LKQ Corporation (LKQ) Q4 2019 Earnings Report, Transcript and Summary

Good morning. My name is Julie, and I'll be your conference operator today. At this time, I would like to welcome everyone to the LKQ Corporation's Fourth Quarter and Full Year 2019 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] I would like to turn the call over to Joe Boutross, Vice President of Investor Relations. You may begin your conference.

Thank you, operator. Good morning everyone and welcome to LKQ's fourth quarter and full year 2019 earnings conference call. With us today are, Nick Zarcone, LKQ's President and Chief Executive Officer; and Varun Laroyia, Executive Vice President and Chief Financial Officer. Please refer to the LKQ website at lkqcorp.com for our earnings release issued this morning as well as the accompanying slide presentation for this call. Now let me quickly cover the Safe Harbor. Some of the statements that we make today may be considered forward-looking. These include statements regarding our expectations, beliefs, hopes, intentions or strategies. Actual events or results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors. We assume no obligation to update any forward-looking statements. For more information, please refer to the risk factors discussed in our Form 10-K and subsequent reports filed with the SEC. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release, as well as the slide presentation. Hopefully, everyone has had a chance to look at our 8-K, which we filed with the SEC earlier today. And as normal, we are planning to file our 10-K in the next few days. And with that, I'm happy to turn the call over to our CEO, Nick Zarcone.

