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Good morning. My name is Denise, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the LKQ First Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you.
Joe Boutross, Vice President of Investor Relations, you may begin your conference.
Thank you, operator. Good morning, everyone, and welcome to LKQ's first quarter 2018 earnings conference call. With us today are Nick Zarcone, LKQ's President and Chief Executive Officer; and Varun Laroyia, Executive Vice President and Chief Financial Officer. Please refer to the LKQ website at lkqcorp.com for our earnings release issued this morning as well as the accompanying slide presentation for this call.
Now, let me quickly cover the Safe Harbor. Some of the statements 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 measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release and slide presentation.
And with that, I'm happy to turn the call over to Nick Zarcone.
Thank you, Joe, and good morning to everybody on the call. We are delighted to share the results of our most recent quarter with you this morning. I will start by providing some high-level comments on the quarter, and Varun will dig in a bit further into the segments and related financial details before I come back to discuss or our updated 2018 guidance and make a few closing remarks.
As noted on slide 4, consolidated revenue was a record $2.721 billion reflecting a 16% increase over the $2.343 billion recorded in the first quarter of last year. Total revenue growth from parts and services was 15.7% during the first quarter while organic revenue growth in parts and services on a global basis came in at 3.7% with our North American operations leading the charge. As mentioned in the Q4 call, very few companies in our sector are generating organic growth at this level.
Please note, we adopted the new revenue recognition accounting standard effective January 1 of 2018 and that had a negative impact on consolidated revenue growth of just under 40 basis points. So, excluding the impact of the new accounting standard, the global organic growth rate was just above 4%. While the quarter-to-quarter impact is difficult to forecast, we expect the accounting standard impact on our reported revenue growth for the remainder of the year to be less than that recorded in Q1.
Diluted earnings per share from continuing operations attributable to LKQ stockholders for the first quarter of 2018 was $0.49, an increase of 9% as compared to the $0.45 reported for the same period of 2017. On an adjusted basis, diluted earnings per share from continuing operations attributable to LKQ stockholders for the first quarter was $0.55, an increase of 12% compared to the $0.49 for the same period last year. These EPS results were a bit short of our expectations, and during that call, we will provide some insights as to both the headwinds faced and our plans for change.
Let's turn to the operating highlights. As you will note from slide 6, total parts and services revenue for our North American segment grew 8.6% during the first quarter of 2018 compared to the comparable quarter last year. Organic revenue growth for parts and services for our North American segment during the quarter was 6.5%, well ahead of expectations. We clearly started the year on a high note in North America, especially when you consider that according to CCC Information Services, collision and liability related auto claims on a national basis were only up 0.8% in the first quarter, although there were significant regional differences, which were basically a reversal of recent years.
According to the CCC data, the traditional Snow Belt states like Illinois, Michigan, Ohio, Pennsylvania, New York and Massachusetts, all experienced material growth in repairable claims, while states like Washington, California, Texas, Georgia and Florida saw year-over-year declines in repairable claims. Our revenue largely tracked these regional differences with the Midwest, Northeast and Canadian regions performing extremely strong, while the revenue growth in the South, East and the West was more tempered. Clearly, Mother Nature helped the cause in some of our larger regions. That said, the 6.5% organic growth far outpaced the CCC data supporting our view that we continue to gain market share.
Also, according to the U.S. Department of Transportation, our performance in Q1 was achieved, while miles driven in the United States were down 0.1% on a nationwide basis in February, although like the claims data, there were significant regional differences.
Organic growth for the aftermarket parts outstripped that of salvage parts, as the repair shops were looking to improve cycle times given the increased volume of work they were processing. Importantly, we continue to see increases in our total aftermarket collision SKU offerings as well as the total number of certified parts available, each growing 6.7% and 13.8% respectively in the first quarter.
Finally, as noted last call, we have a new agreement to distribute batteries to the FCA dealerships in North America, and that program had an approximate 100 basis point positive impact on our North American organic growth rate during the quarter. Achieving this robust level of organic growth in North America came at a cost, particularly in our collision parts business, as we incurred incremental operating expense as a percent of revenue to maintain our industry-leading service levels for our customers.
As mentioned, some regions exhibited much better than expected volumes and we had to move inventory around the system in order to have the right parts in the right place to satisfy customer demand. This dynamic had a negative impact on operating margins in the quarter, which Varun will touch on shortly.
Moving to the other side of the Atlantic, our European segment achieved total parts and services revenue of 26.6% during the quarter. Organic revenue growth for parts and services in Europe was 1.2%, which was below our expectations. Acquisitions added an additional 11.3% to revenue growth during the first quarter of 2018, while the strengthening of the euro and sterling continued during the quarter resulting in an FX-related increase of just over 14%.
On the positive side, our operations in Eastern Europe again led the way with high-single-digit organic growth, and our Benelux operations experienced organic growth well above the overall European average. Conversely, our UK operations, which are currently our largest in Europe, produced roughly flat organic growth on a year-over-year basis and generally experienced the softest quarter since we bought ECP in 2011.
While there were a number of moving pieces, I will mention the three biggest factors. First, while we remain highly confident in the long-term benefits related to the new UK warehouse project, known as T2, we have to acknowledge that the full conversion to the automation became more difficult than we had initially modeled. As mentioned in the past, this project involves moving from the utilization of three smaller legacy warehouses to the utilization of the new large highly automated T2 facility and a reconfigured existing facility. T2 is not only a major logistics initiative, but also a complex software project.
