LKQ Corp

NASDAQ:LKQ

Earnings Call Transcript 2018-Q4

[Operator]

Good morning. My name is Kim, and I will be your conference operator today. At this time, I would like to welcome everyone to the LKQ Corporation Fourth Quarter and Full-Year 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. [Operator Instructions]

Joe Boutross, Investor Relations. You may begin your conference.

[Joseph Boutross, Vice President of Investor Relations]

Thank you, operator. Good morning, everyone, and welcome to LKQ's Fourth Quarter and Full-Year 2018 Earnings Conference Call. With us today are Nick Zarcone, LKQ's President and Chief Executive Officer; and Varun Laroyia, LKQ's 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 the 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 norm, we are planning to file our 10-K in the next few days.

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

[Dominick Zarcone, President and Chief Executive Officer]

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 operations in the fourth quarter and then Varun will dig into the segments, the related financial details, and then discuss our 2019 guidance before I come back with a few closing remarks.

Taken as a whole, we made good progress in the fourth quarter with the various operational initiatives we implemented throughout 2018. We did however experienced some challenges in achieving the expectations we set forth in our previous guidance, primarily related to our European operations.

Make no mistake, these challenges have not changed our focus on the four key themes we outlined in our last call. Our continued pursuit of profitable revenue growth, progress on our margin improvement plans, excellent cash conversion and the optimization of our capital allocation strategy.

Now on to the quarter. As noted on Slide 5, revenue for the fourth quarter of 2018 was $3 billion, an increase of 22% over the $2.5 billion recorded in the comparable period of 2017. Parts and services organic revenue growth for the fourth quarter of 2018 was 2.5%. Net income from continuing operations attributable to LKQ's stockholders for the fourth quarter of 2018 was $40 million, a decrease of 68% year-over-year.

Diluted earnings per share attributable to LKQ’s stockholders for the fourth quarter of 2018 was $0.13 a share as compared to $0.41 for the same period of 2017, a decrease of 68%. The fourth quarter 2018 results include non-cash impairment charges net of tax of $48 million related to the company's equity investment in Mekonomen and $26 million related to goodwill recorded on our 2017 acquisition of an aviation parts recycler. These impairment charges reduced diluted earnings per share for the fourth quarter of 2018 by $0.23. Varun will address both these items in his commentary.

On an adjusted basis, net income from continuing operations attributable to LKQ stockholders was $151 million, an increase of 19.7% as compared to the $126 million for the same period of last year.

As noted on Slide 6, adjusted diluted earnings per share attributable to LKQ stockholders for the fourth quarter of 2018 was $0.48 an increase of 17.1% as compared to the $0.41 for the same period of 2017.

With respect to capital allocation, during the fourth quarter of 2018, the Company repurchased approximately 2.3 million shares of its common stock at an average price per share of $26.41, reflecting a $60 million return of capital to our shareholders.

As stated during our last earnings call, our strong capital position and healthy cash flow affords us the opportunity to continue investing in our strategic growth drivers all simultaneously utilizing a share repurchase program to maintain a balance capital allocation strategy.

Let's turn to the quarterly segment highlights. As you all know from Slide 7, organic revenue growth for parts and services in our North American segment was 3.7% in the fourth quarter of 2018 compared to the comparable quarter of 2017.

Excluding the impact for the battery contract with FCA, which just started on January 1, 2018, organic growth for the rest of the North American segment, was 2.4%. Still, we continue to perform well in North America, especially when you consider that according to CCC, collision- and liability-related auto claims were down 0.9% in the fourth quarter and up only 0.1% for the full-year 2018.

We believe this outperformance in our growth relative to the CCC data is due to the continued increase in the number of vehicles in our collision sweet spot that being model years we did 10 years old and an 18% increase in the number of alternative parts utilized on a per claim basis over the past five years.

Also according to the U.S. Department of Transportation, our performance in Q4 was achieved all miles driven in the United States were down 0.5% from October and up just 0.3% on a nationwide basis in November.

During Q4, the salvage line of business launched the implementation of a software platform that uses predictive analytics and multiple data input beats to refine the analysis in calculating the most accurate part prices, which in turn will be used to determine the value of total loss vehicles to LKQ and provide more accurate pricing determination at the auctions.

We believe the early stages of this price optimization effort played a key role in the organic growth for recycled parts outpacing that of aftermarket parts in the fourth quarter and for the first time in 2018.

Related to our recycling business, I am proud of our North American teams’ environmental efforts in 2018, between our full service salvage and self service businesses, in 2018, we processed over 872,000 vehicles resulting in among other things, the recycling of 1.4 million catalytic converters, 2.2 million tires, 560,000 batteries, 2.4 million gallons of waste oil in over 4 million gallons of fuel. This effort is a key pillar in our mission of being a responsible steward of the environment in a true partner with the communities in which we operate.

We also continue to grow our parts offerings with aftermarket collision SKU offerings and the total number of certified parts available each growing 5.2% and 11.5% respectively in 2018.

Our North American team continued to make solid progress with respect to the margin recovery efforts despite facing ongoing cost pressures, primarily from wage, fuel and freight inflation. These efforts include being disciplined in terms of pricing and discounts, and realizing continued improvements with our telematics and Roadnet platforms. During the fourth quarter 96% of the 326,000 manifests in North America were created through Roadnet with better routing inefficient trucks, fuel consumption and miles driven were reduced by 1.7%.

