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 June 30, 2006
	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)

 

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, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check One):

Large accelerated filer   o

Accelerated filer   x

Non-accelerated filer   o

 

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 August 1, 2006, the registrant had issued and outstanding an aggregate of 53,123,587 shares of Common Stock.

 

 

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

LKQ CORPORATION AND SUBSIDIARIES
Unaudited Consolidated Balance Sheets
(In thousands, except share and per share data)

		June 30,			December 31,
		2006			2005
Assets
Current Assets:
Cash and equivalents		$	4,207		$	3,173
Restricted cash		—			450
Receivables, net		46,534			39,500
Inventory		130,138			103,655
Deferred income taxes		2,246			2,122
Prepaid expenses		2,697			2,437
Total Current Assets		185,822			151,337
Property and Equipment, net		113,216			97,218
Intangibles
Goodwill		229,758			181,792
Other intangibles, net		78			88
Deferred Income Taxes		1,391			2,146
Other Assets		7,127			6,845
Total Assets		$	537,392		$	439,426
Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable		$	17,592		$	15,496
Escrow liability		500			2,611
Accrued expenses
Accrued payroll-related liabilities		9,174			10,115
Accrued procurement liability		2,065			2,537
Other accrued expenses		15,465			11,062
Income taxes payable		662			819
Deferred revenue		3,812			3,440
Current portion of long-term obligations		4,601			1,481
Total Current Liabilities		53,871			47,561
Long-Term Obligations, Excluding Current Portion		102,868			45,996
Other Noncurrent Liabilities		5,905			4,032
Redeemable Common Stock, $0.01 par value, 100,000 shares issued		617			617
Commitments and Contingencies
Stockholders’ Equity:
Common stock, $0.01 par value, 500,000,000 shares authorized 52,835,244 and 51,414,314 shares issued at June 30, 2006 and December 31, 2005, respectively.		528			514
Additional paid-in capital		316,426			307,304
Warrants		—			80
Retained earnings		55,773			32,027
Accumulated other comprehensive income		1,404			1,295
Total Stockholders’ Equity		374,131			341,220
Total Liabilities and Stockholders’ Equity		$	537,392		$	439,426

 

See notes to unaudited condensed consolidated financial statements

 

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LKQ CORPORATION AND SUBSIDIARIES

Unaudited Consolidated Statements of Operations

(In thousands, except per share data)

		Three Months Ended				Six Months Ended
		June 30,				June 30,
		2006		2005		2006		2005
Revenue		$195,037		$136,023		$387,176		$269,830
Cost of goods sold		106,921		71,531		210,649		142,702
Gross margin		88,116		64,492		176,527		127,128
Facility and warehouse expenses		20,086		14,502		40,580		28,956
Distribution expenses		19,808		15,398		39,734		29,493
Selling, general and administrative expenses		24,731		18,719		49,641		36,444
Depreciation and amortization		2,893		2,063		5,629		4,029
Operating income		20,598		13,810		40,943		28,206
Other (income) expense
Interest expense		1,378		735		2,345		1,307
Interest income		(31	)	(40	)	(55	)	(58	)
Other (income) expense, net		(127	)	(78	)	(933	)	(240	)
Total other expense		1,220		617		1,357		1,009
Income before provision for income taxes		19,378		13,193		39,586		27,197
Provision for income taxes		7,716		5,566		15,840		11,169
Net income		$11,662		$7,627		$23,746		$16,028
Net income per share:
Basic		$0.22		$0.18		$0.45		$0.39
Diluted		$0.21		$0.16		$0.43		$0.35
Weighted average common shares outstanding:
Basic		52,802		41,710		52,434		41,488
Diluted		55,706		46,772		55,595		46,322

 

See notes to unaudited condensed consolidated financial statements.

