UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

x

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended September 30, 2008

 

OR

 

o

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Transition Period from                to

 

Commission File Number: 000-50404

 

LKQ CORPORATION

(Exact name of registrant as specified in its charter)

 

DELAWARE

 

36-4215970

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification No.)

 

 

 

120 NORTH LASALLE STREET, SUITE 3300, CHICAGO, IL

 

60602

(Address of principal executive offices)

 

(Zip Code)

 

Registrant’s telephone number, including area code: (312) 621-1950

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes  x No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer x

 

Accelerated filer o

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes  o No  x

 

At October 30, 2008, the registrant had issued and outstanding an aggregate of 139,790,781 shares of Common Stock.

 

 

 



 

PART I

 

FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

LKQ CORPORATION AND SUBSIDIARIES

Unaudited Consolidated Condensed Balance Sheets

(In thousands, except share and per share data)

 

 

 

September 30,

 

December 31,

 

 

 

2008

 

2007

 

Assets

 

 

 

 

 

Current Assets:

 

 

 

 

 

Cash and equivalents

 

$

97,689

 

$

74,241

 

Receivables, net

 

136,553

 

125,572

 

Inventory

 

331,028

 

320,238

 

Deferred income taxes

 

18,022

 

18,809

 

Prepaid income taxes

 

4,630

 

6,344

 

Prepaid expenses

 

8,472

 

8,088

 

Total Current Assets

 

596,394

 

553,292

 

 

 

 

 

 

 

Property and Equipment, net

 

241,093

 

217,059

 

Intangibles:

 

 

 

 

 

Goodwill

 

910,200

 

825,881

 

Other intangibles, net

 

72,194

 

74,951

 

Other Assets

 

28,290

 

21,472

 

Total Assets

 

$

1,848,171

 

$

1,692,655

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Current Liabilities:

 

 

 

 

 

Accounts payable

 

$

60,488

 

$

68,871

 

Accrued expenses:

 

 

 

 

 

Accrued payroll-related liabilities

 

34,788

 

27,542

 

Other accrued expenses

 

44,009

 

45,630

 

Deferred revenue

 

5,203

 

4,844

 

Current portion of long-term obligations

 

19,425

 

16,936

 

Total Current Liabilities

 

163,913

 

163,823

 

 

 

 

 

 

 

Long-Term Obligations, Excluding Current Portion

 

623,028

 

641,526

 

Deferred Income Tax Liability

 

35,992

 

25,607

 

Other Noncurrent Liabilities

 

11,184

 

11,922

 

 

 

 

 

 

 

Commitments and Contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ Equity:

 

 

 

 

 

Common stock, $0.01 par value, 500,000,000 shares authorized, 138,659,781 and 134,149,066 shares issued and outstanding at September 30, 2008 and December 31, 2007, respectively

 

1,387

 

1,341

 

Additional paid-in capital

 

779,545

 

705,778

 

Retained earnings

 

228,974

 

142,039

 

Accumulated other comprehensive income

 

4,148

 

619

 

Total Stockholders’ Equity

 

1,014,054

 

849,777

 

Total Liabilities and Stockholders’ Equity

 

$

1,848,171

 

$

1,692,655

 

 

See notes to unaudited consolidated condensed financial statements.

 

2



 

LKQ CORPORATION AND SUBSIDIARIES

Unaudited Consolidated Condensed Statements of Income

(In thousands, except per share data)

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

490,701

 

$

243,495

 

$

1,467,001

 

$

712,091

 

 

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

274,786

 

135,038

 

808,064

 

391,455

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

215,915

 

108,457

 

658,937

 

320,636

 

 

 

 

 

 

 

 

 

 

 

Facility and warehouse expenses

 

48,479

 

26,188

 

136,783

 

76,432

 

 

 

 

 

 

 

 

 

 

 

Distribution expenses

 

46,636

 

23,803

 

136,731

 

68,191

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative expenses

 

60,929

 

29,107

 

186,791

 

85,969

 

 

 

 

 

 

 

 

 

 

 

Restructuring expenses

 

2,400

 

 

6,723

 

 

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization

 

7,513

 

3,768

 

22,029

 

10,549

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

49,958

 

25,591

 

169,880

 

79,495

 

 

 

 

 

 

 

 

 

 

 

Other expense (income):

 

 

 

 

 

 

 

 

 

Interest expense, net

 

8,192

 

2,241

 

26,904

 

6,067

 

Other expense (income), net

 

1

 

(468

)

(719

)

(1,143

)

 

 

 

 

 

 

 

 

 

 

Total other expense

 

8,193

 

1,773

 

26,185

 

4,924

 

 

 

 

 

 

 

 

 

 

 

Income before provision for income taxes

 

41,765

 

23,818

 

143,695

 

74,571

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

16,697

 

9,259

 

56,760

 

30,202

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

25,068

 

$

14,559

 

$

86,935

 

$

44,369

 

 

 

 

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

0.18

 

$

0.13

 

$

0.64

 

$

0.41

 

 

 

 

 

 

 

 

 

 

 

Diluted

 

$

0.18

 

$

0.13

 

$

0.62

 

$

0.39

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding:

 

 

 

 

 

 

 

 

 

Basic

 

136,585

 

109,326

 

135,481

 

107,678

 

 

 

 

 

 

 

 

 

 

 

Diluted

 

141,190

 

115,111

 

140,458

 

113,237

 

 

See notes to unaudited consolidated condensed financial statements.

 

3



 

LKQ CORPORATION AND SUBSIDIARIES

Unaudited Consolidated Condensed Statements of Cash Flows

(In thousands)

 

 

 

Nine Months Ended September 30,

 

 

 

2008

 

2007

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

86,935

 

$

44,369

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

23,998

 

10,933

 

Stock-based compensation expense

 

4,133

 

2,386

 

Deferred income taxes

 

9,375

 

4,576

 

Excess tax benefit from exercise of stock options

 

(8,192

)

(12,150

)

Other adjustments

 

2,221

 

(94

)

Changes in operating assets and liabilities, net of effects from purchase transactions:

 

 

 

 

 

Receivables

 

(5,738

)

(8,464

)

Inventory

 

(5,675

)

(21,853

)

Prepaid income taxes/income taxes payable

 

9,733

 

5,299

 

Accounts payable

 

(9,798

)

907

 

Other operating assets and liabilities

 

(1,678

)

5,598

 

 

 

 

 

 

 

Net cash provided by operating activities

 

105,314

 

31,507

 

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Purchases of property and equipment

 

(42,212

)

(26,095

)

Proceeds from disposal of assets

 

1,993

 

417

 

Purchases of investment securities

 

 

(5,885

)

Cash used in acquisitions, net of cash acquired

 

(40,258

)

(55,705

)

 

 

 

 

 

 

Net cash used in investing activities

 

(80,477

)

(87,268

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Proceeds from exercise of stock options

 

4,722

 

8,341

 

Proceeds from the sale of common stock

 

 

349,529

 

Repurchase and retirement of redeemable common stock

 

 

(1,125

)

Excess tax benefit from exercise of stock options

 

8,192

 

12,150

 

Debt issuance costs

 

(219

)

(206

)

Repayments of long-term debt

 

(13,659

)

(3,524

)

Net repayments under line of credit

 

 

(88,169

)

 

 

 

 

 

 

Net cash (used in) provided by financing activities

 

(964

)

276,996

 

 

 

 

 

 

 

Effect of exchange rate changes on cash and equivalents

 

(425

)

74

 

 

 

 

 

 

 

Net increase in cash and equivalents

 

23,448

 

221,309

 

 

 

 

 

 

 

Cash and equivalents, beginning of period

 

74,241

 

4,031

 

Cash and equivalents, end of period

 

$

97,689

 

$

225,340

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information:

 

 

 

 

 

Notes issued in connection with business acquisitions

 

$

25

 

$

1,449

 

Stock issued in connection with business acquisitions

 

60,041

 

 

Cash paid for income taxes, net of refunds

 

37,508

 

20,111

 

Cash paid for interest

 

27,619

 

7,148

 

 

 

 

 

 

 

 

See notes to unaudited consolidated condensed financial statements.

