SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended March 31, 2005
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 incorporation or organization)		(I.R.S. Employer Identification Number)
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     ý  No     o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Yes     ý  No     o

 

At May 4, 2005, the registrant had issued and outstanding an aggregate of 20,731,956 shares of Common Stock.

 

 

PART I

FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

LKQ CORPORATION AND SUBSIDIARIES

Unaudited Condensed Consolidated Balance Sheets

( In thousands, except share data )

 

		March 31,			December 31,
		2005			2004
Assets
Current Assets:
Cash and equivalents		$	3,730		$	1,612
Restricted cash		467			—
Receivables, net		30,284			28,305
Inventory		80,040			74,150
Prepaid expenses and other current assets		3,370			3,375
Total Current Assets		117,891			107,442
Property and Equipment, net		72,135			70,730
Intangibles, net
Goodwill		112,655			100,319
Other intangibles, net		91			45
Deferred Income Taxes		4,145			4,621
Other Assets		5,742			5,118
Total Assets		$	312,659		$	288,275
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable		$	9,651		$	8,424
Income taxes payable		4,631			1,251
Accrued expenses and other current liabilities		20,989			19,571
Current portion of long-term obligations		220			317
Total Current Liabilities		35,491			29,563
Long-Term Obligations, Excluding Current Portion		58,889			49,945
Other Noncurrent Liabilities		4,088			4,079
Redeemable Common Stock, $0.01 par value, 50,000 shares issued		617			617
Commitments and Contingencies
Stockholders’ Equity:
Common stock, $0.01 par value, 500,000,000 shares authorized, 20,652,823 and 20,565,413 shares issued at March 31, 2005 and December 31, 2004, respectively.		207			206
Additional paid-in capital		202,590			201,484
Warrants		261			261
Retained earnings		9,541			1,140
Accumulated other comprehensive income		975			980
Total Stockholders’ Equity		213,574			204,071
Total Liabilities and Stockholders’ Equity		$	312,659		$	288,275

 

See notes to unaudited condensed consolidated financial statements.

 

2

 

LKQ CORPORATION AND SUBSIDIARIES

Unaudited Consolidated Statements of Operations

( In thousands, except per share data )

 

		Three Months Ended
		March 31,
		2005			2004
Revenue		$	133,807		$	100,073
Cost of goods sold		71,171			53,077
Gross margin		62,636			46,996
Facility and warehouse expenses		14,454			10,728
Distribution expenses		14,095			10,694
Selling, general and administrative expenses		17,725			14,207
Depreciation and amortization		1,966			1,505
Operating income		14,396			9,862
Other (income) expense
Interest expense		572			537
Interest income		(18		)	(18		)
Other (income) expense, net		(162		)	(87		)
Total other expense		392			432
Income before provision for income taxes		14,004			9,430
Provision for income taxes		5,603			3,795
Net income		$	8,401		$	5,635
Net income per share:
Basic		$	0.41		$	0.29
Diluted		$	0.37		$	0.25
Weighted average common shares outstanding:
Basic		20,631			19,643
Diluted		22,692			22,181

 

See notes to unaudited condensed consolidated financial statements.

 

3

 

LKQ CORPORATION AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

( In thousands )

 

		Three Months Ended
		March 31,
		2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	8,401		$	5,635
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		1,966			1,505
Deferred income taxes		383			705
Writeoff of debt issuance costs		—			346
Other adjustments		18			(47		)
Changes in operating assets and liabilities, net of effects from purchase transactions:
Receivables		(1,154		)	(313		)
Inventory		(1,613		)	(4,368		)
Income taxes payable		3,806			2,081
Other operating assets and liabilities		(496		)	318
Net cash provided by operating activities		11,311			5,862
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment, net		(2,953		)	(6,649		)
Purchase of investment securities		—			(650		)
Decrease in restricted cash in escrow		132			—
Cash used in acquisitions		(15,815		)	(39,638		)
Net cash used in investing activities		(18,636		)	(46,937		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from the sale of common stock and warrant exercises		639			1,847
Debt issuance costs		(43		)	(237		)
Net borrowings of long-term debt		8,847			27,065
Net cash provided by financing activities		9,443			28,675
Net increase (decrease) in cash and equivalents		2,118			(12,400		)
Cash and equivalents, beginning of period		1,612			16,082
Cash and equivalents, end of period		$	3,730		$	3,682
Supplemental disclosure of cash flow information:
Notes issued in connection with business acquisitions		$	—		$	2,250
Stock issued in connection with business acquisitions		—			2,250
Cash paid for income taxes, net of refunds		1,431			702
Cash paid for interest		511			321

 

See notes to unaudited condensed consolidated financial statements.