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LKQ CORPORATION AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(In thousands)

 

		Six Months Ended June 30,
		2006			2005
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income		$	23,746		$	16,028
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		5,629			4,029
Share-based compensation expense		1,131			—
Deferred income taxes		559			831
(Gain) loss on sale of property and equipment		7			(214		)
Gain on sale of investment securities		(719		)	—
Other adjustments		—			42
Excess tax benefit from share-based payment arrangements		(3,861		)	—
Changes in operating assets and liabilities, net of effects from purchase transactions:
Receivables		(1,518		)	(1,893		)
Inventory		(15,365		)	(2,004		)
Income taxes payable		3,705			1,632
Other operating assets and liabilities		(253		)	1,999
Net cash provided by operating activities		13,061			20,450
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment		(16,504		)	(6,471		)
Proceeds from sale of property and equipment		77			738
Proceeds from sale of investment securities		849			—
Expenditures for intangible assets		—			(3		)
Repayment of escrow		(2,561		)	—
Decrease in restricted cash in escrow		450			132
Cash used in acquisitions		(56,254		)	(24,037		)
Net cash used in investing activities		(73,943		)	(29,641		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from the sale of common stock and warrant exercises		4,063			4,414
Excess tax benefit from share-based payment arrangements		3,861			—
Debt issuance costs		—			(300		)
Net borrowings of long-term debt		53,992			5,780
Net cash provided by financing activities		61,916			9,894
Net increase in cash and equivalents		1,034			703
Cash and equivalents, beginning of period		3,173			1,612
Cash and equivalents, end of period		$	4,207		$	2,315
Supplemental disclosure of cash flow information:
Notes issued in connection with business acquisitions		$	6,000		$	300
Cash paid for income taxes, net of refunds		11,554			8,832
Cash paid for interest		1,204			1,357

 

See notes to unaudited condensed consolidated financial statements.

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LKQ CORPORATION AND SUBSIDIARIES

Unaudited Consolidated 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			Warrants			Earnings			Income			Equity
BALANCE, December 31, 2005		51,414		$	514		$	307,304		$	80		$	32,027		$	1,295		$	341,220
Net income		—		—			—			—			23,746			—			23,746
Unrealized gain (loss) on investment in equity securities, net of tax		—		—			—			—			—			126			126
Foreign currency translation		—		—			—			—			—			(17		)	(17		)
Total comprehensive income		—		—			—			—			—			—			23,855
Stock issued as director compensation		2		—			36			—			—			—			36
Stock-based compensation expense		—		—			1,095			—			—			—			1,095
Exercise of stockholder guarantor warrants		785		8			857			(80		)	—			—			785
Exercise of stock options, including related tax benefits of $3,861		634		6			7,134			—			—			—			7,140
BALANCE, June 30, 2006		52,835		$	528		$	316,426		$	—		$	55,773		$	1,404		$	374,131

 

See notes to unaudited condensed consolidated financial statements.

 

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LKQ Corporation and Subsidiaries
Notes to Unaudited Condensed 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, 2005 filed with the Securities and Exchange Commission.

All per share amounts and the number of shares for all periods have been retroactively adjusted to reflect the two-for-one stock split declared on December 15, 2005. See Note 3 for further discussion.

Note 2. Significant Accounting Policies

Receivables

The Company has recorded a reserve for uncollectible accounts of approximately $2.6 million and $2.1 million at June 30, 2006 and December 31, 2005, respectively.

Inventory

Inventory consists of the following (in thousands):

 

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 change in the carrying amount of goodwill during the six months ended June 30, 2006 is as follows (in thousands):

 

Investments

The Company holds common shares in Keystone Automotive Industries, Inc., which are classified as an available-for-sale investment security under Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”). Accordingly, the investment is included in Other Assets at its fair value with the unrealized gain excluded from earnings and included in Accumulated other comprehensive income, net of applicable taxes. The fair value of the investment is estimated based upon the quoted market price for the securities. During March 2006, the Company sold a portion of its investment and has included the realized gain of $0.7 million in Other (income) expense.

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Escrow Liability

In February 2004, in connection with a business acquisition, the Company issued 168,690 shares of its common stock, which were to be held in escrow for a period of two years pending resolution of certain seller representation and warranty provisions specified in the purchase agreement. The terms of the agreement granted the shareholders the option to sell any or all of these shares during the escrow period, provided that all proceeds from such sale were delivered to the Company. In September 2005, the shareholders sold all such shares held in escrow and delivered $2.6 million to the Company. In February 2006, the sellers’ representation and warranty provisions were resolved, and the escrowed funds plus accrued interest at an annual rate of 3% were paid to the sellers.

