Forward-Looking Statements Statements and information in this Quarterly Report on Form 10-Q that are not historical are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and are made pursuant to the "safe harbor" provisions of such Act. Forward-looking statements include, but are not limited to, statements regarding our outlook, guidance, expectations, beliefs, hopes, intentions and strategies. Words such as "may," "will," "plan," "should," "expect," "anticipate," "believe," "if," "estimate," "intend," "project" and similar words or expressions are used to identify these forward-looking statements. These statements are subject to a number of risks, uncertainties, assumptions and other factors, including the unfavorable effects of COVID-19, that may cause our actual results, performance or achievements to be materially different. All forward-looking statements are based on information available to us at the time the statements are made. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by law. You should not place undue reliance on our forward-looking statements. Actual events or results may differ materially from those expressed or implied in the forward-looking statements. The risks, uncertainties, assumptions and other factors that could cause actual results to differ from the results predicted or implied by our forward-looking statements include factors discussed in our filings with theSEC , including those disclosed under the captions "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our 2019 Form 10-K and in our subsequent Quarterly Reports on Form 10-Q (including this Quarterly Report). Overview We are a global distributor of vehicle products, including replacement parts, components and systems used in the repair and maintenance of vehicles, and specialty products and accessories to improve the performance, functionality and appearance of vehicles. Buyers of vehicle replacement products have the option to purchase from primarily five sources: new products produced by OEMs; new products produced by companies other than the OEMs, which are referred to as aftermarket products; recycled products obtained from salvage and total loss vehicles; recycled products that have been refurbished; and recycled products that have been remanufactured. We distribute a variety of products to collision and mechanical repair shops, including aftermarket collision and mechanical products; recycled collision and mechanical products; refurbished collision products such as wheels, bumper covers and lights; and remanufactured engines and transmissions. Collectively, we refer to the four sources that are not new OEM products as alternative parts. We are a leading provider of alternative vehicle collision replacement products and alternative vehicle mechanical replacement products, with our sales, processing, and distribution facilities reaching most major markets inthe United States andCanada . We are also a leading provider of alternative vehicle replacement and maintenance products inGermany , theUnited Kingdom , the Benelux region (Belgium ,Netherlands , and Luxembourg),Italy ,Czech Republic ,Austria ,Slovakia ,Poland , and various other European countries. In addition to our wholesale operations, we operate self service retail facilities across theU.S. that sell recycled automotive products from end-of-life-vehicles. We are also a leading distributor of specialty vehicle aftermarket equipment and accessories reaching most major markets in theU.S. andCanada . We are organized into four operating segments: Wholesale -North America ;Europe ; Specialty and Self Service. We aggregate our Wholesale -North America and Self Service operating segments into one reportable segment,North America , resulting in three reportable segments:North America ,Europe and Specialty. Our 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 factors referred to in Forward-Looking Statements above. Due to these factors and others, which may be unknown to us at this time, 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 and Investments Since our inception in 1998, we have pursued a growth strategy through both organic growth and acquisitions. We have pursued acquisitions that we believe will help drive profitability, cash flow and stockholder value. We target companies that are market leaders, will expand our geographic presence and will enhance our ability to provide a wide array of vehicle products to our customers through our distribution network. See "Investments in Unconsolidated Subsidiaries" in Note 3, "Financial Statement Information," to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to our investments. 33
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Sources of Revenue We report our revenue in two categories: (i) parts and services and (ii) other. Our parts revenue is generated from the sale of vehicle products, including replacement parts, components and systems used in the repair and maintenance of vehicles, and specialty products and accessories to improve the performance, functionality and appearance of vehicles. Our service revenue is generated primarily from the sale of service-type warranties, fees for admission to our self service yards, and diagnostic and repair services. Revenue from other sources includes scrap sales, bulk sales to mechanical manufacturers (including cores) and sales of aluminum ingots and sows from our furnace operations. Other revenue will vary from period to period based on fluctuations in commodity prices and the volume of materials sold. See Note 4, "Revenue Recognition" to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to our sources of revenue. Critical Accounting Policies and Estimates The discussion and analysis of our financial condition and results of operations are based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these financial statements requires us to make estimates, assumptions and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. Our 2019 Form 10-K includes a summary of the critical accounting policies and estimates we believe are the most important to aid in understanding our financial results. Other