So overall, the mechanics that you're thinking of are appropriate, and hence both Nick and I referenced that there will be certain timing associated with payments. But we do expect that to be certain opportunities for us to be able to invest more on the inventory side just given the state of the market on a broader basis. It's not us that's seeing some softer revenues, it's happening to competitors, and we're certainly seeing it from some of the suppliers specifically over in Europe in terms of what they've been calling out. But thank you for the question. We are very pleased with the way cash has been coming through the business and really happy with the momentum that we picked up from the second half of last year, and that's carried into 2019. We believe there is more to come.

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Operator [10]

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Stephanie Benjamin with SunTrust.

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Stephanie Benjamin, SunTrust Robinson Humphrey, Inc., Research Division - Associate [11]

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I was hoping that you could talk a little bit about just the headwind you're seeing from the aviation and glass businesses and when you just hope you would start lapping those. I understand it's just kind of a comp because they are small businesses or small base, but you can see some nice swings quarter-to-quarter. So just for us, just when we should expect the comp and some of that going forward? And then additionally, if you could just walk through in a little bit more detail, just what's driving the kind of significant margin improvement in North America whether it's pricing, just cost control, just a little bit more color and how we can think about that going forward would be helpful.

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Dominick P. Zarcone, LKQ Corporation - President, CEO & Director [12]

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Okay. Great. Well, I'll start. Clearly, we indicated in past calls as it relates to our glass business that when we bought the business, we inherited some less than profitable contracts, and so we have moved away from some of that revenue intentionally. That's all part of the idea of focusing on really profitable revenue growth. That comes with a decline in revenue on an organic basis, if you will. And sometimes you need to be willing to walk away from business, and that's what we've done there, if you will. That projects and some of those contracts really started at the beginning of this year. So by the time we get into the late Q4 and first quarter next year, we hopefully anniversaried that project.

The aviation business, again, you need to keep in mind, which was also, by the way, a negative drag on organic growth in both the first and second quarter. That's a business that's very, very lumpy. The average ticket sale there is not necessarily a few hundred dollars for a part, but we're talking tens of thousands, if not hundreds of thousand dollars for a part. So timing on a quarter-to-quarter basis can have big impacts. Again, our expectation would be -- it's going to be tough sledding there for the rest of the year.

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Varun Laroyia, LKQ Corporation - Executive VP & CFO [13]

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And then, Stephanie, just on actual result. I think on your second part of the question about North American margin improvement. It's actually very, very tightly linked with what Nick started off by saying our focus on profitable revenue. Listen, we've talked about this in the past. Also, there are a number of businesses, there's a lot of revenue that is potentially available. And in the past, the company has taken advantage of it. But as we've kind of looked into the margin pressures and really in terms of what the contribution margin for that additional dollar of revenue whether it be certain customers, whether it be certain product lines, we have consciously walked away from some of that, how should we say, lower margin or EBITDA-free revenue. And yes, we did anticipate the organic growth numbers coming in as a result. And I think the way we would suggest this, Nick mentioned this in his overall comments, that if we look at our core automotive parts and services business, which essentially is full service salvage and also our aftermarket business, that business still grew about 70 basis points year-over-year despite some tough comps from a year ago. So from that perspective, we're very happy in terms of where the focus by the team has been. So think about that specific piece. It's just being conscious about the revenue that we go chase because there is costs associated with picking up the parts in the warehouses, delivering them, in certain cases, having to pay for the returns, and so just being very conscious in terms of the revenue that we choose.

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Operator [14]

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Bret Jordan with Jefferies.

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Bret David Jordan, Jefferies LLC, Research Division - Equity Analyst [15]

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I'll go back to Europe. Your peer in this space was commenting about some sequential maybe improvement around weather-driven demand. I guess could you talk about what you're seeing there sort of in handicapping? How much is economic and how much is weather? And then on that -- on the prior question, just as an add-in, are we talking about the Fiat price or battery distribution business as profitable to sales?