While we and our vendors did extensive testing, it was only once the system was under the full load of all the ECP branches earlier this year that some issues began to surface. In particular, we experienced some replenishment issues and related stock availability at both T2 and some of our branches, which in turn led to temporary service issues. We immediately increased head count at T2 to keep the product flowing and implemented key promotional programs to maintain our customer relationships. The final material software patch was installed a few weeks ago. We have worked through the backlog and now the system is fully functional. That said, we are not fully optimized yet, and it will take a couple of quarters to continue to prove the efficiency at T2.
Based on our early April results, it appears that the sales disruption has been rectified. But we still have work to do on the cost side. In the coming quarters, we will move the Andrew Page national distribution center functions and related branch network replenishment to T2. We are confident that these will be executed without the same issues we experienced during the first quarter.
The second point, Europe like the United States had some unusually severe weather. For example, in March, the UK was hit by three separate storms which the media have referred to as the Beast from the East. While these storms dropped an unusual amount of snow on the Greater London area, the biggest impact was experienced in Scotland and the northern areas of England. There were a few days when some of our replenishment trucks were grounded, and many of our customers and our some of branches closed. While harsh weather is generally favorable to our business, in this case, the severity led to a negative impact on the Q1 results.
Third, the timing of Easter appears to have had a larger negative impact than we anticipated. Last year, you may recall, Easter fell in mid-April and firmly in the second quarter, where this year Easter was on April 1 with Good Friday falling into the first quarter and Easter Monday in the second quarter. So again, we had three temporary setbacks.
With respect to Andrew Page, we have received approval to integrate the non-divestiture Andrew Page business. Andrew Page's branch network and national distribution center is scheduled for integration into T2 by July and the head office function should be consolidated by the end of the year. At this time, we are in the process of selling 11 Andrew Page branches, including the nine required by the UK competition authorities and two additional branches that are focused on the commercial vehicle market. We are currently evaluating the bids we have received for these branches.
During the first quarter, we opened up five new branches in Europe including one new location in Western Europe and four in Eastern Europe. So overall, it was a disappointing result for our European segment with the three temporary setbacks impacting our organic growth and EBITDA margins. That said, we believe the longer term impact of the weather will be favorable, the Easter timing impact will benefit Q2 when compared to last year, and that the T2 and Andrew Page integration issues are now within our control and will be resolved in the next couple of quarters. By Q3, we anticipate we will start to see the benefits and we will exit the year with these items well behind us.
And finally, let's move on to our Specialty segment. During Q1, Specialty reported organic growth for parts and services of 0.3%, with most of the slowdown from historical levels coming late in the quarter. The team implemented selected customer and product mix rationalization decisions that we think will yield positive results over the long term. In the short term, however, this meant for growing business in the quarter, which had lower profitability levels while focusing on developing new business at a more acceptable margin. Importantly, unlike our North American segment, which benefits from severe winter weather, the Specialty segment was negatively impacted by the harsh March storms both on the demand side for our RV-focused products as well as our ability to distribute in certain markets.
Moving on to corporate development, in the first quarter, we acquired an aftermarket radiator and related products distributor in Tennessee. During this quarter, we tempered the volume of our acquisitions primarily to digest what we had acquired in 2017, but not closing the door on attractive acquisition opportunities. With that said, I am pleased with the diligence of our development team and our operating team's effort with respect to ongoing integration efforts. We continue to see a robust pipeline of opportunities to acquire businesses that fit with our growth strategy in each of our operating segments.
With respect to the pending acquisition of Stahlgruber announced back in December, we engaged in pre-notification discussions with the EU Antitrust Commission beginning in January and submitted our formal merger notification filing to the Commission on March 9. On April 4, the Commission received a referral request from one EU country asking that part of the transaction be transferred to that country's competition authority for its assessment. The referral request was not a complete surprise, as there was some overlap of business activity in that particular country. The referral request triggered an automatic 10-day extension to the EU review period and we currently anticipate receiving a formal response from the EU Commission on or before May 3.
The operations in the country subject to the referral request represent only a small portion of Stahlgruber's overall revenue and profits, and we believe we will be able to close on the vast majority of the Stahlgruber business during the second quarter. Importantly, our interactions with the Stahlgruber leadership team over the past several months has only reinforced our view that it is a very high quality organization and a strong business, and that will be a terrific addition to the LKQ Europe family of companies.
And now, I will turn the discussion over to Varun who will run you through the details of the segment results.
Thanks, Nick, and good morning to everyone joining us on the call. I will take you through a consolidated and segment results for the quarter and cover our current liquidity situation before turning it back to Nick for an update on full-year guidance.
Nick described the trends behind our reported revenue of $2.7 billion, a new record for the company, so I will start with our consolidated gross margin. As noted on slide 11 of the presentation, the consolidated gross margin percentage was down 100 basis points versus the comparable quarter last year to 38.7%. Roughly 60 basis points of the decrease is attributable to our North America segment with the balance relating to our European segment.
Segment EBITDA totaled $295 million for the first quarter reflecting a $5 million or 1.7% increase over the comparable quarter of 2017. As a percentage of revenue, segment EBITDA was down 150 basis points to 10.9%. We experienced an 80 basis point increase in our operating expenses largely due to personnel and freight expenses.
During the first quarter of 2018, we also experienced a $1 million increase in restructuring and acquisition-related cost compared to the prior year and an $8 million increase in depreciation and amortization expense largely due to acquisitions. With that, operating income for the first quarter of 2018 was down about $9 million or roughly 4% when compared to the same period in 2017.
