LKQ Q4 2022 Earnings Call Transcript

Quartr
Provided by Quartr
February 23, 2023

There are 8 speakers on the call.

Operator

Good morning. My name is Rob, and I will be your conference operator today. At this time, I'd like to welcome everyone to the LKQ Corporation's 4th Quarter and Full Year 2022 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. Call.

Operator

After the speakers' remarks, there will be a question and answer session. Q and A session. Thank you. Joe Boutrous, Vice President of Investor Relations, you may begin your conference.

Speaker 1

Thank you, operator. Good morning, everyone, and welcome to LKQ's Q4 and full year 2022 earnings conference call. With us today are Nick Zarcone, LKQ's President and Chief Executive Officer and Rick Galloway, our Senior Vice President and Chief Financial Officer. Please refer to the LKQ website atlkqcorp.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.

Speaker 1

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 call 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 filings discussed in our Form 10 ks and subsequent reports filed with the SEC.

Speaker 1

During this call, we will present both GAAP and non GAAP financial measures. Call. 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 ks, which we filed with the SEC earlier today. And as normal, we are planning to file our 10 ks in the coming days.

Speaker 1

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

Speaker 2

Thank you, Joe, and good morning to everybody on the call. Call. This morning, I will provide some high level comments related to our performance in the quarter and full year 2022, and then Rick will dive into the financial details and discuss our 2023 outlook before I come back with a few closing remarks. This month, we are celebrating the 25th anniversary company's founding in February 1998. What started with a few salvage facilities in the U.

Speaker 2

S. Providing a wide array of aftermarket and recycled parts used to repair, maintain and accessorize vehicles. Operations. Our operations are leaders in their respective markets and are well positioned to continue their success in the future. Getting to this point has been the result of the dedication of our past and present teams, and I want to express my sincere appreciation and is always pushing to be the best.

Speaker 2

When LKQ was founded, ESG was not the hot topic that it is today, But ESG has always been a vital part of our strategy. Through our recycling operations, we are enabling the circular economy in doing our part to reduce waste. I am proud of our contributions to date and I can assure you that our emphasis on sustainability We'll continue to be an integral part of our mission. Our success in ESG is being recognized by external parties. On December 5, 2022, MSCI upgraded LKQ to their highest ESG rating of AAA, placing LKQ in the top 5% of all companies that they rate globally.

Speaker 2

And on January 31 this year, LKQ was included in Sustainalytics 2023 Top Rated ESG Companies list. The Q4 of 2022 closed a year where the resilience of our businesses shine through a myriad of uncontrollable headwinds range from economic softness, inflation, supply chain disruptions, labor shortages, energy cost spikes End A War in Europe. From an operating perspective, the 4th quarter was a very strong set of results and I could not be more proud of our team. The continuation of exceptional organic revenue growth and strong margins in our North American wholesale segment when combined with solid organic revenue growth and the highest 4th quarter EBITDA margins in the history of our European segment, offset the impact of the continued headwinds experienced in our Specialty and Self-service segments. The January revenue trends are similar to the levels generated in the Q4.

Speaker 2

While the operations were collectively right on target with the guidance that we provided back in October, The annual tax provision was higher than anticipated, which drove a full year catch up in the 4th quarter and resulted in quarterly EPS at the low end of the guidance range. Rick will provide more detail on the tax provision in a few minutes. Q4. Now on to the strong quarterly results. Revenue for the Q4 of 2022 was $3,000,000,000 driven by FX translation and the divestiture of PGW.

Speaker 2

Parts and Services organic revenue increased 4.5% on a reported basis and 5.9% on a per day basis. The net impact of acquisitions and divestitures decreased revenue by 3.1% and foreign exchange rates decreased revenue by 6.1% for total parts and services revenue decrease of 4.8%. Other revenue fell 20.1%, primarily due to weaker commodity prices relative to the same period in 2021. Net income in the Q4 was $193,000,000 as compared to $235,000,000 Q4 for the same period in 2021. Diluted earnings per share for the Q4 was $0.72 as compared to $0.81 for the same period last year, a decrease of 11%.

Speaker 2

During the quarter, we had tax rate was also higher than anticipated during our Q3 call, which generated an unfavorable $0.05 effect adjusted diluted EPS relative to our guidance. On an adjusted basis, net income in the Q4 was $209,000,000 as compared to $254,000,000 for the same period of 2021, a decrease of 17.5%. Adjusted diluted earnings per share in the 4th quarter was $0.78 as compared to $0.87 for the same period of last year, a decrease of 10.3%. Net income for the full year of 2022 diluted earnings per share for the full year of 2022 was $4.11 as compared to $3.66 Q4 of 2018, an increase of 12.3%. Please note that 2022 results include the gain on sale of PGW.