 

4



 

LKQ CORPORATION AND SUBSIDIARIES

Unaudited Consolidated Condensed Statements of Stockholders’ Equity and Other Comprehensive Income

(In thousands)

 

 

 

 

 

 

 

 

 

 

 

Accumulated

 

 

 

 

 

Common Stock

 

 

 

 

 

Other

 

Total

 

 

 

Shares

 

 

 

Additional

 

Retained

 

Comprehensive

 

Stockholders’

 

 

 

Issued

 

Amount

 

Paid-In Capital

 

Earnings

 

Income

 

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE, December 31, 2007

 

134,149

 

$

1,341

 

$

705,778

 

$

142,039

 

$

619

 

$

849,777

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

 

 

 

86,935

 

 

86,935

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized loss on pension plan, net of tax of $195

 

 

 

 

 

(305

)

(305

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized gain on change in fair value of interest rate swap agreements, net of tax of $3,031

 

 

 

 

 

4,740

 

4,740

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation

 

 

 

 

 

(906

)

(906

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total comprehensive income

 

 

 

 

 

 

90,464

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock issued in business acquisition

 

2,919

 

29

 

60,012

 

 

 

60,041

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Share price guarantee payment

 

 

 

(3,275

)

 

 

(3,275

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock issued as director compensation

 

5

 

1

 

90

 

 

 

91

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Stock-based compensation expense

 

 

 

3,519

 

 

 

3,519

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Activity related to restricted stock awards

 

190

 

2

 

521

 

 

 

523

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercise of stock options, including related tax benefits of $8,192

 

1,397

 

14

 

12,900

 

 

 

12,914

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE, September 30, 2008

 

138,660

 

$

1,387

 

$

779,545

 

$

228,974

 

$

4,148

 

$

1,014,054

 

 

See notes to unaudited consolidated condensed financial statements.

 

5



 

LKQ CORPORATION AND SUBSIDIARIES

Notes to Unaudited Consolidated Condensed Financial Statements

 

Note 1.  Interim Financial Statements

 

The unaudited financial statements presented in this report represent the consolidation of LKQ Corporation, a Delaware corporation, and its subsidiaries. LKQ Corporation is a holding company and all operations are conducted by subsidiaries. When the terms “the Company,” “we,” “us,” or “our” are used in this document, those terms refer to LKQ Corporation and its consolidated subsidiaries. All intercompany transactions and accounts have been eliminated.

 

We have prepared the accompanying Unaudited Consolidated Condensed Financial Statements pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) applicable to interim financial statements. Accordingly, certain information related to our significant accounting policies and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted. These Unaudited Consolidated Condensed Financial Statements reflect, in the opinion of management, all material adjustments (which include only normal recurring adjustments) necessary to fairly state, in all material respects, our financial position, results of operations and cash flows for the periods presented.

 

Operating results for interim periods are not necessarily indicative of the results that can be expected for any subsequent interim period or for a full year.  These interim financial statements should be read in conjunction with our audited consolidated financial statements and notes thereto included in our most recent report on Form 10-K for the year ended December 31, 2007 filed with the SEC.

 

Note 2.  Financial Statement Information

 

Revenue Recognition

 

Revenue is recognized when products are shipped and title has transferred, subject to an allowance for estimated returns, discounts and allowances that we estimate based upon historical information. We have recorded a reserve for estimated returns, discounts and allowances of approximately $10.0 million and $7.5 million at September 30, 2008 and December 31, 2007, respectively.

 

Receivables

 

We have recorded a reserve for uncollectible accounts of approximately $5.5 million and $4.3 million at September 30, 2008 and December 31, 2007, respectively.

 

Inventory

 

Inventory consists of the following (in thousands):

 

 

 

September 30,

 

December 31,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Salvage products

 

$

136,689

 

$

111,775

 

Aftermarket and refurbished products

 

187,628

 

201,408

 

Core facilities inventory

 

6,711

 

7,055

 

 

 

 

 

 

 

 

 

$

331,028

 

$

320,238

 

 

6



 

Intangibles

 

Intangible assets consist primarily of goodwill (the cost of purchased businesses in excess of the fair value of the net assets acquired), and other specifically identifiable intangible assets such as the tradename acquired in connection with our acquisition of Keystone Automotive Industries, Inc. (“Keystone”) in the fourth quarter of 2007, covenants not to compete and trademarks.

 

The change in the carrying amount of goodwill during the nine months ended September 30, 2008 is as follows (in thousands):

 

Balance as of December 31, 2007

 

$

825,881

 

Adjustment of previously recorded goodwill

 

10,309

 

Exchange rate effects

 

(1,659

)

Business acquisitions

 

75,669

 

 

 

 

 

Balance as of September 30, 2008

 

$

910,200

 

 

We adjusted previously recorded goodwill by $10.3 million.  These adjustments included $4.6 million of inventory valuation adjustments, $2.6 million of fixed asset valuation adjustments and $2.0 million of adjustments to the allowance for estimated returns, discounts and allowances, all of which related to the Keystone acquisition.  We made additional purchase price adjustments totaling $1.1 million relating to Keystone and other businesses acquired in the prior year.

 

Other intangible assets totaled approximately $72.2 million and $75.0 million, net of accumulated amortization of $4.1 million and $1.0 million, at September 30, 2008 and December 31, 2007, respectively.  Amortization expense was approximately $3.1 million during the nine months ended September 30, 2008. The expense for the corresponding 2007 period was immaterial. Estimated annual amortization expense is approximately $4.0 million for each of the years 2008 through 2012.

 

Depreciation Expense

 

Included in Cost of Goods Sold is depreciation expense associated with refurbishing and smelting operations.

 

Warranty Reserve

 

Some of our mechanical products are sold with a standard six-month warranty against defects. We record the estimated warranty costs at the time of sale using historical warranty claim information to project future warranty claims activity and related expenses. Our warranty activity during the first nine months of 2008 was as follows (in thousands):

 

Balance as of January 1, 2008

 

$

580

 

Warranty expense

 

2,818

 

Warranty claims

 

(2,858

)

Balance as of September 30, 2008

 

$

540

 

 

We also sell separately priced extended warranty contracts for certain mechanical products. The expense related to extended warranty claims is recognized when the claim is made.

 

7



 

Stock-Based Compensation

 

We account for stock-based compensation in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”).