Non-operating items were favorable by about $2 million versus Q1 2017. Other non-operating income includes foreign exchange gains and losses and various income items such as late payment fees. Interest expense was up $4.5 million, approximately 19% year-over-year due to both higher average balances and interest rates. Pre-tax income during the first quarter of 2018 was $201 million, down $12 million or 5.6% compared to the prior year.
Moving to income taxes, our annual effective tax rate was 26% for the quarter, consistent with the guidance we provided. In the first quarter of 2017, we applied an annual effective rate of 35.25%. So we're showing a $23 million decrease in the income tax provision this year mostly related to the lower U.S. federal tax rate that went into effect with the Tax Cuts and Jobs Act.
Diluted EPS from continuing operations attributable to LKQ stockholders for the first quarter was $0.49, up 8.9%. Adjusted EPS, which excludes restructuring charges, intangible asset amortization and the tax benefit associated with stock-based compensation, was $0.55 reflecting a 12.2% improvement.
Before I turn to segment commentary, I want to acknowledge the disappointment in our margins in the first quarter. At LKQ, we pride ourselves not only on being able to grow revenues as we have demonstrated yet again, but equally importantly to do so profitably. Our management team strives to obtain operating leverage in our businesses. We haven't lost that discipline, but we also know that there is work to be done to address the margin pressure we faced in the first quarter.
I will provide color on the causes and actions underway designed for our long-term success. Starting with North America on slide 13, gross margins during the first quarter were 43.3%, down 110 basis points over the 44.4% reported last year. The aftermarket business represented about 70 basis points of the decline due to several factors. Firstly, rising costs for our supplies and commodities such as sheet metal and resin and ocean freight resulted in higher costs for our inventory. Our net selling prices, however, did not increase to match the higher inventory costs. Efforts are underway to redress this issue on a location, district and region level to offset this headwind.
Secondly, a large part of the organic growth we experienced came through products such as automotive batteries, owing to the cold winter and certified OE parts. Both are lower margin products, which diluted the overall margin profile relative to the prior year.
Thirdly, our self-serve business also contributed to the lower margin percentage, which initially seems unusual given this rising scrap prices. We are generating more gross margin dollars in 2018 than a year ago, though the gross margin percentage decline, as we process higher cost cars this year. Parts revenue tends to not grow significantly when car costs rise due to higher scrap prices and create a dilutive effect on the gross margin percentage.
In Q1, we also recorded an increase to our reserves associated with returns and receivables that in aggregate cost us approximately $0.02 in EPS. We do not expect a similarly-sized charge to recur in 2018. Operating expenses as a percentage of revenue in our North American segment increased by 40 basis points compared to last year. We also saw a benefit of about 50 basis points from eliminating shared corporate costs of the sale of the PGW OEM business in March 2017.
Outside of this benefit, overhead expenses were up 90 basis points related to freight, personnel and vehicle costs. With the high level of sales growth in the quarter, we had to rely on more third-party freight and vehicle rentals to maintain service levels. Like many companies, we too are seeing third-party freight cost rise with driver shortages, wage inflation and higher fuel costs. As Nick mentioned earlier, weather impacted certain regions such as the Northeast and Midwest, which experienced strong revenue growth, though this came at a price as we had to bring on expensive temp labor and incur overtime to keep up with demand. The premium for temp labor and overtime contributed to an increase in personnel costs outpacing revenue growth. Training is underway on a variety of fronts to address these headwinds, including adjusting third-party freight codes to reduce freight surcharges, sourcing less expensive freight options and resource management.
Non-operating income and expenses had a positive impact on segment EBITDA of 30 basis points in 2018 due to a non-recurring asset write-off that was recorded in the first quarter of 2017. In total, segment EBITDA for North America during the first quarter of 2018 was $178 million, a 0.9% increase over the prior year.
Looking at slide 14, scrap prices were up 37% over the comparable quarter last year and up 21% from Q4 of 2017. The benefit from scrap reflects the sequential movement in pricing, as car costs will generally follow scrap prices higher or lower over time. We saw a $13 million positive impact on profitability owing to scrap prices, which was $7 million higher than the benefit we experienced in Q1 of 2017.
Moving on to our European segment on slide 15, gross margins in Europe were 35.9% in Q1, a 110 basis point decline over the comparable period in 2017. The decrease is attributable largely to our UK operations and to the mix shift at Riyadh (00:25:52), given the higher growth of the Central and Eastern European region, which has structurally lower margins.
As Nick mentioned in his remarks, we experienced migration issues with our T2 facility in the first quarter that impacted our gross margin on two fronts. First, on the expense side, we incurred unbudgeted cost to address the issue, including increased personnel expenses to manually receive and stock product. And second, we launched promotional pricing to recapture our customers' business. Going forward, we expect to incur some additional period costs in Q2 and incremental COGS, as we sell through the inventory received in Q1.
The effect of these factors drove the lower gross margin percentage in the UK operations, and we expect these to dissipate in the next couple of quarters. We did have some positive news on gross margins in Europe with our centralized procurement yielding a 40 basis point improvement from supplier rebate programs, and additionally our Sator business in the Benelux showed a 70 basis point improvement with specific strength in private label sales and the ongoing move from a three-step to a two-step model in that market.