Speaker 2

On an adjusted basis, net income for the full year of 2022 was $1,100,000,000 as compared to $1,200,000,000 for the same period of 2021, a decrease of 9.4%. Adjusted diluted earnings per share for the full year was $3.85 as compared to $3.96 for the same period of last year, adjusted earnings exclude the gain of the PGW sale, but includes the impact of the higher tax rate. Now let's turn to some of the quarterly segment highlights. As you will note from Slide 12, organic revenue for parts and services in the 4th quarter for our North American segment increased 10.3% on a reported basis and 12% on a per day basis compared to the Q4 of 2021. We continue to perform well in North America, especially when you consider that according to CCC, collision liability related auto claims From 2,008 to 2010, our North American business grew organically at an average of 7.5%, As we enter 2023 and face the reality of a global recession, our alternative parts offerings clearly become more attractive during these challenging economic periods.

Speaker 2

We are also encouraged by the trend in parts per repair, which reached an all time high in 2022. Important to note is that our sweet spot has expanded and today stands at model years 4 to 15 years of age. All these items combined positions North America well for continued organic growth in 2023. The upward trend in our aftermarket sales volumes and the ongoing improvement in our fill rates continued in the Q4 with fill rates reaching their highest percentage levels in 2022 and today stands at close to the pre pandemic level of 93%. Importantly, as the supply chain recovered When fill rates increased, the entire industry realized a 220 basis point improvement and the aftermarket percentage of APU taking share back from the OEs as we progress throughout the year.

Speaker 2

The supply chain has stabilized and our inventory is generally where we want it to be. The main issue we are confronting Today, our continued delays at some of the railheads due to congestion. As many of you know, on December 7 last year, State Farm announced that they are rolling out expanded non OEM collision repair parts to use in most of the United States. We are excited that State Farm is embracing the aftermarket value proposition that the industry offers, which will ultimately benefit the end consumer. We continue to actively analyze this opportunity and we are well positioned to compete for our fair share of this opportunity and have built our inventory appropriately to do so.

Speaker 2

Our salvage inventory is also healthy and we saw some relief on our cost per vehicle during the quarter. The salvage business had solid organic growth, largely driven by price, But as we entered December, we witnessed an upward trend in our salvage volumes. Total loss rates increased a bit in the 4th quarter, which were largely seasonal and as you can see, it had no impact on our organic growth. These slightly higher loss rates played a role and our ability to source the right level of inventory at auction at attractive prices. As we have stated before, fluctuations and loss rates are largely net neutral events for LKQ.

Speaker 2

Moving on to our European segment. Europe organic revenue growth of parts and services in the quarter increased 4.6% on a reported basis 5.8% on a per day basis, which represents the best 4th quarter per day organic revenue growth since 2016. I'd also like to highlight that Europe's segment EBITDA margin was the highest 4th quarter level since entering the European market in 2011. On a full year basis, Europe's performance is another year of double digit segment EBITDA margins, which is consistent with our One LKQ Europe initiatives and strategy. Rip will cover more emerging details in his prepared remarks.

Speaker 2

Throughout the quarter, our European team was laser focused on the cost structure, including rationalizing headcount to create a more nimble and agile team and focusing our team on a narrow and actionable list of key projects. These projects represent the highest return opportunities that the team can execute in the near term, further cementing the long term resiliency and market leadership of our European segment. On February 1, LKQ Europe announced that it expanded its European salvage network with the acquisition of Dutch based Renoy Group. Founded in 1991, Renoy is a leading supplier of remanufactured engines and recycled OEM car parts. RINOYA operates a salvage dismantling facility in the Netherlands and remanufacturing plants in both the Netherlands and Poland.

Speaker 2

As you know, the roots of our company lie in the dismantling of salvage vehicles to recycle OEM parts. As part of our European strategic plan, We intend to capitalize on that history and knowledge, coupled with our remanufacturing capabilities To grow our salvage network across our European footprint. And with this tuck in acquisition, we take one small incremental step towards that objective. I want to congratulate our STAHLGRUBER team on their 100th anniversary and commend them for building a resilient and market leading business that continues to demonstrate an ability to adapt to the ever changing independent aftermarket, a century since the founding brothers, Otto and Willy Gruber started the business. Today, the Style Grouper business continues its history of embracing change, which positions them well to capture further opportunity as the car park shifts towards EVs and other forms of mobility.

Speaker 2

We can't wait to see the next what the next 100 years brings for STAHLGRUBER. Now let's move on to our Specialty segment. During the Q4, specialty reported a decrease in organic revenue of 10.6%. Throughout 2022, specialty was up against tough 2021 comparisons in the midst of decreased demand Looking at the Specialty segment on a multiyear basis, since 2019, Specialty has generated approximately a 4% compound annual growth rate for organic revenue, outperforming the industry growth of CEMA and RV related products. A few specialty operational highlights would include that specialty continued to realize the full benefits of the seawide synergies, which exceeded our expectations in dollars and operational execution, and specially won O'Reilly's 2022 Top Supply Line Award for the 3rd year in a row.