Moving to the other side of the Atlantic, our European segment achieved total parts and services revenue growth of 47%, primarily driven by the acquisition of Stahlgruber. Organic revenue growth for parts and services was 0.3%, reflecting a pullback from Q3 levels and well below our expectations.

The European demand was soft across many of our key markets, including the UK, Benelux and Italy. During the fourth quarter and full-year our Rhiag business witnessed negative growth in Italy. In Q4, 2018 Italian economy shrank by 0.2% following a 0.1% decline in Q3.

With that, Italy's economy officially tripped into recession and the economic contraction is expected to continue for sometime, which could create a difficult market for our operations as well. Euro Car Parts posted organic growth in Q4 and full-year 2018, but the quarterly results were well below our expectations.

The UK continues to struggle with the Brexit negotiations and the economic uncertainty appeared to have a negative impact on overall demand with most market participants reporting low single-digit organic growth. STAHLGRUBER performs in line with expectations but we are closely monitoring the economic conditions in Germany which have shown signs of a slowdown. When looking at Europe as a whole a soft economic outlook has shaped our expectations for our 2019 organic revenue guidance.

Regarding Brexit the whole world is waiting to see what comes of the ever changing discussions both within the UK and between the UK and the EU. A couple of de-risk revolve around the fact that most of what is consumed in the UK including automotive parts originates outside of the UK. Indeed a majority of the inventory purchased by the ECP and Andrew Page comes from EU countries.

Accordingly a further weakening of the sterling relative the other currencies couldn't place the cost of procurements and any trade disruptions in terms of getting inventory into the country could create issues in servicing customer demand. With respect to the currencies we do hedge a portion of our expected inventory purchases a few months forward using FX contracts.

On the product front all of our UK based businesses have been working to ensure we have a minimum number of months coverage on all types of inventory including fast movers, mid movers, and even certain slow moving SKUs. This is involved a variety of activities including placing advanced orders increasing stock holdings at ECP facilities and working with key suppliers to have them create buffer stock at their facilities within the UK prior to the end of March.

The interest of the ECP and our suppliers are directly aligned and we have been working proactively with these partners several of which have extended payable terms to offset the cash impact of building inventories. While there are many unknowns related to how Brexit will impact the UK in Europe we believe we have the broadest and deepest inventory in the market and our confident that we will be able to meet our customer's needs.

While the overall European market weakness has provided some headwinds we are also actively addressing the Company specific operating challenges we've experienced to assure we can continue to maintain our market-leading positions and capture the opportunities that we believe our long-term European strategy presents for our Company and our stockholders. Some of the changes relate to new productivity programs all others involve changes in leadership. I will cover a few of our key initiatives in my closing remarks.

As I mentioned in our May 2018, Investor Day talent acquisition is a key initiative for European segment and in Q4 we made solid progress on this front. On December 20 the Company announced that Arnd Franz will join LKQ Europe as Chief Operating Officer on April 1. Arnd is currently Corporate Executive Vice President and Member of the Management Board of the MAHLE Group, where he is been responsible for the company’s global automotive sales and application engineering, including their aftermarket business unit.

From 2006 to 2013, he was Executive Vice President and General Manager for MAHLE Aftermarket. Arnd will report directly to John Quinn, CEO of LKQ Europe. Arnd brings nearly 20 years of experience with Tier 1 automotive suppliers across Europe and has a strong record of successful integration efforts. He will be a great addition to the LKQ Europe leadership team.

Specific to Euro Car Parts, on January 2 of this year, the company announced that Andy Hamilton was appointed ECP’s Chief Executive Officer. Andy joined ECP in 2010, where he held several executive roles, the last of which was Chief Operating Officer. During that period, ECP saw unprecedented growth as the network group from 89 to over 220 branches. Prior to ECP, Andy held a variety of management roles for Halfords Group, the UK's leading automotive and leisure retailer with over 500 locations.

Additionally at ECP, we recently added two key people to the leadership team, including a Chief Administrative Officer and a Chief Supply Chain Officer. The Chief Administrative Officer and Varun actually worked together during their respective times at both CBRE and Johnson Controls. The primary task for this position is to focus on ECP support and governance functions with overall responsibility for legal, finance, and human resources, thereby freeing Andy to focus on customer facing and operating matters.

The Chief Supply Chain Officer worked at ECP from 2014 to 2016 and we are excited to have him back on the team. The main responsibilities for this role are ECP’s logistics and supply chain activities, including the leadership of the T2 facility.

Finally, during Q4 we opened up a total of five new branches in Eastern Europe. Since acquiring Rhiag in 2016, we have opened 94 branches in Eastern Europe, and as we enter 2019, we are now focused on maximizing the productivity of our existing branches with just a handful of new openings planned for this year.

Now let's move on to our Specialty segment. During Q4, Specialty reported total revenue growth of 8.9% including organic revenue growth for parts and services of 5.8% and acquisition growth of more than 3%. Specialty continues to deliver strong results with EBITDA margins in the fourth quarter and full-year 2018 both achieving their highest levels since we entered this segment in 2014.