 

4

 

LKQ CORPORATION AND SUBSIDIARIES

Unaudited Consolidated Statements of Stockholders’ Equity and Other Comprehensive Income

( In thousands )

 

																Accumulated
		Common Stock					Additional									Other			Total
		Shares					Paid-In						Retained			Comprehensive			Stockholders’
		Issued		Amount			Capital			Warrants			Earnings			Income			Equity
BALANCE, December 31, 2004		20,565		$	206		$	201,484		$	261		$	1,140		$	980		$	204,071
Net income		—		—			—			—			8,401						8,401
Unrealized gain (loss) on investment in equity securities, net of tax		—		—			—			—			—			(6		)	(6		)
Foreign currency translation		—		—			—			—			—			1			1
Total comprehensive income		—		—			—			—			—			—			8,396
Equity-related compensation expense		—		—			42			—			—			—			42
Exercise of stock options, including related tax benefits of $426		88		1			1,064			—			—			—			1,065
BALANCE, March 31, 2005		20,653		$	207		$	202,590		$	261		$	9,541		$	975		$	213,574

 

5

 

LKQ Corporation and Subsidiaries

Notes to Unaudited Consolidated Financial Statements

 

Note 1.  Interim Financial Statements

 

The accompanying Unaudited Condensed Consolidated Financial Statements include the accounts of LKQ Corporation and its subsidiaries (the “Company”).  All significant intercompany transactions and accounts have been eliminated.  The accompanying Unaudited Condensed Consolidated Financial Statements have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission applicable to interim financial statements. Accordingly, certain information related to the Company’s 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 Condensed Consolidated 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, the financial position, results of operations and cash flows of the Company 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 the Company’s audited consolidated financial statements and notes thereto included in the Company’s most recent report on Form 10-K for the year ended December 31, 2004 filed with the Securities and Exchange Commission.

 

Note 2.  Receivables

 

The Company has recorded a reserve for uncollectible accounts of approximately $1.9 million and $1.7 million at March 31, 2005 and December 31, 2004, respectively.

 

Note 3.  Inventory

 

Inventory consists of the following:

 

		March 31,			December 31,
		2005			2004
		(in thousands)
Salvage parts		$	62,199		$	61,390
Aftermarket parts		14,510			8,999
Cores		3,331			3,761
		$	80,040		$	74,150

 

Note 4.  Intangibles

 

Intangible assets consist primarily of goodwill (the cost of purchased businesses in excess of the fair value of the net assets acquired) and covenants not to compete.

 

The changes in the carrying amount of goodwill during the three months ended March 31, 2005 are as follows:

 

		(in thousands)
Balance as of December 31, 2004		$	100,319
Business acquisitions		12,336
Balance as of March 31, 2005		$	112,655

 

Note 5.  Income Taxes

 

Income taxes provided are based upon the Company’s anticipated annual effective income tax rate.

 

6

 

Note 6.  Recent Accounting Pronouncements

 

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 amends Accounting Research Bulletin No. 43, Chapter 4, to clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges. In addition, SFAS 151 requires that allocation of fixed production overhead to inventory be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005.  The Company is currently assessing the impact that SFAS 151 may have on its results of operations, financial position or cash flows.

 

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment”(“SFAS 123R”), a revision of SFAS 123. SFAS 123R requires the adoption of a fair-value method of accounting for stock-based employee compensation. SFAS 123R was to be effective as of the beginning of the first interim fiscal period that begins after June 15, 2005.  In applying the fair value concepts of SFAS 123R, the Company will be required to choose among alternative valuation models and other assumptions. Although the Company had not completed its assessment of the impact of SFAS 123R, it had initially estimated that it would negatively impact its results of operations for 2005 by approximately $0.5 million or $0.02 per diluted share.

 

On April 14, 2005, the U.S. Securities and Exchange Commission announced a deferral of the effective date of SFAS 123R for calendar year companies until the beginning of 2006. As a result, the Company’s 2005 results of operations will not be impacted by the implementation of SFAS 123R. The Company is currently assessing the impact that SFAS 123R may have on its future results of operations. The Company does not expect that the adoption of this standard will have a material impact on its consolidated financial position or cash flows.

