LKQ Corp

NASDAQ:LKQ

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, and thank you for joining us today for LKQ Corporation's Second Quarter 2018 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you.

Mr. Joe Boutross, LKQ Corporation's Vice President of Investor Relations, you may begin your conference.

[Joseph P. Boutross, LKQ Corp.]

Thank you, operator. Good morning, everyone, and welcome to LKQ's second quarter 2018 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 slide presentation.

And, with that, I'm happy to turn the call over to Mr. Nick Zarcone.

[Dominick P. Zarcone, LKQ Corp.]

Thank you, Joe, and good morning to everybody on the call. We certainly appreciate your time and attention at this early hour as we adjusted the timing of our call. We are pleased to share both the results of our most recent quarter and the progress made on the various initiatives we've implemented since our first quarter call. I will provide some high-level comments and then Varun will dig in a bit further into the segments and related financial details before I come back to discuss our updated 2018 guidance and make a few closing remarks.

Overall, we had an excellent second quarter, highlighted by exceptional revenue growth in each of our segments, progress on improving margins and a successful closing of the STAHLGRUBER acquisition. As noted on slide 4, consolidated revenue was a record $3.031 billion, reflecting a 23% increase over the $2.458 billion recorded in the second quarter of last year. This is the first time the company has crossed the $3 billion threshold in a quarter.

Total revenue growth from parts and services was 22.8% during the second quarter, while organic revenue growth in parts and services on a global basis came in at a robust 7.2%. As mentioned over the past several quarters, very few companies in our sector are generating organic growth anywhere close to our level.

Diluted earnings per share attributable to LKQ stockholders for the second quarter of 2018 was $0.50 as compared to $0.49 for the same period of 2017, an increase of 2%. On an adjusted basis, diluted earnings per share attributable to LKQ stockholders for the second quarter of 2018 was $0.61 a share, an increase of 15% as compared to the $0.53 for the same period of 2017. These EPS results were slightly above our expectations and due largely to the strong revenue growth and progress on the profit enhancement plans discussed last quarter.

Let's turn to the operating highlights. As you'll note from slide 6, total parts and services revenue for our North American segment grew 8.3% in the second quarter of 2018 compared to the comparable quarter of last year. Organic revenue growth for parts and services for our North American segment during the quarter was 7.4%, which was ahead of our expectations. We continue to perform well in North America, especially when you consider that, according to CCC Information Services, collision and liability related auto claims on a national basis were essentially flat in the second quarter of 2018 compared to last year and down sequentially from the 0.8% growth recorded in the first quarter.

As was the case in Q1, there continue to be meaningful variances in growth rates across the geographic regions of North America. We believe that significant outperformance in our growth relative to the CCC data for repairable claims is due to the continued increase in the number of vehicles in our collision sweet spot, that being model years 3 to 10 years old as well as a continued market share gain.

Also, according to the U.S. Department of Transportation, our performance in Q2 was achieved, while miles driven in the United States were up only 0.8% on a nationwide basis in May, although like the claims data there were significant regional differences. The organic growth for aftermarket parts continued to outpace that of salvage parts, as the repair shops continued to focus on improving cycle times given the increased volume of work they were processing.

Importantly, we continue to see increases in the total aftermarket collision SKU offerings as well as the total number of certified parts available, each growing 5.7% and 12.6%, respectively in the second quarter. Our North American team made solid progress with their recovery efforts related to many areas, including reducing unwarranted discounts, driving higher levels of stops and orders per vehicle per day with Roadnet, and reducing fleet maintenance cost per mile.

These are just a sample of the several initiatives in play. We know there is more opportunity to be garnered and we are not done. Importantly, we have the right team in place to execute on our plan and capture these opportunities. Lastly, on North America and as many of you know, during Q1 and Q2 of 2018, three U.S. Code trade statutes were cited by the President of the United States as requiring investigation due to national security concerns and intellectual property rights violations. Today, under the enacted round 1 of Section 301, there has been little impact on LKQ from the tariffs or the subsequent Canadian countermeasures given that most of the U.S. origin product shipped to Canada are indirect or stocking transfers.

With that said, if the imposition of tariffs gains further traction and leads to price inflation in our North American segment, we, like many other domestic distributors exposed to tariffs, expect to pass along these increases to our customers. That said, it'll be important to keep in mind that we will not be able to earn a profit on any increases related to cover the tariffs. So, should tariffs become a real consideration, it will appear as though gross profit and EBITDA as a percent of revenue will be a bit lower.

Moving to the other side of the Atlantic, our European segment achieved total parts and services revenue growth of 44.2%. Organic revenue growth for parts and services was a very strong 8.3%, reflecting a significant snap-back from Q1 levels, and performance well ahead of our expectations. Acquisitions added an additional 28.8% to revenue growth in Europe during the second quarter of 2018, due largely to STAHLGRUBER being included in the June 2018 results, while the strengthening of the euro and sterling when compared to the second quarter of last year resulted in an FX-related revenue increase of 7.1%.

All of the major operating units in Europe achieved organic growth in excess of 7% with the strong results reflecting both the reversal of the negative impact of the timing of Easter experienced in Q1, and the absence of major weather disruptions. In addition, you will recall that the UK had soft revenue growth in Q1 due in part to some of the branch replenishment issues related to bringing the T2 distribution facility online.

During the last call, we mentioned that the software issues related to the automated elements of this large distribution center appeared to have been largely rectified in early April and sales were trending back to normal levels. Based on the excellent Q2 revenue growth at ECP, you can see that that was indeed the case.

As you know, there were two redundant distribution facilities that were slated to close as part of the overall T2 project plan. As previously disclosed, one closed at year-end and, as expected, the other was vacated and handed back to the landlord in the second quarter. So, those costs are now fully behind us.