During the 2018 SEMA Show, the Specialty team launched a new mobile app that is capable of putting the power of their industry best eKeystone business-to-business system into any device. This app harnesses mobile device technology, including voice-to-text capability to allow users to search for products simply by saying a category or brand and utilizes the mobile device camera to scan QR, UPC and vehicle VIN numbers and VIN barcodes.

The eKeystone app includes all the proprietary data in Keystone’s B2B system, thereby providing subscribers access to approximately 800,000 cataloged SKUs, 400,000 images, 20,000 videos, and 40,000 installation instructions and more. We are pleased with the early adoption rates of the app which thus far have generated close to 4,000 downloads from our Keystone Automotive Operations customers.

This was a tremendous initiative and I credit our Specialty teams’ effort to think outside the box and deliver solutions that enhance customer service and drive incremental sales.

Moving on to corporate development, during the fourth quarter, we acquired three wholesale businesses in North America and two wholesale businesses in Europe for a total net consideration of approximately $14 million.

And finally, I would like to highlight that our Board has approved management suggested changes to the structure of our compensation programs, whereby the incentives are directly in lined with our Company wide objectives.

For our key leaders across the globe, the 2019 annual bonus program will incentivize EBITDA, both in dollars and as a percentage of revenue, as well as improvements in free cash flow generation.

For the long-term cash incentive plan, the incentives will be based on return on invested capital, organic revenue growth and EPS growth over a three-year period. In addition, we are creating a new long-term performance share program high to the achievement of the same target metrics.

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

[Varun Laroyia]

Thanks, Nick, and good morning to everyone joining us on the call. I will take you through our consolidated and segment results for the quarter, cover our current liquidity position, and provide 2019 guidance before turning it back to Nick for closing remarks.

The fourth quarter results featured several solid accomplishments and some further opportunities for us to realize. On the positive side, three key points to highlight. Number one, we continue to integrate STAHLGRUBER and I am happy to report that the business is performing in line with expectations and that we are achieving the synergies projected at this stage.

Two, our Specialty segment, which historically had generated its lowest segment EBITDA, margin in the fourth quarter, so an 80 basis points year-over-year improvement in this metric, largely due to effective margin management initiatives.

And finally, three, operating cash flow for the fourth quarter was $190 million, which in total produce the highest annual operating cash flow in the Company's history at $711 million and free cash flow of $461 million. I am very proud of the team's dedication to working capital management, which I am confident will carry through into 2019 and beyond.

On the other side of the ledger, as Nick described, we experienced some softness in revenue growth in the quarter in both North America and Europe. As previously noted, the North America segment was able to withstand the revenue softness relatively well, while in Europe the softness in revenue growth created pressure on a segment EBITDA margin. I will provide further color on this when we discuss segment performance.

There is a larger spread between our GAAP and adjusted figures this quarter than we are typically accustomed to reporting. The variance is attribute to the under-performance of two specific investments, which resulted in an impairment charge in the fourth quarter totaling $75 million on an after-tax basis or about $0.23 per share.

Firstly, we recorded a $33 million goodwill impairment charge related to our aviation recycling business in North America that we acquired in early 2017. The changing market conditions have dampened our outlook for this business, prompting the charge, which was recognized as part of our annual test for goodwill impairment.

And second, in the equity earnings line, which is where we report our share of the results of Mekonomen. We recorded a loss of $46 million in the quarter. This loss is attributable to $48 million non-cash impairment charge on our Mekonomen investment.

We recorded $23 million charge in the third quarter and unfortunately the stock price decline further through December 31, necessitating another write-down. Since year end, Mekonomen has announced its fourth quarter and full-year 2018 results and revised its dividend policy that has resulted in yet another drop in its stock price.

Unless there is a turnaround in the stock price in the coming weeks, we will need to record a further impairment charge in the first quarter. We clearly disappointed in the performance of our investment in Mekonomen, and are hopeful that the worst is behind us.

Now I’ll turn to Slide 13 and 14 of the presentation for a few points on the consolidated results. The consolidated gross margin percentage increase 30 basis points quarter-over-quarter to 38.7% as positive improvements in both Europe and Specialty segments more than offset a negative mix impact related to Europe. Specifically the lower gross margin Europe segment now makes up a larger percentage of the consolidated results following the STAHLGRUBER acquisition, but again as I mentioned we could more than offset this impact.

Our operating expenses increased by 50 basis points quarter-over-quarter primarily attribute to the negative leverage effect in Europe due to revenue softness that I mentioned earlier. Interest expense was up $10 million or 37% compared to the fourth quarter of 2017, due to higher average debt balances primarily related to the STAHLGRUBER financing.

Moving to income taxes, our effective tax rate was 28.3% for the quarter the annual base tax rate was roughly 27.2% which is consistent with third quarter estimate. The higher rate for the fourth quarter reflects a roughly $1 million net negative impact from discrete items. We completed our analysis of the impact from U.S. tax reform and I'm happy to report that there were no adjustments to the provisional amounts in Q4.

Diluted EPS from continuing operations attributable to LKQ stockholders for the fourth quarter were $0.13 down $0.28 relative to the comparable quarter a year-ago. Adjusted EPS was $0.48 reflecting a 17% improvement year-over-year.