 

Note 7.  Stock-Based Compensation

 

The Company has three stock-based compensation plans, the LKQ Corporation 1998 Equity Incentive Plan  (the “Equity Incentive Plan”), the Stock Option and Compensation Plan for Non-Employee Directors (the “Director Plan”), and a separate stock option plan for our Chief Executive Officer (the “CEO Plan”). The Company accounts for its stock compensation arrangements under the provisions of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). The Company has adopted the disclosure-only provisions of SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), as amended by SFAS 148, “Accounting for Stock-Based Compensation-Transition and Disclosures” (“SFAS 148”).

 

Under the CEO Plan, the difference between the fair market value of the option at the time granted in 1998 and the exercise price was recorded as deferred compensation expense and was charged to operations over the vesting period of the options which ended in November 2003.  No stock-based compensation cost is reflected in net income for the Equity Incentive Plan or the Director Plan at the date of issuance of the options, as all options granted under these plans had an exercise price equal to or greater than the market value of the underlying common stock on the date of grant.

 

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS 123 to the Equity Incentive Plan and the Director Plan, including, in 2005, the effect of accelerating the vesting schedules of options granted in 2004:

 

7

 

		Three Months Ended March 31,
		2005			2004
		(in thousands, except per share amounts)
Net income, as reported		$	8,401		$	5,635
Add: Stock-based compensation expense, net of tax, included in net income as reported		25			—
Less: Total stock-based compensation expense determined using the Black-Scholes option pricing model, net of related tax effects		(3,823		)	(653		)
Pro forma net income		$	4,603		$	4,982
Earnings per share:
Basic - as reported		$	0.41		$	0.29
Basic - pro forma		$	0.22		$	0.25
Diluted - as reported		$	0.37		$	0.25
Diluted - pro forma		$	0.20		$	0.22

 

The fair value of stock options used to compute the pro forma disclosures has been estimated using the Black-Scholes option-pricing model. This model requires the use of highly subjective assumptions, including the expected volatility of the underlying stock. Projected data related to volatility and expected life of stock options is based upon historical and other information. Changes in the subjective underlying assumptions can materially affect the fair value estimates.   For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the options’ vesting periods. The following table summarizes the assumptions used to compute the weighted average fair value of stock option grants:

 

		Three Months Ended
		March 31,
		2005				2004
Expected life (in years)		5.8				7.5
Risk-free interest rate		3.94		%		3.87		%
Volatility		40.0		%		40.0		%
Dividend yield		0		%		0		%
Weighted average fair value of options granted		$	7.61			$	9.14

 

A summary of transactions in the Company’s stock-based compensation plans for the three months ended March 31, 2005 is as follows:

 

		Options				Weighted
		Available		Number of		Average
		for		Shares		Exercise
		Grant		Outstanding		Price
Balance, December 31, 2004		1,007,330		3,981,985		$	11.71
Granted		(726,000	)	726,000		17.26
Exercised		—		(87,410	)	7.31
Cancelled		10,200		(10,200	)	14.89
Balance, March 31, 2005		291,530		4,610,375		$	12.66

 

8

 

The following table summarizes information about outstanding and exercisable stock options at March 31, 2005:

 

		Outstanding
				Weighted						Exercisable
				Average		Weighted						Weighted
				Remaining		Average						Average
Range of				Contractual		Exercise						Exercise
Exercise Prices		Shares		Life (Yrs)		Price				Shares		Price
$ 1.00 - $ 3.00		341,700		5.7		$	2.93			227,600		$	2.89
8.00 -  10.00		1,410,725		6.2		8.77				860,535		9.03
12.50 -  15.00		1,454,750		5.4		13.83				1,293,150		13.92
15.83 -  18.87		1,403,200		9.3		17.74				917,000		17.72
		4,610,375		6.9		$	12.66			3,298,285		$	12.94

 

Stock options expire 10 years from the date they are granted. Most of the options granted under the Equity Incentive Plan and the CEO Plan vest over a period of five years. Options granted under the Director Plan vest six months after the date of grant.