 

The fair value of stock options has been estimated using the Black-Scholes option-pricing model. The following table summarizes the assumptions used to compute the weighted average fair value of stock option grants:

 

 

 

Nine Months Ended

 

 

 

September 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Expected life (in years)

 

6.4

 

6.4

 

Risk-free interest rate

 

3.27

%

4.40

%

Volatility

 

39.3

%

40.0

%

Dividend yield

 

0

%

0

%

Weighted average fair value of options granted

 

$

8.54

 

$

4.77

 

 

Estimated forfeitures – When estimating forfeitures, we consider voluntary and involuntary termination behavior as well as analysis of historical forfeitures.  For options granted in 2008, a forfeiture rate of 8.0% has been used for valuing employee option grants, while a forfeiture rate of 0% has been used for valuing executive officer option grants.

 

The components of pre-tax stock-based compensation expense are as follows (in thousands):

 

 

 

Three Months ended September 30,

 

Nine Months ended September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Stock options

 

$

1,205

 

$

595

 

$

3,519

 

$

2,307

 

Restricted stock

 

183

 

 

523

 

 

Stock issued in lieu of quarterly cash compensation for non-employee directors

 

30

 

31

 

91

 

79

 

 

 

 

 

 

 

 

 

 

 

Total stock-based compensation expense

 

$

1,418

 

$

626

 

$

4,133

 

$

2,386

 

 

The following table sets forth the total stock-based compensation expense included in the accompanying Unaudited Consolidated Condensed Statements of Income (in thousands):

 

 

 

Three months ended
September 30,

 

Nine months ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

$

3

 

$

4

 

$

10

 

$

10

 

Facility and warehouse expenses

 

514

 

245

 

1,501

 

713

 

Selling, general and administrative expenses

 

901

 

377

 

2,622

 

1,663

 

 

 

1,418

 

626

 

4,133

 

2,386

 

 

 

 

 

 

 

 

 

 

 

Income tax benefit

 

(567

)

(244

)

(1,633

)

(930

)

Total stock based compensation expense, net of tax

 

$

851

 

$

382

 

$

2,500

 

$

1,456

 

 

8



 

We have not capitalized any stock-based compensation cost during the nine months ended September 30, 2008 and 2007.  As of September 30, 2008, unrecognized compensation expense related to unvested stock options and restricted stock is expected to be recognized as follows (in thousands):

 

 

 

Stock
Options

 

Restricted
Stock

 

Total

 

 

 

 

 

 

 

 

 

Remainder of 2008

 

$

1,148

 

$

183

 

$

1,331

 

2009

 

4,570

 

727

 

5,297

 

2010

 

4,209

 

727

 

4,936

 

2011

 

3,369

 

727

 

4,096

 

2012

 

2,447

 

727

 

3,174

 

2013

 

85

 

22

 

107

 

 

 

 

 

 

 

 

 

Total unrecognized compensation expense

 

$

15,828

 

$

3,113

 

$

18,941

 

 

Segments

 

During the third quarter of 2008, we commenced a reorganization of our vehicle replacement products operations into ten operating segments, combining our wholesale recycled original equipment manufacturer (“OEM”) products and aftermarket products on a geographic basis, with a separate operating segment for our self-service retail OEM products and one for our refurbishing operations. These segments are aggregated into one reportable segment because they possess similar economic characteristics and have common products and services, customers, and methods of distribution.

 

The following table sets forth our revenue by product category (in thousands):

 

 

 

Three Months ended
September 30,

 

Nine Months ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Recycled and related products and services

 

$

174,679

 

$

139,673

 

$

488,966

 

$

397,898

 

Aftermarket, other new and refurbished products

 

230,328

 

57,750

 

746,618

 

179,816

 

Other

 

85,694

 

46,072

 

231,417

 

134,377

 

 

 

 

 

 

 

 

 

 

 

 

 

$

490,701

 

$

243,495

 

$

1,467,001

 

$

712,091

 

 

Recent Accounting Pronouncements

 

Effective January 1, 2008, we adopted SFAS No. 157, “Fair Value Measurements” (“SFAS 157”) as it pertains to financial assets and liabilities. In accordance with the provisions of FASB Staff Position 157-2, we elected to defer the adoption of SFAS 157 relating to the fair value of non-financial assets and liabilities. We are currently evaluating the impact, if any, of applying SFAS 157 to our non-financial assets and liabilities. SFAS 157 established a framework for reporting fair value and expands disclosures required for fair value measurements. Although the adoption of SFAS 157 did not have a significant impact on our consolidated financial position, results of operations or cash flows, we are now required to provide additional disclosures as part of our financial statements. These additional disclosures are provided in Note 10.

 

Effective January 1, 2008, we adopted SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). The adoption of SFAS 159 did not have a significant impact on our consolidated financial position, results of operations or cash flows.

 

In December 2007, the SEC issued Staff Accounting Bulletin (“SAB”) 110 to amend the SEC’s views discussed in SAB 107 regarding the use of the simplified method in developing an estimate of expected life of share options in accordance with SFAS No. 123R. We will continue to use the simplified method until we have the historical data necessary to provide a reasonable estimate of expected life in accordance with SAB 107, as amended by SAB 110.

 

In December 2007, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). Under SFAS 141R, companies will be required to, among other things,  recognize the assets acquired, liabilities assumed, including contractual contingencies, and contingent consideration at fair value on the date of acquisition. SFAS 141R also requires that acquisition-related expenses be expensed as incurred, restructuring costs be expensed in periods subsequent to the acquisition date, and changes in accounting for deferred income tax asset valuation allowances and acquired income tax uncertainties after the measurement period be included in income tax expense. SFAS 141R will be effective on January 1, 2009 and will change our accounting for business combinations upon adoption. We are currently assessing the impact that the adoption of SFAS

 

9



 

141R will have on our consolidated financial position, results of operations and cash flows.

 

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities — an amendment of SFAS No. 133” (“SFAS 161”). SFAS 161 requires enhanced disclosures about derivative and hedging activities and is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. As SFAS 161 specifically relates to disclosures regarding derivative and hedging activities, it will not impact our consolidated financial position, results of operations or cash flows.

 

Note 3.  Capital Structure

 

On September 25, 2007, we completed the sale of 23,600,000 shares of our common stock pursuant to a registration statement filed with the SEC. Pursuant to the same registration statement, the selling stockholders named in the registration statement sold 4,000,000 shares of our common stock. We received $349.5 million, net of the underwriting discount and net of offering related expenses of approximately $0.7 million, for the common stock we issued and sold. We did not receive any proceeds from the sale of shares by the selling stockholders. We also received approximately $2.8 million in proceeds from the exercise of 1,000,000 stock options by certain members of management in connection with the offering.

 

On November 5, 2007, our Board of Directors approved a two-for-one split of our common stock payable as a stock dividend. Each stockholder of record at the close of business on November 16, 2007 received an additional share of common stock for every outstanding share held. The payment date was December 3, 2007, and the common stock began trading on a split-adjusted basis on December 4, 2007. All share and per share amounts for all periods presented have been adjusted to reflect the stock split.

 

On March 4, 2008, in connection with the acquisition of Texas Best Diesel, L.P., we issued 838,073 shares of our common stock.

 

On August 25, 2008, in connection with the acquisition of Pick-Your-Part Auto Wrecking (“PYP”), we issued 2,080,561 shares of our common stock.

 

Note 4.  Stock-Based Compensation Plans

 

We have two stock-based compensation plans, the LKQ Corporation 1998 Equity Incentive Plan (the “Equity Incentive Plan”) and the Stock Option and Compensation Plan for Non-Employee Directors (the “Director Plan”). Under the Equity Incentive Plan, both qualified and nonqualified stock options, stock appreciation rights, restricted stock, performance shares and performance units may be granted.