In January 2005, in connection with a business acquisition, the Company held $0.6 million in restricted cash. During the quarter ended March 31, 2005, the amount of cash restricted was reduced by $0.1 million. In accordance with the terms of the purchase agreement, the restrictions were to be removed by January 31, 2006 or the Company was to be reimbursed from funds held in escrow. These restrictions were not removed by the specified date and the Company received reimbursement from the sellers of $0.5 million during the quarter ended March 31, 2006, which, pending final release of the restricted cash, the Company had included in Escrow liability. During June 2006, the remaining restrictions were removed, and in July 2006, the Company reimbursed the sellers the $0.5 million.

Income Taxes

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

Stock-Based Compensation

On January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”), requiring it to recognize expense related to the fair-value of its share-based compensation awards (see Note 4). The Company elected to use the modified prospective transition method, pursuant to which prior periods are not restated. Compensation expense for all share-based payments granted or modified after the effective date is recognized prospectively based upon the requirements of SFAS 123R, and compensation expense for all unvested share-based payments as of January 1, 2006 that were issued subsequent to the filing of the registration statement for the Company’s initial public offering in October 2003 is recognized prospectively based on the grant-date fair value estimated in accordance with the original provisions of SFAS 123, “Accounting for Stock-Based Compensation,” net of estimated forfeitures. The Company has elected to recognize compensation expense on a straight-line basis over the requisite service period of the award.

Prior to the adoption of SFAS 123R, the Company accounted for its stock compensation arrangements under the provisions of SFAS 123, as amended by SFAS 148, “Accounting for Stock-Based Compensation-Transition and Disclosures” (“SFAS 148”), which allowed the application of existing accounting rules under Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”). Under APB 25, the Company recognized compensation expense based on an award’s intrinsic value, the difference between the exercise price of the option and the fair market value of the underlying common stock at the time the options were granted. For nonqualified stock options granted with an exercise price equal to the market value of the stock on the date of grant, no compensation cost was recognized. As required by SFAS 148 prior to the adoption of SFAS 123R, the Company provided pro forma net income and pro forma earnings per share disclosures for stock-based awards, as if the fair-value-based method defined in SFAS 123 had been applied.

The following table sets forth the total stock-based compensation expense resulting from stock options included in the Company’s Unaudited Consolidated Statements of Income (in thousands):

 

 

As a result of adopting SFAS 123R on January 1, 2006, the Company’s net income for the three month and six month periods ended June 30, 2006 was $0.2 and $0.7 million lower, respectively, than if it had continued to account for share-based compensation under APB 25. If the Company had not adopted SFAS 123R, basic earnings per share for the three month and six month periods ended June 30, 2006 would have been $0.23 and $0.47 as compared to $0.22 and $0.45, respectively, and diluted earnings per share for the three month and six month periods ended June 30, 2006 would have been $0.21 and $0.44 as compared to $0.21 and $0.43, respectively .

The Company has not capitalized any stock-based compensation cost during the six months ended June 30, 2006. As of June 30, 2006,

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a total of $5.8 million in unrecognized compensation expense is expected to be recognized as follows:

Remainder of 2006		$0.8 million
2007		1.5 million
2008		1.4 million
2009		1.2 million
2010		0.9 million

 

The unrecognized compensation expense outlined above does not include the fair value of the 120,000 options expected to be granted in October 2006 under the provisions of the Stock Option and Compensation Plan for Non-Employee Directors.

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:

		Six Months Ended
		June 30,
		2006		2005
Expected life (in years)		6.4		5.8
Risk-free interest rate		4.33	%	3.94	%
Volatility		40.0	%	40.0	%
Dividend yield		0	%	0	%
Weighted average fair value of options granted		$9.18		$7.61

 

Expected life — The expected life represents the period that the Company’s stock-based awards are expected to be outstanding. Due to the limited information available regarding historical exercise experience, the Company has elected to use the simplified expected term method as permitted by the Securities and Exchange Commission Staff Accounting Bulletin No. 107.