With respect to Andrew Page, we continue to integrate and rationalize the Andrew Page branches that we were allowed to retain. And I am happy to report that the entire Andrew Page branch network is now completely being replenished out of the T2 distribution facility.

Additionally, Andrew Page's national distribution center was vacated and returned to the landlord a few weeks ago, with the head office functions still to be consolidated by year-end. At this time, we are in the process of selling 11 Andrew Page branches, including the 9 required by the UK competition authorities and two additional branches that are focused on the commercial vehicle markets. We anticipate the divestiture will close shortly.

During the second quarter, we opened up a total of 17 new branches in Europe, including two new locations in Western Europe and 15 new locations in Eastern Europe. Overall, it was a terrific quarter for our European operations from a revenue perspective, and we made meaningful positive progress on the margin front, which Varun will discuss in more detail.

Let's move on to our Specialty segment. During the second quarter, Specialty reported total revenue growth of 13.6%, including organic revenue growth for parts and services of 4.1% and then the Warn acquisition added an additional 9 points of growth.

As you may recall, Specialty was negatively impacted by the harsh March storms both on the demand side for our RV-focused products and our ability to distribute and serve certain markets. Given this dynamic, we believe that during the second quarter, there was a bit of pent-up demand that we were able to capture, further validating the sustainability and resiliency of our business model.

Also, the industry leading product design and development efforts at Warn continues under LKQ's ownership. Warn recently introduced the next generation of powersport winches called AXON and VRX, products that have received tremendous positive feedback from both our customers and industry press.

Moving on to corporate development matters; on May 31 of 2018, the company announced the closing of its acquisition of STAHLGRUBER. This transaction demonstrates our ongoing strategy to expand our European footprint. We believe that STAHLGRUBER's leading market position in Germany, unparalleled distribution network, unique value proposition and strong leadership team will play a pivotal role in our efforts to grow LKQ's business in Europe.

As many of you know, prior to the closing of the STAHLGRUBER acquisition, the European Antitrust Commission cleared the transaction with the exception of the wholesale business of STAHLGRUBER in the Czech Republic, which was referred for review to the Czech Republic competition authority. Accordingly, the operations in the Czech Republic, which represented an immaterial portion of STAHLGRUBER's revenue and profitability, have been temporarily retained by the seller. That said, we have filed our application with the Czech Republic antitrust authorities and have responded in early July to their comments. We remain optimistic about receiving clearance to acquire the Czech-based business of STAHLGRUBER and we'll report on our progress during our Q3 call.

In addition to our acquisition of STAHLGRUBER, we completed four small acquisitions of wholesale businesses in Europe, including one in the UK and three in Sweden for a total net consideration of approximately $7 million during the quarter.

And I will now turn the discussion over to Varun who will run through the details of the segment results.

[Varun Laroyia, LKQ Corp.]

Thanks, Nick, and good morning to everyone joining us on the call. I will take you through our consolidated segment results for the quarter and cover our current liquidity before turning it back to Nick for an update on full year guidance.

Overall, we are pleased with our results for the quarter. After a disappointing start to the year, we feel we're headed back in the right direction. While there is still a ways to go to get our margins back to the desired levels, the initiatives we've put in place are showing promise with some benefits reflected in the second quarter and others primed for the rest of the year.

As Nick mentioned, we closed the STAHLGRUBER transaction in late May. So, we have one month of operating results in our Q2 figures. I'll highlight the impact of STAHLGRUBER in the quarter as relevant later in my remarks. As noted on slide 13 of the presentation, the consolidated gross margin percentage was down 100 basis points quarter-over-quarter to 38.3%. Roughly 70 basis points of the decrease is attributable to our Europe segment with the balance relating to our North America segment. Segment EBITDA totaled $342 million for the first quarter, reflecting a $36 million or a 12% increase over the comparable quarter of 2017.

As a percentage of revenue, segment EBITDA was down 110 basis points to 11.3%. We saw a 30 basis points increase in our operating expenses, largely due to freight and vehicle expenses in our North America segment. And during the second quarter of 2018, we experienced a $13 million increase in restructuring and acquisition-related costs compared to the prior year and a $10 million increase in depreciation and amortization expense, both largely due to the STAHLGRUBER acquisition that we closed on May 30.

With that, operating income for the second quarter of 2018 increased by about $12 million or roughly 5% when compared to the same period of 2017. Non-operating items were unfavorable by about $6 million versus Q2 of 2017. The change in gains on bargain purchase and an impairment loss on Andrew Page related to the branches to be divested represent $5 million of the unfavorable variance. Other non-operating income primarily related to foreign currency losses represented the remaining variance.

Interest expense was up $14 million year-over-year due to higher average balances and higher interest rates. And interest in the second quarter related to the STAHLGRUBER financing was $11 million. Pre-tax income during the second quarter of 2018 was $218 million, down $8 million or 3% compared to the prior year.

Moving to income taxes, our effective tax rate was 27.9% for the quarter. We updated our estimate of the annual effective tax rate during the second quarter to 27%, up 100 basis points from our previous estimate in Q1. The higher rate is driven mostly by the effects of the STAHLGRUBER transaction, including non-deductible interest and deal costs, as well as the higher effective tax rate in Germany. For your long-term forecasting, please note that about 60 basis points of the rate increase is related to non-deductible interest and deal costs, and should fall off in 2019.

Diluted EPS from continuing operations attributable to LKQ stockholders for the second quarter was $0.50, up $0.01 relative to the comparable quarter a year ago. Adjusted EPS, which excludes restructuring charges, intangible asset amortization, acquisition and divestiture-related gains and losses, and the tax benefit associated with stock-based comp, was $0.61, reflecting a 15% improvement.