Speaker 2

Now on to our self-service segment. Organic revenue for parts and services for our self-service segment increased 4.8% Q4. Self-service was again challenged by commodity pricing as seen in the material decline of other revenue, which impacted our expectations for the quarter. On the corporate development front, the Q4 was fairly quiet. While we did not complete any material transactions during the quarter, our corporate development team is actively assessing various opportunities that exist across our operating segments.

Speaker 2

As the global economies continue to soften, That may lead to multiple compression and we are well positioned to execute on synergistic acquisitions that fit our strategic objectives. Outside of Q4 corporate development efforts, I am pleased to announce that this past January, We entered into a memorandum of understanding with Korea Zinc Company Limited, a world class general nonferrous metal smelting company. Under the memorandum of understanding, we will work towards a potential large scale joint venture related to the recycling of lithium ion EV batteries in the United States. This is again evidence that we will continue to strategically position the company Turning to ESG. During the Q4, we continued to build out our ESG program by focusing on our people efforts and various social initiatives.

Speaker 2

Here are a few worth noting. Every colleague employed by LKQ Elite Ukraine for at least 6 months received a one time hardship payment to support paying for energy and the general increase in the cost of living Owing TO the Russian invasion. Our U. K. And German operations also implemented one time hardship payments to support our employees in those markets given the state of the overall European economy.

Speaker 2

We initiated a voluntary daily pay benefit in the United States that allows our employees And we launched our 1st employee inclusion group, the LKQ Veterans Network, program that embraces our proud community of employee veterans and veteran allies who support and encourage each other In 2022, our North American salvage operations continued our leadership as the largest recycler of vehicles by processing over 753,000 vehicles resulting in among other things recycling of approximately 3,600,000 gallons of fuel, 2,200,000 gallons of waste oil, 2,000,000 tires, 700,000 batteries and approximately 955,000 tons of scrap metal. The end result of these efforts resulted in nearly $13,000,000 recycled and repurposed parts being sold into the collision and mechanical repair shop industry that otherwise would have ended up in landfills. Let's turn to the inflationary environment, again a key item of interest for most listeners on this call. As I discussed this time last year, We expected inflation to be a headwind throughout 2022 and that expectation became a harsh reality all year across each of our segments. Fortunately, we are beginning to see some moderation with inflation in the U.

Speaker 2

S. And recently we witnessed the rate of inflation drop Q4 last 3 months in a row across the Eurozone. Eurozone inflation stood at approximately 8.5% in January, continued to face high inflation rates with certain countries running in the high single to low double digits. In the U. S, the labor markets continue to be strained and unpredictable in the midst of higher interest rates and mounting fears of a recession.

Speaker 2

Daily, we read about high profile layoffs, yet new claims for unemployment benefits Remain at a Historic Low. As of late, wage inflation is beginning to slow In certain areas of our business are seeing reductions in turnover, but these reductions are not material and we are far from out of the woods, but it is validation that our retention and employee engagement programs are gaining traction. Our engagement efforts aren't simply an HR mandate. They are programs that stretch across all levels of the organization and are a key component of our culture. Our global engagement score of 74 is significantly above the average company's of our size.

Speaker 2

Studies have shown that employees who are engaged are 14% more productive and that companies with engaged employees are 23% more profitable than those with disengaged employees. So from a business perspective, positive employee engagement is critical, but importantly, it's the right thing to do for our most important asset people. Lastly, before I turn the discussion over to Rick, who will run through the details of the segment results and discuss our outlook for 2023. I am pleased to announce that on February 21, our Board of Directors approved a quarterly cash dividend to stockholders of record at the close of business on March 16, 2023.

Speaker 3

Thank you, Nick, and good morning to everyone joining us today. Before I go into details of the Q4, I'd like to reflect on what LKQ accomplished in the last year. We entered 2022 with a strong position based on the success of our operational excellence initiatives and solid balance sheet after reporting the highest profitability in the company's history in 2021. We expected there to be headwinds in 2022 from the areas Nick mentioned. As you can see on the bridge on Slide 5, these headwinds did set us back, The LKQ team drove operational improvements to produce roughly $0.40 of operating increases relative to 2021.

Speaker 3

We also sustained the positive momentum around cash flow generation with free cash flow of just over $1,000,000,000 in 2022 and healthy conversion ratio of 60% of EBITDA. Our work on free cash flow in recent years supported some noteworthy accomplishments in the last year. LKQ achieved investment grade ratings from all 3 major rating agencies, returned $284,000,000 shareholders through quarterly dividends and increase the quarterly amount by 10% in October. Repurchased roughly 20,000,000 shares of LKQ's stock for just over $1,000,000,000 Which combined with the carryover benefit from 2021 purchases added $0.23 of EPS compared to 2021 and all while maintaining a net leverage ratio at less than 1.5 times EBITDA. In early January 2023, we replaced our prior credit facility, which included a $3,150,000,000 revolver with a new unsecured facility, including a $500,000,000 term loan and a $2,000,000,000 revolver.