With respect to operating expenses as a percentage of revenue, we experienced a 120 basis point increase on a consolidated European basis versus the comparable quarter a year ago, of which 90 basis points were attributable to higher personnel costs, mostly related to branch openings and the Sator three-step to two-step model evolution which, as we've previously discussed, has higher SG&A costs, though offset by higher gross margin. To a lesser extent, we incurred additional costs in Q1 owing to information technology projects, as we continue to work on solutions to rationalize the many systems we operate across Europe today. European segment EBITDA totaled $76 million, a 4% decrease over last year.
Our goal for Europe remains double-digit segment EBITDA margins over the next 36 months, barring the impact of any acquisitions that may be dilutive and Q1 was a step in the opposite direction. While we believe some of the Q1 issues will be behind us soon, we have more work to do, and John and the European management team are intensely focused on this task.
Turning to our Specialty segment on slide 17, the Warn acquisition from November of last year created some noise in the quarter-over-quarter comparison and Q1 was the first full quarter for the business as part of the LKQ family. The Warn business has continued to perform well and, as previously discussed, has a higher margin profile than the base specialty segment. The base specialty business performed well in spite of flat revenues by protecting its margins. As Nick mentioned, Specialty dropped some low margin business, which had a positive impact on the overall gross margin percentage.
Operating expenses as a percentage of revenue in Specialty were higher relative to the prior year, the primary variances related to higher personnel, vehicle and fuel expenses. Segment EBITDA for Specialty was $42 million, up 18.4% from Q1 of 2017. And as a percentage of revenue, segment EBITDA was up 60 basis points to 11.9%, a solid performance by the team, given the revenue headwinds.
Let's move on to capital allocation. As presented on slide 18, you will note that our cash flow from continuing operations for the first quarter was approximately $145 million. We talked earlier this year about the growth in inventory related to buying opportunities in our North America business. In the first quarter, we started to work down the inventory levels, and for North America, this resulted in a net cash inflow, while Specialty and Europe were outflows owing to lower than expected revenues. We remain optimistic about our ability to generate strong cash flows from operations for the full year of 2018.
CapEx for the quarter was $62 million. The largest capital changes reflect the net pay-down of almost $118 million of debt, largely funded by the cash flows from operations and cash on hand. As we've shown in the past, if we slow down the acquisition pipeline, we have the ability to pay down our outstanding debt given our free cash flow generation.
Moving to slide 19, as of March 31, we had approximately $3.3 billion of total debt outstanding and $246 million of cash, resulting in net debt of about $3.1 billion or about 2.7 times last 12 months' EBITDA. We have approximately $1.5 billion of availability on our line of credit, which together with our cash yields a total liquidity of $1.7 billion. On the 9th of April, we closed €1 billion of senior notes with €750 million maturing in April 2026 at a rate of 3.625% and a €250 million maturing in April 2028 at a rate of 4.125%. We are very happy with the support we saw in the market and the terms we were able to obtain despite the ongoing volatility in the capital markets. Funding the Stahlgruber transaction at a weighted average rate of 3.75% over both an 8-year and a 10-year tranche is a terrific outcome. We plan to mitigate a portion of the holding costs by paying down euro-denominated debt until the closing date.
With that, I'll now turn the call back to Nick to cover the updated guidance.
Thank you, Varun, for that financial overview. In light of the results achieved in the first quarter, we have adjusted our annual guidance on a few of the key financial metrics. With respect to organic growth for parts and services, we anticipate North America will remain reasonably strong, and the European and Specialty segments will show improvement as we progress through the year. That said, we have adjusted the top end of the full-year guidance range for global organic growth down from 6% to 5.5% to reflect both the 3.7% reported for Q1, a gradual acceleration in Europe in Specialty, and some continued headwinds from the new revenue recognition accounting standard.
In terms of adjusted EPS, we have moved the range down to $2.20 at the low end to $2.30 at the high end to reflect both the actual results for Q1 and the fact that some of our profit improvement plans will take time to catch hold and yield results. That adjustment yields a range for adjusted net income of $685 million to $715 million, down $35 million from the prior guidance. We have also trimmed our capital spending plan a bit to a range of $235 million to $265 million. We also anticipate that the lower earnings will impact cash flow from operations, but the slightly lower revenue growth should require less working capital investment, which partially offsets the earnings impact. Accordingly, the revised cash flow guidance is $625 million to $675 million, a $25 million reduction.
We still believe the effective tax rate will be approximately 26%, and the guidance assumes current levels as it relates to FX rates and scrap steel pricing. Importantly, our guidance does not – again, does not include any impact from the pending acquisition of Stahlgruber. We will come back and update our guidance once that transaction has closed.
In closing, I am proud of the hard work and dedication our 43,000 employees delivered for the company, our stockholders, and most importantly our customers during the quarter. I am equally proud of our team's commitment to effectively manage the dynamics of the business, which they can control, while not losing focus on growing the business, developing our people, and continuously looking for opportunities to generate leverage and synergies from both our existing and recently acquired operations. Although we are facing some short-term headwinds, I am very confident in our team's ability to effectively implement their respective plans and continue to create significant value over the medium and longer term horizons.
With that, operator, we are now ready to open up the call for questions.
Your first question comes from Ben Bienvenu with Stephens, Inc. Your line is open.
Hi. Thanks. Good morning for taking my question.
Good morning, Ben.
I want to ask about North America. The margins, in particular you described the dynamic around some of the incongruities in inventory where you needed them or where you have them, but the 6.5% growth is well above, I think, what you or we expected. And so I'm wondering, as you move through the year, can you leverage that business in light of a stronger growth environment? And how do you manage through that inventory incongruity in terms of availability, as you move through the year?