Moving to the segments with North America on Slide 17, gross margins during the fourth quarter were 43.5% of flat compared to the prior year. Our pricing initiatives in the aftermarket line have been successful in realizing gross margin benefits that we experience in offsetting decrease in a salvage operations at car costs have moved higher with the mix shifting towards newer model year purchases.

Similar to our aftermarket line we are implementing pricing tools for salvage products to enhance the gross margin generated on each car. Our self-service operations gross margins were roughly flat on a year-over-year basis with non-recurring insurance recovery of setting the negative impact of declining scrap steel prices.

Shifting to operating expenses for North America we saw an increase of 10 basis points both compared to last year and sequentially. There were a few factors working in opposite directions this quarter. Facility expenses increased 50 basis points due to higher rent and utilities expenses and non-recurring these terminations charge. Consistent with the first three quarters we faced headwinds related to freight and vehicle expenses and these costs drew a 30 basis point increase over the prior year.

We actively working to address these headwinds as well as wage inflation and rising benefit costs to the margin initiatives noted previously and also through cost controls throughout the organization. Going the other direction we had non-recurring gain on an asset sales in the fourth quarter of 2018 that had a favorable 30 basis point impact. The remaining 40 basis points improvement primarily related to a reduction in bad debt expense reflecting our strong emphasis on receivable collections.

And finally, we saw a 40 basis point unfavorable movement in segment EBITDA related to the non-controlling interest line. While the operating results of a whole - of a non wholly-owned subsidiaries impact the reported gross margin and operating expense figures, the allocation of the profit or loss from these businesses fall below operating profit.

Last year we allocated a loss from our non wholly-owned subsidiaries in North America to the minority shareholders, but reported income in these businesses in 2018 thereby creating the unfavorable year-over-year comparison. In total segment EBITDA from North America for the fourth quarter of 2018 was $153 million roughly flat compared to the prior year.

Looking at Slide 19, scrap prices were flat versus the comparable quarter a year-ago, but down relative to the third quarter of 2018 by 3%. As we previously mentioned the impact from scrap reflects the sequential movement in pricing as car costs will generally follow scrap prices higher or lower over time.

Changes in scrap steel prices had a negative effect of approximately $5 million on segment EBITDA or a little over $0.01 on adjusted diluted EPS. The management team remains intensely focused on margin realization and the cost mitigation initiatives launched last year.

Moving on to our European segment in Slide 20, gross margin in Europe was 36.7% in the fourth quarter, a 100 basis point increase over the comparable period of 2017. Our Sator business in the Benelux region continued to show margin expansion, contributing a 30 basis point improvement to the segment with specific strength in private-label sales and the ongoing move from a 3-step to a 2-step model in that market. Our centralized procurement yielded a 40 basis point improvement from supplier rebate programs.

With respect to operating expenses, we experienced a 120 basis point increase on a consolidated European basis versus the comparable quarter from a year ago. The lower sales growth had a negative impact on operating leverage. STAHLGRUBER results, as I previously mentioned were consistent with the previously disclosed projection for the year.

European segment EBITDA totaled $107 million, a 38% increase over last year. As shown on Slide 22, relative to the fourth quarter of 2017, both the pound sterling and the euro both weakened by 3% against the dollar causing about a $0.01 negative effect from translation on adjusted EPS in the quarter.

Segment EBITDA as a percentage of revenue was 7.5% for the fourth quarter of 2018, down 50 basis points from the same period last year due to revenue softness and lower than expected results both in the United Kingdom and Italy.

The management team has implemented cost controls over all geographies, including reviews of discretionary spending and stringent additional approvals for headcount. The European team has reiterated its commitment to the previously stated objective to deliver double-digit segment EBITDA margins by the end of the three-year period that started in January 2018.

Turning over to our Specialty segment on Slide 23. This business continues to deliver solid results. The gross margin percentage improved by 230 basis points in the fourth quarter relative to the comparable period of 2017. Of this amount, 120 basis points related to a non-recurring amortization impact in 2017 related to one purchase accounting, and additional 30 basis points increase is attributable to mix.

Operating expenses as a percentage of revenue in Specialty were flat relative to the prior year. Higher vehicle and fuel expenses and FX causes were partially offset by a reduction in bad debt expense falling on from the previously mentioned focus on collections.

Segment EBITDA for Specialty was $28 million, up 20% from the fourth quarter of 2017, and as a percentage of revenue segment EBITDA was up 70 basis points to 8.5%.

Let's move on to capital allocation and the balance sheet. As presented on Slide 25, you will note that our operating cash flows for 2018 was $711 million or up $192 million, a 37% increase versus 2017. Operating cash flows for the quarter was strong at $190 million following the momentum in the third quarter or into an emphasis on receivables collections, and moderate inventory growth. CapEx for the quarter was $78 million and $250 million for the full-year.

In the fourth quarter, we made further pay downs on a credit facility borrowings, while repurchasing $60 million of LKQ stock under the repurchase program launched late last October. For the full-year of 2018, we paid down $206 million on a credit facility borrowings all of this was funded by a strong operating cash flows.