Speaker 3

Our confidence in the balance sheet and ability to generate robust cash flow factored into the decision to reduce the size of the facility. We were pleased to complete this new facility ahead of the prior facility becoming current and lock in funding over the next 5 years at a competitive rate structure. Generating these successful outcomes despite challenging conditions is a credit to the entire LKQ team, and I want to thank all of them for their contributions. Now turning to the Q4 results, starting with segment performance. Going to Slide 14.

Speaker 3

Wholesale North America continued its strong performance posting a record 4th quarter segment EBITDA margin of 18.5%, a 330 basis point improvement over last year. We saw gross margin improvement of 150 basis points, driven by favorable mix and the sale of the lower margin PGW business as well as pricing and productivity initiatives. Overhead expenses were favorable by 180 basis points, offset inflationary cost increases and benefited operating leverage. As mentioned in prior quarters, we believe there will likely be some moderation and segment EBITDA margin in upcoming quarters as the benefits of the 2022 price increases fall away, with the resultant EBITDA margin expected to be in the high-seventeen percent, low-eighteen percent range for 2023. Europe also delivered its highest Ever 4th quarter margin at 10.0 percent, up 110 basis points from the prior year period.

Speaker 3

As seen on Slide 15, gross margin improved by 10 basis points as we work to offset inflation with pricing and procurement initiatives. Overhead expenses decreased by 70 basis points with an emphasis on cost structure and improved leverage due to the 5.8% per day organic revenue growth. Inflation related to personnel, freight and fuel costs remains a critical concern across the European markets. The team is actively addressing the pressures through productivity initiatives. Europe produced a segment EBITDA margin of 10.2% for the full year, the 2nd consecutive year of double digit margins.

Speaker 3

I want to commend the Europe team for achieving this result despite the onset Moving to Slide 16. Specialty's EBITDA margin of 6.2% declined 130 basis points compared to the prior year coming from a decrease in overhead expense leverage driven by an organic revenue decline of 9.1% per day as they anniversary a tough comp from the prior year when the business delivered a 6% organic revenue growth in the 4th quarter on top of the 17% growth in Q4 2020. Inflationary pressures also pushed overhead expenses as a percentage of revenue higher, including personnel, freight and fuel expenses. The overhead expense increase were partially offset by lower incentive compensation and benefits from operating expense synergies largely generated from the Seawait acquisition. As you can see on Slide 17, self-service profitability improved sequentially from the low point in Q3, but remained on the low end of our historical range at 5.2% for the Q4 and below our expectations.

Speaker 3

Metals prices continued to have a negative effect on results with the unfavorable lag effect and reduced operating leverage caused by the lower metals revenue dollars. When we broke out self-service as a separate segment in Q1 2022, we highlighted that this business would have cycles, mostly driven by commodity price volatility. We are working through a down cycle now and the team is focused on buying the right quantity of cars at the best price to drive margin dollars higher. With the uncontrollable commodity dynamic in this business, we will emphasize generating margin dollars and free cash flow rather than targeting a specific margin percentage. Now on to the consolidated results.

Speaker 3

We reported diluted earnings per share of $0.72 and adjusted diluted earnings per share of $0.78 which was a $0.09 reduction relative to Q4 last year. As previously mentioned, our operational performance showed year over year improvement and was in line with our expectations. However, the solid operational performance was more than debt by unfavorable year over year effects of $0.04 from volatility in metals prices and $0.03 from the foreign currency exchange effects caused by the stronger dollar. Additionally, we had a negative effect of $0.03 from higher interest rates as benchmark rates were markedly higher in Q4 2022. As Nick mentioned, taxes were the most significant unfavorable variance for the quarter, reflecting a $0.15 year over year impact and a $0.05 negative variance relative to the guidance provided back in October.

Speaker 3

As a reminder, In the Q4 last year, we recognized almost $0.10 in tax provision benefits from discrete items and the reduction in our full year effective rate. We experienced the opposite effect in Q4 2022 as we recorded a negative provision effect of approximately $0.05 from increasing full year effective rate and unfavorable discrete items. The effective rate increase primarily related to this shifts Q4 results to shifts in the geographic distribution of income. We mitigated about $0.07 of the decline with our lower share count resulting from our share repurchase program. During the Q4, we incurred $11,000,000 in restructuring expenses, The majority of which relate to a new program we kicked off late in the year.