 

Stock options expire 10 years from the date they are granted. Most of the options granted under the Equity Incentive Plan vest over a period of five years. Options granted under the Director Plan vest six months after the date of grant.  We expect to issue new shares of common stock to cover future stock option exercises.

 

On January 11, 2008, we issued 190,000 shares of restricted stock to key employees. The grant-date fair value of the awards was approximately $3.6 million, or $19.14 per share. Vesting of the awards is subject to a continued service condition, with 20% of the awards vesting each year on the anniversary of the grant date. The fair value of each share of restricted stock awarded was equal to the market value of a share of our common stock on the grant date.

 

A summary of transactions in our stock-based compensation plans for the nine months ended September 30, 2008 is as follows:

 

 

 

Restricted

 

 

 

Stock Options

 

 

 

Shares and

 

 

 

 

 

Weighted

 

 

 

Options

 

Restricted

 

 

 

Average

 

 

 

Available

 

Shares

 

Number

 

Exercise

 

 

 

For Grant

 

Outstanding

 

Outstanding

 

Price

 

 

 

 

 

 

 

 

 

 

 

Balance, December 31, 2007

 

6,852,680

 

 

11,032,102

 

$

5.06

 

 

 

 

 

 

 

 

 

 

 

Granted

 

(1,617,250

)

190,000

 

1,427,250

 

19.19

 

Exercised

 

 

 

(1,397,266

)

3.38

 

Cancelled

 

98,690

 

 

(98,690

)

16.61

 

 

 

 

 

 

 

 

 

 

 

Balance, September 30, 2008

 

5,334,120

 

190,000

 

10,963,396

 

$

7.01

 

 

10



 

The following table summarizes information about outstanding and exercisable stock options at September 30, 2008:

 

 

 

 

 

Outstanding

 

 

 

 

 

Exercisable

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Average

 

Weighted

 

 

 

Average

 

Weighted

 

 

 

 

 

Remaining

 

Average

 

 

 

Remaining

 

Average

 

Range of

 

 

 

Contractual

 

Exercise

 

 

 

Contractual

 

Exercise

 

Exercise Prices

 

Shares

 

Life (Yrs)

 

Price

 

Shares

 

Life (Yrs)

 

Price

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

$0.75

 

158,000

 

2.3

 

$

0.75

 

158,000

 

2.3

 

$

0.75

 

2.00 - 2.19

 

1,108,170

 

3.9

 

2.09

 

1,108,170

 

3.9

 

2.09

 

3.13 - 3.99

 

1,819,900

 

3.3

 

3.47

 

1,724,300

 

3.2

 

3.47

 

4.16 - 4.72

 

4,223,286

 

5.9

 

4.44

 

3,966,901

 

5.9

 

4.44

 

7.56 - 7.60

 

246,000

 

7.0

 

7.59

 

243,600

 

7.0

 

7.59

 

9.33 - 12.42

 

1,954,840

 

7.8

 

10.04

 

870,860

 

7.8

 

10.14

 

18.87 - 22.58

 

1,453,200

 

9.3

 

19.17

 

141,970

 

9.3

 

19.12

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

10,963,396

 

6.1

 

$

7.01

 

8,213,801

 

5.3

 

$

4.80

 

 

At September 30, 2008, a total of 10,915,758 options with an average exercise price of $6.98 and a weighted average remaining contractual life of 6.0 years were exercisable or expected to vest. The total grant-date fair value of options that vested during the nine months ended September 30, 2008 was approximately $3.4 million.

 

The aggregate intrinsic value (market value of stock less option exercise price) of outstanding, expected to vest and exercisable stock options at September 30, 2008 is $109.2 million, $109.1 million and $100.0 million, respectively. The aggregate intrinsic value represents the total pre-tax intrinsic value, based on the Company’s closing stock price of $16.97 on September 30, 2008, which would have been received by the option holders had all option holders exercised their options as of that date. This amount changes based upon the fair market value of our common stock. The total intrinsic value of stock options exercised was $22.4 million during the nine months ended September 30, 2008. There were 2,788,310 stock options exercised during the nine months ended September 30, 2007 with an intrinsic value of $33.0 million.

 

Note 5. Long-Term Obligations

 

Long-Term Obligations consist of the following (in thousands):

 

 

 

September 30,

 

December 31,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Senior secured debt financing facility:

 

 

 

 

 

Term loans payable

 

$

640,121

 

$

650,252

 

Revolving credit facility

 

 

 

Notes payable to individuals in monthly installments through November 2010, interest at 3.5% to 10.0%

 

2,332

 

8,210

 

 

 

642,453

 

658,462

 

Less current maturities

 

(19,425

)

(16,936

)

 

 

 

 

 

 

 

 

$

623,028

 

$

641,526

 

 

We obtained a senior secured debt financing facility (“Credit Agreement”) from Lehman Brothers Inc. (“Lehman”) and Deutsche Bank Securities, Inc. (“Deutsche Bank”) on October 12, 2007, which was amended on October 26, 2007. The Credit Agreement has a six year term and includes a $610 million term loan, a $40 million Canadian currency term loan, a $100 million U.S. dollar revolving credit facility, and a $15 million dual currency facility for drawings of either U.S. dollars or Canadian dollars. The Credit Agreement also provides for (i) the issuance of letters of credit of up to $35 million in U.S. dollars and up to $10 million in either U.S. or Canadian dollars, (ii) for a swing line credit facility of $25 million under the $100 million revolving credit facility, and (iii) the opportunity for us to add additional term loan facilities and/or increase the $100 million revolving credit facility’s commitments, provided that such additions or increases do not exceed $150 million in the aggregate and provided further that no existing lender is required to make its pro rata share of any such additions or increases without its consent. Amounts under each term loan facility are due and payable in quarterly installments of increasing amounts that began in the first quarter of 2008, with the balance payable in full on October 12, 2013. Amounts due under each revolving credit facility will be due and payable October 12, 2013.  We are also required to prepay the term loan facilities upon the sale of certain assets, upon the incurrence of certain debt, upon receipt of certain insurance and condemnation proceeds, and with up to 50% of our excess cash flow, with the amount of such excess cash flow determined based upon our total leverage ratio.

 

11



 

As of September 30, 2008, we had no borrowings on our $115 million revolving credit facility. Availability on the revolving credit facility is reduced by outstanding letters of credit totaling approximately $22 million. Lehman Commercial Paper Inc. (“LCP”) filed for protection under Chapter 11 of the Federal Bankruptcy Code in the U.S. Bankruptcy Court for the Southern District of New York on October 5, 2008. LCP accounts for $15 million of revolver funding commitment and serves as our swing line lender. Accordingly, we no longer believe this $15 million revolver commitment is available, so in effect our availability on the line has been reduced to $78 million. Our ability to access the swing line credit facility is also uncertain as a result of the bankruptcy filing. We believe that the LCP bankruptcy will not have a material adverse effect on our liquidity.

 

The Credit Agreement contains customary representations and warranties, and contains customary covenants that restrict our ability to, among other things (i) incur liens, (ii) incur any indebtedness (including guarantees or other contingent obligations), and (iii) engage in mergers and consolidations. The Credit Agreement also requires us to meet certain financial covenants, including compliance with the required senior secured debt ratio.  We were in compliance with all restrictive covenants as of September 30, 2008.