STAHLGRUBER's results were consistent with the projected impact as we discussed during Investor Day with a negative impact on the quarter totaling approximately $0.02. While the STAHLGRUBER operating results were solid for the month of June, the negative impacts from pre-acquisition interest cost related to the euro note offerings, the tax impact from non-deductible interest cost, and the dilution effect from issuing 8 million shares caused the overall negative impact on the quarter, as we had communicated on May 31 at our Investor Day.

Moving to the segments, with North America on slide 16, gross margins during the second quarter were 43.1%, down 80 basis points over the 43.9% reported a year ago. The decrease was primarily attributable to mix, with strong revenue growth in some of our lower-margin product lines, including batteries and reman engines.

Additionally, we experienced some softening in salvage margins, as a result of increasing car costs. The base aftermarket business performed consistently with the prior year comparable period. And while we don't typically talk much about sequential changes, I want to highlight a few points related to activities in the second quarter.

Our second quarter gross margin percentage declined sequentially by 20 basis points. Though this variance was driven mostly by our self-service business as a result of the rising cost trend we referenced last quarter. On a positive note, our aftermarket business increased its gross margin percentage sequentially by 30 basis points.

The North American management team has made a good start towards addressing cost pressures, by adjusting net prices in aftermarket to boost margin without sacrificing revenue growth. We are encouraged by the progress the team made in the quarter and are optimistic about our ability to maintain these net pricing levels.

Moving on to operating expenses as a percentage of revenue in our North America segment, these increased by 30 basis points compared to a year ago, but were down 20 basis points sequentially. Consistent with last quarter, we're still facing headwinds related to freight and fuel costs like many other distributors, and these costs drove a 60 basis point increase over the prior year. We are actively working to address these headwinds to the extent we can, given the macroeconomic scenario, including adjusting third-party freight costs to reduce freight surcharges, sourcing less expensive freight options, and resource management.

Going in the other direction, we had a partial offset of 30 basis points from a non-recurring charge in Q2 of 2017 related to a contingent liability. Non-operating income and expenses had a negative impact on segment EBITDA of 20 basis points in 2018, due to an increase in various miscellaneous expenses in the second quarter of 2018.

In total, segment EBITDA of North America during the second quarter of 2018 was $175 million, roughly flat compared to last year and as a percentage of revenue was down 130 basis points from the prior year quarter. Sequential EBITDA margin is down 30 basis points, which reflects a seasonal pattern in our North America business. Prior to 2018, four of the prior five years had lower margins in Q2 versus Q1 in a range of 20 to 140 basis points.

We also started to incur the incremental employee benefit costs as discussed on prior calls in Q2, which negatively impacted our sequential margin. In this context, we're encouraged by the relatively small sequential decrease, but we're clearly not where we think we can be.

Looking at slide 18, scrap prices were up 33% over the comparable quarter last year and flat relative to Q1 of 2018. The benefit from scrap reflects the sequential movement in pricing, as car costs will generally follow scrap prices higher or lower over time. As such, there was minimal year-over-year impact from changes in scrap prices on our reported results.

Moving on to our European segment on slide 19, gross margins in Europe were 36% in Q2, a 120 basis point decline over the comparable period of 2017. The decrease is attributable largely to our UK operations and to the mix shift given the acquisitions and organic growth of the Central and Eastern European region which has structurally lower margins.

As we've discussed over the past few months, the migration issues with our T2 facility in the first quarter had an ongoing negative impact in Q2, as some of the incremental costs capitalized into inventory were recorded in the income statement as the inventory turned. Going forward, we expect to see the remaining incremental capitalized costs flow through COGS in the second half of the year, primarily in Q3.

We did have some positive news on gross margins in Europe with our centralized procurement, yielding a 30 basis point improvement from supplier rebate programs. Also, our Sator business in the Benelux region showed continuing margin expansion, contributing a 30 basis point improvement to the segment with a specific strength in private label sales and the ongoing move from a three-step to a two-step model in that market. The STAHLGRUBER impact on gross margin percentage was immaterial in the quarter.

With respect to operating expenses as a percentage of revenue, we experienced a 30 basis point decrease on a consolidated European basis versus the comparable quarter a year ago. The improvement was primarily attributable to leverage as we could grow revenue at a greater rate than our costs, including facility, freight and advertising expenses. European segment EBITDA totaled $111 million, a 33% increase over a year ago.

As shown on slide 21, relative to the second quarter of 2017, the British pound was up 6% and the euro had strengthened 8% against the U.S. dollar. Segment EBITDA as a percentage of revenue was 8.6% for Q2 2018, down 80 basis points from the same period a year ago. Our goal for Europe remains double-digit segment EBITDA margins over the next 36 months.

Excluding the impact of the STAHLGRUBER acquisition, which was dilutive by 10 basis points, Q2 was a step in the right direction with a sequential margin improvement of 130 basis points. We have more work to do and the European management team are intensely focused on this task.

Related to Europe, I'd also like to share some news on our equity interest in Mekonomen, a leading car parts and service chain in the Nordic region. We don't control the entity and so do not consolidate Mekonomen's results in our reported figures. Instead, we record our share of its income in the equity earnings of unconsolidated subsidiaries line on our income statement.

Since we acquired our shares of Mekonomen, its market cap has declined by approximately 25% as of June 30. While we concluded that no permanent impairment has occurred as of June 30, we will be monitoring developments closely over the next quarter as we evaluate the possibility of an impairment. That said, we remain optimistic about Mekonomen's future prospects, including its recently announced acquisition in Denmark and Poland. And we look forward to continuing our partnership with them in Europe.

Turning to our Specialty segment on slide 22, the business continues to deliver solid results. The Warn business is performing well and, as previously disclosed, has a higher margin profile than the base Specialty segment. Warn contributed 90 basis points to the growth in the gross margin percentage. The base Specialty business, i.e. without Warn, generated a 4.1% organic revenue growth rate in the quarter, which was a nice rebound from Q1 and we were encouraged that we were able to do so, while maintaining gross margin expansion.