Speaker 3

We initiated the 2022 Global Restructuring Program in recognition of the ongoing macroeconomic concerns heading into 2023. All of the segments have submitted plans to improve operational efficiencies by streamlining functions, closing underperforming locations and halting nonessential projects. The total cost of the 2022 program are estimated to be in the range of $30,000,000 to $40,000,000 to be incurred over the next few years. Projected cost savings of $20,000,000 related to the program are included in our 2023 guidance, and we expect annual run rate benefits of approximately $30,000,000 Q1, bringing the year to date total to $1,028,000,000 the 3rd consecutive year we have exceeded $1,000,000,000 With the supply chain issues abating, we made good progress in rebuilding our inventory levels in wholesale North America and Europe. As shown on Slide 35, we increased our inventory values in these segments.

Speaker 3

Though note that the dollar increase doesn't directly equate to a quantity change Q1. Given the higher input costs, we are comfortable with our current inventory holdings and are pleased with improvements in aftermarket fill rates. We will continue to evaluate our inventory holdings and may increase our balances in 2023, but not to the extent seen in 2022. The supply chain finance program contributed to an increase in days payable outstanding in Europe in 2022. With the signing of the new credit facility, certain restrictions around the program were eliminated, and we view further program expansion to be an opportunity in the next few years.

Speaker 3

For the year, the cash conversion is 60% conversion of EBITDA to free cash flow, in line with our targeted range of 55% to 60%. We finished at the high end of the range and our guidance partially due to the lower than projected capital expenditures. For the year, capital expenditures were 1.7 percent of revenue, which is below our targeted 2.0% to 2.25% range. We have experienced delays in receiving capital assets such as trucks as a result of supply chain delays. As a result, some of our 2022 orders will be delivered in 20 3 and reflected in capital expenditures in the 2023 financials.

Speaker 3

As of December 31, we had total debt of $2,700,000,000 with a total leverage ratio of 1.5 times EBITDA, which is comfortably inside our target range of below 2 times. Please note that going forward, I will reference total leverage statistics rather than net leverage as the new credit facility changed the metric to total leverage. Our effective borrowing rate rose to 4% for the quarter due to the market rate hikes in the U. S. And Europe.

Speaker 3

We have $1,800,000,000 in variable rate debt, so 100 basis point rise in interest rates would increase annual interest expense by $18,000,000 In the Q4, we repurchased 3,000,000 shares for $152,000,000 and paid a quarterly dividend totaling $74,000,000 I will conclude our thoughts on projected 2023 results as shown on Slide 6 through 8. The Ukraine Russia conflict continues without further escalation or major additional impact on the European economy and miles driven. On foreign exchange, our guidance includes recent European rates with balance of the year rates for the euro of $1.08 and the pound sterling at $1.22 We expect organic parts and service revenue growth of between 6 8%. Please note that we have 1 fewer selling day in 2023 and have included associated Headlights, taillights and bumper covers. We are projecting full year adjusted diluted EPS in the range of $3.90 to $4.20 with a midpoint of $4.05 This is an increase of $0.20 or 5% at the midpoint relative to the 2022 actual figure.

Speaker 3

Looking at slide 7 in the presentation, you can see how we get from the 2022 actual EPS to our 2023 guidance. Operating performance is expected to generate growth of $0.24 relative to the 2022 results, mostly related to Wholesale North America from volume growth and Europe due to margin improvement. We do expect a continuation of challenging conditions for specialty from softening demand for RV related products and self-service related to commodity prices and input cost inflation. Share count benefits are projected to add $0.10 to the full year 2023 EPS over and above the share count benefit associated with the deployment of our PGW proceeds. Note that there are no share repurchases assumed for 2023 in this figure.

Speaker 3

This amount reflects the carryover benefit from 2022 purchases. So we're expecting very solid improvement on the operations side in 2023, which will drive year over year growth despite some non operational challenges. The exchange rate benefit is nominal and is offset by softening in metals prices. The PGW divestiture creates a $0.02 headwind, Reflecting the net reduction caused by lost profits, partly offset by the share count benefit generated from the redeployment of proceeds into share repurchases. Interest is projected to be a significant cost increase with our weighted average borrowing rate on variable rate debt having already risen from close to 1% in 2022 to about 4% by year end.

Speaker 3

We anticipate an additional $0.13 in interest expense in 2023 on a year over year basis due to higher average market rates. We have included an effective tax rate of 26.3% in the 2023 guidance, roughly in line with the final 2022 rate. We expect to deliver approximately $975,000,000 free cash flow for the year, achieving 55 percent EBITDA conversion to free cash flow despite a few key headwinds. As seen on Slide 8, we expect to produce incremental cash flows relative to 2022 from operations, including increased profitability and Tradeworking Capital Improvements to counteract the following uses of cash. First, as mentioned previously, we underspent on capital expenditures in 2022, including equipment delays and expect to see an increase of approximately $78,000,000 relative to the prior year.