 

Borrowings under the Credit Agreement accrue interest at variable rates, which depend on the type (U.S. dollar or Canadian dollar) and duration of the borrowing, plus an applicable margin rate. The weighted-average interest rates on borrowings outstanding against the Company’s senior secured credit facility at September 30, 2008 and December 31, 2007 were 4.91% and 7.53%, respectively. Borrowings against the senior secured credit facility totaled $640.1 million and $650.3 million at September 30, 2008 and December 31, 2007, respectively, of which $17.4 million and $10.0 million are classified as current maturities, respectively.

 

The weighted average interest rate at September 30, 2008 includes the effect of the following interest rate swap agreements, which we entered into in March 2008 and September 2008 in order to hedge a portion of the variable interest rate risk on our variable rate term loans:

 

Notional Amount

 

Effective Date

 

Maturity Date

 

Fixed Interest Rate

 

 

 

 

 

 

 

 

 

$

200,000,000

 

April 14, 2008

 

April 14, 2011

 

2.74

%

$

50,000,000

 

April 14, 2008

 

April 14, 2010

 

2.43

%

$

250,000,000

 

September 15, 2008

 

October 14, 2010

 

2.63

%

 

Beginning on the effective dates of the interest rate swap agreements, we will, on a monthly basis through the maturity date, pay the fixed interest rate and receive a variable rate of interest based on the London InterBank Offered Rate (“LIBOR”) on the notional amount.  The interest rate swap agreements qualify as cash flow hedges, as defined by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (“SFAS 133”).  As of September 30, 2008, the fair market value of these market contracts was approximately $7.8 million. The fair market value of the interest rate swaps is subject to changes in value due to changes in interest rates. Hedge ineffectiveness for the nine months ended September 30, 2008 was immaterial.

 

12



 

Note 6. Commitments and Contingencies

 

We are obligated under noncancelable operating leases for corporate office space, warehouse and distribution facilities, trucks and certain equipment. The future minimum lease commitments under these leases at September 30, 2008 are as follows (in thousands):

 

Three months ended December 31, 2008

 

$

12,805

 

Years ended December 31:

 

 

 

2009

 

45,282

 

2010

 

37,560

 

2011

 

29,869

 

2012

 

23,784

 

2013

 

18,761

 

Thereafter

 

54,094

 

 

 

 

 

 

 

$

222,155

 

 

Litigation and Related Contingencies

 

On December 2, 2005, Ford Global Technologies, LLC (“Ford”) filed a complaint under Section 337 of the Tariff Act of 1930 with the United States International Trade Commission (“USITC”) against Keystone and five other named Respondents, including four Taiwan-based manufacturers (collectively, the “F-150 Respondents”). On December 12, 2005, Ford filed an Amended Complaint. Both the Complaint and the Amended Complaint contended that the F-150 Respondents infringed 14 design patents covering eight parts on the 2004-2005 Ford F-150 truck (the “Ford Design Patents”). Ford asked the USITC to issue a permanent general exclusion order excluding from entry into the United States all automotive parts that infringe the Ford Design Patents and that are imported into the United States, sold for importation in the United States, or sold within the United States after importation. Ford also sought a permanent order directing the F-150 Respondents to cease and desist from, among other things, selling, marketing, advertising, distributing and offering for sale imported automotive parts that infringe the Ford Design Patents. On December 28, 2005, the USITC issued a Notice of Investigation based on Ford’s Amended Complaint. The USITC’s Notice of Investigation was published in the Federal Register on January 4, 2006.

 

On January 23, 2006, the F-150 Respondents filed their Response to the Complaint and Notice of Investigation. In the Response, the F-150 Respondents denied, among other things, that any of the Ford Design Patents is valid and/or enforceable and, accordingly, denied each and every allegation of infringement. The F-150 Respondents further asserted several affirmative defenses. In interlocutory rulings, the Administrative Law Judge (“ALJ”) struck the F-150 Respondents’ affirmative defenses of patent exhaustion, permissible repair, license and patent misuse and the affirmative defense that each of the patents is invalid for failure to comply with the ornamentality requirement of 35 U.S.C.§171. Additionally, the ALJ granted Ford’s request to drop four patents from the investigation. A hearing before the ALJ took place the last week of August 2006.

 

On December 4, 2006, the ALJ issued an Initial Determination upholding seven of Ford’s design patents and declaring the remaining three design patents to be invalid. Both Ford and the F-150 Respondents petitioned the USITC to review and set aside portions of the ALJ’s Initial Determination. The F-150 Respondents’ petition also sought review of the ALJ’s interlocutory rulings concerning certain of their affirmative defenses. On March 20, 2007, the USITC decided not to review the ALJ’s Initial Determination.

 

On June 6, 2007, the USITC issued its Notice of Final Determination. The Notice of Final Determination denied the F-150 Respondents’ petition for reconsideration and their motion for leave to supplement their petition. In addition, the USITC issued a general exclusion order prohibiting the importation of certain automotive parts found to infringe the seven Ford design patents found valid. The USITC’s decision became final on August 6, 2007 upon the expiration without action of the 60-day Presidential review period.  On May 18, 2007, Ford filed a Notice of Appeal with the United States Federal Circuit Court of Appeals. On August 23, 2007, the F-150 Respondents filed a Notice of Appeal with the United States Federal Court of Appeals. The appeals were consolidated, and the parties have submitted their respective briefs to the appellate court.

 

On May 2, 2008, Ford filed with the USITC another complaint under section 337 of the Tariff Act of 1930. The complaint alleges that LKQ Corporation, Keystone Automotive Industries, Inc., and six other entities (collectively, the “Mustang Respondents”) import and sell certain automotive parts relating to the 2005 Ford Mustang that infringe eight Ford design patents. On May 29, 2008, the USITC issued a Notice of Investigation based on Ford’s complaint. The USITC’s Notice of Investigation was published in the Federal Register on June 5, 2008. On June 23, 2008, the Mustang Respondents filed their Response to the Complaint and Notice of Investigation. In the Response, the Mustang Respondents denied, among other things, that any of the Ford design patents is valid and/or enforceable and, accordingly, denied each and every allegation of infringement. The Mustang Respondents further asserted several affirmative defenses. The parties are conducting discovery. The USITC has set September 7, 2009 as the target date for completion of the investigation.

 

13



 

We will continue to vigorously defend the December 2005 action and the May 2008 action. At the time the exclusion order was issued in the December 2005 action, the parts that were subject to the order comprised only a minimal amount of our sales. Similarly, the parts that relate to the May 2008 action comprise only a minimal amount of our sales. However, as such parts become incorporated into more vehicles over time, it is likely that the amount of our sales of such parts will increase or would have increased substantially. If the design patents in question are ultimately upheld as valid and infringed, it is not anticipated that the loss of sales of these parts over time will be materially adverse to our financial position, results of operations or cash flows. However, depending upon the nature and extent of any adverse ruling, auto manufacturers may attempt to assert similar allegations based upon design patents on a significant number of parts for several of their models, which over time could have a material adverse impact on the entire aftermarket parts industry.

 

We also have certain other contingent liabilities resulting from litigation, claims and other commitments and are subject to a variety of environmental and pollution control laws and regulations incident to the ordinary course of business. We believe that the probable resolution of such contingencies will not materially affect our financial position, results of operations or cash flows.