Risk-free interest rate — The Company bases the risk free interest rate used in the Black-Scholes option-pricing model on the implied yield currently available on U.S. Treasury zero-coupon issues with the same or a substantially equivalent remaining term.

Expected volatility — The Company uses the trading history and historical volatility of its common stock, and because of limited historical data available on the price of its own publicly traded shares, the volatility of similar entities whose share prices are publicly available, in determining an estimated volatility factor for the Black-Scholes option-pricing model.

Expected dividend yield — The Company has not declared and has no plans to declare dividends and has therefore used a zero value for the expected dividend yield in the Black-Scholes option-pricing model.

Estimated forfeitures — When estimating forfeitures, the Company considers voluntary and involuntary termination behavior as well as analysis of its historical option forfeitures.

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 the effect of accelerating the vesting schedules of certain options granted in 2004 and 2005 (in thousands, except per share amounts):

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		Three Months			Six Months
		Ended			Ended
		June 30, 2005			June 30, 2005
Net income, as reported		$	7,627		$	16,028
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		(438		)	(4,153		)
Pro forma net income		$	7,189		$	11,900
Earnings per share:
Basic — as reported		$	0.18		$	0.39
Basic — pro forma		$	0.17		$	0.29
Diluted — as reported		$	0.16		$	0.35
Diluted — pro forma		$	0.15		$	0.26

 

Prior to the adoption of SFAS 123R, the Company included all tax benefits associated with share-based compensation as operating cash flows in the Statement of Cash Flows. SFAS 123R requires any reduction in taxes payable resulting from tax deductions that exceed the recognized compensation expense (excess tax benefits) to be classified as financing cash flows. The Company has included $3.9 million of excess tax benefits in its cash flows from financing activities for the six months ended June 30, 2006. During the six months ended June 30, 2005, excess tax benefits of $1.9 million were included in net cash provided by operating activities.

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 has adopted SFAS 151 and its adoption did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”). SFAS 154 replaces Accounting Principles Board Opinion No. 20 “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements-An Amendment of APB Opinion No. 28.” SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. SFAS 154 requires “retrospective application” of the direct effect of a voluntary change in accounting principle to prior periods’ financial statements where it is practicable to do so. SFAS 154 also redefines the term “restatement” to mean the correction of an error by revising previously issued financial statements. SFAS 154 is effective for accounting changes and error corrections made in fiscal years beginning after December 15, 2005 unless adopted early. The Company has adopted SFAS 154 and its adoption did not have a material impact on the Company’s consolidated financial position, results of operations or cash flows, except to the extent that the statement subsequently requires retrospective application of a future item.

In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 provides guidance on the measurement, recognition, and disclosure of tax positions taken or expected to be taken in a tax return and requires that a tax position should only be recognized if it is more likely than not that the position will be sustained upon examination by the appropriate taxing authority. FIN 48 also provides guidance on derecognition, classification, interest and penalties, transition and disclosure. The cumulative effect of applying the provisions of FIN 48 will be reported as an adjustment of beginning retained earnings in the period of adoption. FIN 48 is effective for the Company’s fiscal year beginning January 1, 2007. The Company is currently assessing the impact of FIN 48 on the Company’s consolidated financial position, results of operations and cash flows.

Note 3. Capital Structure

On February 14, 2001, the Company issued warrants to purchase 3,922,224 shares of its common stock at an exercise price of $1.00 per share to certain stockholder guarantors in exchange for their guaranty of $10 million of the debt outstanding under the Company’s credit agreement. The warrants became exercisable upon issuance and were to expire on February 14, 2006. Warrants to purchase 785,072 shares of the Company’s stock were outstanding at December 31, 2005, all of which were exercised prior to the expiration date. The stockholder guaranties were cancelled in June 2002 when the Company entered into a new credit facility.

On December 15, 2005, the Company’s Board of Directors approved a two-for-one split of the Company’s common stock (in the form of a stock dividend). Each stockholder of record at the close of business on January 3, 2006 received an additional share of common stock for every outstanding share held. The payment date was January 13, 2006, and the common stock began trading on a split-adjusted basis on January 17, 2006.