Speaker 3

2nd, the higher interest rates will require increased cash payments for interest expense, which we are currently projected at roughly $50,000,000 3rd and final, we anticipate increased tax payments of $60,000,000 due to profitability increases and the timing of payments. Thanks for your time this morning. With that, I'll turn the call back to Nick for his closing comments.

Speaker 2

Thank you, Rick, for that financial overview. In closing, 2022 was another banner year for our company And again, Phil, David, the strength of our strategy, our business model, and most importantly, our people. Let me restate our key strategic pillars, which continue to be central to our culture and objectives as we've entered the New Year. 1st, we will continue to integrate our businesses and simplify our operating model. 2nd, We will continue to focus on profitable revenue growth and sustainable margin expansion.

Speaker 2

3rd, We will continue to drive high levels of cash flow, which in turn gives us the flexibility to maintain a balanced capital allocation strategy and 4th, we will continue to invest in our future. With these pillars in place, company. Coupled with our industry leading teams, we are well positioned to both face the challenges the New Year presents and to continue to deliver positive year over year operating results for our shareholders. As always, I want to thank the over 45,000 people who work at LKQ for all they do to advance our business each day and for driving our mission forward regardless of the challenges. Time and time again, our teams have shown That these challenges are opportunities for growth, both for themselves and for the overall organization.

Speaker 2

And with that, operator,

Operator

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

Speaker 3

Okay. Thanks and good morning. I wanted to ask about your recycling business in Europe after you've acquired Renoy. I I mean, I know it's not large in the scheme of things, but perhaps you could just update us on the recycling footprint you have today in Europe and whether the time is right

Speaker 2

Yes. Good morning, Craig, and thanks for the question. So for many years, we've had operation in Scandinavia, in Sweden. We call it a TRACO. It's been operating quite well for quite some time.

Speaker 2

It's not a huge business, but it is a nicely profitable business. And we started in Scandinavia and particularly Sweden because that recycling market looks the most like the U. S. Market. When you think about how the insurance companies participate in the industry and the utilization of recycled parts.

Speaker 2

And so that was our beachhead, if you will, and it's proven to be a very nice investment. Obviously, Renoir is our maiden voyage on to the continent, And we anticipate that there will be incremental opportunities to expand the footprint. The recycling business in Europe is, generally speaking, is different than in the U. S. It is largely driven by the commodities as opposed to parts sales.

Speaker 2

And as you know, as a distributor of parts, we're more focused on on the parts side and the commodity side. And so it's going to take some time for the European market to shift. There are some regulatory changes going on in Europe as relates to the circular economy and utilization of green parts. We think this is going to be a good time to slowly kind of build up our presence. We've got Ebola of intellectual capital here in the U.

Speaker 2

S. We think it's going to be a good time to extend that to the other side of the Atlantic, but it's going to be a slow process, Craig. You should not expect any major shifts over the next year or 2 or 3. But we think we're incredibly well positioned to expand our footprint on the recycling side in Europe, and it's all a matter of finding the right businesses to acquire, the right management teams, the right values, The right environmental practices, but we're optimistic that there will be more tuck ins like Hanoi as time unfolds. Thank you.

Operator

Your next question comes from the line of Scott Stember from Roth MKM. Your line is open.

Speaker 4

Good morning, guys, and thanks for taking my questions as well. Good morning, Scott.

Speaker 2

Can you talk about

Speaker 4

State Farm, what you're seeing early experiences, how fast it's ramping up? And then also, Are you hearing anything about State Farm potentially expanding past the 2 or 3 SKUs that they're currently using right now?

Speaker 2

Yes. So State Farm made their announcement just in December. It's not like going over to the wall and flipping the switch, right? You have a couple decades of history of repair shops being kind of driven into their head that State Farm did not use aftermarket parts. And so it's going to be a slow transition.

Speaker 2

Our volumes of those 3 part types On State Farm claims is moving up. And so we think that it's on track for the hit the overall opportunity for 2023. I think we quantified that in our last call as being under $100,000,000 We've had 1 month, right, January under our belt. If you kind of extrapolate that out, we think that they're going to continue to push their new policy throughout the marketplace, but it's going to take a little bit of time to get up to kind of full speed.

Speaker 4

Got it. And then as Paul

Speaker 2

There is no indication at this point in time, but again, we're not But what, 45 days after the announcement that they're going to extend the program to new product types. That's certainly our hope. We think that is the logical thing to do, but we thought that was the logical thing to do for the last 20 years.

Speaker 4

Got it. Well, clearly in a better spot than we were 10 years ago.

Speaker 2

Absolutely.

Speaker 4

And just if I could just slip one last question in Europe, I don't know if you gave granular detail by market, but what are you seeing at The countercyclical benefits of the aftermarket or the mechanical parts aftermarket starting to kick in, maybe just give us a little color there.