Specialty underwent a program to rationalize some low-margin business which had a positive impact on the overall gross margin percentage in the quarter. Operating expenses as a percentage of revenue in Specialty were 120 basis points higher relative to the prior year. The primary variances related to higher personnel, vehicle and fuel expenses and the impact of Warn, which has a higher overhead expense structure than the base business. Segment EBITDA for Specialty was $56 million, up 15% from Q2 of 2017. And as a percentage of revenue, segment EBITDA was up 20 basis points to 13.6%.

Moving on to capital allocation and the balance sheet, as presented on slide 24 you will note that our cash flow from continuing operations for the first six months of 2018 was $329 million. We talked in February about the growth in inventory related to buying opportunities in our North American business.

In the first half of the year, we've maintained a modest cash outflow of $13 million related to inventory, as we could support our strong organic growth without a significant investment in inventory. Receivables represent an outflow through the first six months which follows the seasonality of the business with our highest sales in the first half of the year.

Payables represent a $25 million outflow through June of this year, which is nearly a $90 million swing to the negative relative to a year ago. Payables fluctuate from period to period based on purchasing activity and timing of payments. Payables is one of the more volatile line items on the cash flow, and historically we've seen periods with inflows followed by outflows and vice versa. So, I expect to see some bounce-back in the second half. Overall, we remain optimistic about our ability to generate strong cash flows from operations for the full year of 2018.

CapEx for the quarter was $53 million and $115 million for the year-to-date period. The largest capital changes reflect the impact of the STAHLGRUBER transaction. In April, we issued €1 billion senior notes in 8- and 10-year tranches at a weighted average rate of 3.75% to fund the STAHLGRUBER transaction. Additionally, we borrowed approximately $80 million on our line of credit and issued 8.1 million shares to complete the financing of the transaction.

Moving to slide 25, as of June 30, we had approximately $4.5 billion of total debt outstanding and $345 million of cash, resulting in a net debt number of about $4.1 billion or 3.1 times last 12 months EBITDA. Excluding the STAHLGRUBER transaction, with the debt pay-down in the first quarter and a further pay-down in the second quarter totaling $162 million for the first six months, we continue to make good progress in reducing our net leverage.

At this net debt ratio, our credit facility margin increased by 25 basis points in June. So, we'll see a higher interest cost on all of our credit facility borrowings until we reduce our net leverage ratio below the 2.75 times tier of the credit facility. The impact of this interest rate increase was included in our STAHLGRUBER accretion estimate. And finally, we have approximately $1.6 billion of availability on our credit facility, which together with our cash yields total liquidity of $1.9 billion.

With that said, I'll turn the call back to Nick to cover the updated guidance.

[Dominick P. Zarcone, LKQ Corp.]

Thanks, Varun. In light of the results achieved in the second quarter and the closing of STAHLGRUBER, we have adjusted our annual guidance on a few of the key financial metrics. With respect to organic growth for parts and services, we anticipate all the segments will continue to report reasonably strong results, though not quite at very high levels achieved in the second quarter. Accordingly, we have adjusted the bottom end of the full year guidance range for global organic growth up from 4% to 4.5% and have kept the top end of the range steady at 5.5%.

In terms of adjusted earnings per share, we have moved the range up to $2.25 to $2.33 a share, with a midpoint of $2.29. This reflects both the better-than-anticipated results for the second quarter, the anticipated accretion from the STAHLGRUBER transaction, offset by the weaker euro and sterling which are down 4% and 6% respectively from when we set guidance last quarter, and the slight uptick in the estimated effective tax rate as we continue to refine the impact of the tax law changes and the STAHLGRUBER acquisition.

Currencies and taxes collectively account for approximately a negative $0.04 a share impact relative to our prior guidance. So, as to be clear, starting with the midpoint of our prior guidance which was $2.25 a share, we added $0.05 for STAHLGRUBER, $0.03 for the strong Q2, and then backed off the $0.04 for the negative currency and tax rate impacts to get to the new midpoint of $2.29 a share. Those adjustments yield a range for adjusted net income of $710 million to $735 million.

We also anticipate that the higher earnings will have a positive impact on cash flow from operations and have revised the guidance range to $660 million on the low end and $710 million at the high end, a $35 million increase. We have also increased our capital spending plan a bit to a range of $255 million to $285 million, reflecting the inclusion of STAHLGRUBER and the addition of a few large facility expansion opportunities, primarily in our North American wholesale operations.

We believe the effective tax rate will be approximately 27% and the guidance assumes the current levels as it relates to FX rates. This guidance does not include any impact from the pending tariffs nor does it assume any meaningful impact from scrap price fluctuations, though there is a reasonable amount of speculation in the market that prices may come under pressure if the Chinese restrict the amount of imported recycled material.

In closing, I am very proud of the hard work and dedication of our 49,000 employees and I am equally proud of the team's efforts to effectively address the headwinds encountered in the first quarter. While we have made good progress, there is substantial room for improvement and I am confident in our team's ability to effectively implement their respective plans.

Finally, I would like to publicly welcome the entire STAHLGRUBER organization to the LKQ team. We could not be more excited to have you as our colleagues and partners, and we look forward to working with you in the months and years ahead.

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

[Operator]

And your first question comes from the line of Craig Kennison with Baird. Your line is open.

[Craig R. Kennison, Robert W. Baird & Co., Inc.]

Hey, good morning. Thanks for taking my question. Nick, I realize the trade dynamics are fluid, but a bigger picture, how would you frame your sourcing exposure geographically? I guess, I'm asking, for example, what percentage of European costs of goods sold would be sourced from Europe, the U.S.A. and China and maybe the same question for the U.S., just so we can put some context around these tariffs.