Trade working capital has defined as receivables and inventory offset by payables as a percentage of revenue improved by 250 basis points, reflecting our commitments towards delivering strong cash flow.

I am very heartened by the scale of improvement we could deliver as this has come ahead of the structural change to the incentive compensation program in 2019 and more broad-based working capital efficiency programs.

Moving to Slide 27, we amended and extended our credit facility in the fourth quarter. The changes increase the capacity of a revolving credit facility to $3.15 billion, offset by a lower term loan, extended the maturity through to January 2024, simplify the pricing tiers and immediately reduced our borrowing margin by 25 basis points.

As of the 31 December, we had $332 million of unrestricted cash, resulting in net debt of about $4 billion or 2.9x last 12 months EBITDA. Breaking through the lesson 3x benchmark is a crucial threshold as a further lowers the cost of our credit facility borings based on the revised pricing tiers as part of the credit facility amend and extend, we executed in the fourth quarter.

On Slide 28, we've had the key metrics that we track, though please note that we are excluding the impact of STAHLGRUBER in the calculations to eliminate short-term movements caused by large investments. We will add STAHLGRUBER into the calculations once we've analyzed the transaction.

Now I'd like to detail our annual guidance for 2019. Please note that the guidance assumes that scrap prices and FX rates hold at current levels and the annual tax rate is dialed in at 27%. Additionally, the guidance assumes no material disruptions associated with the United Kingdom's potential exit from the European Union.

We have set organic parts and services revenue growth at 2% to 4%. Given our fourth quarter revenue growth, the economic uncertainty in Europe and are continuing emphasis on profitable revenue growth, we are moderating our growth assumptions for 2019.

Diluted EPS, on a GAAP basis is a range of $2.05 to $2.17 while adjusted diluted EPS is the range of $2.34 to $2.46. We are projecting solid business growth from a margin improvement efforts and an incremental $0.09 from a full-year of Stahlgruber. On the negative side, lowest scrap prices and a stronger U.S. dollar reduce the year-over-year expectations by $0.07.

Cash flows from operations reflect a range of $775 million to $850 million. We believe our focus on working capital management and increase profitability will drive higher cash flows in 2019.

Capital spending set at a range of $250 million to $300 million, a modest increase from the current year level, though flat to slightly down on a year-over-year basis, when we normalize the expected increase or into a full-year of STAHLGRUBER CapEx and various European projects, most notably the ERP implementation. Taking the lower and the top ends of both OCF and CapEx, we expect to generate free cash flow in excess of $500 million in 2019.

In summary, we remain encouraged by the strength of a market leading businesses do acknowledge that we still have further work to do related to fully realizing the benefits of our initiatives to offset the ongoing cost pressures and to continue to improve profitability.

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

[Dominick Zarcone, President and Chief Executive Officer]

Thank you, Varun for that financial overview. I believe that we are taking the necessary steps to position the Company for continued long-term success. Looking back on 2018, we crossed major milestones that our team of over 50,000 employees across the globe should be proud of, including achieving the highest annual topline revenue in the Company's history, up 22% over 2017, generating the highest annual cash flow figures in the Company's history. With operating cash flow and free cash flow up 37% them 36% respectively over 2017 levels.

Closing the STAHLGRUBER acquisition the largest acquisition in the Company's history, completing the largest capital raise in the Company's history through notes with a in tenure maturities at attractively low fixed interest rates and amending our credit facility to provide more flexibility and better pricing.

With that let me summarize a few of the key initiatives for 2019. First, we have built strong businesses with leading companies in our core geographies. Our focus will now shift towards operational excellence through the integration and simplification of our operating model. The management team will concentrate on leveraging the strengths of the business units for profitable revenue growth, margin improvement and cash conversion.

Second, all of our businesses will be closely monitoring cost to drive-out duplicative expenses, heighten controls over discretionary spending and react quicker the changing market conditions.

Third, we will invest in our future through long-term projects like the ERP implementation in Europe, a centralized European catalog system, and the multi-year development of a new NDC in the Netherlands. All these projects often don't produce an immediate benefit they are essential for positioning the business for future growth and profitability.

Finally, the revamped compensation programs well help ensure the management incentives are in even tighter alignment with the key priorities of the Company and the expectations of our stockholders. In closing, I am proud of how our team of over 50,000 employees performed doing 2018 in the midst of various operating challenges in both North America and Europe.

Our team never took their eye off the ball and continued to work tirelessly to create and evolve what we all believe is a unique company. Our extensive distribution networks the breadth and depth of our inventory and our industry-leading fulfillment rates position as well to deliver consistent profitable growth and drive higher levels of operating efficiencies across all segments. This focus on operational excellence should translate into continued long-term value for our shareholders.

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

[Operator]

[Operator Instructions] Your first question comes from the line of Daniel Imbro of Stephens. Please go ahead. Your line is open.

[Daniel Imbro, Stephens Inc.]

Yes. Hey, good morning, guys. Thanks for taking my questions.

[Dominick Zarcone, President and Chief Executive Officer]

Good morning, Dan.

[Varun Laroyia]

Good morning, Daniel.

[Daniel Imbro, Stephens Inc.]