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Note 4. Stock-Based Compensation Plans

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”).

A summary of transactions in the Company’s stock-based compensation plans for the six months ended June 30, 2006 is as follows:

 

The total intrinsic value of stock options exercised was $10.1 million during the six months ended June 30, 2006. There were 0.8 million stock options exercised during the six months ended June 30, 2005 with an intrinsic value of $4.8 million.

The following table summarizes information about outstanding and exercisable stock options at June 30, 2006:

		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
$1.50		322,200		4.6		$    1.50		322,200		4.6		$         1.50
4.00 -5.00		1,682,210		5.5		4.31		1,059,200		5.1		4.36
6.25 -7.50		2,230,400		4.5		6.92		2,026,650		4.2		6.96
7.92 -9.44		2,499,573		8.1		8.86		2,135,928		8.1		8.87
15.13 - 17.28		136,000		9.3		15.37		121,600		9.3		15.21
18.68 - 21.70		475,400		9.6		19.59		2,000		9.5		19.51
		7,345,783		6.4		$    7.72		5,667,578		6.0		$         7.06

 

The aggregate intrinsic value of outstanding and exercisable stock options at June 30, 2006 is $82.8 million and $67.6 million, respectively.

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. The Company expects to issue new shares of common stock to cover future stock option exercises.

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 844,000 shares of LKQ common stock with an exercise price of $8.84 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 857,000 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 600,000 shares of LKQ common stock at an exercise price of $8.33 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.

On March 3, 2005, the Company’s Board of Directors authorized the submission to the Company’s stockholders of an amendment to the Equity Incentive Plan to increase the shares reserved for issuance under the plan from 10,000,000 to 14,000,000. The amendment was approved by the Company’s stockholders on May 9, 2005.

On January 13, 2006, the Company’s Board of Directors granted options to employees to purchase a total of 461,600 shares of LKQ common stock at an exercise price of $19.51 per share. The options vest over a period of five years.

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Note 5.   Long-Term Obligations

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

 

On February 17, 2004, the Company entered into a new unsecured revolving credit facility that originally was scheduled to mature in February 2007, replacing a secured credit facility that would have expired on June 30, 2005. 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. On June 1, 2005, the agreement was further amended to increase the maximum availability to $135.0 million, to extend the maturity date to June 1, 2010 and to modify certain other terms. 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 3.00 to 1.00. The revolving credit facility contains customary covenants, 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 1.625%, 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 2006 and 2005.

The weighted-average interest rate on borrowings outstanding against the Company’s credit facility at June 30, 2006 and December 31, 2005 was 6.34% and 7.25%, respectively. Borrowings against the credit facility totaled $93.0 million and $38.0 million at June 30, 2006 and December 31, 2005, respectively, and are classified as long-term obligations.

During the six months ended June 30, 2006, as part of the consideration for business acquisitions completed during the period, the Company issued promissory notes totaling approximately $6.0 million. The notes bear interest at annual rates of 3.5 % to 5.0%, and interest is payable at maturity.  In February 2006, at the request of the holder of one of the notes, the Company made a principal payment of approximately $0.5 million on such note, subject to the conditions that the holder use the funds to invest in the common stock of the Company and that the shares purchased be deposited with the Company as collateral for the accuracy of certain seller representation and warranty provisions specified in the purchase agreement.  The holder delivered 23,900 shares of the Company’s common stock to the Company as part of this arrangement.

Note 6.   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 June 30, 2006 are as follows (in thousands):

 

 

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.

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Note 7.   Earnings Per Share

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

 

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):

 

 

Note 8.   Business Combinations

During the six month period ended June 30, 2006, the Company acquired a 100% equity interest in each of eight businesses (six in the recycled OEM automotive parts business, one in the aftermarket automotive parts business and, on January 31, 2006, Transwheel Corporation, an aluminum alloy wheel refurbishing and distribution business) for an aggregate of $56.8 million in cash, of which $0.6 million is to be paid subsequent to June 30, 2006, and $6.0 million in notes issued. The acquisitions enabled the Company to serve new market areas and become a significant provider of refurbished wheels.

