Good morning. My name is Lisa, and I will be your conference operator today. At this time, I would like to welcome everyone to LKQ Corporation's Third Quarter 2021 Earnings Conference Call. [Operator Instructions]. Thank you. I would now like to turn the call over to Joe Boutross, Vice President of Investor Relations for LKQ Corporation.

Thank you, operator. Good morning, everyone, and welcome to LKQ's Third Quarter 2021 Earnings Conference Call. With us today are Nick Zarcone, LKQ's President and Chief Executive Officer; and Varun Laroyia, Executive Vice President and Chief Financial Officer. Please refer to the LKQ website at lkqcorp.com for our earnings release issued this morning as well as the accompanying slide presentation for this call. Now let me quickly cover the safe harbor. Some of the statements that we make today may be considered forward-looking. These include statements regarding our expectations, beliefs, hopes, intentions or strategies. Actual events or results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors. We assume no obligation to update any forward-looking statements. For more information, please refer to the risk factors discussed in our Form 10-K and subsequent reports filed with the SEC. During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release and slide presentation. Hopefully, everyone has had a chance to look at our 8-K, which we filed with the SEC earlier today. And as normal, we're planning to file our 10-Q in the next few days. And with that, I am happy to turn the call over to our CEO, Nick Zarcone.

Thank you, Joe, and good morning to everybody on the call. This morning, I will provide some high-level comments related to our performance in the quarter, and then Varun will dive into the financial details as well as our outlook for the balance of 2021, before I come back with a few closing remarks. This was another quarter of significant operating progress at LKQ, driven by excellent execution in delivering solid financial performance, all while navigating the challenges with the supply chain and the current cost environment. We were able to produce yet another record quarter, and this represents the fifth consecutive quarter with the highest EPS reported in their respective quarters. The third quarter also reflects the second time we've been able to achieve more than $1 of earnings per share on an adjusted basis and reflects the highest third quarter segment EBITDA margin in the history of the company. We are particularly pleased that our European business delivered its highest segment EBITDA level in over 9 years, exceeding the 11% level. Varun will dig into the margin details shortly. While I recognize the listeners are primarily focused on the financial results, I know our performance is a reflection of the dedication and effort of our 45,000 team members around the globe who are working hard to serve our customers. I hope you can appreciate that I am more excited about the performance of my team than the quarterly results as they are the key to continued excellence. With respect to capital allocation, as you hopefully read from our press release issued this morning, I am very pleased to announce that our Board of Directors has declared the company's first-ever quarterly cash dividend. This dividend declaration and our existing stock repurchase program are key components of our strategic plan…

Thank you, Nick, and good morning to everyone joining us today. Our third quarter results reflect continued evidence of the benefits of the operational excellence initiatives we instituted a few years ago. Record profitability and continued robust free cash flow just don't happen by accident. The team's focus on getting the fundamentals right, continuous improvement and winning each day has driven these strong results under what are incredibly challenging conditions, with a congested supply chain and strong inflationary pressures. I'd like to start with a few highlights before getting into the details. As you heard from Nick, Europe achieved segment EBITDA of 11.5% for the quarter. This gives us the confidence to narrow the full year segment EBITDA range for 2021 further to 9.8% up to 10.3%, effectively lifting the floor by a further 30 basis points. Specialty delivered yet another excellent organic revenue quarter at 13.7% despite the ongoing supply chain challenges. This is the fourth consecutive quarter of robust double-digit organic revenue growth for the segment. Cash flow generation remains strong. And the conversion ratio relative to earnings continues to be above our long-term expectation despite a challenging environment. The share repurchase program carried on with a further 4.3 million shares purchased in the quarter, bringing the year-to-date total to 12 million shares and the program to date of 29.3 million shares repurchased. And finally, the initiation of a regular quarterly dividend reflects the confidence in our strategy and the strength of our business, underscoring our commitment to deliver long-term value to our stockholders. Now I'll move to the consolidated financial results. As Nick described, Q3 was another successful quarter with growth in revenue, EBITDA margin, cash flow and earnings per share. Gross margin was again a highlight for the quarter, increasing 150 basis points relative to the…

Thank you, Varun. Let me restate our key initiatives, which continue to be central to our culture and our objectives. First, we will continue to integrate our businesses and simplify our operating model. Second, we will continue to focus on profitable revenue growth and sustainable margin expansion. Third, we will continue to drive high levels of cash flow, which in turn will give us the flexibility to maintain a balanced capital allocation strategy. And fourth, as always, we will continue to invest in our future. As Henry Ford once said, obstacles are those frightful things you see when you take your eyes off of your goal. 2021 continues to be a year where our global teams have never lost sight of our shared goal of driving long-term value for our stockholders. And for that, I offer a heartfelt thank you to each of our 45,000-plus team members that make it happen each and every day. And with that, operator, we are now ready to open the call for questions.