than as described below, there have been no changes to those critical accounting policies or estimates that have had a material impact on our reported amounts of assets, liabilities, revenue or expenses during the six months endedJune 30, 2020 . COVID-19 Projections and Assumptions In the first and second quarters of 2020, we prepared forecasts of future revenues, profits and cash flows to use in multiple analyses, including the interim goodwill impairment test, other impairment tests of long-lived assets, assessments of the recoverability of inventory, determination of customer and supplier rebate balances, calculation of the annual effective tax rate and evaluations of the realizability of deferred tax assets. Our first quarter projections assumed that the COVID-19 impact would be severe, with revenue down in the second quarter of 2020 compared to our prior forecasts, but temporary, as revenue would improve gradually in the second half of 2020. We expected that cost mitigation actions would dampen the negative impact of the projected revenue decline but still result in a significant reduction in profitability in the second quarter of 2020. Actual results for the three months endedJune 30, 2020 tracked in the same direction as our forecast, but the decline was significantly less severe than projected. Our updated forecasts for use in preparing theJune 30 financial statements reflect a further recovery in revenue and profitability in the second half but with amounts still below the comparable prior year period. We expect to generate positive free cash flows in the second half of 2020 but at a lower level than the first half of the year. As the economic impact of the pandemic is dependent on variables that are difficult to project and in many cases are outside of our control, it is possible that the estimates underlying our analyses may change materially in future periods. This is particularly the case because it appears that the prevalence of the virus outbreak fluctuates depending on various factors, including the level of economic and social activity in a region.Goodwill and Indefinite-Lived Intangibles Impairment We are required to test goodwill and indefinite-lived intangible assets for impairment at least annually and between annual tests whenever events indicate that an impairment may exist. When testing goodwill for impairment, we are required to evaluate events and circumstances that may affect the performance of the reporting unit and the extent to which the events and circumstances may impact the future cash flows of the reporting unit to determine whether the fair value of the assets exceeds the carrying value. Developing the estimated future cash flows and fair value of the reporting unit requires management's judgment in projecting revenues and profits, allocation of shared corporate costs, tax rates, capital expenditures, working capital requirements, discount rates and market multiples. Many of the factors used in assessing fair value are outside the control of management, and it is reasonably likely that assumptions and estimates can change in future periods. If these assumptions or estimates change in the future, we may be required to record impairment charges for these assets. In response to changes in industry and market conditions, we may be required to strategically realign our resources and consider restructuring, disposing of, or otherwise exiting businesses, which could result in an impairment of goodwill. Our goodwill impairment assessment is performed at the reporting unit level. A reporting unit is an operating segment, or a business one level below an operating segment (the "component" level), for which discrete financial information is prepared and regularly reviewed by segment management. However, components are aggregated as a single reporting unit if they have similar economic characteristics. For the purpose of aggregating our components into reporting units, we review the long-term performance of Segment EBITDA. Additionally, we review qualitative factors such as type or class of customers, nature of products, distribution methods, inventory procurement methods, level of integration, and interdependency of 34
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processes across components. Our assessment of the aggregation includes both qualitative and quantitative factors and is based on the facts and circumstances specific to the components. We have four operating segments: Wholesale -North America ,Europe , Specialty and Self Service. Each of these operating segments consists of multiple components that have discrete financial information available that is reviewed by segment management on a regular basis. We have evaluated these components and concluded that the components that compose each of the Wholesale -North America ,Europe , Specialty, and Self Service operating segments are economically similar and thus were aggregated into those four separate reporting units for our interim goodwill impairment test in the first quarter of 2020. Our goodwill would be considered impaired if the carrying value of a reporting unit exceeded its estimated fair value. The fair value estimates are established using weightings of the results of a discounted cash flow methodology and a comparative market multiples approach. We believe that using two methods to determine fair value limits the chances of an unrepresentative valuation. Discount rates, growth rates and cash flow projections are the assumptions that are most sensitive and susceptible to change as they require significant management judgment. Impairment may result from, among other things, deterioration in the performance of our reporting units' businesses, increases in our cost of capital, adverse market conditions, and adverse changes in applicable laws or regulations, including modifications that restrict the activities of our reporting units' businesses. To assess the reasonableness of the fair value estimates, we compare the sum of the reporting units' fair values to the Company's market capitalization and calculate an implied control premium, which is