I wanted to start on the European business and kind of the outlook for expenses. One clarifier and then a question. Varun, did I hear you right, where there any one-time expenses that drove that deleverage or was it just the lower sales growth of the business that drove the year-over-year decline?

[Varun Laroyia]

Yes. So if you look at the European margins, Daniel, it was specifically the revenue softness, which caused a loss of operating leverage on that. There weren't any specific one-time is there were, some of the smaller ones, not that material. But that was really associated with some management departures that had been undertaken. But other than that nothing that would come to mind beyond that.

[Operator]

You next question comes from the line of Stephanie Benjamin of SunTrust. Please go ahead. Your line is open.

[Stephanie Benjamin, SunTrust Robinson Humphrey, Inc.]

Hi. Thanks for the question. Good morning. My question really just goes with expectations and I know reiterated the expectations in Europe to continue to really see that margin improvement in double-digit EBITDA growth in reiteration of that. I'm just wondering, as I look to the guidance for 2019, I think expectations are for a softer topline growth kind of similar to the fourth quarter. So I'm just kind of wanting to hear the puts and takes for you to - for your expectations for margin improvement in Europe in 2019, so you don't see kind of that continued operating deleverage we saw in fourth quarter. So just kind of wanting to hear the offsets of there would be great. Thanks.

[Varun Laroyia]

Yes. Absolutely, Stephanie. Good morning. It’s Varun Laroyia. Great question. I think, if you kind of look back into 2018 with regards to our European segment. Going back to Q1, you'll recall we had some challenges in the UK operations with our Tamworth facility. Coming out of that, obviously there was a capitalized cost to recover that central distribution center and then they're on, there was also some price discounting that was taking place. So that was kind of one piece that we don't really expect to continue into the future as we think about 2019.

The other piece is, as you think about the broader European landscape. Italy, we know has been soft. And clearly there was a deleverage that ended up taking place out there. And then obviously, some other elements, we get the full-year benefit of some of the distribution centers that we had shutdown in anticipation of Tamworth coming through, and the same thing with Andrew Page also.

So, as you think of some of those kinds of puts and takes, clearly there are certain elements that impacted our 2018 operational results in the European landscape. And as we think about 2019, we do believe that those elements would have stabilized and despite the lower economic activity expected across the European segment, we believe that with the active cost containment programs that are in place, we do believe that we will get better operating leverage from that segment.

[Dominick Zarcone, President and Chief Executive Officer]

Stephanie, this is Nick. As we go through the planning process each year and a very detailed budgeting process, clearly the expectations for every one of our businesses around the globe is not only to generate good organic growth, but also to improve their margins. And that is true in Europe. It's true actually in the North American and Specialty businesses as well.

And I think you will find the underpinning really of the consensus that Varun walked through is an assumption and some pretty detailed plans by our operating businesses to improve margins across the board with one exception and that's the self-serve business here in the United States, which has to deal with scrap prices, and there's only so much they can do to offset the negative impact from scrap as it relates to our operating margins. But again, it's important to understand that the expectation internally is that all of our businesses on an annual basis have plans to find positive operating leverage in their business.

[Operator]

Your next question comes from the line of Bret Jordan of Jefferies. Please go ahead. Your line is open.

[Bret Jordan, Jefferies LLC]

Hey. Good morning, guys.

[Varun Laroyia]

Hey. Good morning, Bret.

[Dominick Zarcone, President and Chief Executive Officer]

Good morning, Bret.

[Bret Jordan, Jefferies LLC]

Hey. Varun, can you give us an update on where we are from a working capital standpoint or your thoughts on leveraging working capital maybe what you could do with payables in Europe or the U.S.?

[Varun Laroyia]

Yes, absolutely. I think, if I take your question Bret in terms of what's driving – what drove free cash flow higher in 2018 and as to what gives us the confidence going into 2019 for the free cash flow guidance, two key pieces, really to think through. One, 2018 to 2019 that clearly is the higher profitability from the focus on pursuing profitable revenue, the margin realization initiatives that we launched last year, and also the cost containment programs that are currently in place. So that's kind of just the starting point for free cash flow.

The second point is just active working capital management. And if you think about the momentum that we saw in the third quarter, which we continued into the fourth quarter, really the focus has been on some very simple elements in the balance sheet. Within our cash flow statement, you can actually see this come through, the focus with collections. In 2017, it was a $56 million outflow and in 2018 it was basically flat. So we didn't invest, despite the fact that business grew significantly. We didn't really invest that much more in receivables because we were actually going and collecting the cash that was due to us.

The second point is if you look at inventory, inventory did grow also on a year-over-year basis with the larger scale of business, but it was about $77 million lower than what it was in 2017, right. And then the final piece quite frankly is the opportunity that's still out there for us to go get. The single biggest piece, which kind of held us back I'd say is, on a year-over-year basis there was $122 million swing on accounts payable. It was a significant outflow, right.

And so as you think about each of these key elements, and as to what we continue to focus on, simplistically there is further opportunity in any case. I think the final piece, which actually is a rapper across the entire working capital and free cash flow piece is the incentive compensation plans and these obviously have been aligned with the goals in 2019.

We don't specifically call out the weightings of each of those elements, but I will share with you, it is not a token measure. It is a substantial chunk of people's incentive compensation to generate free cash flow.