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Dominick P. Zarcone, LKQ Corporation - President, CEO & Director [16]

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So as it relates to Europe as a whole, your question I think really relates to what are we seeing here early in the third quarter, and we've got basically 3 weeks' worth of data, which is not enough to form a trend. Some of our operations are seeing a slight uptick on the revenue side but again it's 3 weeks, and we're headed into the big holiday season, that's in the vacation season over in Europe. And so we are not going to -- we're not working under the assumption that there's going to be significant upticks in revenue growth in the back half of the year. We think it's tough sliding. Reality is we talk to our competitors, we talk to our customers, the garages and actually our suppliers, and everyone is I think working under the assumption that these industry conditions are going to be with us for a while. If they turn, we think we will be a huge beneficiary of that, but we think it's prudent to work on the assumption that it's going to be -- these business conditions are going to be with us for the balance of the year.

On the -- your question as to the battery business, again, we started that in 2018 as a new program. We fully anniversaried that. We are continuing to distribute the battery on behalf of the FCA organization, that being the Mopar batteries to their dealers across the United States. That is a good relationship and a good contract for us.

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Operator [17]

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Chris Bottiglieri with Wolfe Research.

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Christopher James Bottiglieri, Wolfe Research, LLC - Research Analyst [18]

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Really, there will be a call in September, but I'm impatient as are most investors. So I want to cut that like lay out what you've already told us and trying to think through kind of what we do know already today. So you kind of stated there will be non-GAAP restructuring costs, which you've laid out, and then there's currently already a 30 basis point headwind from integration systems, and that will not be non-GAAP. You would expect that 30 basis points to accelerate looking forward as you get further on those projects. And then on top of that, as you go to the planning process, there will be more potential cost to recognize these savings. So I guess the question is, will those additional cost be non-GAAP or those be just a headwind to earnings? And how should we begin to think about 2020? I would think this would cause a decrease to European margins and free cash flow, but want to just kind of get anything you do know today will be helpful.

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Varun Laroyia, LKQ Corporation - Executive VP & CFO [19]

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Chris, it's Varun here. So yes, you are right. And just for the broader attendees on the call also, Nick did mention that in the second week of September, we will provide an update on the various European initiatives that we talked about at the Investor Day last May. So there will be a full deep dive associated with the various initiatives and really as to how we see the overall 3-plus year program that we talked about a little over a year. Your specific question with regards to restructuring, yes. But again, I do want to clarify the $25 million to $30 million of restructuring that we have premiered already, and you would have seen that in the second quarter numbers also. We've actually started that activities, if not, as if you're starting it now. It actually impacts each of our 3 reportable segments, not only Europe.

The other piece I would like to call out is with regards to the broader European optimization and integration program. The restructuring that we've currently talked about is not the entirety of that piece. So yes, if you got it forward, there will be costs associated with the integration. And really the point is to kind of give the markets a foreshadowing language with regards to transformation costs, right? There will be a cost associated with being able to integrate those businesses, and we will provide an update of that also in the September time frame. And again, I think it's helpful for the investment community to understand in the business as usual versus costs associated with taking the business to the next level and essentially digging the mote that much deeper around what we expect to be best-in-class businesses in any case. So there will be some costs associated with being able to make those investments, but also to get some of the cost structure that's currently embedded out there. But again, more on that when we get to the September review.

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Operator [20]

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Ryan Merkel with William Blair.

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Ryan James Merkel, William Blair & Company L.L.C., Research Division - Research Analyst [21]

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So I have 2 questions on Europe. So first, what percent of Europe segment sales would you define as more discretionary in nature? And the reason I ask, I'm just trying to get a better understanding of the cyclicality that we might see if the Europe macro stays soft.

And then secondly, on the Europe optimization plan, what is the main scope of work for the consultants that you hired? And the reason I asked that is because you're already restructuring, and I presume you've already looked at divesting assets. So maybe just a little more clarity there will be helpful.