[Dominick P. Zarcone, LKQ Corp.]

Thanks, Craig, and good morning. Yeah. The tariff issue is trying to hit a moving target, right, because there's five different programs under two different trade statutes that are somewhere between 40 years old and 60 years old that are currently at play. The reality is in our North American business, the entirety of the salvage supply chain is from the U.S. So, there's no impact related to our salvage business.

The vast majority of our aftermarket product comes from Taiwan. And Taiwan is not deemed to be China. So, it's not really impacted by the tariffs that are exclusively kind of focused on China. But the last of the five programs which has very little detail around it, Craig, relates to Section 232 of the Trade Expansion Act of 1962 where the President is talking about putting a 20% or 25% tariff on all imported automobiles and auto parts. But that's on a country-by-country specific basis, and they haven't been clear as to what countries are included in that. So, that's probably potentially the biggest exposure.

When you look at the original tariff item related to steel and aluminum under Section 232, there is really no impact on us because that really related to raw materials. Under Section 301 of the Trade Act of 1974, there's three different rounds. Round one put the tariffs on 818, what they call, tariff headings. That went into effect actually on July 6, so that's real and live. We have about 60 products that fall under those 818 headings and so the tariff impact there will be less than $5 million.

Round two, which was proposed on June 20, it put a 25% surcharge on another 284 tariff headings, and we think the impact there is rather minimal. The round three, which was just kind of introduced as a possibility a couple weeks ago, put another 10% surcharge on another 6,031 tariff headings. And that's probably going to have a bigger impact actually on our PGW business, because a lot of the windshields that we distribute on the aftermarket side come from China and our Specialty business, if you will.

We don't see a lot of impact on our European business from the tariff structure and the trade issues that are in the press these days, because almost all of the inventory that we sell in Europe is procured either from European or Asian sources. We're not buying product from the U.S. and moving it over to Europe. So, hopefully that helps.

[Craig R. Kennison, Robert W. Baird & Co., Inc.]

It does. Thank you, Nick.

[Operator]

And your next question comes from the line of Ryan Merkel with William Blair. Your line is open.

[Ryan J. Merkel, William Blair & Co. LLC]

Thanks. Good morning, and congratulations on the quarter B.

[Dominick P. Zarcone, LKQ Corp.]

Thanks, Ryan.

[Ryan J. Merkel, William Blair & Co. LLC]

So, I have a question on North America aftermarket gross margins. I think – it sounds like you've made some progress on passing along product price increases that you've seen from your suppliers, along with passing on for higher freight. Did I hear that correctly? And then, the second part of that question is, by the end of the year, do you think you'll make more progress such that price/cost in that aftermarket piece can be neutralized?

[Varun Laroyia, LKQ Corp.]

Hey, Ryan, good morning. It's Varun Laroyia calling in. Yes, listen, to your question about aftermarket, the base business, which is our traditional crash parts, we have been able to offset some of the margin pressures. As we'd mentioned, our recovery plans are well underway. The North American management team has been working hard on these pieces and they continue to go through tiers of customers, as we had spoken about previously. So, yes, they've made good progress.

But again, as we'd mentioned previously, given the size and scale of the activity, this element will keep ramping up through the second half also. So, while we were in a position to essentially get our aftermarket margins flat on a year-over-year basis in the second quarter versus where they were trending previously, so that's been stabilized. And, yes, we do expect that piece to continue to ramp up through the back end of the year.

[Ryan J. Merkel, William Blair & Co. LLC]

Great. Thank you.

[Operator]

Your next question comes from the line of Ben Bienvenu with Stephens, Inc. Your line is open.

[Benjamin Bienvenu, Stephens, Inc.]

Hey, thanks. Good morning, guys.

[Dominick P. Zarcone, LKQ Corp.]

Good morning, Ben.

[Benjamin Bienvenu, Stephens, Inc.]

I want to ask about, in North America, the relationship between organic growth and margins. I suspect April was a challenge to the quarter as it relates to the disparity in demand across geographies that you saw in the first quarter. And I'm just curious as to how much of that sustained inclement weather into April lifted organic growth, but also suppressed gross margins. And then, as we think about the sequential move into the back half of the year, do you think you can show margins up year-over-year in the back half?

[Dominick P. Zarcone, LKQ Corp.]

Ben, this is Nick. I'll start and I'll let Varun jump in afterwards. So, there's no doubt that the demand in our North American business, particularly on the collision side of the business, has been very strong. You saw some very good growth in Q1, some continued excellent growth in Q2 and that growth was really pretty consistent throughout the quarter. On the margin side, we were coming off of a soft Q1 and so the margins in the quarter actually got better as we marched through the three months of the quarter. That's why Varun indicated just a moment ago that we anticipate that we're going to continue to make good progress through the back half of the year.

But, Varun, do you want to add?

[Varun Laroyia, LKQ Corp.]

Yeah, absolutely. Hey, Ben, good morning. Yes. Listen, I think to the second part of your question in terms of what we anticipate versus a year ago for North America margins and if you turn to slide 16 of the earnings deck, you'll see that the first half typically is a strong set of results for us from a margin perspective. And then, typically seasonality does tend to play its part with regards to mix.

So, for example, in the first half of the year, we do tend to have more collision parts in the North America mix and that typically tends to tail off. But if you think about the dip that we have traditionally experienced first half to the second half, we don't expect that to be as significant to what we've seen in prior years. So, back to the point about a year ago 12.9% and 12.7% in Q3 and Q4 for North American margins, we would not see that, call it, 160, 170-point decline from the first half that we just reported for 2018.

[Benjamin Bienvenu, Stephens, Inc.]

Understood. Thanks so much.