then evaluated against recent market transactions in our industry, or in the case of our interim test against transactions during the 2008-2009 financial crisis. If we were required to recognize goodwill impairments, we would report those impairment losses as part of our operating results. We determined no impairments existed on any of our four reporting units when we performed our interim goodwill impairment testing in the first quarter of 2020, as each of those reporting units had a fair value estimate that exceeded the carrying value by at least 12%, the level at which ourEurope reporting unit exceeded its carrying value. We did not identify a triggering event in the second quarter that necessitated an interim test of goodwill impairment. See Note 3, "Financial Statement Information" to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information related to our interim goodwill impairment test. We review indefinite-lived intangible assets for impairment annually or on an interim basis if events or changes in circumstances indicate that the carrying value may not be recoverable. We determined that the effect of the uncertainty relating to the COVID-19 pandemic on our forecasted results represented a change in circumstances indicating that the carrying value of the Warn trademark, which is our only indefinite-lived intangible asset, may not be recoverable. As a result, we performed a quantitative impairment test in the first quarter as ofMarch 31, 2020 using the relief-from-royalty method and determined no impairment existed, as the trademark had a fair value estimate which exceeded the carrying value by approximately 9%. We did not identify a triggering event in the second quarter that necessitated an interim test of impairment. Recently Issued Accounting Pronouncements See "Recent Accounting Pronouncements" in Note 3, "Financial Statement Information" to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for information related to new accounting standards. Financial Information by Geographic Area See Note 14, "Segment and Geographic Information" to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for information related to our revenue and long-lived assets by geographic region. 1 LKQ Europe Program We have undertaken the 1 LKQ Europe program to create structural centralization and standardization of key functions to facilitate the operation of theEurope segment as a single business. Under this multi-year program, we have recognized to date and expect to continue to recognize the following:
•Restructuring expenses - Non-recurring costs resulting directly from the implementation of the 1 LKQ Europe program from which the business will derive no ongoing benefit. See Note 5, "Restructuring and Acquisition Related Expenses" to the unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q for further details. •Transformation expenses - Period costs incurred to execute the 1 LKQ Europe program that are expected to contribute to ongoing benefits to the business (e.g. non-capitalizable implementation costs related to a common ERP system). These expenses are recorded in Selling, general and administrative expenses. •Transformation capital expenditures - Capitalizable costs for long-lived assets, such as software and facilities, that directly relate to the execution of the 1 LKQ Europe program.
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Costs related to the 1 LKQ Europe program incurred to date are reflected in Selling, general and administrative expenses and Purchases of property, plant and equipment in our unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q. We continue to expect that costs of the program, reflecting all three categories noted above, will range between$100 million and$125 million for the period from 2020 through 2021 with an additional$80 million to$100 million between 2022 and the original projected completion date of the project in 2024. Beginning in the second half of March, management delayed certain projects under the 1 LKQ Europe program to reduce expenses and preserve capital in response to the COVID-19 pandemic. Based on our expectations in the second quarter of 2020 that the impacts on our business from COVID-19 had stabilized, we restarted the program inJuly 2020 with substantially the same initiatives and projects as prior to the pandemic, although we are evaluating the impact of the delay on our estimates of the related expenditures and timelines. We may also identify additional initiatives and projects under the 1 LKQ Europe program in future periods that may result in additional expenditures, although we are currently unable to estimate the range of charges for such potential future initiatives and projects. COVID-19 Impact on Our Operations In lateFebruary 2020 , the Italian government began placing restrictions on activity as a result of the COVID-19 outbreak. Sales volumes fell as fewer cars were on the road and less maintenance activity was performed. While our Italian operation is an important part of our European business, it represented approximately 10% of the segment's revenue in 2019, and thus the disruption did not have a material impact on the Company. By mid-March, the COVID-19 impact began spreading across the rest of the geographies where we operate at a very rapid pace. Governments adopted aggressive restrictions on the operation of non-essential businesses and personal movement, which reduced miles driven and collisions. While our businesses have been deemed essential in most jurisdictions in which we operate, the change in behavior driven by the COVID-19 restrictions negatively impacted our sales volume. Our organic parts and services revenue declined by 16.8% in the second quarter of 2020, relative to the comparable prior period, but showed improvement over the quarter as governments gradually lifted restrictions for nonessential businesses and personal movement. As anticipated, April experienced the most negative revenue impact, with organic parts and services revenue (on a per day basis) down 30.3%. As movement restrictions lessened in May and June, we experienced organic parts and