 

Note 7 Earnings Per Share

 

The following chart sets forth the computation of earnings per share (in thousands, except per share amounts):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

25,068

 

$

14,559

 

$

86,935

 

$

44,369

 

 

 

 

 

 

 

 

 

 

 

Denominator for basic earnings per share-Weighted-average shares outstanding

 

136,585

 

109,326

 

135,481

 

107,678

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Stock options

 

4,587

 

5,785

 

4,868

 

5,559

 

Restricted stock

 

18

 

 

109

 

 

Denominator for diluted earnings per share-Adjusted weighted-average shares outstanding

 

141,190

 

115,111

 

140,458

 

113,237

 

 

 

 

 

 

 

 

 

 

 

Earnings per share, basic

 

$

0.18

 

$

0.13

 

$

0.64

 

$

0.41

 

 

 

 

 

 

 

 

 

 

 

Earnings per share, diluted

 

$

0.18

 

$

0.13

 

$

0.62

 

$

0.39

 

 

The following chart sets forth the number of employee stock options outstanding but not included in the computation of diluted earnings per share because their effect would have been antidilutive (in thousands):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Antidilutive securities:

 

 

 

 

 

 

 

 

 

Stock options

 

1,460

 

31

 

1,460

 

894

 

 

14



 

Note 8.  Business Combinations

 

During the nine month period ended September 30, 2008, we acquired a 100% interest in each of four businesses (three in the recycled OEM parts business and one wheel polishing business) including on August 25, 2008, PYP, an auto recycler with nine recycling locations in California, and on March 4, 2008, Texas Best Diesel, L.P., a recycled OEM heavy truck parts business.  The acquisitions enabled us to expand our presence in an existing market and also become a provider of recycled OEM heavy truck parts.  The aggregate consideration for these businesses totaled approximately $41.6 million in cash, net of cash acquired, and $60.0 million in stock issued.  The cash consideration for PYP included a $3.3 million contingent payment to the former owners based on a share price guarantee for shares sold in the market during the month following the acquisition date.  The guarantee period was closed as of September 30, 2008, and we do not anticipate any further payments to the former owners of PYP.  As the payment was based on a contingency involving share prices, the $3.3 million has not been included in the cost of the acquired entity for purchase accounting but instead reduced additional paid-in capital.  We expect to receive a refund of a portion of the purchase price during the fourth quarter resulting from a working capital adjustment.

 

During the nine month period ended September 30, 2007, we acquired a 100% interest in each of eight businesses (five in the recycled OEM products business, two in the aftermarket products business and one that refurbishes and distributes head lamps and tail lamps) for an aggregate of $52.2 million in cash and $1.4 million in notes issued. The acquisitions enabled us to expand our presence in existing markets, serve new market areas and become a provider of refurbished head lamps and tail lamps.

 

On October 12, 2007, we completed our acquisition of 100% of the outstanding common stock of Keystone. The acquisition of Keystone enabled us to become the largest nationwide provider of aftermarket collision replacement products and refurbished bumper covers and wheels. During the nine months ended September 30, 2007, we incurred $1.5 million in direct costs associated with the acquisition.  In September 2008, we received a refund of approximately $1.3 million of the purchase price for an overpayment on Keystone shares at the acquisition date.

 

The acquisitions are being accounted for under the purchase method of accounting and are included in our financial statements from the dates of acquisition.  The purchase prices were allocated to the net assets acquired based upon estimated fair market values at the dates of acquisition. In connection with acquisitions made subsequent to September 30, 2007, the purchase price allocations are preliminary as we are in the process of determining the following: 1) whether any operations acquired will be closed or combined with existing operations; 2) valuation amounts for certain of the inventories and fixed assets acquired and the fair value of liabilities assumed; and 3) the final estimation of the tax basis of the entities acquired. During the nine months ended September 30, 2008, we made adjustments to the preliminary purchase price allocations to finalize the inventory and fixed asset valuations, reserve balances and the estimated tax basis for certain of the businesses acquired in 2007. These adjustments increased goodwill related to these 2007 acquisitions by approximately $10.3 million.

 

The purchase price allocations for acquisitions completed and adjustments made to preliminary purchase price allocations during the nine months ended September 30, 2008 and 2007 are as follows (in thousands):

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Receivables, net

 

$

5,645

 

$

3,062

 

Inventory

 

5,912

 

9,546

 

Prepaid expenses and other assets

 

493

 

314

 

Property and equipment

 

6,797

 

8,927

 

Goodwill

 

85,978

 

34,922

 

Current liabilities assumed

 

(7,548

)

(2,776

)

Deferred taxes

 

1,195

 

 

Purchase price payable in subsequent period

 

 

(190

)

Notes issued

 

(25

)

(1,449

)

Stock issued (See Note 3)

 

(60,041

)

 

Long-term obligations assumed

 

(1,423

)

(118

)

Payment of prior year purchase price payable

 

 

1,956

 

 

 

 

 

 

 

Cash used in acquisitions, net of cash acquired

 

$

36,983

 

$

54,194

 

 

We recorded goodwill of $86.0 million during the nine month period ended September 30, 2008, of which $75.7 million is expected to be deductible for income tax purposes. Of the $34.9 million of goodwill recorded during the nine month period ended September 30, 2007, $12.9 million is expected to be deductible for income tax purposes.

 

15



 

The following pro forma summary presents the effect of the businesses acquired during 2008 and 2007 as though the businesses had been acquired as of January 1, 2007 and is based upon unaudited financial information of the acquired entities (in thousands, except per share data):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenue as reported

 

$

490,701

 

$

243,495

 

$

1,467,001

 

$

712,091

 

Revenue of purchased businesses for the period prior to acquisition:

 

 

 

 

 

 

 

 

 

Keystone, net of eliminations

 

 

174,212

 

 

553,271

 

Other acquisitions

 

25,316

 

36,026

 

105,527

 

121,760

 

Pro forma revenue

 

$

516,017

 

$

453,733

 

$

1,572,528

 

$

1,387,122

 

 

 

 

 

 

 

 

 

 

 

Net income as reported

 

$

25,068

 

$

14,559

 

$

86,935

 

$

44,369

 

Net income of purchased businesses for the period prior to acquisition, including adjustments for interest and amortization:

 

 

 

 

 

 

 

 

 

Keystone

 

 

(2,869

)

665

 

(118

)

Other acquisitions

 

2,235

 

753

 

9,434

 

3,370

 

Pro forma net income

 

$

27,303

 

$

12,443

 

$

97,034

 

$

47,621

 

 

 

 

 

 

 

 

 

 

 

Earnings per share-basic, as reported

 

$

0.18

 

$

0.13

 

$

0.64

 

$

0.41

 

Effect of purchased businesses for the period prior to acquisition:

 

 

 

 

 

 

 

 

 

Keystone

 

 

(0.03

)

 

 

Other acquisitions

 

0.02

 

0.01

 

0.07

 

0.02

 

Pro forma earnings per share-basic

 

$

0.20

 

$

0.11

 

$

0.71

 

$

0.43

 

 

 

 

 

 

 

 

 

 

 

Earnings per share-diluted, as reported

 

$

0.18

 

$

0.13

 

$

0.62

 

$

0.39

 

Effect of purchased businesses for the period prior to acquisition:

 

 

 

 

 

 

 

 

 

Keystone

 

 

(0.03

)

 

 

Other acquisitions

 

0.01

 

0.01

 

0.06

 

0.02

 

Pro forma earnings per share-diluted

 

$

0.19

 

$

0.11

 

$

0.68

 

$

0.41

 

 

Unaudited pro forma supplemental information is based upon accounting estimates and judgments that we believe are reasonable. Revenue between LKQ and Keystone has been eliminated. The unaudited pro forma supplemental information also includes purchase accounting adjustments (including a $2.9 million increase in Keystone’s reported cost of goods sold during the nine months ended September 30, 2007, resulting from a write-up of Keystone inventory to fair value), adjustments to depreciation on acquired property and equipment, amortization expense associated with the Keystone tradename, adjustments to interest expense, and the related tax effects. These pro forma results are not necessarily indicative either of what would have occurred if the acquisitions had been in effect for the period presented or of future results.