Hey, Ben, good morning. It's Varun Laroyia speaking here. Listen, you had a great question and I think if you kind of go back to the fourth quarter discussion that we had where we had invested a significant sum into our North America inventory piece, it actually was the right decision looking back as we kind of previously mentioned in light of the strong organic revenue that we experienced. Interestingly, again the revenue growth was in our traditional crash box. So you look at bumpers, look at grills, things along those lines, which essentially paid off. So from that perspective, the inventory investment worked well. The other piece I will share with you is that during the quarter, we essentially – the net cash inflow from inventory was in North America off the back of the higher organic revenue, although Europe and Specialty was a net cash outflow due to the lower than expected sales.
And Ben, this is Nick. The reality is, we buy our inventory – our crash inventory, aftermarket inventory from Taiwan, as you know. We do that literally a couple of months in advance because it takes time not only to get it onto the ship but over to our facilities. Most of our aftermarket inventory is shipped directly to specific warehouses in the U.S. And so those purchases and those shipments were put in place back in Q4 absolutely in anticipation that we're going to have a normal winter.
The reality is the winter hit harder in some places than other, and we actually had to spend a reasonable amount of money moving inventory around in the system, particularly getting it up into the Midwest and Northeast where there was significant demand for our product. That should dissipate because our expectation is that the winter storms are absolutely behind us, although some of them hit here in April in the Midwest, but they are behind us and we will go into a more normal cadence from a geographic perspective. And so we shouldn't have the same level of expense in getting the right parts to the right place to service our customers.
Okay. Great. And just one quick clarifier if I could ask on the guidance. When I'm looking at the bridge in your presentation, I see the year-over-year business growth went from $0.14 to $0.09, Andrew Page and Tamworth 2 went away, and then the tax reform rate went from $0.28 to $0.26, contributive to the bridge. I'd be curious, I may have missed this in your explanation, what happened there on the tax rate, and I think we've got an explanation on Andrew Page and T2. And then just on the exchange rate, the one last question there, we're at more favorable rates today than we were at the exit of fourth quarter, so why unchanged there on the $0.03 impact of exchange rates? Thanks.
Yeah. Thanks, Ben. So essentially – let me start off with each of those elements that you mentioned. So the year-over-year business growth piece really is linked in with what we had initially anticipated coming through into our European segment. If you think about the T2 and the Andrew Page accretion that we had shared as part of guidance, which was about $0.03, basically that will not be taking place as of now based on the commentary that we shared a few minutes ago. In addition to that, if you think about some of the headwinds we faced in our North America business, we feel confident of being able to recover those, but in terms of the time that's gone by in Q1, we don't believe we can recover that at this point in time.
And then with regards to the tax reform piece specifically at $0.28, so our overall tax rate is consistent at the 26% rate guidance that we had given essentially due to the lower earnings. Essentially that number kind of comes down by a couple of cents essentially. So, that's the kind of $0.28 to the $0.26 EPS from a tax reform piece.
And then in terms of Andrew Page and T2, that gets eliminated in terms of what we had anticipated. And then the final piece, I think, you had mentioned was in terms of exchange rates, listen the exchange rates are flat versus what we've kind of given guidance. We kind of said that there'd be a $0.03 increase from the prior year. We picked up about $0.015 in Q1, but if you think about the two key trading currencies that we have, both the sterling and also the euro, that's one piece in terms of how the earnings are getting impacted in those markets, number one. And quite frankly, if you see as to where those two currencies are trading this week versus when we had given kind of guidance, they're roughly kind of flat. I think the sterling was at an average rate of about $1.38 at the beginning of the year, it's at $1.39 to $1.40. And then the only two other currencies that we have some fairly substantial trading in is the Canadian dollar which is down and then also the Czech koruna. So overall, the FX piece remains flat at the $0.03 versus what we had guided.
Thanks. I'll get back in the queue.
Your next question comes from James Albertine with Consumer Edge. Your line is open.
Hi gentlemen, and good morning and thanks for taking my question.
Good morning, Jamie.
If I may just ask a clarification first before I ask my question. I just want to make sure I heard you right, Nick, on your comment a moment ago. It sounded like you had your conference call for the fourth quarter on the 22nd of February, winter happened in March, costs happened in March and you corrected a lot of that in April. Am I hearing that correctly?
Yes, Jamie. I mean the reality is we've set guidance during our fourth quarter call, which was late February. At that point in time, we had the January results closed, February was not closed, obviously March was not closed, the weather in the UK had not occurred, the weather impacting the Specialty business had not occurred, the issues at T2 were continuing to accelerate. We haven't really – we didn't put the final software patch in there until really a couple of weeks ago early April. And so if you want to think of it, the deterioration of the performance during the quarter accelerated as we went through.
North America specifically though, Nick, if I could just drill in on that, 6.5% organic growth, let's say that holds in 2Q. Could we expect leverage in 2Q or is that unrealistic?
Well, I think, you were – probably as Varun indicated, the issues impacting gross margins will probably hang around a little bit longer because those are not quite fixed, those are more – it can take a little bit more time to get after. But some of the operating expenses, we shouldn't have the same level of freight and expense in moving product around the country in the second and third quarter like we had during the first quarter. I mean the reality is we were scrambling to satisfy the demand from all of our customers in those areas that had gotten really hit hard by the winter weather and accordingly had good demand for the products that we are selling.