[Operator Instructions]. Your first question comes from the line of Bret Jordan with Jefferies.

When you think about the Elitek or Elitek business and I guess the incremental margin that you own the hardware. I guess scans would have a fairly high incremental margin. How do you see that business sort of shaping out from a longer-term contribution? I guess what sort of size and maybe what the margin profile might be if you think out a year or 2 or 3?

Yes. Great question, Bret. When we first started thinking about services as a nice adjacency to our parts distribution business, and that came back in 2017, part of the reason it was so attractive is because services businesses have significantly higher margins. And I will tell you that our Elitek margins are well ahead of our parts distribution margins, and it requires relatively little capital. So the return on invested capital is very attractive, very attractive. Again, this is still a relatively small business for us, kind of in and around that $50 million range. But our goal is to grow it very, very rapidly, not by orders of 5% or 10% a year, but our goal would be to multiply the size of the business over the next several years. It will probably never be a $1 billion or $2 billion business for us, but it's a great adjacency at really attractive margins and, probably most importantly, a really good return on invested capital.

Okay. And a quick question. One of your peers in Europe was commenting about share shifts and maybe share gains, particularly around the U.K. market. Do you see anything changing over there from a competitive landscape? Are smaller players giving up share at a higher rate? Or maybe give us some color there.

Sure. Overall, Bret, I will tell you, we are incredibly pleased, incredibly pleased with how our U.K. business performed in the quarter. There's no great data with respect to share on a quarterly basis, but we are absolutely sensing, and this goes across pretty much all of our businesses, not just the U.K., that small distributors are getting squeezed right now. And the larger, more well-capitalized market participants are doing much better. Our revenue was not overly robust in the third quarter in the U.K., but our margins hit an all-time high since we acquired ECP back in 2011. And we continue to be the market share leader in the U.K. by a wide margin. We think we're going to continue to keep that position into perpetuity. And we are very happy with our third quarter performance and long-term outlook for the business over there.

Your next question comes from the line of Stephanie Moore with Truist.

Congrats on a nice quarter. I wanted to touch a little bit, I know in your prepared remarks, and Varun specifically stated that a lot of the margin improvement in Europe was pricing-driven. But also I know that there's a lot of moving pieces at the current moment as you kind of work through your 1 LKQ. So maybe if you could just give us an update on where we stand today, if anything was accelerated versus prior plans and how we should think about progression as we go into the fourth quarter in terms of some of these initiatives. And if COVID has kind of gotten in the way of any of those.

Yes, great question. We would probably characterize, since the World Series is going on, use a baseball analogy, we're probably in the fourth inning in the 1 LKQ Europe Program. We stated back in 2019 and then again at our Investor Day in 2020 that our midterm goal was to get annual margins, not quarterly margins, but annual margins, in and around that 11% range. We think we can do better than that on a longer-term basis. We've gone from effectively 8% when we announced the whole program margins in Europe to what we think is going to be, as Varun indicated, pretty close to 10% this year. And so yes, we would think we're in about the fourth inning. COVID clearly has thrown everybody some curveballs, it has thrown out some curveballs. Some things just got delayed a little bit. Other things got accelerated. Originally, the Innovation and Service Center in Katowice, Poland was later in our plan, and we actually pulled that forward. Really think about that as a shared service center, where we're moving some administrative activities to a much lower cost marketplace. And so that's gotten pulled forward. The ERP implementation got pushed back effectively by a quarter or two. But we still have a lot of runway to go on our program. There's a lot of initiatives that are still in the forefront that we need to execute on. But overall, we are extremely pleased with our progress thus far and confident in our ability to get to the longer-term goals.