 

On January 7, 2005, the Company’s Board of Directors authorized the Compensation Committee to make the 2005 annual grant of stock options to employees (the “2005 Options”). On January 14, 2005, the Compensation Committee granted options to purchase a total of 422,000 shares of LKQ common stock with an exercise price of $17.68 per share. The vesting schedule for each of the 2005 Options is as follows: June 14, 2005 with respect to 50% of the number of shares subject to such option and, with respect to an additional 5.555% of the number of shares subject to such option, January 14, 2006 and each six month anniversary thereafter until January 14, 2010.  This vesting schedule is different than the typical vesting schedule for options granted under the Equity Incentive Plan.

 

 On January 10, 2005, the Compensation Committee amended the vesting schedule of a total of 428,500 options granted to employees in 2004 under the Equity Incentive Plan, accelerating the vesting schedule to make all unvested shares subject to the options exercisable on January 10, 2005. The Compensation Committee decided to accelerate the vesting schedule of these options primarily as a supplement to compensation due to the expected reduction of cash bonuses to employees for the 2004 calendar year. The bonus formula established by the Company in January 2004 resulted in reduced 2004 bonuses for many LKQ employees as compared to 2003. In addition, the Compensation Committee decided it was in the best interests of stockholders to accelerate these options as the Company will avoid compensation expense in future periods that would otherwise result from the effectiveness of SFAS 123R for periods beginning subsequent to December 31, 2005.

 

On January 28, 2005, the Company’s Board of Directors granted options to purchase a total of 300,000 shares of LKQ common stock at an exercise price of $16.66 per share. The options were immediately exercisable with respect to all of the shares subject to the options. This vesting schedule is different than the typical vesting schedule for options granted under the Equity Incentive Plan.

 

Note 8.  Long-Term Obligations

 

Long-Term Obligations consist of the following:

 

		March 31,			December 31,
		2005			2004
		(in thousands)
Revolving credit facility		$	56,000		$	47,000
Notes payable to individuals in monthly installments through November 2010, interest at 3.0% to 10.0%		3,090			3,242
Secured equipment note, payable in monthly installments through July 2008		19			20
		59,109			50,262
Less current maturities		(220		)	(317		)
		$	58,889		$	49,945

 

On February 17, 2004, the Company entered into a new unsecured revolving credit facility that matures in February 2007, replacing a secured credit facility that would have expired on June 30, 2005. As a result, the Company recorded a loss of $346,000 in 2004 from the write-off of debt issuance costs related to the previous secured facility. The new revolving credit facility initially had a maximum availability of $75.0 million, which was amended to $100.0 million on January 31, 2005. In order to make any borrowing under the revolving credit facility, after giving effect to such borrowing, the Company must be in compliance with all of the covenants under the credit facility, including, without limitation, a senior debt to EBITDA ratio which cannot exceed 2.50 to 1.00. The revolving credit facility contains customary covenants,

 

9

 

including, among other things, limitations on the payment of cash dividends, restrictions on the payment of other dividends and on purchases, redemptions and acquisitions of the Company’s stock, limitations on additional indebtedness, certain limitations on acquisitions, mergers and consolidations, and the maintenance of certain financial ratios.  The interest rate on advances under the revolving credit facility may be either the bank prime lending rate, on the one hand, or the Interbank Offering Rate (“IBOR”) plus an additional percentage ranging from .875% to 1.375%, on the other hand, at the Company’s option. The percentage added to IBOR is dependent upon the Company’s total funded debt to EBITDA ratio for the trailing four quarters. The Company was in compliance with all covenants throughout 2005 and 2004. The weighted-average interest rate on borrowings outstanding against the Company’s credit facility at March 31, 2005 and December 31, 2004 was 4.06% and 3.16%, respectively. Borrowings against the credit facility totaled $56.0 million and $47.0 million at March 31, 2005 and December 31, 2004, respectively, and are classified as long-term obligations.