And indeed, when the body shops were full up, if you will, they were incredibly focused on cycle time, and there was a shift, there was no doubt. And that's why our aftermarket product grew at a significantly faster rate than the salvage products because we can – generally speaking, we can get that to the shops faster, same day sometimes, than our salvage product, particularly if the salvage product is coming from a different state or a different part of the region, if you will. But getting that product to the customers quickly has cost. So we do anticipate that we should pick up some benefit on the operating expense line in Q2, Q3.
Yeah. I know I burned through questions there, but – yeah, go ahead, sorry.
Sorry, Jamie, just to kind of add two key comments to what Nick just mentioned. One, in terms of Q2, the lingering operating costs on the T2 piece that will come through in Q2 also while we're seeing early signs of are actually stepping up, there will be some associated cost, so there's some lingering overhang from a European perspective specifically that I wanted to highlight.
The other piece I wanted to talk to was in terms of the timing, and as to as Nick mentioned, January was on target, on budget and also the initial couple of weeks in Feb were on target also. As I kind of mentioned, we got hit by a couple of cents on our returns reserve and some very specific bad debts related to export revenue. Those kind of activities really take place on a quarterly basis and that really came through when we closed the quarter. So, that's the other piece I wanted to highlight, which obviously, from a timing perspective we would not have known because that was something that came through at the end of March.
Great. Well, I've taken my share, guys. Thanks. I'll get back in queue. Appreciate your answers.
Thank you, Jamie.
Thanks, Jamie.
Your next question comes from Ryan Merkel with William Blair. Your line is open.
Hey. Thanks. Good morning, everyone.
Good morning, Ryan.
Good morning, Ryan.
So let me ask a couple of questions on Europe. I think you said that sales have been rectified. Is that to mean that organic growth is back to that 4%-plus level here in April?
Yes. The Varun's comment on sales being rectified really goes to ECP and some of the issues that we were having with the software in the automation and the like. And so we're all of 25 days into the quarter, but the last couple weeks, the revenue at ECP has been tracking to their original budget. We need to (00:47:21).
Okay. And then as a follow-up, just on to the margins and profitability, I think you said that you're going to exist the year at more normal levels. So I just want wanted to be clear, do you think by 4Q, you've got all these issues behind you? That's the first part of the question. And then secondly, what do you define as normal EBITDA margins in Europe?
Yeah. So we do anticipate by the end of the year we're going to be kind of back to historical levels in each of our operating businesses in Europe. Part of what you got to keep in mind is, when the issues start to occur and we needed to keep product moving through T2, the answer there was to bring in a fair amount of incremental labor to manually move some of the product around.
As you know, in Europe, the cost of the central distribution centers gets capitalized into your cost of goods sold. So, all that – we have a lot of inventory on the shelves today that will end up getting turned, say, in the second quarter, that has that higher level of costs, so you're not going to see – while the revenue, we think, will come back nicely, you're not going to see an immediate pickup in gross margin until we turn that inventory that has all that temporary labor, if you will, embedded in the cost.
By the time you get to Q4, all that inventory should have been sold through the system and the margins should pick up. The reality is we thought initially that Europe would have margins well into the 9% for the year, given the impact of Q1 and the fact it's going to take some time to kind of work through the issues in the UK, if you will, margins in Europe will probably be in the low to mid-8s on a EBITDA basis for the year as a whole.
Okay. That's very helpful. Thank you.
Yeah.
Your next question comes from Craig Kennison with Baird. Your line is open.
Hey. Good morning. Thanks for taking my question.
Good morning, Craig.
Good morning, Craig.
Good morning. So really this is a board-level question that I think addresses questions that I'm getting from your shareholders. Basically the board historically has incentivized revenue growth, EPS growth and ROE, but with margin improvement seemingly elusive, has the board considered maybe resetting those incentives to align better with margin expansion and ROIC?
So the references that you made to revenue, EPS and ROE, that is one part of the overall compensation program for the senior folks here at LKQ and that's really the long-term incentive plan. And the other kind of incentives that we all work towards really go to, what we call our management incentive plan, the annual bonus plan, if you will, Craig, and on that it is entirely EPS-driven. In order to hit the EPS targets, we need to generate the margins that we're expecting for the year. So while it's not a direct tie to EBITDA margins, you can't hit the EPS estimates without hitting the margin estimates as well. So it is implicitly embedded in the fact that we need to generate good margins in order to get paid.
And then along those lines, in Europe, I think the plan was to get to 10% EBITDA margins in the next 36 months, which would be 2020. Is that still a realistic target? Thank you.
Yes. Craig, it's Varun out here. Yes, listen, clearly Q1 was a step in the opposite direction, but in terms of our commitment to getting to the 10% EBITDA margin level for our European segment, that remains as is. Clearly, it means that we need to kind of get back, and based on the prior question that Nick answered, we were expecting Europe to actually tick a little bit higher than the 8.8% full year for 2017 based on T2 and also Andrew Page. Clearly with Q1 coming in at 7.3%, full year is, as Nick mentioned, between low to mid-8s. But in terms of the exit rate has to be higher based on the second half acceleration coming on segment EBITDA margins in Europe to help us get back on track to the 10% goal that we've previously stated.
Great. Thank you.
Thanks, Craig.
Your next question comes from Bret Jordan with Jefferies. Your line is open.
Hey, good morning, guys.
Good morning, Bret.