[Operator]

Your next question comes from the line of James Albertine with Consumer Edge. Your line is open.

[James J. Albertine, Consumer Edge Research LLC]

Great. Thank you. Good morning. Appreciate taking the question.

[Dominick P. Zarcone, LKQ Corp.]

Good morning, Jamie.

[James J. Albertine, Consumer Edge Research LLC]

Good morning. Wanted to ask sort of more of a strategic question and congratulations on closing STAHLGRUBER. But wanted to look – kind of looking ahead and you traditionally take some time off after larger scale deals like STAHLGRUBER. But wanted to see kind of what your view was on sort of the growth strategy looking out over the longer term. Or are you at a size now where it makes more sense to sort of reinvest in sort of internally making sure the margin trajectories in North America, Europe and so forth sort of stabilize and start to grow again? And we can kind of think of this as about sort of optimizing the portfolio you have versus growing via acquisition and sort of via roll-up into the future.

[Dominick P. Zarcone, LKQ Corp.]

Yeah. Jamie, this is Nick. And I'll just take everyone back to May 31 at our Investor Day at T2. And what we mentioned then is we've just come off the largest acquisition in the history of the company, the acquisition of STAHLGRUBER which, again, we are thrilled to have as part of our family of companies and we think there's huge benefits that will accrue in the years to come, but that's – there's a big integration to go on there. But the reality is we expect to do both. We'll continue to grow our business through acquisition over the next three to five years.

Having said that, we also need to optimize – I think that's the word to use and I think it was a very good choice of words – we need to optimize what we currently owned. And so, it's not really an either/or. As I indicated back on May 31, no one should expect another blockbuster transaction, anything close to something like STAHLGRUBER in the near term, right, because we have a lot on our plate and we're going to be focused on making sure we get the integration right.

But over time as our leverage comes down and the like, if and when the right opportunity arises, we would be willing to again do something on a slightly larger scale, but we need to get our – we need to get STAHLGRUBER integrated, we need to get our leverage down. But that doesn't in any way, shape or form take our eye off the ball of optimizing what we own, getting the margins up in not – in all of our businesses really. Again, we've been very clear about the goals in Europe. We absolutely want to drive higher margins in North America. There's a lot of blocking and tackling that goes into that. And so, we're focused on both.

[James J. Albertine, Consumer Edge Research LLC]

Okay. Great. Thanks so much, Nick, and best of luck.

[Dominick P. Zarcone, LKQ Corp.]

Thanks.

[Operator]

Your next question comes from the line of Bret Jordan with Jefferies. Your line is open.

[Bret Jordan, Jefferies LLC]

Good morning, guys.

[Dominick P. Zarcone, LKQ Corp.]

Good morning, Bret.

[Varun Laroyia, LKQ Corp.]

Hey, good morning.

[Bret Jordan, Jefferies LLC]

Could you give us an update where we are as far as sort of purchasing synergies in Europe? I think you said you picked up 30 bps on some supplier rebates. But maybe how much of our purchasing has been consolidated and you talked at Sator about the private label programs, how are we across the board in private label and maybe percentage mix, and where you see that going?

[Varun Laroyia, LKQ Corp.]

Hey, Bret, it's Varun. Good morning. Yeah. Listen, in terms of our overall European procurement program, continues to make great strides. We have a team that's been actively working with our key suppliers, and so that's how you've kind of seen that improvement come through on a year-over-year basis. We haven't given exact numbers in terms of what level has been covered at this point of time.

But clearly, I can assure you, we'd call it 45 to 50 days into the STAHLGRUBER transaction, the teams have been spending a lot of quality time out there also to consolidate as to what the opportunity is with the STAHLGRUBER transaction, obviously net pricing analysis being done on several thousand SKUs at this point of time. And so, we remain optimistic not only about the STAHLGRUBER purchasing synergies, but the overall European procurement program.

With regards to your second part of the question on Benelux and Sator, yes, absolutely. Listen, we've talked about this previously, the rise of private label brands. Certainly, Sator has been making great strides on that from that perspective. But really, I'll probably take you back in terms of one of our core critical businesses, ECP. They're the ones that have actually been going down the path of the private label brands.

So, they've certainly shown the path to the European teams. Sator has picked up on that also. And then, obviously, we do know through our equity investment in Mekonomen in terms of the margin profile of private label brands. So, we do see that to be a key pillar for our European margins getting to that double-digit EBITDA margin rate by the end of the 36-month period that started January 2018.

[Dominick P. Zarcone, LKQ Corp.]

Yeah. And, Bret, what I would add is, obviously, when you make a large acquisition, you don't get the procurement savings day one, right? So, if you go back to when we bought Rhiag back in 2016, we put out some broad guidance as to what we thought we could get from a procurement benefit across the European platform by combining purchasing, negotiating kind of common elements, common contracts with our suppliers, if you will. At the time, we thought we could get $10 million of procurement. And we're very well on the way of getting that.

With respect to STAHLGRUBER, we really won't see the benefit of that really until very late in the first year of acquisition, which would put us into kind of mid-2019. One is you need to go and actually renegotiate some of the contracts, then you need to actually start buying at those new levels. But then you need to turn the inventory, right? And so, there's a little bit of a time lag, but we are very confident in our ability to really get our arms around all of the procurement savings that we've noted, both as it relates to the historical acquisitions and obviously as it relates to STAHLGRUBER.

[Bret Jordan, Jefferies LLC]

Okay. Do you have a feeling for what percentage of your sales are private label?

[Dominick P. Zarcone, LKQ Corp.]

It really varies business by business. We don't disclose this, but ECP has the highest level of private label and STAHLGRUBER probably has the lowest level of private label business. And Sator and Rhiag are kind of in between, if you will.

[Bret Jordan, Jefferies LLC]

Okay. Great. Thank you.