Thank you, Joe, and good morning to everybody on the call. This morning, I will provide some high-level comments related to our performance in the quarter and then Varun will dive into the financial details and 2020 guidance before I come back with a few closing remarks. Q4 was a strong quarter for our company, and we are very pleased with the results. As we mentioned at the outset of 2019, we were focused on a few key initiatives, and I am proud to say our segment teams have embraced and executed on each. There is more opportunity ahead, and we will continue to work hard to move the company forward. Let me reiterate the key initiatives, which continue to be central to our culture and objectives as we've entered 2020. First, we will continue to integrate our businesses and simplify our operating model. For example, in 2019, we launched our 1 LKQ Europe program and provided a clear road map to drive the business to double-digit EBITDA margins. Additionally, in 2019, we divested our airplane recycling business and merged auto Kelly Bulgaria with a competitor, thereby removing a couple of low-margin non-core businesses from our lineup and freeing up management time. Second, we will continue to focus on profitable revenue growth and sustainable margin expansion. In 2019, we were able to grow margins despite facing low revenue growth and macro headwinds in Europe, with our teams doing an exceptional job of addressing costs with their productivity efforts. North America, in particular, witnessed year-over-year improvement in segment EBITDA margins of 100 basis points in 2019. Third, we will continue to drive higher levels of cash flow which, in turn, will give us the flexibility to maintain a balanced capital allocation strategy. In 2019, we generated record cash flow from operations of over $1 billion and free cash flow of nearly $800 million, reflecting year-over-year increases of 50% and 73%, respectively. Last year, we paid off $301 million worth of debt and repurchased 10.9 million shares of our stock for over $290 million. And fourth, we have and will continue to invest in our future. In 2019, we made two strategic acquisitions in the automotive diagnostic space, which positions our North American business to be at the forefront of this rapidly growing market opportunity and will allow us to continue expanding our customer offerings. As noted on Slide 5, total revenue for the fourth quarter was $3 billion, reflecting growth of 0.2%, a slight increase from what was recorded in the comparable period of 2018. Parts and Services organic revenue growth for the fourth quarter was 0.9%. Acquisitions added 20 basis points of growth, while currencies had a negative impact of 1%, for total parts and services revenue growth of 0.1%. Net income during Q4 was $140 million compared to $40 million for the same period of last year, an increase of 247% year-over-year. Diluted earnings per share for the fourth quarter was $0.46 compared to $0.13 for the same period of 2018, an increase of 254% year-over-year. On an adjusted basis, net income was $167 million, an increase of 10% compared to the $151 million for the same period of last year. Adjusted diluted earnings per share for the fourth quarter was $0.54 compared to $0.48 for the same period of 2018, a 13% increase. We are again pleased with the level of EPS growth considering the marginal uptick in revenue. Let's turn to some of the quarterly segment highlights. As you will note from Slide 7, organic revenue growth for parts and services in our North American segment was 2.5% in the quarter. This organic performance includes a benefit from the GM strike, which was partially offset by declines in our glass and heavy-duty truck businesses. Excluding these dynamics, organic growth would have been 1.3%. We continue to perform well in North America, especially when you consider that, according to CCC, collision and liability-related auto claims decreased 1% in the fourth quarter. Also, according to the U.S. Department of Transportation, our performance in Q4 was achieved while miles driven in the U.S. were down 0.1% year-over-year in November. Related to our recycling businesses, I am proud of the impressive environmental efforts of our North American team in 2019. Between our full service and self-service salvage businesses, during the year, we processed over 887,000 vehicles, resulting in, among other things, the recycling of 4.2 million gallons of fuel, 2.6 million gallons of waste oil, 2.5 million tires and 630,000 batteries, all reflecting solid increases over 2018. This effort is a key pillar of our mission of being a responsible steward of the environment and 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 growing 4.9% and 10.0%, respectively, in 2019. Lastly, on North America, during the quarter, we continued the development of our mobile app-based delivery manifest management system, which we call InTouch Mobile. InTouch Mobile is a proprietary, internally developed platform that will automate delivery management and route accounting procedures that we are converting from a manual to paperless process. InTouch Mobile will also enhance the customer service experience, improve route and driver efficiencies and simplify various accounting functions. We are excited about this implementation and optimistic about the potential productivity it will generate. At the end of Q4, 85% of our full service and aftermarket locations were live on the system. Moving to our European segment. Organic growth for parts and services in the fourth quarter was 1.2%. Acquisitions in Europe added 0.7% of revenue growth, while the strong dollar resulted in a negative impact of 2%. As noted by other public companies with European exposure, the soft economic backdrop continues to create an industry headwind. Indeed, our performance on a relative basis appears to be strong, which gives us confidence that we continue to take market share. While we don't disclose country-by-country detail in the fourth quarter, we witnessed positive organic revenue growth in each of our markets in which we operate, except for Germany and Italy. As it relates to the 1 LKQ Europe program, we continue to gain operational momentum on multiple fronts, and the segment is performing in line with the metrics and multi-year plan we set forth last September. As I've stated in the past, talent acquisition and to build out our organizational structure is a key component to implementing our 1 LKQ Europe program. And in Q4, we made very good progress on the talent front. Going forward, we are implementing a