LKQ Corp (LKQ) 2006 Q1 法說會逐字稿

Good day ladies and gentlemen, and welcome to the LKQ Corporation earnings conference call. My name is Sarah and I will be your coordinator for today. [OPERATOR INSTRUCTIONS] I would now like to turn the call over to Mark Spears. Please proceed sir.

Thank you. Before we get started, I just want to talk about forward-looking statements. The statements in this press release and webcast include forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements regarding our expectations, beliefs, hopes, intentions or strategies.

Forward-looking statements involve risks and uncertainties, some of which are not currently known to us. Actual events of results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors. These factors includes the risk factors and other risks that are described in our Form 10-K, filed March 8th 2006 and in other reports filed by us from time to time with Securities and Exchange Commission.

We assume no obligation to publicly update any forward-looking statements to reflect events or circumstances arising after the date on which it was made except as required by the law.

Hi good morning, thanks for joining LKQ Corporations, first quarter 2006 earnings call. On the call today are two members of management, Mark Spears and myself. My name is Joe Holsten. I am the CEO of the company. I will provide some high level overview of our performance as well as some observations on the business and our industry and Mark will provide a more detailed discussion of the quarter's financial results.

As stated in our press release, we are very pleased with the Q1 performance of the company and in many of our markets we encountered record mild winter weather conditions. The fact that we exceeded prior guidance, we believe in a strong reflection on the geographic diversity of our company and the strength of our business model.

We reported $192.1 million in revenue for the first quarter, which represents close to 44% growth over Q1 in 2005 and organic revenue growth of just over 12%. Our EBITDA margin was 12.4% for the quarter compared to 12.3% in the first quarter of 2005. Had it not been for the low gross margins of our newly acquired aluminum smelter operation and Transwheel purchase accounting, our 2006 EBITDA would have been at 12.7% and Mark will go through an explanation of this in more detail later in the call.

Our net income increased close to 44% to $12.1 million for the quarter and diluted EPS increased 16% to $0.22. I might remind you that in early October 2005, we closed on a follow-on stock offering with LKQ issuing 6.4 million more shares, and this primarily accounts for the diluted EPS growth rate being less than our net income growth rate.

As we discussed on our March 2nd earnings call, we acquired four businesses in the first quarter of 2006 including three recycling businesses. We acquired Michael Auto Parts located in Orlando, Florida that serves the professional repair market. This business generated approximately $12 million of sales in 2005.

We also acquired two retail businesses, one near Charleston, South Carolina and one in Port Allen, Louisiana. These two businesses had less than $3 million of combined revenue last year. Our objective during 2006 is to grow and improve these two businesses and to build their facilities into modern self service retail facilities.

We still expect the effect of these three recycling transactions on our 2006 diluted earnings per share to be insignificant as the two retail businesses will be undergoing significant start up activities. We previously indicated and still expect these three businesses to provide between $0.01 and $0.02 of diluted earnings per share in 2007. We have been particularly pleased with the integration of Michael Auto Parts into our Florida recycling operations. During this fiscal year we will be able to close a small distribution hub, eliminate three routes, reduce our buyer workforce and leverage LKQ's better pricing to our [fair] model and catalytic converters to improve profitability.

And you know at the end of January, we entered into a new product line with the acquisition of Transwheel Corporation, an aluminum alloy wheel refurbishing and distribution business that had about $28.5 million of revenue in 2005 from the sale and restoration of wheels.

Transwheel currently operates some six locations related to wheel refurbishing and/or distribution facilities. In order for Transwheel in the past to secure a large number of quality wheel cores to refurbish, Transwheel procured large bulk shipments of used wheel cores, primarily from core brokers. After sorting out all the wheels that they could refurbish and had demand for, Transwheel would then melt the unusable wheels in a small aluminum smelter they operate. The smelter was merely used more economically disposed of the unusable product.

For the two months in the first quarter of 2006, that we owned Transwheel, the smelter's third party aluminum revenue was $4.4 million at a gross margin of about 6%.