Speaker 2

Yes. So, as Rick And I both indicated organic growth in Europe in the Q4 was a little bit over 5% on a per day basis, on a same day basis, Which was terrific. Every single one of our markets was up nicely and either in and around that mid single digit range with the exception of one business, which is we call it components business. On a year over year basis, that was still negative because that's the business that used to sell into Russia. And if you recall, we shut Every single element of that down the day that Putin rolled tanks over the border.

Speaker 2

And so on a year over year basis, That volume is just gone. But all the geographic platforms showed really good organic growth in the Q4.

Speaker 5

Got it. Thanks guys.

Operator

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

Speaker 5

Hey, good morning guys.

Speaker 3

Good morning, Brett. Good morning.

Speaker 6

You called out strength in alternative parts utilization in North America. Is that tailwind from OE certification programs or what they're doing in collision on the OE side driving prices up to the point where it forces more alternative parts utilization or What do you see as the tailwind in that mix?

Speaker 2

Well, we believe that in the Q4, the biggest part of that tailwind Is that the aftermarket, including ourselves, is by far the largest player. We actually had inventory to sell. As you recall, we had supply chain challenges coming out of 2021 into 2022 and our fulfillment rates Because of that, we're down. I mean, historically, we've been in this the mid-ninety percent range. And as we indicated prior quarters, we were down into the low to mid-80s, right?

Speaker 2

The fact that we actually have the inventory need to be responsive to customer demand Is the primary reason the whole aftermarket industry was able to grab over 2 percentage points of share back from the OEs. And we think that and we're very proud of that. Obviously, we're the largest player in the aftermarket parts space. We're charging hard to take share, not just from the OEs, but from our smaller competitors as well.

Speaker 1

Okay, great. And then on

Speaker 6

the recycling of batteries in North America, the partnership you talked about, can you give us a little more detail sort of is that something that uses your existing infrastructure and obviously not a lot of batteries in the vehicle park yet, but where do you see that being a contributor?

Speaker 2

Yes. This is not a play for 2023 or even 2025, Brett. This is a 10 to 15 year play, right? And What ultimately we believe is it's pretty well documented that there's not enough lithium being mined to produce all these batteries that can go on the EVs that folks are anticipating going to be on the road. And so recycling the key elements out of existing EV batteries is going to become critical.

Speaker 2

We don't have the technology to do that. We recycle parts, but we don't know how to recycle chemical elements, right? But that's where Korea's Inc. Comes in. I mean, they are truly a world class organization when it comes to reclaiming and recycling all sorts of various non ferrous metals.

Speaker 2

And we believe that's a combination of Their ability and process technology on the one hand with our ability to source cores and batteries on the other hand is a could be a great partnership. Now it's a memorandum of understanding, right? It's not a joint venture yet. Goals over the next couple of years to figure out and work together to develop a plan that could be profitable for both companies. But it's moving us into the next generation of Mobility and we're very excited about it and we think, Kreia's Inc.

Speaker 2

Will be a terrific partner for us.

Speaker 5

Great. Thank

Operator

Your next question comes from the line of Brian Butler from Stifel. Your line is open.

Speaker 7

Good morning, guys. Thank you very much for taking my questions.

Speaker 2

Good morning, Brian.

Speaker 3

Just on the first one on the

Speaker 7

guidance, when you think about the $975,000,000 in cash flow, I mean, it sounds like that's kind of the minimum. And if you were to try to back up into an EBITDA number using the conversion of the 55 to 60, that kind of puts you at $1,770,000,000 kind of just under 13% margins. Is that kind of the right way

Speaker 5

to think of The low end of EBITDA?

Speaker 3

Yes. So we the way we're looking at it thanks for the question. The way we're looking at it is 55% is the minimum of where we're sort of guiding on the conversion piece of it. As we're driving into this thing, the mix between what happened year over year in the earnings with the interest payments, the tax payments coming down and the capital expenditures. I think we've got a gap, call it 50 Plus or minus, we kind of gear right in that range.

Speaker 3

That's where I would kind of look on the free cash flow piece. And then backing into that, we've guided 55% to 60%. We think that's a pretty reasonable approach where we hit the 60% in the prior year 2022, bringing that down a little bit with the CapEx expenditures in 2023 is how we end up getting that 975 Okay.

Speaker 7

But just think I mean, again, just kind of backing it into trying to guess at the EBITDA. I mean, as that gets to the 60%, you would expect the EBITDA to also Be higher as well. Is that a fair way to look at it?

Speaker 5

Yes. That's

Speaker 3

a fair way.

Speaker 5

Yes. Yes.

Speaker 7

Okay. And then on a follow-up question, When you think about the CapEx, the additional spend that kind of moved from 20222023, I mean, if you kind of even that out over 2 years, you kind of were at $1,000,000,000 based on your guidance. That's exactly right. You'd be at about $1,000,000,000 guidance. So what was the Okay, great.