recently announced European organizational structure of key functional departments, including private label, which we are now calling components, product management and procurement, supply chain and information technology. On the operational side, we have announced both a new CEO for Rhiag, Italy, who came from the outside, and the promotion of an internal person to lead the Stahlgruber organization. On the corporate side, we have announced the recruitment of a human resources leader for all of Europe and also appointed leaders for information technology, product management, procurement and components. The implementation of these strategies will promote the harmonization of processes and infrastructure, the implementation of best practices and the establishment of common standards in each of the functions. We believe this will position the business to achieve better results, make faster and better decisions and work more efficiently. Supporting the organizational structure, in Q4, we identified Zug, Switzerland as the future home of our European segment corporate office. We expect to officially open the office in mid-2020. With a key initiative of investing in our future, we began the construction of our new central distribution center for our Fource business in the Benelux region. Located in the Netherlands, this new facility will enable us to consolidate the activities of five small existing distribution centers into a single location, which will have automation similar to that found at T2 in the U.K. and Sulzbach-Rosenberg, in Germany, albeit on a slightly smaller scale. Regarding Brexit, our U.K. operations have taken necessary precautions to protect the interest of our customers for every milestone of this exit process. We have a sufficiently deep inventory from European and Asian suppliers, strong supply processes and significant measures in place to provide our customers with the service they expect from us even in the face of Britain's recent departure announcement from the common market. In fact, we believe the size of our business and its industry-leading processes will enable us to continue to expand our market share in the U. K. and the Republic of Ireland, acting as a key partner for our customers even in the face of what could be a momentous change. As Europe has become a larger portion of our global revenue and is a part of our board's ongoing director refreshment process, on December 6, we announced the addition of Xavier Urbain to our Board of Directors. As the former Group Chief Executive Officer of Netherlands based CEVA Logistics, Xavier's experience with building a global business across both developed and emerging market will add tremendous value at the board level into our operating teams as we continue to execute on the 1 LKQ Europe program. Lastly, in Q4, we opened three new branches in Eastern Europe and two new branches in Western Europe. Now let's move on to our Specialty segment. During the fourth quarter, Specialty reported a total revenue decrease of 6%, a performance well below our expectations. The primary drivers for this decline were twofold. First, two major suppliers altered their go-to-market strategies, which essentially bypassed wholesale distributors for a portion of their volumes. We believe these are isolated cases and not reflective of a broader trend. Second, in the fourth quarter, a few companies who use our specialty unit to fulfill orders they received through online marketplaces witnessed impactful interruptions during the critical selling period of late November and December. These interruptions were related to these companies having their sales halted temporarily due to intellectual property complaints submitted to the marketplace facilitators. Today, these companies have had varying degrees of success, countering those claims in getting back online. Confronted with these headwinds, our specialty team is aggressively seeking new business by expanding our product line and targeting new and relevant customers. Additionally, specialty continues to focus on measures to right-size their cost structure given the top line challenges, hoping to offset some of the reduction in EBITDA margin. At the 2019 SEMA Show, Warn announced that Ford Motor Company is offering a Warn winch for it's 2020 F-250 and F-350 Super Duty trucks. These new winches will be available as a factory- orderable option or a dealer-installed after sale accessory on properly equipped Super Duty models beginning in mid-2020. Additionally, at the Chicago Auto Show this month Jeep announced that the new limited addition 2020 Jeep Wrangler JPP 20 is equipped with a Warn Rubicon Zeon Winch along with Warn's proprietary Spydura Rope. As was announced at Specialties RV Expo last month, we continue to expand our RV OEM warranty program with the addition of Winnebago, a rapid adoption of our OE warranty program offerings to top tier manufacturers is a clear validation of our unrivaled distribution network in customer service capabilities. There was a relatively quiet quarter from a corporate development perspective, we closed on two transactions in the US, a diagnostic and repair service provider in a niche business that manufacturers and distributes replacements and labels, with a total net consideration of $13 million. In addition, we announced the execution of a definitive agreement to sell the company's equity interest in two Czech Republic wholesale automotive parts distributors, and that's pending regulatory approval. Finally, as you are aware, the coronavirus has generated significant headlines, which has led to many questions regarding our supply chain. First, I'd like to say that, on behalf of LKQ, our thoughts go out to all those impacted by the virus. Clearly, with this outbreak, everyone is in uncharted waters, and it is simply too early to say what interruption companies could face across the business world. The coronavirus outbreak occurred just prior to the Chinese New Year. As a normal course of business and anticipating the annual shutdown related to the Chinese holiday, we had already procured and received most of the Chinese manufactured products needed for the first quarter. Importantly, our segment teams are proactively monitoring the situation and are in constant dialogue with our supply chain partners to help assure we maintain continuity in our operations and effectively manage the inventory levels we need to service our customers. And I will now turn the discussion over to Varun, who will run you through the details of the segment results and discuss our 2020 guidance.