Of course 6% gross margin reduces LKQ's over all gross margin percentage. So while at a very little margin in effect, this is nothing more in the way than to allow Transwheel to more economically obtain a greater wheel core stock than it could procure without the smelter.

As planned, we began to direct all LKQ wheel cores to Transwheel during the rest to 2006, with the addition of the LKQ wheel core, we will be evaluating the importance of the smelter operation in light of Transwheel now receiving LKQ's core wheels.

Also related to Transwheel, at the end of Q1, we note that have eliminated one of their transfer runs that overlapped with an LKQ existing product transfer truck. We vacated the Transwheel Chicago distribution facility and relocated the Transwheel operations to our Chicago packer market location.

And as we speak we are sending refurbished wheel inventory to five LKQ markets and turning on the LKQ name as a supplier of refurbished wheels and shock optimating systems in those five markets which include Alabama, Northern California, Oregon, Massachusetts and the New Jersey, New York City markets.

We made good progress in integrating the Fit-Rite aftermarket business that we acquired at the end of 2005 with our other aftermarket businesses where it made sense. In Pittsburgh we've merged the Action Crash and Fit-Rite businesses together and merged the Fit-Rite Queens, New York location into the LKQ Hunts Point facility in the Bronx. We merged the Fit-Rite Cherry Hill, New Jersey location into [Bodymasters] operations to the south side of Philadelphia and we have combined locations in the Newark, New Jersey and Poughkeepsie, New York markets.

In terms of other potential geographic acquisitions, we continue to work with a fairly robust backlog of acquisition candidates that includes both recycled and aftermarket businesses and we would expect to close on additional transactions during 2006.

In our aftermarket operations we opened our Chicago warehouse in February 2006 and at the end of the first quarter, have a approximately $1.7 million part inventory in stock or in transit for the 60,000 plus square foot facility. At the end of Q1, we had also aggregated approximately $700,000 of new aftermarket inventory stock at our recycling facilities in Portland, Oregon.

We're pleased that our insurance relationships and programs continue to expand during the quarter. The carrier in Rhode Island, [Amaca] has named us as their preferred vendor for recycled in aftermarket products across the U.S. and are acquiring -- requiring their appraisers to search for alternative parts prior to beginning the repairs process.

On our Q4 earnings call we mentioned the piloting of a new electronic search review process that we're offering to the insurance industry called LKQ [flat look]. While still in the pilot stage with a carrier in three states. Initial results are positive and we're now moving to introduce the product to a second carrier as well. It is also our intent to market LKQ last look directly to the collision-repair shop.

We have begun a pilot in Michigan with a national carrier AAA that will require several DRP shops to send LKQ repair estimates for all their repairs. They will not be allowed to begin the repair process until LKQ signs off of the parts request.

While [smelt] program, now at 50 estimate reviews per day, we do belive the program has potential for expansion. As we've mentioned on previous calls, we've been in several pilot programs where we supply auto part retailers with recycled and/or aftermarket parts. One of these pilots was with Advanced Auto Parts, a leading retailer of automotive aftermarket parts, accessories, batteries and maintenance items. Advanced has approximately 2,900 stores in 40 states.

We're currently in the process of rolling out a supply arrangement wherein LKQ will provide recycled and aftermarket products and refurbished wheels to Advanced. We will supply these products directly to Advance's stores from our national network of facilities as Advanced's customers place such orders for our parts. Products will be marketed by Advanced under Advanced's right choice program.

Since we will be in a rollout, to start up, roll out and training phase of this very new program, we do not expect any earnings accretion during 2006. We are in the initial rollout stages and like any new program, communication, product, line training, familiarization of the product and delivering positive experiences that we are positive we will deliver will be shared in the Advanced organization. As Advanced has 2,900 stores, we think this will take time.

LKQ will also need to gradually adjust its procurements in order to achieve better full rates of the type of product that AAP customers may seek, while at the same time protecting our historical gross margin.