[Operator]

Your next question comes from the line of Chris Bottiglieri with Wolfe Research. Your line is open.

[Chris Bottiglieri, Wolfe Research LLC]

Hi. Thanks for taking the question.

[Dominick P. Zarcone, LKQ Corp.]

Good morning, Chris.

[Chris Bottiglieri, Wolfe Research LLC]

Hi, good morning. I was hoping given the rapid moves in commodity, and just give us a quick refresh, a primer on the puts and takes to your P&L. So you're hit on the self-service side, but what about your core North American wholesale business? That's where you have inventory on hand. Initially, you would think increases are positive to get LIFO liquidations, but as you kind of turn through it, how should we be thinking about them? How that impacts margins?

[Dominick P. Zarcone, LKQ Corp.]

Yeah. So, the impact to commodities has a very little impact on our, what we call our full-service North American salvage business, if you will. These are the cars that we're buying at auction and dismantling. Because the real commodity play there is the scrap. And the scrap is a couple hundred dollars on a $2,000 purchase for which we're hoping to park the car out for maybe north of $4,000. So, there's a very little impact. Biggest impact clearly on the self-serve business where the majority of the revenue from the self-serve, more than 50% of the revenue is actually from the residual metals that we end up selling off in the form of scrap.

On the aftermarket part side in North America, a lot of the product that we bring in from the Far East is either made of steel, think about hoods and fenders and the like, or plastics. The shallow, the mirror, the bumper covers, grills and so resin prices are really key there. And so, like in any business as the cost of raw materials for the suppliers that we buy from moves around, they're going to try and recoup some of their cost through higher selling prices to their customers. And we've seen a little bit of that, we talked about that in Q1. We're doing what we can to adjust our prices to take care of that.

[Chris Bottiglieri, Wolfe Research LLC]

Got you. Okay.

[Dominick P. Zarcone, LKQ Corp.]

Does that help?

[Chris Bottiglieri, Wolfe Research LLC]

Yeah. That does help. And then as a related follow-up, you had referenced in the call something, the effective – the Chinese considering pulling back from purchasing recycled materials. Just want to get your – what are the puts and takes that they actually do do that? Do you have less competition for buying parts? Are there like lateral effects that we should be aware of? And then, like do you have an ability to source more aftermarket to offset that, if it is problematic? Just overall picture there would be helpful.

[Dominick P. Zarcone, LKQ Corp.]

Yeah. So, the reference that I made about the Chinese is earlier this year, the Chinese government put in regulations to effectively limit the volume of recycled materials. That's everything from paper to cardboard to metals and the like flowing into China. And really as it related to metals is they wanted a cleaner source of metals because sometimes when the metals that they were bringing into the country, you think about copper wiring, right, the copper is always coated with something, fabric or plastic and the like. And they basically put a halt on the importation of some of that material.

And so, at first, their ports weren't fully compliant with the law and more recently we're hearing that they are by the end of the year going to put a hard stop. And that's going to have potentially an impact on prices. We just don't know where. But that's why I made the comment. The reality is, again, in our core North American business, most of the product comes in from Taiwan. Taiwan is deemed to be a different country. And so, the Chinese import laws as it relates to recycled materials do not relate to Taiwan.

[Chris Bottiglieri, Wolfe Research LLC]

Got you. Okay. Thank you. Appreciate it.

[Operator]

Your next question comes from the line of Michael Hoffman with Stifel. Your line is open.

[Michael E. Hoffman, Stifel, Nicolaus & Co., Inc.]

Thank you very much, Nick, Varun and Joe, for taking the question. Could we look at page 17 on your deck, and could you help us bridge what is in the 90 basis points of headwind from gross margin? What's making up that 90 basis points so we understand what you're dealing with and can get a hand around?

[Varun Laroyia, LKQ Corp.]

Yeah. Michael, good morning. It's Varun Laroyia out here. Yeah, listen, going back to the margin decline on a year-over-year basis in our North America business, really it's the vast majority of it is mix driven. If you think about the base aftermarket business, as I mentioned on the call, and then to one of the questions earlier also, that was pretty much comparable on a prior year period.

But if you think about the strong revenue growth similar to what we had called out even in Q1 in some of our lower-margin product lines, think about batteries, this is coming off the FCA Mopar deal that we announced and essentially got the first full quarter in Q1. While it has contributed to organic revenue, we are nowhere close to getting the margins that we would on our traditional aftermarket crash parts, or for that matter reman engines. Again, great from a revenue growth perspective, but again significantly lower-margin business.

And then, finally, with the salvage side of it, also specifically on our self-service business, the rising car cost trend as a result of scrap metal prices going up, that obviously doesn't allow us to get the same level of margin for the parts we pick off those vehicles. So, that really is what comprises the kind of 90 basis points kind of down on a year-over-year basis.

[Michael E. Hoffman, Stifel, Nicolaus & Co., Inc.]

Okay. But can you give us the actual portions of that? So, how much of this is batteries versus reman engines versus salvage?

[Varun Laroyia, LKQ Corp.]

Yeah. Michael, we don't typically disclose that entire piece in terms of what the key elements of that would be. But if you think about the key components, roughly call it 50 basis points, 30 basis points, 20 basis points between aftermarket, the salvage, self-service operations. So, that really is what we say. So, again, I would not call out anything that was de minimis, but again full-service and salvage are a key piece of it. And in the aftermarket, outside of the base business, which has some of the lower-margin product line that also roll up, those are the key pieces.

[Michael E. Hoffman, Stifel, Nicolaus & Co., Inc.]

So, if I may follow on it, when we were in England and the presentations were given, there was a high degree of confidence that the company would return to the starting year margin by year-end. Is that still the case in North America?

[Varun Laroyia, LKQ Corp.]