Thank you, Nick, and good morning to everyone joining us on the call. Overall, we are pleased with our fourth quarter and full year performance, as it relates to progress in our key financial priorities of profitable revenue growth, margin expansion and free cash flow generation. Resetting the team's focus to these priorities, while implementing large-scale changes to our compensation plans was a formidable task, and we are incredibly pleased with how quickly the organization adapted to these progressive changes to deliver solid results in 2019. With North America in a strong position and the 1 LKQ Europe program picking up momentum, we are excited about our prospects for 2020 and beyond. Before diving into the results, let's start with the key financial highlights. The consolidated segment EBITDA margin for Q4 improved 80 basis points relative to the prior year. This was led by the North America segment, which not only generated the highest fourth quarter margin in the previous 5 years, but the highest by 120 basis points. Europe and Specialty were roughly flat, although Europe faced a 30 basis point headwind from transformation expenses. Q4 was a relatively low revenue growth quarter, so the ability to maintain or grow margins speaks to the improved resilience of the business. The restructuring programs we implemented earlier in the year have certainly helped in this regard and helped kick start the focus on costs and productivity. As we guided last quarter, after a couple of historically high quarters of cash flow generation, the expected moderation of operating cash flows occurred in the fourth quarter. That said, we were still able to add approximately $100 million in operating cash flows for the quarter to finish the year well over $1 billion, a record high for the company. We are cautiously optimistic going into the year, as reflected in our original guidance of $775 million to $850 million, but to finish over $1 billion is a tremendous accomplishment. I want to thank our team members across the enterprise for their efforts in making this a reality. What was anticipated to be a 3 year journey has taken us a little over a year. This is the LKQ culture that I am immensely proud of. I'll now cover our consolidated and segment results. Similar to last quarter, to save myself some words and the accompanying earnings deck being largely self-explanatory, when I refer to net income and diluted EPS, please note that I will be referring to the amounts from continuing operations attributable to LKQ shareholders. In addition, Nick covered the details of net income and earnings per share, so I will not repeat. Please turn to Slides 12 and 13 of the presentation for highlights on the consolidated fourth quarter results. The consolidated gross margin percentage increased 100 basis points quarter-over-quarter to 39.7%, with the improvement primarily coming from North America. Please note that the reported margin includes $4 million in restructuring-related costs classified in COGS, which represents a 10 basis point negative impact on gross margin. There's a little bit of rounding impact on the components, though adjusted gross margin, which excludes restructuring, is up 120 basis points. Overhead expenses increased 40 basis points to 29.7, primarily driven by North America and higher transformation costs in Europe. Restructuring and acquisition-related costs were $16 million as a result of ongoing expenses for the initiatives we announced in the second quarter of 2019 and acquisition integration. Interest expense was favorable by $4 million, a decrease of 11% compared to the fourth quarter of '18, owing to lower interest rates and lower average debt balances. Other income was favorable by $18 million, of which nearly all the variance relates to changes in miscellaneous gains and losses from acquisitions and divestitures, as well as impairment charges. Please note that these items are excluded from our calculation of adjusted EPS. Moving to income taxes. Our effective tax rate was 26.5%, which reflects a reduction in expense for the year to date catch-up caused by the finalization of the annual effective tax rate. Equity and earnings of unconsolidated subsidiaries, which relates mostly to our investment in Mekonomen, reflected income of $1 million versus expense of $46 million in the fourth quarter of 2018. You will recall that we recorded a $48 million impairment charge on the Mekonomen investment a year ago. Please now turn to Slide 16 for highlights on segment performance, starting with North America. Gross margin was 46.1% or 260 basis points higher than the prior year. The margin expansion reflects the continued benefits of initiatives in both our aftermarket and salvage operations, as well as efforts in our glass business. Two additional items in the quarter took these to new highs. One, the positive revenue impact from the GM strike drove a favorable mix impact on gross margin. And two, precious metal prices had reached record levels, providing a boost to revenue per vehicle in our salvage operations. Falling scrap prices remained a drag on segment gross margin. Sequential changes in scrap prices had a unfavorable impact of $9 million for the quarter compared to a negative impact of $5 million a year ago, creating a $4 million year-over-year negative swing. However, self-service was able to show a quarter-over-quarter margin improvement due to the positive impact from sales of precious metals I referenced earlier. Operating expenses increased 90 basis points to 32.5% in the fourth quarter. As previously referenced, the North America segment produced 2.5% organic growth in parts and services revenue, which had a positive leverage effect, but there were several offsetting factors that pushed expenses higher than a year ago. First, incentive compensation contributed a 50 basis point year-over-year increase. Strong operating performance required upward revisions in bonus accruals, pushing expense higher than a year ago. Second, bad debt expense had an unfavorable impact of 30 basis points. Though to be perfectly clear, this wasn't a deterioration in collections this year as the variance is largely attributable to a high level of recoveries in Q4 of 2018 and saw a negative year-over-year comp. Third, a gain on the sale of a former Nashville facility a year ago drove a 30 basis point increase in overhead expenses as we did not have a similar gain this past quarter. Finally, as mentioned in the last few quarters, facility expenses continued to trend higher this year due to expansions and rate increases related to renewals, creating a further 20 basis point impact. Favorably, North America showed positive leverage of 30 basis points in other personnel costs through lower insurance claim costs, disciplined hiring and the implementation of the cost reduction plan described in the second quarter. In total, segment EBITDA for North America in the fourth quarter was $180 million, up $27 million or 180 basis points higher from the prior year. Closing out on North America. We know that we can't count on events like the GM strike or record high precious metal prices to be present every quarter. We undeniably saw a margin benefit from both these items, though I don't want to discount the margin achievement as pure good fortune. As the old saying goes, sometimes, you have to make your own luck. And the North America team deserves credit for being ready to serve the market when the GM strike disrupted supply. Being disciplined operators and seizing available opportunities, the North America team was able to deliver a fantastic quarter. Moving on to the European segment on Slide 19. Gross margin in Europe was 36.6%, down 10 basis points relative to the comparable period of 2018. Restructuring expenses in the U.K. represented a negative 20 basis point impact for the quarter. Outside of these charges, the segment gross margin was up 10 basis points, with benefits from higher purchasing rebates, mostly offset by lower margins in our Benelux, Eastern European and Italian operations due to lower prices and product mix. With respect to operating expenses, we experienced a 10 basis point decrease on a consolidated European basis versus the comparable quarter a year ago. For Q4 2019, there was a 30 basis point headwind associated with the ongoing transformation efforts related to the 1 LKQ Europe program. Personnel expenses were favorable in 2019 by 40 basis points due to restructuring program savings and the benefits of a hiring freeze across the segment. European segment EBITDA totaled $108 million or 90 basis points increase over last year. As shown on Slide number 21, relative to the fourth quarter of '18, the pound sterling was roughly flat, though the euro weakened by 3% against the dollar, causing a negative effect from translation. Overall, there was a $0.02 headwind on adjusted EPS for the quarter, with roughly equal parts coming from the impact of transaction gains losses and translation. Segment EBITDA was 7. 