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.  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 June 30, 2005, the purchase price allocations are preliminary as the Company is 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 its inventories acquired; and 3) the final estimation of the tax basis of the entities acquired. During the six months ended June 30, 2006, the Company made adjustments to the preliminary purchase allocations to finalize the inventory valuations and the estimated tax basis for certain of the businesses acquired in 2005. These adjustments increased goodwill related to these 2005 acquisitions by $1.1 million.

The purchase price allocations for the acquisitions completed during the six months ended June 30, 2006 and 2005 are as follows (in thousands):

 

 

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The Company recorded goodwill of $48.0 million and $17.9 million during the six month periods ended June 30, 2006 and 2005, respectively, of which $46.0 million and $17.9 million is expected to be deductible for income tax purposes, respectively.

The following pro forma summary presents the effect of the businesses acquired during 2006 and 2005 as though the businesses had been acquired as of January 1, 2005 and is based upon unaudited financial information of the acquired entities (in thousands, except per share data):

 

 

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.   Long Term Incentive Plan

On January 26, 2006, the Company’s Board of Directors approved, and the Company’s stockholders approved at the annual meeting on May 8, 2006, the LKQ Corporation Long Term Incentive Plan. The purpose of the Long Term Incentive Plan is to offer certain key employees the opportunity to receive long term performance rewards.  Each participant will be entitled to a performance award for each performance period under the plan. Performance periods will begin on January 1 and end on December 31 of the third calendar year thereafter. One half of any performance award achieved is payable promptly after the end of the performance period. A participant must be an employee of the Company throughout the performance period to be eligible for the first 50% payment.  The other half of the performance award is deferred and payable in three equal installments on each one year anniversary of the end of the performance period over a total of three years.  A participant must be an employee on each such anniversary date to be eligible for the respective deferred payment, unless the participant is not an employee as a result of death, total disability or normal retirement at age 65, in which case the participant (or his or her estate) will be entitled to all of the deferred payments upon such death, disability or retirement. Interest on the deferred portion of the performance award will accrue at the prime rate and be payable to the participant at the same time as the deferred installments are paid. During the six months ended June 30, 2006, the Company has recorded expense related to this plan totaling approximately $0.8 million.

Note 10.   Subsequent Events

In July 2006, the Company acquired a recycled OEM automotive parts self-serve retail business with locations in Aurora, Colorado

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and Daytona Beach, Florida. This business acquisition enables the Company to expand its presence in an existing market and serve a new market area.

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 light vehicles (cars and light trucks). Buyers of light vehicle replacement products have the option to purchase from primarily three 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 generically as “aftermarket” products; and recycled products originally produced by OEMs, which we refer to as recycled OEM products. We participate in the market 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 light vehicle repair market. In the first six months of 2006, we completed an acquisition in the wheel refurbishment and distribution business, with four locations for the refurbishment and distribution of wheels and two additional distribution locations. This acquisition allowed us to expand our product

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offerings to our customers. We also acquired one aftermarket products company and six recycled OEM automotive parts businesses (three in the self-serve retail business, one serving the professional repair market and two serving both the self-serve retail and professional repair markets) in the first six months of 2006.  In July 2006, we acquired a recycled OEM automotive parts business in the self-serve retail business. These business acquisitions enable us to expand our presence in existing markets and serve new market areas. We are not involved in the manufacture of automotive products and do not maintain any manufacturing or remanufacturing operations.

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 products;

·       the availability and cost of inventory;

·       variations in vehicle accident rates;

·       competition in the vehicle replacement 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 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. We focus on companies that will expand our geographic presence and our ability to provide a wider choice of alternative light vehicle replacement products and services to our customers.

Sources of Revenue

Since 2004, our revenue from the sale of light vehicle replacement products and related services has ranged between 83% and 92% of our total revenue. We sell the majority of our light vehicle replacement products to collision repair shops and mechanical repair shops. Our light vehicle 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 product prices, the age of the vehicle being repaired, and competitor pricing. The pricing for aftermarket products and refurbished wheels is determined based on a number of factors, including availability, quality, demand, new OEM replacement product prices, and competitor pricing.