It is our hope and our belief that over time, we could realize a material amount of sales and profit from this relationship and an annual revenue in the range of 25 to $50 million could be achievable.

We also would like to point out what we think it is our national footprint, that is the main contributor at our ability to obtain programs like the one I just discussed.

At the end of Q1, we operated 34 transfer runs and close to 400 local delivery routes that carried primarily aftermarket parts and refurbished wheels and 63 transfer runs and close to 400 local delivery routes that carry primarily recycled parts. In various areas, these recycled part transfer runs and routes also deliver aftermarket products. In total, LKQ has a delivery system approaching 800 daily local delivery routes.

We acquired approximately 32,000 cars in our wholesale recycling business during the quarter, which was about 30% more than we acquired during the first quarter of 2005. The percentage of vehicles that we acquired from salvage auctions in 2005 accounted for around 93% of our total incoming product flow. And we have a seen healthy car availability at the auctions during the first quarter.

We continue to increase our sales staff for our recycle business and we've done so by an average of 53 people more in Q1 2006 compared to Q1 2005. This is a 14% headcount growth with approximately 25 employees coming from acquisition and 28 from organic hiring. Additionally we're investing in a technology upgrade program to serve as a base for enhanced growth, to better manage call flow and sales productivity, the first stage being new telco installations, which will provide for new flexibility in caller routings and sales staffing.

In summary, we're pleased with our growth prospects and we continue to use a low double-digit organic revenue growth as our operating model. And as you could see, we did gain over 12% organic growth during the quarter, we believe in spite of the very short and mild winter in the Midwest and northeast areas of the country.

At this point, I'd like to ask Mark to provide a more detailed discussion on the company's financial reports.

Thank you Joe and good morning everyone. Let's take a look at the tables in our press release. You'll note we've also included a table that reconciles net income to earnings before interest, taxes, depreciation and amortization otherwise known as EBITDA. We also added supplementary data schedules relating to our income statement that showed growth in margin percentages. Also note we did have a 2-for-1 stock split in January 2006. So all our earnings per share amounts, our stock price amounts and share accounts present a reflective split.

Looking at our income statement in related tables now, our first quarter 2006 revenue was up 43.6% to $192.1 million from $133.8 million in Q1 2005. Our organic revenue growth was 12.4% for the quarter. Our first quarter 2006 gross margin was 46% versus 46.8% in the first quarter of 2005.

As Joe previously discussed, the Transwheel business was acquired this year and it has an aluminum smelter that operates at a very low margin. In addition, Transwheel performs certain types of refurbishing activities. were required to write-up certain components of their inventory in their opening balance sheet that relate to these refurbishing activities. And that's required by Financial Accountant Standard number 141, business combinations.

The inventory write up amount was approximately $300,000, with two thirds of that resulting in higher cost of sales in the first quarter of 2006. Accordingly, our first quarter gross margin excluding the effect of these two items was 47.1%.

Our facility and warehouse expenses for Q1 grew $6 million or 41.8% over Q1 2005. The majority of this growth was from our 2006 business acquisitions and the full year impact of our 2005 business acquisitions, which accounted $4.4 million of the growth or 30.3% expense growth. Excluding effects of business acquisitions, the first quarter of 2006 had increased costs over the first quarter of 2005 related to labor and labor related cost growth of $0.9 million. This primarily related to increased staff needs as our parts volume continues to grow.

In addition, insurance and legal claim costs, utility costs and repairs and maintenance costs growth over 2005 was $0.6 million. These costs tend to be incurred more sporadically during the year.

Our distribution expenses for Q1 grew $5.8 million or 41.4% over Q1 2005 of which $3.2 million or 22.8% expense growth was due to our business acquisitions. Excluding distribution expense growth related to our business acquisitions, our Q1 2006 distribution expenses grew close to 18.6% over Q1 2005 while organic revenue growth was 12.4% for Q1 2006.