6% for the quarter, up 10 basis points compared to the same period last year and includes a 30 basis point headwind owing to transformation expenses I referenced earlier. On a full year basis, segment EBITDA was 7. 8%, within the range we communicated on September 10, the 1 LKQ Europe call. And to be clear, this figure includes 20 basis points of transformation costs for the year. Turning to the specialty segment on Slide 22. The gross margin percentage declined by 100 basis points in Q4 due to equal impacts from sales mix, including a decrease in revenue from drop shipment sales, and timing of adjustments for customer rebate accruals. On the other hand, operating expenses improved by 50 basis points with reductions in personnel and freight costs more than offsetting higher vehicle expenses. Segment EBITDA for specialty was $25 million, and as a percentage of revenue was down 10 basis points to 8.4%. With the backdrop of a revenue decline in the fourth quarter, the specialty team continues to take action to control costs, as was evidenced by the year-over-year decrease in operating expense dollars. Let's move on to liquidity and the balance sheet. As presented on Slide 24, you'll note that our operating cash flow for 2019 was roughly $1.1 billion or 50% higher than 2018. The key working capital accounts, that is trade receivables, inventory and payables, generated a cash inflow of $46 million for the year compared to an outflow of $205 million a year ago. Our purchasing teams did great work in driving this improvement by applying a disciplined approach to inventory and soft trading conditions and working with our vendor partners to improve payment terms. CapEx for the year was $266 million, resulting in free cash flow of $798 million, a 73% increase over the prior year. To put this into perspective, our 2019 free cash flow was higher than our 2018 operating cash flow despite a $16 million year-over-year increase in CapEx. As discussed the last time, we analyzing the efficiency of our cash flows and what [ph] level of earnings we can convert to cash on a sustainable basis. Looking at slide 25, you can see a positive trend in the free cash flow to EBITDA conversion ratio this year based on the programs we put in place in the second half of 2018. We made significant strides this year to move this ratio closer to where we believe we can operate over the long term. There is further opportunity to improve our conversion, though we do not expect 2019 growth percentages to repeat at the same rate in 2020. In line with our ongoing judiciousness on capital allocation and capital structure, we concluded that redeeming our $600 million four and three quarters US dollar bonds due in 2023 using cash on hand and lower cost revolver debt was the best use of our liquidity. The cash generated during the fourth quarter was used to pay approximately $200 million of the bond redemption costs with the remaining funds provided by our credit facility. Additionally, we took the opportunity to exercise a purchase option on our North America headquarters in line with our long term commitment to the national area. We continue to believe that our balance sheet is in good position to support our business objectives. And finally, moving to Slide number 27, as of the 31st of December, we had $523 million of cash on hand, resulting in net debt of about $3.5 billion. Our net debt. leverage ratio remained level with the third quarter at 2.6 times, but still represents good progress from the 2.9 times rate as of December of 2018. We believe we’ll be able to decrease the stat again in 2020. Now, I would like to detail our annual guidance for 2020. Please note that the guidance assumes that scrap prices and foreign exchange rates hold at current levels, and the annual effective tax rate is 27.5%. Additionally, the guidance assumes no material disruptions associated with the United Kingdom's exit from the European Union, the coronavirus outbreak or any escalation in trade wars or tariffs. We believe North America is poised to carry its strong performance into 2020. We expect that Europe will continue to face some challenging economic conditions, though with the 1 LKQ Europe program and the various restructuring initiatives should take hold and produce further benefits. Specialty is actively seeking new revenue streams to combat the recent weakness and in the interim will remain focused on right sizing its cost structure for the revenue expectation. We have set organic parts and services revenue growth at 50 basis points to 250 basis points. Please note that with the leap here we'll have an extra selling day in the first quarter, and we'll hold that for the full year. Also, please note that exiting the low margin FCA battery contract will be a headwind of approximately 30 basis points on global organic and approximately 90 basis points on North America organic growth in 2020. Diluted EPS on a GAAP basis is a range of $2.20 to $2.32 while adjusted diluted EPS is a range of $2.46 to $2.58 cents. We are projecting solid business growth from a margin improvement efforts, especially in Europe. As discussed last September, we expect to take a step forward in our drive to double digit margins by producing a segment EBITDA margin for Europe in the range of 8.5% to 9.2%. Starting from a 7.8% base in 2019, the high end of the range will be a stretch, but we remain confident in our ability to finish within the range. Additionally, we should benefit with lower full year interest expense owing to the ongoing debt pay down. Cash flows from operations reflect a range of 1,150 billion. The midpoint of our guidance is roughly on par with our 2019 actual figure. Keep in mind that our 2019 cash flow growth was approximately 50%. We reached the $1 billion mark in operating cash flows a few years ahead of my expectations, meaning we benefited from significant working capital enhancements that we can't count on to repeat each year at the same level. We believe we can sustain the new elevated level of operating cash flows with continued focus on trade working capital management and the implementation of the vendor finance program in Europe. And finally, capital spending is set at a range of $250 million to $300 million, a modest increase from the current year level. And so finally, in summary, the fourth quarter was a solid overall result, with strong performance by North America, offsetting some softness in Europe and Specialty. The fourth quarter reinforced that we need to be disciplined in cost control to manage through low growth periods. We believe that our restructuring programs focused on productivity and the l LKQ Europe project has increased the resiliency of the model and positioned us for future success. Overall, we remain optimistic about our prospects for the future. With that, I'll now turn the call back to Nick for closing remarks.