[Operator]

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

[Dominick Zarcone, President and Chief Executive Officer]

Hey, good morning, Chris.

[Varun Laroyia]

Good morning, Chris.

[Christopher Bottiglieri, Wolfe Research, LLC]

Hey, good morning. I wanted to ask about – with revenue growth is slowing a little bit, also recognizing that you're going through implementing a number of projects with fixed margins. Can you help frame for us OpEx growth next? What's kind of like your run rate assumption from SG&A for organically from inflation that what's the net impact of costs saving initiatives versus investments to cut costs, just how you're thinking about that next year?

[Varun Laroyia]

Yes. So Chris, its Varun Laroyia. With regards to cost containment efforts and also OpEx, a few things to kind of think through, firstly here in North America, a bunch of our wage inflation or the freight elements essentially get analyzed.

And again, what we have seen – I've seen over the last four to five months as being not a de-acceleration or a downward trend, but basically being a flattening out of some of those expenses that are kind of coming through. So that's point number one.

And clearly from the second half of the fourth quarter, we saw fuel come down, also some not enough to offset the various elements given the fact that wage pressures have kind of flown into the freight costs also.

And as you think about going into 2019, the cost containment efforts specifically what headcount had, we essentially trying to make the business more resilient with the revised projections from a growth perspective, which I believe actually very pragmatic. And quite frankly, the cost structure will follow this level of pragmatism rather than building up across infrastructure, which was geared for far higher growth level as such, right.

And then finally if you think about it, as Nick mentioned in his opening comments, also the overall expectation for each of our businesses is to secure a positive operating leverage. And again, with the change in the incentive compensation plans, there is margin growth both in absolute dollars, but also on a margin percentage that we expect.

So again there are only so much that one can do in terms of being able to realize certain margin benefits. But clearly the cost containment and the OpEx productivity is a key lever and being able to deliver higher year-over-year margins.

[Operator]

Your next question comes from Craig Kennison from Baird. Your line is open.

[Dominick Zarcone, President and Chief Executive Officer]

Good morning, Craig.

[Varun Laroyia]

Good morning, Craig.

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

Good morning. Thanks for taking my question. On a new compensation plan, what are the thresholds for your key performance indicators that you would need to reach in order to generate the incentive?

[Dominick Zarcone, President and Chief Executive Officer]

Yes. Craig, we don't disclose the absolute thresholds, but you can be assured that they are tied exactly into the 2019 budget, which is tied exactly into the guidance step Varun gave just a bit ago.

[Operator]

Your next question is from Brian Butler from Stifel. Your line is open.

[Brian Butler, Stifel, Nicolaus & Company, Inc.]

Good morning. Thank you for taking my question. Could you provide a little bit more color maybe on the parts and service business down at the geographic level in Europe and U.S. kind of thoughts on how we should think about growth rates and margins – EBITDA margins for each part of that?

[Varun Laroyia]

Sure. We don't officially provide guidance on a segment basis, but again 2% to 4% overall, I think you could probably assume that North America, we think North America on an annual basis will be somewhere in the middle of that range. We think Europe is going to be towards the lower end and specialty towards the upper end. So we're really spread across the three businesses.

I think it's also important to recognize that this will vary as we roll through the four quarters of the year. It's not a nice – set of growth in Q1 and Q2 2018 had monster comps that were working against, if you recall that the organic growth in North America in Q1 2018 was in around the 7% range.

So that is creating a pretty big hurdle. If you will there are a couple things that we anticipate in Q1 that will run against organic growth first, we annualize the battery contract with FCA just to refresh everyone's memory that added about 1% to our organic growth as to what we reported in 2018. So that positive increment will come off the boards if you will.

It is also become a parent that as FCA was ramping their activities with us, that there was some kind of one-time benefits if you will that we got in getting the program up and running and that will not return in 2019. We're really at a steady state now with the FCA battery shipments. And so we're anticipating batteries were actually be down year-over-year in the first quarter.

Also AeroVision clearly not meeting our expectations that's the business where we took the impairment charge here in Q4, our expectation is the businesses underperforming and it will also be down in the first quarter on a year-over-year basis. From a margin perspective, again, we're anticipating upticks and margins in each of our businesses with North America being muted a little bit by the significant downdraft on the scrap prices, which has noted in the deck hit us for the better part of $0.04 a share so for the year. And that will be a particularly pronounced kind of in the first quarter, I'm assuming scrap prices hang in where they are today.

[Operator]

[Operator Instructions] Your next question comes from Ryan Merkel from William Blair. Your line is open.

[Dominick Zarcone, President and Chief Executive Officer]

Good morning, Ryan.

[Ryan Merkel, William Blair & Company L.L.C.]

Hey, good morning, everyone.

[Varun Laroyia]

Good morning, Ryan.

[Ryan Merkel, William Blair & Company L.L.C.]

So on free cash flow conversion guidance in 2019 applies a little bit of improvement, about 70% my math is right? But I'm wondering what is your long-term target and then more importantly how long it going to take to get there?

[Varun Laroyia]

Yes, Ryan. So I think as we kind of spoke last May at an Investor conference, I kind of laid out a chart for our investors and obviously a number of view from a sell side perspective also just in terms of the way the business had been trending. And really what I use is I try and keep it as simple as possible and take out all the noise and rate specifically focused on three key elements of working capital.