 

Note 9. Commitments and Contingencies

 

The Company is 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 March 31, 2005 are as follows:

 

		(in thousands)
Nine months ended December 31, 2005		$	8,335
Years ended December 31:
2006		9,427
2007		8,627
2008		7,413
2009		3,715
2010		986
Thereafter		2,790
		$	41,293

 

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

 

Note 10. Earnings Per Share

 

The following chart sets forth the computation of earnings per share:

 

		Three Months Ended
		March 31,
		2005			2004
		(in thousands, except per share amounts)
Net income		$	8,401		$	5,635
Denominator for basic earnings per share-Weighted-average shares outstanding		20,631			19,643
Effect of dilutive securities:
Stock options		894			936
Warrants		1,167			1,602
Denominator for diluted earnings per share-Adjusted weighted-average shares outstanding		22,692			22,181
Earnings per share, basic		$	0.41		$	0.29
Earnings per share, diluted		$	0.37		$	0.25

 

10

 

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

 

		Three Months Ended March 31,
		2005			2004
		(in thousands)
Antidilutive securities:
Stock options		260			200
Warrants		—			100

 

Note 11.  Business Combinations

 

During the three month period ended March 31, 2004, the Company acquired a 100% equity interest in each of three businesses (two in the recycled OEM automotive parts business and, on February 20, 2004, Global Trade Alliance, Inc., one of the largest suppliers of aftermarket collision automotive replacement parts in the Midwest) for an aggregate of $41.9 million in cash, of which $2.3 million was to be paid subsequent to March 31, 2004, and 123,296 shares of the Company’s common stock.  The acquisitions enabled the Company to serve new market areas, become a significant provider of aftermarket automotive collision parts and become a provider of self-service retail automotive parts.

 

On January 31, 2005, the Company acquired Bodymaster Auto Parts, Inc. and an affiliated company  (“Bodymaster”) that operate in the aftermarket collision automotive replacement parts business for an aggregate of $15.8 million in cash.  The acquisition enables the Company to serve new market areas. In connection with the acquisition of Bodymaster, the Company held $0.6 million in restricted cash. In accordance with the terms of the purchase agreement, the restrictions will be removed by January 31, 2006 or the Company will be reimbursed from funds currently held in escrow. During the quarter ended March 31, 2005, the amount of cash restricted was reduced by $0.1 million.

 

The acquisitions are being accounted for under the purchase method of accounting and are included in the Company’s financial statements from the dates of acquisition.

 

11

 

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed for the acquisitions completed during the three months ended March 31, 2005 and 2004. The initial purchase price allocations may be adjusted within one year of the purchase date for changes in estimates of the fair value of assets acquired and liabilities assumed.

 

		2005			2004
		(in thousands)
Restricted cash		$	599		$	—
Receivables, net		825			2,229
Inventory		4,277			7,672
Prepaid expenses		37			221
Property and equipment		390			4,882
Goodwill		12,336			35,901
Other intangibles		49			—
Deferred tax assets		—			758
Other assets		40			69
Current liabilities assumed		(2,738		)	(7,049		)
Long-term obligations assumed		—			(495		)
Notes issued		—			(2,250		)
Purchase price payable		—			(50		)
Common stock issued		—			(2,250		)
Cash used in acquisitions, net of cash acquired		$	15,815		$	39,638

 

The Company recorded goodwill of $12.3 million during the three month period ended March 31, 2005, all of which is expected to be deductible for income tax purposes.  Of the $35.9 million of goodwill recorded during the three month period ended March 31, 2004, $3.9 million is expected to be deductible for income tax purposes.

 

12

 

The following pro forma summary presents the effect of the businesses acquired during 2005 and 2004 as though the businesses had been acquired as of January 1, 2004 and is based upon unaudited financial information of the acquired entities:

 

		Three Months Ended March 31,
		2005			2004
		(in thousands, except per share amounts)
Revenue as reported		$	133,807		$	100,073
Revenue of purchased businesses for the period prior to acquisition		1,749			22,647
Pro forma revenue		$	135,556		$	122,720
Net income as reported		$	8,401		$	5,635
Net income of purchased businesses for the period prior to acquisition		21			1,133
Pro forma net income		$	8,422		$	6,768
Earnings per share-basic
As reported		$	0.41		$	0.29
Effect of purchased businesses for the period prior to acquisition		0.00			0.05
Pro forma earnings per share-basic		$	0.41		$	0.34
Earnings per share-diluted
As reported		$	0.37		$	0.25
Effect of purchased businesses for the period prior to acquisition		0.00			0.05
Pro forma earnings per share-diluted		$	0.37		$	0.30

 

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.

 

Note12.  Subsequent Events

 

In April 2005, the Company acquired 100% equity interests in two companies, one in the recycled OEM automotive parts business in South Carolina and one in the self-service retail automotive parts business in Tennessee, for an aggregate of approximately $7.8 million in cash and $0.3 million in notes issued.  The acquisitions enable the Company to serve new market areas.