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Since 2004, approximately 8% to 17% of our revenue has been 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, storage, and towing fees. Our cost of goods sold also includes labor and other costs we incur to acquire and dismantle such vehicles. Since 2004, our labor and labor-related costs related to acquisition and dismantling have accounted for approximately 10% of our cost of goods sold for vehicles we dismantle. 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 located primarily overseas, with the majority of our overseas vendors located in Taiwan. Our cost of goods sold for refurbished wheels includes the price we pay for wheel cores, freight, and costs to refurbish the wheels, including overhead costs.

In the event we do not have a recycled OEM product or suitable aftermarket product in our inventory, we attempt to purchase the part from a competitor. We refer to these parts as brokered products. Since 2004, the revenue from brokered products that we sell to our customers has ranged from 5% 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 six months of 2006 was as follows:

 

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, 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 2004, personnel costs have accounted for approximately 75% 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,

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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 related accidents. In addition, the cost of salvage vehicles tends to be lower as more weather related accidents generate a larger supply of total loss vehicles.

Critical Accounting Policies and Estimates

The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. 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. On an ongoing basis, we evaluate our estimates, assumptions, and judgments, including those related to revenue recognition, warranty costs, inventory valuation, allowance for doubtful accounts, goodwill impairments, self-insurance programs, contingencies, asset impairments, stock-based compensation, and taxes. We base our estimates on historical experience and on various other assumptions that we believe are reasonable under the circumstances. The results of these estimates form the basis for our judgments about the carrying values of assets and liabilities and our recognition of revenue. Actual results may differ from these estimates.

Revenue Recognition

We recognize and report revenue from the sale of light vehicle replacement products when they are delivered and title has transferred, subject to a reserve for returns, discounts, and allowances that management estimates based upon historical information. A replacement product would ordinarily be returned within a few days of shipment. Our customers may earn discounts based upon sales volumes or sales volumes coupled with prompt payment. Allowances are normally given within a few days following product shipment. We analyze historical returns and allowances activity by comparing the items to the original invoice amounts and dates. We use this information to project future returns and allowances on products sold.

We also sell separately priced extended warranty contracts for certain mechanical products. Revenue from these contracts is deferred and recognized ratably over the term of the contracts.

Warranty Reserves

We issue a standard six-month warranty against defects on some of our mechanical products. We record an accrual for standard warranty claims at the time of sale using historical warranty claim information to project future warranty claims activity and related expenses. We analyze historical warranty claim activity by referencing the claims made and aging them from the original product sale date. We use this information to project future warranty claims on actual products sold that are still under warranty at the end of an accounting period. A 10% increase in our historical 2005 annual warranty claims would result in an additional annual expense of approximately $0.2 million.

Inventory Accounting

Salvage Inventory. Salvage inventory is recorded at the lower of cost or market. Our salvage inventory cost is established based upon the price we pay for a vehicle, and includes buying; dismantling; and, where applicable, auction, storage, and towing fees. Inventory carrying value is determined using the average cost to sales percentage at each of our facilities and applying that percentage to the facility’s inventory at expected selling prices. The average cost to sales percentage is derived from each facility’s historical vehicle profitability for salvage vehicles purchased at auction or from contracted rates for salvage vehicles acquired under direct procurement arrangements.

Aftermarket and Refurbished Wheel Inventory. Aftermarket and refurbished wheel inventory is recorded at the lower of cost or market. Our aftermarket inventory cost is based on the average price we pay for parts, and includes expenses incurred for freight and buying, where applicable. For items purchased from foreign sources, import fees and duties and transportation insurance are also included. Our refurbished wheel inventory cost is based on the average price we pay for wheel cores, and includes expenses incurred for freight, buying and refurbishing overhead.

For all inventory, our carrying value is reduced regularly to reflect the age and current anticipated demand for our products. If actual demand differs from our estimates, additional reductions to our inventory carrying value would be necessary in the period such determination is made.

 

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