Thank you, Varun for that financial overview. In closing, 2019 turned out to be a solid year of our company. Our North American operations extended its record of improving operating margins. The European team designed and began the implementation of 1 LKQ Europe, a multi year program that we believe will lead to enhanced levels of productivity and profitability. The specially team broadened its industry leading efforts in supporting the warranty programs of the RV OEMs and was diligent in honing its cost structure. And all the businesses made significant progress on what counts most, generating cash. Indeed, over $1 billion of cash from operations which we used in equal measure to reduce our leverage and repurchase our shares. None of this progress would have been possible without the collective efforts of the 51,000 people I am proud to call my colleagues and co-workers. To the men and women of LKQ I offer my sincere thanks and appreciation for all you did to both serve our customers and work in the best interest of our shareholders. And with that operator, we are now ready to open the call for questions.

Thank you. [Operator Instructions] Your first question comes from the line of Daniel Imbro with Stephens Inc. Please go ahead.

Yeah. Hey, good morning, guys. Thanks for taking the question.

Good morning, Daniel.

Good morning.

Wondering on the North American gross margins, obviously really strong in the fourth quarter, you noted some of the tailwinds more transitory, record metal prices, GM strike, but things that the freight backdrop do seem to be getting better heading into 2020. So can you help us think about the gross margin trajectory for the company as we head into 2020 as we weigh those put and takes?

Absolutely, Daniel, and good morning to you, but also to everyone else joining us on the call this morning. I know it's fairly early, specifically out on the west coast. Listen with regards to North America as Nick and I mentioned earlier, we’re really happy with the way our North America business has continued to perform and execute against its margin enhancement initiatives. You'll recall, we started this entire program way back in 2018. And ready for the third quarter of ‘18 onwards, we slowly but surely continued to execute and move the needle up. The fourth quarter of 2019, as I was very clear about was it was significantly better than even our expectations. Clearly the GM strike was not planned. It was not in the budget, for example, but the agility and the nimbleness of our aftermarket team to be able to capitalize on that opportunity gives us a great amount of satisfaction that we have the right operators at the helm. In addition to that, if you think of it from a salvage perspective, that's another business of us that has really continued to perform very strongly across North America, across the entire year. And then with the record high, precious metal prices coming through, yet again, our salvage business both on the full service but also on self service, they essentially changed certain processes in terms of being able to harvest those precious metals. Again, capitalizing and the agility coming through of being able to capitalize on that opportunity. And that really is key for us. As we move forward into 2020, we are certainly not banking on those record high prices of precious metals continuing, as you know, the GM strike has ended. And so yes, the overall 14 points of segment EBITDA margin is significantly richer than what we would expect to be the usual cadence associated with that. If you were to try and bracket in terms of what the precious metals and say the GM strike benefited in the quarter, I probably give you roughly about 120 basis points of that - the uptick that we had, you know, we certainly – a large part of it was due to precious metals, but also due to the GM strikes. So if you kind of think of it year-over-year, the 180 basis points move up, I'd say about 120 of that 180 was related to precious metals and also GM strike. So think about from that perspective, the business without those two elements probably would have still been up at least 60 bps, you know, on a year-over-year basis. So again, continuing to execute on its margin enhancement initiatives. So just want to put that piece in terms of the 14 points is not the new normal. So please do not include that into your 2020 model going forward. There were some elements in the market that we were able to capitalize on.

Thanks.

Your next question comes from a line of Stephanie Benjamin with SunTrust. Please go ahead.

Hi, good morning, I wanted to touch a little bit on some of the weakness that you’ve been seeing really last couple quarters in Italy – Italy and Germany, also announced some new leadership changes there as well. So maybe if you could kind of discuss what's driving some of the - the slow down, you know, is it macro, a little bit more company specific transitional issues, and, you know, just kind of some of the plans in place where we might expect to see some improvement there and some timing would be helpful? Thank you.

Good morning, Stephanie. This is Nick. The macro economic conditions in Italy, I think is no surprise to anybody. It's very poor. The country has been in recession now for several quarters and that is absolutely flowing through the overall market dynamics. We are seeing and all of our competitors as we talked to people at trade shows and just in the business in general, there's been a downdraft in overall activity. That said, we did believe that we needed a leadership change. And so we have brought somebody on board from the outside to head up the Italian operation. Actually, it's an individual that worked with Arnd Franz at Molly [ph] and he worked under Arnd for about a dozen years. We're very confident in his abilities and believe that we will be able to, you know, move that business forward as we migrate through 2020. The German marketplace obviously a big market, again, experienced some overall softness The leadership change there is not necessarily related to the performance of the Stahlgruber business, which overall was good during 2019, but more of a recognition that we needed a single leader within the Stahlgruber business there. The structure when we acquired the business was there three kind of leaders who shared responsibilities, and we just needed a single head of that business. And so we made that change early this year. You know, we're not expecting the budget, if you will. This is not assuming that there's going to be a market uptick in either the Italian or the German markets that we do anticipate that we will be able to get better organic growth in both those countries and than we did in 2019.