 

Note 9. Restructuring and Integration Costs

 

We have undertaken certain restructuring activities in connection with our October 2007 acquisition of Keystone. The restructuring activities primarily include reductions in staffing levels resulting from the elimination of duplicative functions and staffing and the closure of excess facilities resulting from overlap with existing LKQ facilities. To the extent these restructuring activities are associated with Keystone operations, they are being accounted for in accordance with EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” Restructuring activities associated with our existing operations are being accounted for in accordance with SFAS No. 146, “Accounting for Costs Associated With Exit or Disposal Activities.”

 

16



 

In connection with the Keystone restructuring activities, as part of the cost of the acquisition, we established reserves as detailed below. Upon finalization of restructuring plans or settlement of obligations for less than the expected amount, any excess reserves will be reversed with a corresponding decrease in goodwill.  Any additional reserves required after the close of the purchase accounting period will be recorded through charges to restructuring expense.  Accrued acquisition expenses are included in accrued expenses in the accompanying Unaudited Consolidated Condensed Balance Sheets.

 

The changes in accrued acquisition expenses directly related to the Keystone acquisition during 2007 and the nine months ended September 30, 2008 are as follows (in thousands):

 

 

 

Severance
Related
Costs

 

Excess
Facility
Costs

 

Other

 

Total

 

 

 

 

 

 

 

 

 

 

 

Reserves established

 

$

11,233

 

$

2,823

 

$

488

 

$

14,544

 

Payments

 

(1,727

)

(85

)

(488

)

(2,300

)

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2007

 

9,506

 

2,738

 

 

12,244

 

 

 

 

 

 

 

 

 

 

 

Reserves adjusted

 

(800

)

(700

)

 

(1,500

)

Payments

 

(7,524

)

(462

)

 

(7,986

)

 

 

 

 

 

 

 

 

 

 

Balance at September 30, 2008

 

$

1,182

 

$

1,576

 

$

 

$

2,758

 

 

Severance related costs are expected to be paid through 2009. The excess facility costs are expected to be paid over the remaining terms of the leases through 2013.

 

Restructuring and integration costs associated with our operations of $2.4 million and $6.7 million are included in Restructuring expenses on the accompanying Unaudited Consolidated Condensed Statements of Income for the three and nine months ended September 30, 2008, respectively. These charges include costs to move inventory between facilities, migrate systems, and standardize processes and procedures totaling $1.8 million and $4.7 million for the three and nine months ended September 30, 2008, respectively. We also recognized costs associated with the closure of existing facilities due to overlap with acquired Keystone locations of $0.6 million and $2.0 million for the three and nine months ended September 30, 2008, respectively.

 

We have established a reserve for the costs related to the closure of existing facilities.  The other restructuring charges are generally expensed and paid in the same reporting period.  The changes in accrued restructuring expenses for the nine months ended September 30, 2008 are as follows (in thousands):

 

 

 

Excess Facility Costs

 

 

 

 

 

Balance at December 31, 2007

 

$

 

 

 

 

 

Reserves established

 

2,047

 

Payments

 

(599

)

 

 

 

 

Balance at September 30, 2008

 

$

1,448

 

 

The excess facility costs are expected to be paid over the remaining terms of the leases through 2016.

 

17



 

Note 10. Fair Value Measurements

 

SFAS 157 establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted market prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

 

We use the market approach to value our financial assets and liabilities, and there were no changes in valuation techniques during the nine months ended September 30, 2008.  The following table presents information about our financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2008 (in thousands):

 

 

 

Balance as
of September 30,

 

Fair Value Measurements as of September 30, 2008

 

 

 

2008

 

Level 1

 

Level 2

 

Level 3

 

Assets:

 

 

 

 

 

 

 

 

 

Cash equivalents

 

$

68,492

 

$

68,492

 

$

 

$

 

Interest rate swaps

 

7,771

 

 

7,771

 

 

Cash surrender value of life insurance

 

4,665

 

 

4,665

 

 

 

 

 

 

 

 

 

 

 

 

Total Assets

 

$

80,928

 

$

68,492

 

$

12,436

 

$

 

 

 

 

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

 

 

 

 

Deferred compensation liabilities

 

$

4,137

 

$

 

$

4,137

 

$

 

 

 

 

 

 

 

 

 

 

 

Total Liabilities

 

$

4,137

 

$

 

$

4,137

 

$

 

 

Note 11. Income Taxes

 

We calculate our interim income tax provision in accordance with Accounting Principles Board Opinion No. 28, “Interim Financial Reporting” and FASB Interpretation No. 18, “Accounting for Income Taxes in Interim Periods.” At the end of each interim period, we estimate our annual effective tax rate and apply that rate to our interim earnings. We also record the tax impact of certain unusual or infrequently occurring items, including changes in judgment about valuation allowances and the effects of changes in tax laws or rates, in the interim period in which they occur.

 

The computation of the annual estimated effective tax rate at each interim period requires certain estimates and significant judgment including, but not limited to, the expected operating income for the year, projections of the proportion of income earned and taxed in state and foreign jurisdictions, permanent and temporary differences, and the likelihood of recovering deferred tax assets generated in the current year. The accounting estimates used to compute the provision for income taxes may change as new events occur, additional information is obtained or as the tax environment changes.

 

Our effective tax rate for the nine months ended September 30, 2008 was 39.5% compared with 40.5% for the comparable prior year period.

 

18



 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Overview

 

We provide replacement systems, components, and parts needed to repair vehicles (cars and trucks). Buyers of vehicle replacement products have the option to purchase from primarily four sources: new products produced by original equipment manufacturers (“OEMs”), which are commonly known as OEM products; new products produced by companies other than the OEMs, which are sometimes referred to as “aftermarket” products; recycled products originally produced by OEMs, which we refer to as recycled OEM products; and OEM products that have been refurbished. We participate in the markets for recycled OEM products, as well as the market for collision repair aftermarket products. We obtain aftermarket products and salvage vehicles from a variety of sources, and we dismantle the salvage vehicles to obtain a comprehensive range of vehicle products that we distribute into the vehicle repair market. We also refurbish and sell bumpers, wheels, head lamps and tail lamps.

 

We are the largest nationwide provider of recycled OEM products and related services, with sales, processing, and distribution facilities that reach most major markets in the United States. In October 2007, we acquired Keystone Automotive Industries, Inc., the nation’s leading distributor of aftermarket collision parts. As a result, we are the largest nationwide provider of aftermarket collision replacement products, and refurbished bumper covers and wheels. We believe there are opportunities for growth in both product lines through acquisitions and internal development.