Morning, Bret.
On the Specialty business, I think you said the word noise with Warn. Was Warn in your opinion sort of inflating the growth rates of Specialty and the number that we saw was more in line, and I guess in the sense that you called out RV as a softer category and related to weather, is there anything particularly going on in that space?
Yeah, Bret, let me answer the first part of the question. So, with regards to Warn which we closed on the 1st of November, really the noise was associated with Q4 results with regards to the step up of the inventory as a result of acquisition accounting. So really this was the first full quarter that we had with the business being part of our family.
In terms of the growth, that specifically does not get caught up in our organic growth. We actually called Warn out separately as acquisition growth. So really if you think and you back off that Warn acquisition, the organic growth that we called out at the kind of 30 bps, that basically is the kind of bifurcation to kind of think through the revenue growth piece of it. With regards to RV sales, let me kind of put it back to Nick to give you some sense on that.
Yeah. So the RV sales were basically in line with the overall growth. I mean, none of the Specialty business, if you will, was dramatically higher or dramatically lower, if you will, than the overall organic, though it did drop off in March. And we think a fair amount of that had to do with the dislocation from the storms because particularly kind of in the traditional winter states, if you will, when all those snowstorms went rolling through, people weren't outfitting their RVs and the like. That may just be a timing issue and may come back, but we're being cautious in our outlook there, Bret.
Okay. And then the impact from T2 on the UK business, sounds like you had out of stocks as well as a number of other issues over there and some weather. You used to talk about core store sales or stores open for more than 12 months in the ECP business. Can we get a feeling for how that business looked in the quarter and maybe what we're seeing in April? Are we seeing recovery in comp?
Yeah. So the overall growth in the UK was flat year-over-year as I mentioned in my comments. And the reality is the traditional stores, these stores open more than a year were a little bit flat and the new stores didn't add a whole lot to the overall growth.
And just to add one point, as you know, we obviously shut certain stores as part of the Andrew Page integration once we had the ability and the stay separate hold order was removed. We did shut 10 stores within the quarter also, which obviously shows as negative organic. So, just want to kind of highlight that piece.
Okay. So your comp was flat despite the disruption from the T2 out of stocks?
Yes.
Okay. And T2 was back running – I guess, are we running T2 still or are we trying to fix T2 and running off of legacy distribution right now?
No, no, no, no. You got to understand, it's not like the T2 facility was totally shut down. All of our 225 branches, ECP branches in the UK are being fulfilled exclusively on the traditional service parts out of T2. It was on the margin, there were throughput issues with the facility. So I mean we're processing tens of thousands of fulfillment orders each and every day out of T2. The issue that was happening, Bret, is at some point in time, the trucks need to leave the distribution center to go replenish the branches so they have stock for the next day. We get orders all the way up into – replenishment orders all the way up to 5, 6 o'clock in the evening, the trucks leave by 8 o'clock in the evening. Some of those late orders weren't getting queued in in time and weren't getting picked. And so, that replenishment wasn't happening. And as you know, in the UK, over half of our revenue in the UK gets delivered within 60 minutes of when we get the call from the customer requesting a product.
So if the product is not in the branch, it's not going to get sold and it was just on the margin, there were some fast-moving parts that didn't get picked in time, didn't hit the delivery truck and weren't in the branch in the next day, okay? It's not like T2 was down for days at a time. Nothing could be further from the truth. It was just the throughput wasn't as strong as it was designed to be, okay? And we were putting software patches in as we are proceeding through the quarter trying to fix the issue working hand in hand obviously with our outside vendors who help design and install the entire system.
You all see the T2 facility in action on our Analyst Day on the 31st of May because we're holding it over at T2. You're going to see it is a massive facility. And so we're just on the margin, we were out of stock in certain parts and so instead of fulfilling our branches at 99.9% of the time, we were fulfilling the branches at a slightly lower rate and that had an impact on revenue. Again based on the two weeks of data that we have from when that last software patch was put into place, the revenue at T2, the fulfillment, the stocking levels all seem to be holding with the original budget. So we have confidence that the revenue will come back. It's not lost forever. We do though have inventory in the shelves that include all that incremental cost. So it's going to take some time to bleed through. And so we won't get the same – the pickup on the gross margin line won't be as pickup on the revenue line. Hopefully, that helps.
Okay, thanks. That does. Thank you.
Thanks, Bret.
Your next question comes from Ryan Brinkman with JPMorgan. Your line is open.
Hey, good morning, guys. It's David Kelly on for Ryan. Just a couple of quick ones for me, and I guess just first trying to bridge the gap between your North American organic growth and the CCC data you referenced, and I know you've spoken about the shifting vehicle population within your age sweet spot, how it's been a headwind for you. Do you think we're reaching that inflection point where the vehicle age mix is again either a positive now or will be a positive in the next, call it, 12 months or so? And then just as a follow-up, how do you view or what's your view on underlying collision repair demand in 2018?
Yeah. So we don't see huge shifts in the car park, which is I think where your question was headed. Clearly as we've included in our standard investor materials that sweet spot, if you will, in 2018 as we've said for some time is coming back into our favor, if you will. And you think about the number of cars that are in that 3- to 10-year timeframe, which is really the sweet spot for collision products, if you will. Again, there are big, big regional differences in the CCC data as relates to the growth. And those states that I talked about, think about the high population Snow Belt winter states, we had exceptionally strong results. The West and the Southeast were – we still had growth, but not as high.