Speaker 7

Can you give a little color just kind of on what drove that and then maybe kind of what's the right way to think about CapEx on a longer term basis?

Speaker 3

Yes. So we look at 2% of revenue, 2% to 2.25% of revenue is usually the kind of guide that we've given. We hit 1.75, I think it was 1.77, something like that, in 2022 as things pushed out, primarily trucks, equipment pushed out with the supply chain issues. And then when you think year over year, right in that 2% range that we've been kind of guiding to. So there may be ebbs and flows back and forth between different years, but that 2% to 2.25% is the right way to look at it.

Speaker 7

Okay, perfect. And then just last one. Is there any risk on the inventory build that specialty If cars kind of that market, that demand remains soft, is that something we should be watching?

Speaker 3

No, I don't think so. So we have a traditional build throughout the year and we ended up decreasing that a little bit and then driving that down to the end of the year to end up virtually flat year over year on overall inventories. And it's something that we're watching very closely with the demand and so nothing to be concerned about in that area.

Speaker 7

Okay, great. Thank you for taking my questions.

Operator

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

Speaker 5

Yes. Hey, good morning everybody. Thanks for taking our questions.

Speaker 2

Good morning, Daniel.

Speaker 5

I want to start on the European side. I think at the end of your prepared remarks, You talked about Europe having some specific projects they're working on. Can you provide some more color just around what those are? Is that just the growth into collision parts? Are there other cost project that Varun and the team are working on.

Speaker 5

Any kind of quantification as we think about potential margin impacts from those initiatives?

Speaker 2

The answer, Daniel, not beside that the answer is yes, right. We've got a number of different projects over in Europe. Rick mentioned restructuring, the 2022 restructuring plan. That hits all of these segments, including the European segment. It's part folks should think about restructuring at LKQ as part of our continuous improvement plan that every year we're looking to find ways optimize our business and to get excess cost or better throughput and efficiency from each of our operations.

Speaker 2

And so yes, there are some restructuring plans over in Europe just like North America and Specialty. We're looking at programs to continue to drive organic revenue growth, particularly volume growth. And Varun and team are focused on some key programs there. They pulled in headcount a little bit, particularly at the kind of at the head office levels, not just in Zug, But across the operating platforms as well, just to make sure that our administrative costs are aligned with The realities of 2023 and the economic climate. So it's a number of different initiatives, Daniel, none of which We're going to put a pinpoint as to what it means from a euro or dollar perspective, but it's all with the goal of continuing to drive organic revenue growth and better margins.

Speaker 2

And as I think Rick indicated in his prepared comments, We're anticipating that the margins in Europe will go up by 20 to 30 basis points in 2023, and that's been included in the guidance that works it out.

Speaker 5

Great. Gary, that's helpful color. And then I wanted to Just circle back on the potential battery remanufacturing JV. If you take a step back and just think about how State Farm handled The aftermarket after one accident 20 years ago. I mean, have you guys talked to the insurance companies?

Speaker 5

Do you think that they're actually going to reinsure remanufactured EV batteries or if there's one accident, does that become a category that insurance companies just won't touch because of liability? Trying to think through what the actual end market could be there. Can insurance companies actually do that?

Speaker 2

Yes. So Daniel, you need to separate the collision business For the mechanical repair business. And the EV batteries, what we're doing right now with Bumblebee and Green Bean, the 2 companies that we bought Over the last year or so that we manufacture batteries, that has nothing to do with the collision business. That just has to do with The failure of the batteries and the life batteries to extend the life of the vehicle, okay. The memorandum of understanding on recycling with Korea Zinc, again, has nothing to do with remanufacturing.

Speaker 2

That is truly recycling to get to the core elements that are inside that EV. And so You need to keep them there's a big difference between remanufacturing and recycling. Recycling, there's not a battery left to go back into another vehicle, right? Remanufacturing is where we truly look at the battery, we replace certain cells. That is not an insurance driven product.

Speaker 2

If you have a 9 year old DB and your battery is failing, You are not going to get reimbursed a nickel from your insurance company to go replace that battery. That's going to be an out of pocket expense.

Speaker 5

Got it. So this is more on the it's on the mineral extraction or kind of recycling side, the potential to gain. Yes. Okay. That's helpful.

Speaker 5

Thanks, guys.

Operator

Yes. And there are no further questions at this time. Mr. Nick Zarcone, I turn the call back over to you for some final closing remarks.

Speaker 2

Well, as always, we greatly appreciate everyone's time and attention on this call. We know it's a busy reporting period and we appreciate you spending the hour with LKQ. Again, I couldn't be more proud of Our team and the results that we posted up not only in the Q4 of 2022, but the full year as a whole. We're looking forward to being back on line with you in about, I don't know, 60 days or so in late April, when we announce our Q1 results. Thank you for your time and we'll be talking to you soon.

Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.

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Earnings Conference Call
LKQ Q4 2022
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