So receivables plus the inventory offset by accounts payable and there's a slide in the deck that you'll see really, which I cannot highlight with regards to where we went 17 versus the kind of progress you've made in 2018. In 2018 the denominator is actually trailing 12 months performer revenue, which includes a full-year of the transactions, namely Stahlgruber.

So we don't taking reported numbers, we actually taking performer numbers so you can kind of work the count and actually works against us. But that's where the focus has been. And quite frankly, I think, with the incentive compensation, peaceful, so being tied into free cash flow generation. I am quietly confident that our businesses will continue to deliver.

Again, step back and look at the history of the Company, which has been very growth oriented and at this stage of our maturity curve as a company, north of $12 billion is what we kind of forecasting for total revenues in 2019. There are elements that if not growth at all costs and so just management of that piece. But there's an embedded culture and as you know culture is take time before they kind of change.

So again, we put out guidance, which I think is above where the market was expecting us to be. But again, we have plans in place to be able to go deliver on it. I don't want to get ahead of ourselves in terms of what's going for 2020, 2021, 2022.

I'd say its one step at a time and I'm really happy to report to successive quarters of improvement on that side. We've clearly put our money where our mouth is with regards to 2019 also in raising overall free cash flow guidance and one step at a time, but I'm confident in terms of the plans we've put in place and as to how those are currently tracking.

[Operator]

Your next question comes from Daniel Imbro from Stephens. Your line is open.

[Daniel Imbro, Stephens Inc.]

Yes. Thanks [indiscernible], hop back in the queue for a follow-up guys. Last quarter, Varun you updated us on your attention to unlock cash flow through increased factoring in the European business specifically at Stahlgruber. Can you provide some more color on that market or an update? And can you remind us on how you guys think about the longer-term opportunity from increasing your factoring in that market?

[Varun Laroyia]

Yes. So Daniel I think you kind of referring to the unwind of the factoring program that we had through one of STAHLGRUBER subsidiaries. So it wasn't a case of starting up a factoring program. It was actually unwind off a factoring program, which would result in those receivables coming back to us.

So that's what it was. We don't really have an active factoring program we don't want to go down that path. It really where the opportunity is as we've talked about from a European perspective, a number of the same supplier community does provide product into the North American folks out here.

So again, they are well tuned in terms of what the expectations are and we do have a tremendous opportunity from a European perspective to be able to unlock that piece, whether it'd be through a vendor financing program or through an extension of peoples, the end goal is the same to be able to have our payables essentially match the days inventory on hand to a point right. And that's how the conversion would work and then obviously active management on idea so with regards to receivables.

So you are right about the fact that there is an opportunity for our European business. And again it has been contemplated in the plans we've put together with that business and it also reflects the targets that are being tossed with for 2019.

But again just to confirm, there was no startup off the factoring program. It was actually unwind of the factoring program for one of the STAHLGRUBER subsidiaries in the fourth quarter.

[Operator]

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

[Christopher Bottiglieri, Wolfe Research, LLC]

Hi, thanks for taking the second question. Just a question North America, so now you guys are getting a lot tougher on discounting and trying to contain the pricing, what are the CI’s you're thinking about the Caliber and Abra merger? How do you guys manage through that and kind of to what extent you've articulated something that your guidance from this will be helpful? Thank you.

[Dominick Zarcone, President and Chief Executive Officer]

A great question, obviously both Caliber and Abra are excellent organizations. They've been incredibly good customers of ours for years and years. No surprise. There are a couple of our largest customers, just due to the total number of shops that they operate. On a combined basis, they're going to be at about 1,050 shops across the country, if you will. And they've got posted plans to grow that to north of 1500 shops I think over the next three years or so.

We've got a great relationship with both organizations, and we look forward to being a great partner with them as they continued to move forward in their business plans. Again we believe that we provide an excellent level of service to these organizations. That's why they are big customers of ours.

We can get them the parts they need, when they need them. There's no doubt about it. They already get our largest discounts, if you will, because they're already, amongst our top three or four customers. So we don't anticipate any major changes there.

To the extent that they have market overlap because you got to remember this is a very much a local business. And what happens to go on, say in Dallas, doesn't have anything to do with goes on, and say up in Boston or in Portland, Oregon, right? It's a local business.

And to the extent in any given market, local market, they have overlap where we can find ways to be more efficient in servicing the combined organization. We're absolutely going to have discussions with them to see how we can make their business better and our business better. So again we have tremendous relationships at the very senior levels of both organizations. We're not anticipating any major shifts in our business as a result of the merger.

[Operator]

I now turn the call back over to Nick Zarcone.

[Dominick Zarcone, President and Chief Executive Officer]

So that completes our 2018 full-year earnings call. We absolutely appreciate the time and attention you've given us here this morning. We look forward to chatting with everyone in about 60 days at the end of April when we announced our first quarter results. So again, we think we ended the year, a strong some real progress on a couple of key factors, particularly, the working capital on the cash flow, which is Varun indicated will carry us into the future. And we're look forward to chatting with you again in 60 days. Thank you.

[Operator]

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