But when you think about the 6.5% organic, again about 100 basis points of that came from that new program that we have in distributing batteries, which says everything else was up 5.5%. The core aftermarket collision product was up well north – well north of the 5.5%. Engines and transmissions were in that 5% to 6% range. Collision product from salvage, again because people were buying more aftermarket than salvage, was kind of in the lower single digits. Our glass business was double digits, which was terrific. Some of the product lines that have been slow growers over the past several quarters continue to be slow growers. Paint was flat. Paint accessories if you think about sandpaper and Bondo and tools and the like was down just a little bit. Cooling continued to be negative, if you will. But again, it was a terrific quarter from a overall North American revenue perspective.
Again, Mother Nature absolutely helped this out because the winter was – from our perspective, particularly in the Snow Belt states whereas a – for us a better than average winter, more severe winter, which leads to more collisions. And the CCC data would absolutely support that with a number of those states having repairable claims in the 5% to 6% growth rate, if you will. The Western, Southwest and the Southeast, most of those states were actually negative year-over-year. So we're comfortable that North America will continue to grow nicely for the rest of the year. I'm not going to say that we're going to be able to do 6.5% because we know that Mother Nature helped us, but we think it's going to remain very healthy. And we think that's in part because of our competitive position, in part because of the continued soft tailwinds related to the car park and the sweet spot. The reality is we think alternative part usage is again trending up just a little bit at a time but every little bit helps, and then obviously a good weather condition. So, hopefully, that answers your question.
Yeah. That's great. I really appreciate all the color.
Your next question comes from Michael Hoffman with Stifel. Your line is open.
(01:04:01) for giving me the chance to ask the questions. So, Nick, I have an AB kind of my – on my read-through what you're saying is that the top line is going to be okay relative to your original expectations. You're bearing more costs to execute that for the reasons you've said, I think that's accurate. Specifically to 2Q, am I right reading through that 2Q EBITDA in North America and again Europe will be up versus 1Q on a margin basis, but down year-over-year? But I'll reverse the negatives, it gradually starts lifting each subsequent quarter to finish the year at the levels you've adjusted to. Is that the right way to think about what I'm hearing?
Yeah. Well, again, Michael, as you know, we don't provide quarterly guidance if you will. But traditionally, you can see how our margins flow from a quarter-to-quarter basis. We would anticipate that those quarterly flows, if you will, will occur if you're in 2018 as well, particularly in North America.
Okay. So I just want to make sure do you expect the trend sequentially to improve?
We think that the traditional trends of how margins flow throughout the year will be consistent in 2018. Last year, if you will, between Q1 and Q2, Q1 was 14.6% and Q2 was 14.4%, so pretty close to the same. We would probably expect something similar where Q2 margins would be very similar to Q1 margins here in 2018. We may get a little bit of a pickup as I indicated on the operating expense line, but again some of the programs we're putting in place aren't going to fully catch hold until the back half of the year.
Okay. That's the clarity I was trying to get. And then one last follow-up, this is a tough question, but I got to ask it. So, what was the message you were giving about the outlook for the business when you were in the bond market at the end of March or beginning of April?
Taken as a whole, our business continues to be incredibly strong. Our credit stats even with – the softness in Q1, the credit stats really don't move it hardly at all. I mean our leverage ratios and the like aren't as impacted by $0.01 here or there in EPS. And obviously, we were able to price on a very attractive basis.
Yeah, absolutely. And Michael again just to add to what Nick just said, apart from the credit stats, the overall underlying cash flow generation of the business, that continues to move in the right direction. So even in a sequential quarter basis Q4 going into Q1, we kind of more than doubled our overall free cash flow in any case. Nothing has been impacted from that perspective, all the kind of inventory that we had invested in in the fourth quarter in North America with growth coming through actually was a net cash inflow from the inventory piece of it. So the underlying credit stats, the underlying improving credit history the company has, the underlying cash generation abilities of the business, nothing has changed from that perspective. And the bigger picture of things, we had a pretty robust outlook in any case. And over the long term, we price two tranches, 8 years and 10 years. We are building the business for the long term and we believe that that will continue.
So just to be clear, you told the bond market, when you're in the market that you're going to have a soft first quarter, but showed them all the good fundamental credit trends and that's why – because it priced well, but they knew that you had a soft first quarter.
No. The bond market, Michael, is much less focused on quarter-to-quarter earnings. There were no discussions about quarterly flow when we were on the roadshow.
Okay. I just wanted to make sure I understood that. Okay, thank you.
Okay. Thanks, Michael.
There are no further questions at this time. I turn the call back over to Mr. Zarcone.
Well, we thank everyone for your time here today. I know we ran a little bit long, but given the release, we wanted to make sure we could get to everybody's questions. Again, we need to leave this conversation recognizing that LKQ is a very strong company. We are very optimistic about the prospects of our company, not only just for the rest of the year, but for a long time to come.
We have the preeminent competitive position in almost every business that we have around the globe, and we've got 43,000 people working hard to service our customers each and every day. We run into some headwinds, we understand that, we have plans in place to make corrections. It's not going to happen overnight, but we're very confident in our ability to get back to our traditional levels of growth and profitability in each of our businesses. And that's the message I'd leave with you here this morning.
So again, we thank you for your time and your participation in our call, and we look forward to seeing many of you in Tamworth at the end of May for our Analyst Day and then obviously chatting with you again in July when we report our second quarter results. Thanks.
This concludes today's conference call. You may now disconnect.