Great. Thank you for the color. I'll leave it at that.

Okay, great.

Your next question comes from line of Craig Kennison with Baird. Please go ahead.

Good morning. And thank you for taking my questions.

Good morning, Craig.

Yeah. Good morning. We do appreciate the comprehensive slide deck in 7 a.m. call. So thank you for that. Just want to touch on this Specialty business, you've got so much good news. But there was unexpected weakness in that category. Guess I want to understand should we expect weakness for at least the next three quarters as you kind of anniversary the impact of a relationship that - that has exited? And then two, what gives you confidence that there's that - that change is not part of a broader trend where you could get disintermediated more broadly? Thank you.

Sure, Craig. Yeah. Built into the plan is an assumption that the Specialty business is going to be relatively flat during 2020. Maybe even down just a touch based on as you indicated, the need to anniversary some of these changes. We highlighted kind of two key customers, one of which is the result of an acquisition, where one of our customers was the acquired entity and the acquirer or always went through act. And so when they - when they bought our customer, they just put their volume through their direct distribution system. We don't think - we think that's a one-off. The other entity has a very unique market position with an incredible brand name. And they had the ability to take some, not all their value, but some of their volume back internally. And again, we think it's unique related to their brand identity as opposed to anything else. So we're not - we don't see it as an ongoing - as a ongoing trend.

Thank you.

No problem.

Your next question comes from line of Michael Hoffman with Stifel. Please go ahead.

Thank you very much. Nick, Varun and Joe. On the cash flow, if I follow the math of what's in the guidance, make an assumption about D&A. So the midpoint of net income 695 gets a 324 D&A approximately, I'm at 10, 15 [ph] on cash flow from ops. So that says you're going to get another positive incremental, not as great as 2019 I get it. But working capital still helping, are we looking at that correctly?

Yeah, I think. Michael, good morning. Its Varun out here. Listen, you kind of followed us, you know, from a cash perspective for the past few years and stuff. And all I can say is thank you yet again to a broader colleagues across all of LKQ for just a tremendous result coming on from a cash perspective. To kind of give you a little bit more and kind of get to your specific answer in any case, you know, when we put in place working capital metrics, and really what we call internally for our field folks is trade working capital, this is inventory, plus the receivables offset by payables, the underlying quality and I think you can kind of work the math out through the public tables that we've put out there in any cases. The company has made progress on all three fronts. It wasn't just a case of pushing up tables. It wasn't just a case of throttling back or being more judicious on the inventory. We picked up days inventory on hand in terms of lower on these inventory on hand. We push DPO [ph] up a little bit. And we've also gotten some DSO down, albeit very little, because we haven't changed any terms on our customers. All we really focused on is collecting past due receivables, right. But the sheer scale at which our business has been able to deliver on this is, as I said, I'm just tremendously pleased with that. And so if you think of it from a EBITDA conversion level to OCF, yeah, I mean, that's a high percentage versus where we've historically been. In 2018 we moved up. In 2019 we moved up significantly. And to kind of give you a rough math, just on trade working capital, it was down $250 million across inventory, receivables and tables, despite the fact that reported revenues were up $630 million. If you kind of go back to our Investor Day in May of 2018, you can recall, I kind of shown a trend to everybody in terms of how trade working capital as a percentage of revenue had been steadily increasing for the previous five years, up to kind of north of $0.24 in the revenue dollar. That is the one that we focused on. And by focusing on those very specific items, not confusing everyone in terms of what we were trying to do, we've made a tremendous amount of progress. And so, as you think about it, yes, we do expect to grow some, but as I said, it's at this point of time we are now in a sustainability mode, okay. How do we continue to hit the conversion levels that we were able to achieve in 2019? I do not expect this level of trade working capital decline in 2020. But again, there were certain elements that we had to get reset, which we've been able to do and that's a case of continuing to deliver on the sustainability of EBITDA conversion. So that's really where we are. But I think your math roughly holds.

Thank you.

Your next question comes from a line of Bret Jordan with Jefferies. Please go ahead.

Good morning, guys.

Good morning.

On the working capital conversation Varun, can you give us an update as to where we are on payables? I guess specifically on the European side of the business? I think your accounts payable were a little bit higher than they were in the prior year. But you know, clearly versus the O'Reilly's of the world much lower. So, I guess what's the thought there?