 

Our revenue, cost of goods sold, and operating results have fluctuated on a quarterly and annual basis in the past and can be expected to continue to fluctuate in the future as a result of a number of factors, some of which are beyond our control. Please refer to the risk factors enumerated in Item 1A in our 2007 Annual Report on Form 10-K filed with the SEC on February 29, 2008, and the updates to Item 1A included in Part II of our Quarterly Reports on Form 10-Q filed subsequently.  Due to these risk factors, our operating results in future periods can be expected to fluctuate. Accordingly, our historical results of operations may not be indicative of future performance.

 

Acquisitions

 

Since our inception in 1998 we have pursued a growth strategy of both organic growth and acquisitions. We have pursued acquisitions that we believe will help drive profitability, cash flow and stockholder value. Our principal focus for acquisitions is companies that will expand our geographic presence and our ability to provide a wider choice of alternative vehicle replacement products and services to our customers.

 

In the first nine months of 2008, we acquired four businesses (three in the recycled OEM parts business and one wheel polishing business). In October 2008, we acquired two additional recycled OEM heavy truck parts businesses.  The 2008 business acquisitions enabled us to expand our presence in an existing market and become a provider of recycled OEM heavy truck parts.

 

Sources of Revenue

 

Since 2005, our revenue from the sale of vehicle replacement products and related services, and since February 2008, heavy truck parts, has ranged between 81% and 89% of our total revenue, of which between 5% and 13% of our total revenue has come from our self-service facilities. We sell the majority of our vehicle replacement products to collision repair shops and mechanical repair shops. Our vehicle replacement products include engines, transmissions, front-ends, doors, trunk lids, bumpers, hoods, fenders, grilles, valances, wheels, head lamps, and tail lamps. We sell extended warranty contracts for certain mechanical products. These contracts cover the cost of parts and labor and are sold for periods of six months, one year, or two years. We defer the revenue from such contracts and recognize it ratably over the term of the contracts. We also sell damaged vehicles to vehicle repairers. The demand for our products and services is influenced by several factors, including the number of vehicles in operation, the number of miles being driven, the frequency and severity of vehicle accidents, availability and pricing of new parts, seasonal weather patterns, and local weather conditions. Additionally, automobile insurers exert significant influence over collision repair shops as to how an insured vehicle is repaired and the cost level of the products used in the repair process. Accordingly, we consider automobile insurers to be key demand drivers of our products. While they are not our direct customers, we do provide insurance companies services in an effort to promote the increased usage of alternative replacement products in the repair process. Such services include the review of vehicle repair order estimates, as well as direct quotation services to their adjusters. There is no standard price for recycled OEM products, but rather a pricing structure that varies from day to day based upon such factors as product availability, quality, demand, new OEM replacement product prices, the age of the vehicle being repaired, and competitor pricing. The pricing for aftermarket and refurbished products is determined based on a number of factors, including availability, quality, demand, new OEM replacement product prices, and competitor pricing.

 

Since 2005, approximately 11% to 19% of our revenue has been obtained from other sources. These include bulk sales to mechanical remanufacturers, scrap sales, and sales of aluminum ingots and sows. We derive scrap metal from several sources, including OEM’s and other companies that contract with us to dismantle and scrap certain vehicles (which we refer to as “crush only” vehicles) and from vehicles that have been used in both our wholesale and self service recycling operations. Our revenue from other sources has increased since 2004 primarily due to our obtaining an aluminum smelter through a business acquisition in 2006, higher

 

19



 

scrap sales from our recycle and wheel operations, and higher bulk sales of certain products.  Subsequent to September 30, 2008, scrap metal prices have fallen significantly, which will have a negative effect on our revenue (Item 3 of this Quarterly Report on Form 10-Q provides further description of this price risk).

 

When we obtain mechanical products from dismantled vehicles and determine they are damaged, or when we have a surplus of a certain mechanical product type, we sell them in bulk to mechanical remanufacturers. The majority of these products are sorted by product type and model type. Examples of such products are engine blocks and heads, transmissions, starters, alternators, and air conditioner compressors. After we have recovered all the products we intend to resell, the remaining materials are crushed and sold to scrap processors.

 

Cost of Goods Sold

 

Our cost of goods sold for recycled OEM products includes the price we pay for the salvage vehicle and, where applicable, auction, storage, and towing fees. We are facing increasing competition in the purchase of salvage vehicles from shredders and scrap recyclers, internet-based buyers, and others. Our cost of goods sold also includes labor and other costs we incur to acquire and dismantle such vehicles. The acquisition and dismantling of salvage vehicles is a manual process and, as a result, energy costs are not material.

 

Our cost of goods sold for aftermarket products includes the price we pay for the parts, freight, and other inventoried costs such as import fees and duties, where applicable. Our aftermarket products are acquired from a number of vendors. Our cost of goods sold for refurbished wheels, bumpers and lights includes the price we pay for inventory, freight, and costs to refurbish the parts, including direct and indirect labor, rent, depreciation and other overhead costs related to refurbishing operations.

 

In the event we do not have a recycled OEM product or suitable aftermarket product in our inventory to fill a customer order, we attempt to purchase the part from a competitor. We refer to these parts as brokered products. Since 2005, the revenue from brokered products that we sell to our customers has ranged from 2% to 6% of our total revenue. The gross margin on brokered product sales as a percentage of revenue is generally less than half of what we achieve from sales of our own inventory because we must pay higher prices for these products.

 

Some of our mechanical products are sold with a standard six-month warranty against defects. We record the estimated warranty costs at the time of sale using historical warranty claim information to project future warranty claims activity and related expenses.   We also sell separately priced extended warranty contracts for certain mechanical products. The expense related to extended warranty claims is recognized when the claim is made.

 

Expenses

 

Our facility and warehouse expenses primarily include our costs to operate our distribution, self-service, and warehouse facilities. These costs include labor for both plant management and facility and warehouse personnel, stock-based compensation, facility rent, property and liability insurance, utilities, and other occupancy costs.

 

Our distribution expenses primarily include our costs to deliver our products to our customers. Included in our distribution expense category are labor costs for drivers, local delivery and transfer truck rentals and subcontractor costs, vehicle repairs and maintenance, insurance, and fuel.

 

Our selling and marketing expenses primarily include our advertising, promotion, and marketing costs; salary and commission expenses for sales personnel; sales training; telephone and other communication expenses; and bad debt expense. Since 2005, personnel costs have accounted for approximately 77% to 80% of our selling and marketing expenses. Most of our recycled OEM product sales personnel are paid on a commission basis. The number and quality of our sales force is critical to our ability to respond to our customers’ needs and increase our sales volume. Our objective is to continually evaluate our sales force, develop and implement training programs, and utilize appropriate measurements to assess our selling effectiveness.

 

Our general and administrative expenses include primarily the costs of our corporate and regional offices that provide corporate and field management, treasury, accounting, legal, payroll, business development, human resources, and information systems functions. These costs include wages and benefits for corporate, regional and administrative personnel, stock-based compensation, long term incentive compensation, accounting, legal and other professional fees, office supplies, telephone and other communication costs, insurance and rent.

 

Seasonality

 

Our operating results are subject to quarterly variations based on a variety of factors, influenced primarily by seasonal changes in weather patterns. During the winter months we tend to have higher demand for our products because there are more weather r