Yes. Well, if you think about – when we've kind of broken out our Q1 headwinds specifically on the gross margin piece of it, you'll recall one of the key pieces we had called out were rising commodity prices in our traditional aftermarket crash part piece. And so, I think that really is where the key piece was.

The team has been successful in being able to offset those prices. But with regards to the mix, given what we see from scrap metal prices in the full-service salvage or for that matter what we've seen come through on some of the other product lines, that is something, will just be a mix piece. So, to the time we don't lap the comps on, say, the battery business which will be in Q1 of 2019, we will see that, but in terms of that is a small part of our business, but the big base of our North America wholesale by far is the aftermarket. And that's trending well. Okay?

[Operator]

And your next question comes from the line of Stephanie Benjamin with SunTrust. Your line is open.

[Stephanie Benjamin, SunTrust Robinson Humphrey, Inc.]

Hi. Good morning.

[Dominick P. Zarcone, LKQ Corp.]

Good morning, Stephanie.

[Varun Laroyia, LKQ Corp.]

Good morning, Stephanie. And again, welcome to the LKQ call and we appreciate you initiating coverage on us.

[Stephanie Benjamin, SunTrust Robinson Humphrey, Inc.]

Absolutely. Thank you. So, just kind of looking back at the European margins during the quarter, obviously, a lot of moving parts. Just looking at the apparent mix between Western Europe and Eastern Europe and just kind of the margin gap there, is there anything near term or long term that can be done to kind of close the gap between those two regions' margin structure?

[Dominick P. Zarcone, LKQ Corp.]

Stephanie, the difference between Eastern Europe and Western Europe, that's really structural, if you will, almost across the board and we've seen financial statements from a lot of different companies, obviously, all over Europe. The Eastern Bloc just structurally has lower gross margins and lower EBITDA margins. The market there seems to be willing to work for just a lower level of profitability. And to be competitive, our Eastern Bloc countries also have lower margins than in the West.

We think that's going to persist for the foreseeable future. We don't see a huge shift in the market. That said, we still believe we can earn a good return on capital on the Eastern Bloc operations, if you will, because those companies are growing a lot faster. And so from an absolute euro perspective, if you will, we can grow the EBITDA faster in Eastern Europe than Western Europe just because of the top line growth.

[Varun Laroyia, LKQ Corp.]

The only one additional piece I'll add to just complement Nick's comments here, are if you go back to our Investor Day and John had laid out the key pillars of the margin enhancement for our European business, there was some of the slightly longer-term initiatives which will actually benefit all of our European segment. So, things such as logistics and warehousing optimization or for that matter shared services, back office, rationalizing the infrastructure side a bit, that certainly is a slightly longer-term piece of it, but that really allows us to make some significant moves into our cost structure.

So, as Nick mentioned, the margin is what those markets will bear. But in terms of us being able to further optimize relative to competition given our size, scale and footprint in that region, we believe we will be best-in-class even on segment EBITDA margins relative to competition in that market.

[Stephanie Benjamin, SunTrust Robinson Humphrey, Inc.]

Great. Very helpful. Well, thanks so much.

[Dominick P. Zarcone, LKQ Corp.]

Thank you.

[Operator]

And your final question comes from the line of Scott Stember with C.L. King & Associates. Your line is open.

[Scott L. Stember, C.L. King & Associates, Inc.]

Good morning, and thanks for taking my question.

[Dominick P. Zarcone, LKQ Corp.]

Good morning, Scott.

[Varun Laroyia, LKQ Corp.]

Good morning, Scott.

[Scott L. Stember, C.L. King & Associates, Inc.]

Can we just maybe just go back to price increases that we have talked about in the aftermarket business in North America? Last quarter you guys had talked about having to be careful with raising prices, just given the fact that you need to stay within a certain pocket below the comparable OEM prices. Can you maybe just talk about what you're experiencing on that front and maybe that just will give us a gauge of how quickly you can get through the price increases that you need altogether? Thanks.

[Dominick P. Zarcone, LKQ Corp.]

Yeah. Sure, Scott. I mean, the reality is in Q2 and true going forward, it has less to do with actually raising prices and it has more to do to make sure that the level of discounts that we're giving to our customers are actually earned. The reality is not everyone earns the same level of discount. And clearly, the bigger customers who buy large volumes consistently over a longer period of time get a higher level of discount off a list than the smaller customers, and it's making sure that our sales team is being incredibly rigorous and focused on giving the right level of discount.

And that's where we've made some progress here in Q2. We think we're going to make continued progress through the back half of the year. And it gets you to the same spot, right, that if you're really being more disciplined on the level of discounts, if that can increase revenue that helps obviously improve your margins, if you will. But again, we want to be – we are very careful. It's a tightrope that we need to walk. We don't want to turn off the revenue growth by being too aggressive on the price front, right, because at the end of the day, we want to continue to take market share and we want to continue to broaden the overall base.

[Scott L. Stember, C.L. King & Associates, Inc.]

Got it. That's all I have. Thanks.

[Dominick P. Zarcone, LKQ Corp.]

Okay. Great. Thank you.

[Operator]

And I'd now like to turn the call back over to CEO, Nick Zarcone, for closing remarks.

[Dominick P. Zarcone, LKQ Corp.]

I would like to thank everyone for their time and attention here today. I know we've ran a little bit long. Sorry about that, but we wanted to answer everybody's questions. Again, we think we had a great quarter, but we're not done, and we're working really hard and we'll continue to focus on improving the margins of all of our businesses around the globe. And we look forward to sharing our further progress with you at the end of October when we report third quarter results. And we hope to have another good report for you at that point in time. So, again, thanks for your time and attention and we'll talk to you in about 90 days.

[Operator]

This concludes today's conference call. You may now disconnect.