Related to organic distribution expense growth, fuel expense increased by 37.1% and our subcontracted delivery costs increased by 37.9% for the first quarter 2006 over the first quarter of 2005. Both of these were significantly related to the fuel price increases. In fact, if fuel costs for the companies we owned back in 2005 had stayed at the 2005 level, our organic distribution expense growth would have been close to 14%.

In Q1 2006, fuel expense and subcontracted delivery costs ran approximately 18.5% of our distribution expenses or 1.9% of revenue. Excluding effects of the acquisitions, we operated approximately 8% more recycled transfer runs and recycled local delivery routes in the first quarter of 2006 compared to the first quarter of 2005.

Selling, general and administrative expenses grew 7.2 million or 40.5% over Q1 2005, of which $4.2 million or 23.9% expense growth, was due to our 2006 business acquisitions, and of course the full year impact of our 2005 business acquisitions.

During the first quarter of 2006, compared to the first quarter of 2005, we had 0.6 million in higher compensation expense accruals related to stock option expense that we had to incur for the first time. We also had 0.4 million in our new long term incentive plan or [L-Cent] expense, which was the first quarter we incurred this cost. This new plan is outlined in our proxy statement.

Our selling expenses tend to be fairly variable in nature due to our commission inside sales force. Our general and administrative costs are usually less variable in relation to revenue growth. For the quarter, our EBITDA grew 4.6% to $23.9 million. EBITDA was 12.4% of revenue for the quarter compared to 12.3% in Q1 2005. Our operating income for Q1 2006 grew 41.3% over Q1 2005 to 20.3 million. Operating income as a percentage of revenue was 10.6% in the quarter compared to 10.8% in Q1 2005.

Remember when I talked earlier about the effect on our gross margins in the first quarter of 2006 related to Transwheel's aluminum smelter and the adjustment related to FAS 141 business combination accounting. Without the effect of these two items and the expensing of stock options, our EBITDA would have been 13.1% and our operating income at 11.3% for the first quarter of 2006. So our primary operations did expand margins over 2005 by 80 basis points on EBITDA margin and 50 basis points on operating income margins. We had net interest expense in Q1 2006 of $942,000 compared to net interest expense of 554,000 in Q1 2005. This was primarily related rising interest rates.

Other income in Q1 2006 was $806,000 compared to $152,000 in Q1 2005. This increase was primarily related to a $719,000 gain on selling equity securities in Q1 2006.

Our Q1 2006 pretax income grew 44.3% to $20.2 million over Q1 2005. For Q1 2006, our effective tax rate was 40.2% compared to 40.0% in Q1 2005. Net income for the quarter increased 42.8% to $12.1 million from $8.4 million in Q1 2005. Our diluted earnings per share increased 15.8% to $0.22 in the quarter from the $0.19 in Q1 2005.

We reported diluted weighted average common shares outstanding for EPS purposes as 55.5 million shares Q1 2006 versus 45.4 million shares in Q1 2005. And note that our diluted weighted average share counts increased by 22.2% for the quarter, which is why EPS growth was only approximately 16%. The large share increase was primarily due to our October 2005 follow-on stock offering of 6.4 million shares plus exercise of stock options and warrants and the increase in our stock price.

Let's take a look now at our cash flow table. We generated $4.1 million in cash from operations during the quarter as we invested heavily in inventory. From the end of 2005, we funded an additional $13.5 million in inventory growth with 75% of that related to recycled inventory. CapEx, excluding business acquisitions for the first quarter, was net of $8.6 million. Cash paid for our business acquisitions during Q1 was $29.1 million.

During the quarter, we issued stock related to the exercise of stock options and warrants that resulted in shares issued and net dollars proceeds received that totaled approximately 1.1 million shares for $2.3 million in net proceeds. We issued no stock related to business acquisitions in Q1 2006.

In looking at our Q1 2006 balance sheet, you will note we had 82.9 million in debt, which included 71.0 million in debt under our unsecured credit facility with our bank group. As of April 26, our credit facility debt was 73.5 million. Total borrowings allowed under this bank facility is $135 million. This facility matures on June 1, 2010. We feel confident this credit facility could be quickly increased when we have a need.