Yeah. So I'll give you - I'll give you two key points out that Bret. Number one, as I said in my previous response, we made progress both - actually across all three elements of trade working capitals, so day's inventory on hand has come down. DPO has moved up and then DSO is marginally down by about a day. But DPO is up by about four days for the entire enterprise. Now think of it from that perspective and as we think of the cash conversion cycle, we picked up the better part of seven to eight days in terms of where we were even say a year ago, right. So great progress on that front, and from two years ago that much more. Specifically to your question about how is the European payables program coming along. Listen it is coming along right at expectations. There were two key elements that I talked about. The end outcome really is to ensure that we have better payment terms across our European business. No different to say some of the big box folks enjoy out here in the North America business. Clearly they've been at it for the better part of a decade and a half, almost kind of two decades. We were just kind of getting started a year ago and really where we've come through is, we focus on the largest markets with regards to the vendor financing program and really there's two kind of alternatives for our suppliers. The end result being we need better payment terms. And a number of our suppliers have either signed up to the vendor financing program, which is great news. And there are others who say listen, if you're kind of go through that entire process of getting invoices, going through an EDI link, connecting to financial situation, it's too complicated, we will give you the terms that you're looking for. The end result is we are seeing you know, with contracts that are essentially kicking in for 2020, we are seeing that payment terms being extended in line with what our expectations are and then to kind of close the loop for you, if you kind of go back to the September 10th 1 LKQ Europe call that we had, we were very specific in terms of what level of cash we anticipated generating, which is about $200 million, by the end of 2021 we are right on track. We’re very confident that 2020 will play out exactly the way we planned. The team has made tremendous progress out there and yeah, happy with how things are progressing.

Thank you.

Your next question comes from the line of Chris Bottiglieri with Wolfe Research. Please go ahead.

Nice, she got it. Quick question on Europe margin targets, you guys gave the analyst day back in September, it kind of gave some annual targets for the next couple of years. Obviously, macro remains really challenging. You've added some leadership changes, just kind of curious what your latest thinking is, those are still the right targets and kind of like what you've learned as you delve deeper to those plans? Thank you.

Good morning, Chris. As we indicated in our prepared remarks, the 1 LKQ Europe program is on track and on plan. The expectation is that - kind the guidance, if you will, that we provided on September 10, related to the margin accretion over the next couple years, that those ranges are still valid. As Varun indicated in his comments, 2020 getting to the top, top end of the range is going to be a bit of a stretch. But within the range, we are comfortable. And so really, there's been no change. I mean, it's, it's only been, you know, the better part of a little bit more than a quarter that we're into the program. We're affecting the changes that we believe were necessary to get us to the promised land, if you will. We are making progress. You know, there are going to be some things that are not going to go according to plan, and they're going to be some other things that actually do better than, than we expect. And so we're taking it on a quarter-by-quarter basis, but by enlarge we are comfortable with the guidance provided back in September.

Thank you.

Your next question comes from the line of Scott Stember with C.L. King. Please go ahead.

Good morning. And thanks for taking my questions.

Good morning, Scott.

Just going back to Specialty, you outlined the issues that happened in the quarter. We expect that to continue, I guess, at least for the next couple of quarters. But you then said that you would expect organic sales to be flat. So I'm assuming you're expecting some of these like the additional RV OEM warranty program that some of the positive developments at SEMA. So maybe just talk about how that will progress to actually offset which seems to be a pretty sizable losses in sales that you had this past year. Thanks.

Yeah. So you know, during 2019 the Speciality group started supplying the OE manufacturers actually they're dealing that work with warranty parts, because we can do it for efficiently than the OEs can do themselves. Again, that was a slow ramp. But now we're at the point where we have every major OE manufacturer in the barn if you will, where we are the leading and the supplier of their, of their warranty parts. And so we will get a positive benefit of that through 2020, as each of those programs ramp up and anniversary. We've got some other key elements, we’ve talked about Warn, which is our Winch, business, with several new programs that we think are going to provide positive benefits. And then you know, the historical legacy of the Specialty group, which is the kind of the automotive accessories, you know, that businesses is doing okay. And so we do believe that there's going to be some gives and some takes, which is taken as a whole will largely offset each other.

Got it. Thank you.

No problem.

Thank you.

There no further question at this time, I will turn the call back over to the presenters for closing remarks.

Well as always we greatly appreciate your time and attention. We know that this reporting season is incredibly busy for all of you and the time you spent with us is greatly appreciated. We are looking forward to a very good and productive 2020. We will come back together in about 60 days to report our first quarter results. And again, I just want to reiterate to all the men and women of LKQ, we really appreciate everything they have done and will continue to do to make our company perform well and serve our customers and our shareholders. So with that, we bring the call to a close. And thank you for your time and attention today.

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