Great. And then talking about the supply chain disruption, and I agree there's always a new headline every day. I think you made the point, particularly with the free cash flow, is unable to purchase some of the inventory to meet desired demand levels that you would like in the quarter, but you're working with your partners now. I mean is this a function of it just taking longer and it's just being more the ability to kind of have that flexibility, that it's just not arriving as quickly? Or are you having to use other modes of transportation? I would love just to get more color as you manage just the current situation.

Yes. The big issue with the supply chain, and this is not unique to LKQ, it's not unique to our industry, right? The fact of the matter is out in California, there's 80 ships anchored, waiting for a berth in the ports. If you did that on a national basis, I think you're somewhere around 100 ships. Many of those ships have our product -- our containers sitting on it, right? And it's not just an issue with the ports. The reality is there's a lot of data out there that's showing that there's just not enough truckers turning up to get the containers out of the ports. There's a severe shortage of drivers. Most folks estimate this country is down about 80,000 truck drivers. The warehouses where the containers ultimately need to go are clogged. And importantly, containers get put on a chassis, which is then connected to the tractor of the semi-tractor combination, there's a severe shortage of chassis available. So the supply chain is a bit of a mess completely. And so yes, it's taking much longer for us to get our product, say from Taiwan into the United States. It's costing us some more money. It's important to recognize that the inventory is ours when it hits the port in Taiwan. So that's our inventory, not the supplier's inventory, sitting out on the water. And so we're being very thoughtful as to putting in advance orders, making sure we can do whatever we can to get the inventory that we need. The bad news is we're not -- we don't have the inventory levels that we prefer. The good news is we think we're doing significantly better than our small competitors. I mean think about it, we bring in 16,000 containers a year, that's about 300 a week, from the Far East for our North American aftermarket parts business. Our small competitors, they'd be lucky if they bring in 300 a year or even 50 a year. So we feel we're -- from a fulfillment rate basis, we're doing much better than the small competitors. And we know that because there have been a few smaller folks basically waving the white flag and asking if we'd be interested in buying their business. So again, it's going to be a challenge going forward. We think we're doing a pretty effective job of managing our way through that challenge.

Your next question comes from the line of Craig Kennison with Baird.

Just a follow-up, Nick, on your last point with respect to looking at small businesses to acquire. Would there be any case to make that you could buy them for something close to the value of their inventory just to help with your own fulfillment rates?

Well, in many of the cases, the only thing of value to us would be their inventory. We don't need additional warehouses in the United States. We don't need more fleet. Clearly, we all share the same customers, so inventory would be particularly attractive.

Okay. And then I guess I wanted to ask a question about the innovation center in Poland, which we watched the video on that earlier this quarter. But could you just give us a feel for the kind of tools or applications that you would expect to develop? And how those tools kind of improve your moat in Europe?

Craig, it's Varun out here. Let me take this one. So essentially, the innovation center is effectively what we had talked about as part of the 1 LKQ Europe Program of setting up a lower-cost shared service center, no different to global business services at other companies. Within the industry but also among broader companies, having a lower-cost back office to do commoditized transaction processing, but also, in the case of Poland, we believe there is some good digital and technology talent. And that really is the background to what we're trying to do from a Katowice perspective. As you know, we obviously have Bangalore. And now putting up another center certainly gives us the geographic breadth, language capabilities, not just to do some of the more, I'd say, regularly expected back-office activities, but also to invest in things such as digital. We clearly know that while B2B and the different market, the do-it-for-me market, is clearly the biggest piece serving Europe, but there is some adjacency associated with B2C. And being able to do some of that back-office work and the technology work out of Katowice in Poland, which does have talent, we believe there is some goodness associated with it. That really is the backdrop to the Katowice, Poland innovation center.

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

Just can you circle back on the metals, and both scrap and precious. When you think about what's kind of -- maybe what's embedded in the full year guidance and how that compares to, I guess, historical levels that typically have been a little bit lower?