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Dominick P. Zarcone, LKQ Corporation - President, CEO & Director [22]

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Yes. So I'll start with the second half of that question, Ryan. It's important to keep in mind that restructuring activities and what I'll call the optimization project, they're linked but they're separate. The restructuring initiatives are all about kind of rightsizing our business with the current market conditions, and that involves a consolidation of facilities and the elimination of lower margin activities at a local level as Varun described. The optimization project in Europe is really a longer-term focus, and really the intent is to gain efficiencies by morphing the European organization and operating structure from what today is a fairly independent country-based model to a slightly more integrated model that leverages a higher level of centralized resources.

To be clear, in Europe, we sell in the local markets and our focus on customer service needs to remain to be a very local activity. So nothing is going to change there. But there are many activities where we can create a better customer experience across the European platform and become more efficient by utilizing a more centralized structure particularly when you think about things like procurement, category management, logistics, IT and the like. Getting from here to there is no easy task, okay, and it's not going to happen overnight. It's going to happen over several years. But we believe, and some of the initial work with our outside consultants have clearly documented, that there could be some very significant benefits of doing this, and that's why we're headed down the path. There are costs to get there, things like the new ERP program, which is going to get kicked off -- which was kicked off back in October. It's going to roll out over the next 4 to 5 years. We need to create a Central European office as opposed to the virtual structure that we have today. We need to establish some offshore or nearshore back-office infrastructure activities and the like. And we are in the middle of the process, we're mid-flight, if you will, in identifying and quantifying both the opportunities and the expenses to get us there, and that's really what we're going to chat about come September. So the focus of the program largely is how to shift the org structure both from truly a structural perspective and operating perspective from being a less integrated kind of independent country model to a more integrated central model. And that is going to require a lot of heavy lifting to do that. But the benefits, we believe, are quite significant. And at the end of the day, it will create a better customer experience, which will help drive revenues and the like.

As it relates to discretionary versus nondiscretionary, the reality is most of the parts that we sell in Europe are parts for kind of day-to-day service on your car. And in some cases, and take if your battery doesn't -- is out and you can't crank your car over, right, that's a nondiscretionary item. You need to go get a new battery so you call a work. But what we find on the margin when the economy gets softs, European consumers are no different than American consumers. The first thing they do when things start to get tight is you take a hard focus on your household cash flow and you tend to buy down. And so we're still selling a battery to the shop. But maybe instead of the harder battery with a 7-year warranty that goes out at a pretty high price point, the consumer gets a more value line battery that's cheaper for them. We still sell a battery, but it's a lower revenue battery, it's a lower margin dollar battery even. And so it's hard to put the number, Ryan, as to what is absolutely discretionary versus nondiscretionary. When your oil lights comes on to say it's time to change your oil, you don't have to go do that tomorrow. If you're trying to save some money, you may defer that for a few months.

Earlier in the spring, I was at a [CAPA] conference, CAPA is a big trade organization for the parts manufacturers in Europe and had an opportunity to meet with the heads of almost all of our major suppliers, a lot of our other peers in the distribution side of the industry and the like. And our suppliers indicated that they saw their aftermarket activities start to trend down late in 2018, and so we're not even a year into it. So I think we've got -- and that's why were a little bit cautious in the expectations for the back half of the year. I think it's going to be another 6 months before we begin to kind of lap the impact of the soft environment.

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Operator [23]

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This ends the time allotted for the Q&A session. I would now like to turn the call back over to Nick Zarcone for final remarks.

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Dominick P. Zarcone, LKQ Corporation - President, CEO & Director [24]

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Well, we certainly appreciate your time and attention this morning. As I indicated earlier, we are encouraged about the [progress] we've made in many regards, particularly the margin structure in North America, the cash flow numbers, which were terrific. We have a lot of work to do in Europe to understand that, and we look forward to sharing with you in mid-September kind of the update on those activities. So again, I appreciate your time and attention, and we'll talk to you in September. Thank you.

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Operator [25]

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Thank you for attending today's conference. You may now disconnect. Have a good day.