services revenue (on a per day basis) declines of 13.2% and 7.3%, respectively. However, the pace of improvement has flattened into July as the increasing level of COVID-19 cases, especially inthe United States , appears to have slowed the recovery. In the second half of 2020, we expect revenue to decrease on a year over year basis, but at a lower rate than reported for the first half. This expectation is based on the assumption that there will not be a recurrence in the second half of 2020 of the extensive lockdown measures taken in March and April. Such measures may materialize with the expansion of economic and social activity in a region if the prevalence of the virus outbreak increases as a result thereof. Recognizing the demand changes in the first quarter of 2020, we took action in all of our business units to reduce our cost structure. These actions included, but were not limited to, employee furloughs and reductions in force, decreases in hours and overtime, lowering compensation for salaried employees, a hiring freeze, elimination of temporary labor, route consolidation, deferral of projects, and temporary branch closures. These cost actions contributed to a reduction of approximately 18% of quarterly selling, general and administrative expenses compared to our first quarter 2020 run rate. We estimate that the cost actions generated an additional$10 million benefit in cost of goods sold. Some of the savings from the cost actions were delayed as we paid out vacation balances in April and covered medical benefits for employees inthe United States during their furlough period. We pursued certain financial assistance and relief programs that were available to us from governments inEurope andCanada , primarily in the form of grants to offset personnel expenses; throughJune 30, 2020 , we qualified for$33 million of assistance, and we estimate that we may qualify for additional assistance in the second half of 2020, but at a lower level than we received in the second quarter of 2020. However, these actions lagged the revenue impact, which meant there was a negative timing impact of COVID-19 on our first half profitability in addition to the negative effect from reduced revenue. If our revenue increases in the second half of 2020 as projected, we still expect that some of the costs that were reduced as a result of COVID-19 will remain at a lower level; the management team has been implementing productivity initiatives to create lower cost structures going forward. We also emphasized the preservation of capital with a deferral of growth driven capital projects, reductions in inventory orders, more active monitoring of customer receivables and terms, income and value added tax payment deferrals, and suspension of our share buyback program. This focus was successful as we improved our liquidity position relative toMarch 31 despite a decline in profitability. One of our top priorities is the health and safety of our employees, customers and the communities in which we operate. We are using our best efforts to follow all governmental instructions and safety guidelines with respect to the operations of our facilities. We have implemented protocols across our business units to help ensure the health and safety of our employees, customers and communities including, but not limited to: restricting access to and enhancing cleaning and disinfecting protocols of our facilities; use of personal protection equipment; adhering to social distancing guidelines; instituting remote work arrangements for many of our employees; and restricting travel. 36
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See the Results of Operations and Liquidity sections for further detail on the year over year trends.
Key Performance Indicators We believe that organic revenue growth, Segment EBITDA and free cash flow are key performance indicators for our business. Segment EBITDA is our key measure of segment profit or loss reviewed by our chief operating decision maker. Free cash flow is a financial measure that is not prepared in accordance withU.S. generally accepted accounting principles ("non-GAAP"). •Organic revenue growth - We define organic revenue growth as total revenue growth from continuing operations excluding the effects of acquisitions and divestitures (i.e. revenue generated from the date of acquisition to the first anniversary of that acquisition, net of reduced revenue due to the disposal of businesses) and foreign currency movements (i.e. impact of translating revenue at prior period exchange rates). Organic revenue growth includes incremental sales from both existing and new (i.e. opened within the last twelve months) locations and is derived from expanding business with existing customers, securing new customers and offering additional products and services. We believe that organic revenue growth is a key performance indicator as this statistic measures our ability to serve and grow our customer base successfully. •Segment EBITDA - Refer to Note 14, "Segment and Geographic Information," in Part I, Item 1 of this Form 10-Q for a description of the calculation of Segment EBITDA. We believe that Segment EBITDA provides useful information to evaluate our segment profitability by focusing on the indicators of ongoing operational results. •Free Cash Flow - We calculate free cash flow as net cash provided by operating activities, less purchases of property, plant and equipment. Free cash flow provides insight into our liquidity and provides useful information to management and investors concerning our cash flow available to meet future debt service obligations and working capital requirements, to make strategic acquisitions and to repurchase stock. These three key performance indicators are used as targets to determine incentive compensation at various levels of the organization, including senior management. By using these performance measures, we attempt to motivate a balanced approach to the business that rewards growth, profitability and cash flow generation in a manner that enhances our long-term prospects. 37
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