Brian, it's Varun. Actually, let me take that one. So yes, within -- in the third quarter, as I called out, the total metals benefit, both scrap and catalytic inverter, so precious metals, was about $12 million or roughly about $0.03 within the $1.02 of adjusted EPS. Relative to what we experienced in the first half of the year, if you recall, in Q1, it was a $34 million upside; in Q2 was roughly $57 million, so significant upside. But really, what we saw come through was starting in September, we saw scrap metal prices, but also more to the point, precious metal prices began to drop pretty significantly. And so that piece, despite the fact that those metal prices were dropping, car costs remained relatively high. And so the overall metals benefit was muted. And really what we've seen exiting September, as we've shown on Slide #27 also for the benefit of everybody, you see that bigger slide begin to take place in September. And so from a Q4 forecast perspective, we are actually, as of now, anticipating that to be a negative impact from metals pricing rather than an ongoing benefit. So if you think about the first half versus the second half, in the first half, we said we pretty much got close to, I'd say, $90 million of EBITDA from metals, be it precious or scrap. In the third quarter, it was about $12 million, which kind of gives you a year-to-date of about $103 million. And in the fourth quarter, we see an unwind of anything up to $30 million taking place. So that's how you should think about it. Clearly, it's a volatile market as of now. Things are changing on a daily, weekly basis, but that's how we think about the metals pricing, which underpins our forecast that we've provided.

All right. That's very helpful. And then shifting gears, can we talk about collision repair? And with the supply chain disruption that you're seeing, has there been a greater demand for recycled parts? And just kind of what trends you're seeing there maybe on price in that -- the attractiveness of those items?

Yes. Brian, this is Nick. You've hit the nail on the head. Obviously, the aftermarket part availability is constrained a bit because of all the supply chain challenges we've already talked about. Salvage parts come from the local markets, right? We buy total loss vehicles locally, we dismantle them locally and then we can distribute on a local basis. And there absolutely has been a bit of a shift. And I would say this primarily benefits us relative to anybody else because we are the only company that can offer both salvaged and recycled product and the aftermarket collision parts. And so we have absolutely are seeing our -- the growth in our salvage business in the quarter and actually for the last few quarters has been well above the growth and the revenue trends in the aftermarket product. And part of that is due to the strong mechanical business, engines and transmissions, that we talked about in our formal comments. And part of it is this ability to, in certain times, shift the customer from an aftermarket product that we may not have an inventory to a salvage product that we can get to them same day or next day. So the salvage business has been very good. And again, we're the only company in this country that offers both product lines.

Perfect. And then if I could maybe just ask one last one. When you look at the replacement parts cost for EV vehicles versus internal combustion, what trends are you still seeing there? I mean is it still EV parts continue to be more expensive? Or as we're seeing more EVs out there, are those prices coming down for the replacement parts?

Yes. No, broadly, we are, we're maybe in the top of the first in the whole EV marketplace and the transition and the like. So there are no big trends. There are no shifts. What we will tell you is that when you look at hybrid electric vehicles and battery electric vehicles, technical service parts command anywhere from a 2x to 6x premium relative to their comparable internal combustion engine counterparts. And there's a number of reasons for that. One is the technical complexity, not just with batteries, but also with the electrification of components previously belt-driven such as air conditioning, compressors and water pumps. For an example, this is just one example. A 2013 Prius with an electric water pump, that water pump sells for 3x the value of a 2013 Corolla that has a belt-driven water pump. In the U.K., for example, a 2017 Golf with an internal combustion engine, that water pump sells for about £77. The Lexus hybrid EV, the water pump is £278. And so yes, the EV parts are much more expensive. We think that's going to continue to be the case for a long, long time. And that's why we are doing what we can, and we're at the initial stages of gearing up our ability to distribute those EV-related parts. The reality is the aftermarket for EV vehicle parts is nascent, but there's nobody in a better position to distribute those parts than LKQ.

Your next question comes from the line of Daniel Imbro with Stephens Inc.

Congratulations on the good quarter. I've got a couple of quick questions. One on the follow-up on pricing. I don't think you just mentioned it there. But obviously, pricing at the OEMs took it up during the quarter. Can you quantify maybe how much same fuel inflation you saw in North America here? And then longer term related to price, now that the OEMs took a price and I saw that you guys followed very rationally, is there maybe a backdrop for the OEMs become more rational taking up price going forward, knowing that you're going to follow and maybe the whole market can be more rational passing through some of these costs in North America?