 

13

 

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

 

Overview

 

The repair of automobiles includes the purchase of automotive replacement parts. Buyers of replacement parts have the option to purchase from primarily three sources: new parts produced by original equipment manufacturers, which are commonly known as OEM parts; new parts produced by companies other than the OEM’s, sometimes referred to generically as “aftermarket” parts; and recycled parts originally produced by OEM’s, which we refer to as recycled OEM products. We have historically sold primarily recycled OEM products. In 2004, we expanded our product lines to include aftermarket collision automotive replacement parts. We believe that this expansion of our product offerings will allow us to fill more of our customers’ requests.

 

Since our formation in 1998, we have grown through both internal development and acquisitions. For the first 18 months of our existence, we focused on growth through acquisitions. Our acquisition strategy has been to target companies with strong management teams, a record of environmental compliance, solid growth prospects and a reputation for quality and customer service.

 

Internal growth is an important driver of our revenue and operating results. Since 1999, we have continued to focus on growing our recycled product sales and operating results within our existing organization. We have done so by developing our regional distribution networks and by creating overnight product transfers between our facilities to better leverage our inventory investment and to increase our ability to fill customer demand.

 

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. Factors that may affect our operating results include, but are not limited to:

 

•                  fluctuations in the pricing of new OEM replacement parts;

 

•                  the availability and cost of inventory;

 

•                  variations in vehicle accident rates;

 

•                  increasing competition in the automotive parts industry;

 

•                  changes in state or federal laws or regulations affecting our business

 

•                  changes in the types of replacement parts that insurance carriers will accept in the repair process;

 

•                  our ability to integrate and manage our acquisitions successfully;

 

•                  fluctuations in fuel prices;

 

•                  changes in the demand for our products and the supply of our inventory due to severity of weather and seasonality of weather patterns;

 

•                  the amount and timing of operating costs and capital expenditures relating to the maintenance and expansion of our business, operations and infrastructure; and

 

•                  declines in the value of our assets.

 

Due to the foregoing factors, our operating results in one or more future periods can be expected to fluctuate. Accordingly, our results of operations may not be indicative of future performance.

 

Sources of Revenue

 

Our revenue from the sale of automotive replacement products and related services has typically ranged between 91% and 93% of our total revenue. We sell the majority of our automotive replacement products to collision repair shops and mechanical repair shops. Our automotive replacement products include, for example, engines, transmissions, front-ends, doors, trunk lids, bumpers, hoods, fenders, grilles, valances, headlights and taillights. 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. 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. We provide insurance companies services that 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 part prices and the age of the vehicle being repaired. The pricing for aftermarket collision automotive replacement parts is determined based on a number of factors, including availability, quality, demand, new OEM replacement part prices and competitor pricing.

 

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Approximately 7% to 9% of our revenue is obtained from other sources. These include bulk sales to mechanical remanufacturers, scrap sales and sales of damaged vehicles that we sell to vehicle repairers.

 

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 fees, storage, and towing. Our cost of goods sold also includes other costs such as labor and other costs we incur to acquire and dismantle such vehicles. Our labor and labor-related costs related to buying and dismantling account for approximately 10% of our salvage cost of goods sold. 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 collision automotive replacement parts includes the price we pay for the parts, freight and other inventoried costs such as labor and other costs to acquire, including import fees and duties, where applicable. Our aftermarket collision automotive replacement parts are acquired from a number of vendors located primarily overseas, with the majority of our overseas vendors located in Taiwan.

 

In the event we do not have a recycled replacement part or suitable aftermarket replacement part in our inventory, we attempt to purchase the part from a competitor. We refer to these parts as brokered parts. The revenue from products that we obtain from third party recyclers to sell to our customers ranges from 7% to 10% 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. Our warranty expense is approximately 1% of our total cost of goods sold. Our warranty reserve activity during the first three months of 2005 was as follows:

 

Balance as of December 31, 2004		$	280,000
Warranty expense		634,000
Warranty claims		(634,000		)
Balance as of March 31, 2005		$	280,000

 

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 processing, redistribution, self-service and warehouse facilities. These costs include labor for both plant management and facility and warehouse personnel, 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. Personnel costs account for approximately 80% of our selling and marketing expenses. Most of our wholesale recycled 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. We are continually evaluating our sales force, developing and implementing training programs, and utilizing appropriate measurements to assess our selling effectiveness.

 

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