Daniel, let me answer that one. With regards to inflationary pressures, let's be clear about it, no one is immune to them at this point of time, okay? It's not just us, it's not just the OEMs, it's across every pretty much sector across the economy. So that's kind of point number one. It's just a fact of life at this point of time. The second one is, yes, folks that are acting on a rational basis, they're trying to protect margins. You've obviously seen 2 of the 3 big OEMs report in the last 48 hours, and as to what they've been talking about with regards to chip shortages and as to what's happening to new car sales and stuff. But yes, there's less discounting taking place within their markets also. And obviously, I think you follow some of the auto retailers also in terms of what's happening out there. So at this point of time, given the scarcity of being able to get product in, given the supply chain challenges, we expect folks are acting on a rational basis because no one really knows, as of now, how long the supply chain congestion is expected to last. So if someone does want to not act on a rational basis for a week, 2 weeks, a month, a quarter, at some point of time, it will come back and bite him. It's no different to what we at LKQ did when the pandemic initially struck in Q1 of 2020, moved incredibly fast to kind of take care of what we could control, which was our cost structure. And that obviously has now morphed into inflation and also supply chain congestion. So we expect folks will be acting on a rational basis because no one really knows how long this is going to continue to last. And so what the OEMs may or may not do, listen, I can't speculate sitting out here, that is their call. We do know that what we at LKQ do and what we plan to do, given the market conditions, the key in all of this is to be nimble, is to be agile and to be dynamic and be able to react as an organization at relatively short notice. And just really happy with the way our teams continue to do that.

Yes. That makes sense. And then a follow-up on personnel expenses, Varun. I think in your prepared comments, you noted that North America and Europe saw some pressure from temporary labor. Obviously, you take what you just said, over the last 18 months, you guys took out a bunch of costs, a bunch of duplicative positions. Can you maybe talk about how transitory you view these labor headwinds, how you're navigating the backdrop and whether you're having to add back any of those costs? Or is this just something to do with the demand you're seeing today?

Yes. No, absolutely. And great question out there, Daniel. Yes, listen, 18 months ago, when the pandemic initially struck, it was a case of ensuring that our balance sheet and our cost structure was aligned to what the new demand forecast realities were, okay? And so as a distribution business, we were able to move quick. And as that dragged on, I think before the end of the second quarter of 2020, we actually moved those temporary reductions into permanent reductions. And I think folks appreciated what we did. At this point of time, it is all demand-related, whether it be in Europe, whether it be in North America or for that matter, in our Specialty segment. And that piece is being exacerbated by the fact that there's just a real shortage of talent. Nick talked about, say, for example, on the delivery side. It's the same thing across the business. Because as of now, folks have kind of moved on to online in a pretty big way, and so warehouse demand, warehouse folk demand has been strong. And so from that perspective and the talent and the labor shortages, we're having to pay up. And we will do so because that is the kind of core of our business. So with regards to it being transitory or not, this is where the reality is. Unlike commodity prices, fuel or metals or whatever it is, there could be certain spikes and drops within their cycle, wages are notoriously sticky. Once you've been paying at a certain rate, you can't go back 3 months or 6 months later and say, "Oh, actually, you know what, now there's a different situation and now this is what we will be doing." That is just not the way to drive trust in what we call our single most valuable asset. So that is not what we do. Yes, what we do, do is here at LKQ, we have a very strong value proposition for being part of the LKQ family, whether it be our retirement plan offerings, whether it be our health care benefits, the tuition reimbursements, the scholarships and many of those kind of pieces. And yes, we are also doing certain one-off items, all in all, to try and ensure that the entire overall base doesn't move into the future literally dollar for dollar. So there are certain elements which we believe are going to drive talent retention, rather than someone wanting to move just for the next extra dollar or 2 as such. But that's really how we're thinking about it.

At this time, there are no further questions. I would like to turn the call back over to Nick Zarcone for closing remarks.

Well, thank you, everyone. We certainly appreciate your time and attention here this morning. We look forward to chatting with you on the 17th of February when we announce our fourth quarter results. And importantly, I'd like to just highlight and have you circle your calendars. We are going to be having an Analyst and Investor Day in late February or early March, probably the last week in February or the first week of March in 2022. And so we look forward to having an opportunity to more broadly share our thoughts as to the future of our company at that point in time. So again, we appreciate your time and attention, and we hope you have a great day.

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