As we indicated on our last earnings call, we expect that 2006 organic revenue growth will be in the low double digits with the balance of the growth being the full year impact of 2005 business acquisitions and of course our 2006 business acquisitions. We expect net income to be within a range of 40.5 million to $42.5 million and diluted earnings per share to be between $0.72 and $0.76. Included in the guidance is an estimated $0.03 per share effect of expensing stock options for the first time.

For the second quarter of 2006, we expect net income to be within a range of $10 million to $11 million and diluted earnings per share to be between $0.18 and $0.20 per share. We anticipate that net cash provided by operating activities for 2006 will be approximately $40 million. We estimate our full year 2006 capital expenditures related to property and equipment excluding any needs of any future acquisitions we may do, will be approximately $36 to $38 million. We estimate that weighted average diluted shares outstanding for the full year 2006 to be approximately 56 million.

These shares are not -- these share numbers are estimates and as such will be affected by factors such as any future stock issuances, the number of our options and warrants exercised in subsequent periods and changes in our stock price.

I'd like to turn back to Joe and open up for any further comments and questions.

Okay, thanks Mark. Just in summary, we believe the company continues to have a compelling and successful business model, which provides an attractive value proposition to a wide array of customers and to the insurance industry in particular. We also believe that our company is in a unique position to leverage our inventories of both recycling parts, recycled parts, aftermarket products and now our refurbished wheels by having the ability to sell out of these combined inventories in response to customer requests. We continue to pursue opportunities to further leverage our existing asset investments, our customer base and to continue to grow through a geographical expansion of our markets.

Sarah, if you would open it up for questions we'd like to move to the Q&A portion of our call.

[OPERATOR INSTRUCTIONS] Your first question comes from the line of Scott Stember with Sidoti & Company. Please proceed.

Good morning guys.

Hi, Scott.

Did you ever talk about the two businesses strength wise, aftermarket versus recycled in the quarter?

We - there was just a little bit of break up at the beginning of that question Scott. Do you mind repeating it please?

Yes, no problem. If you could just talk about the break out or maybe talk about both businesses. Would that 12% comp be evenly spread out between both types of businesses?

I'm sorry, yes. We continue to see slightly faster growth in the aftermarket side of the business. And that was true in the first quarter. The spread was as the aftermarket business has grown to over $40 million in the quarter, the width of that spread is starting to contract a little bit. But it's certainly fair to say the aftermarket side of business continues to grow at a slightly faster pace than the recycling side.

And just going back to the aftermarket. Have you guys heard anything anecdotally from insurance companies or the body shops that in the wake of the State Farm case going away that apparently you see some increased utilization by insurance companies back to aftermarket?

Some of the more recent data we received from Mitchell would indicate that the aftermarket side of the business continues to grow its share. As matter of fact, it appears that -- the last report I had from Mitchell and this is a little outdated -- but, it looks like OEM parts given up about another 0.5% of market with aftermarket getting a piece of that and recon and recycled a small piece of it as well.

Our latest discussions with State Farm in particular indicates to us that they're still evaluating their position in light of their victories in the courts. And while State Farm hasn't told us anything specifically certainly remains our expectations that is a matter of time till they start to write to aftermarket products in the repair process.

Scott Stembler Okay. And Joe you mentioned I'm not sure if I heard correctly about the volume of vehicles that you guys have bought at auction. Did you say they were down 30%?

No, it was up -- up 30%.

Oh, okay. I apologize. So obviously the activity you guys are seeing have option is very robust right now?

Yes, Q1, Q1 activities -- the auction was pretty healthy. It started to diminish a little bit toward the end of March. And it has pretty much stayed at that level through the first few weeks of April.

Okay. And can you maybe just lastly comment on how things are shaking out in April if the weather turning back the other way is helping comps right now?

Yes, April off to a start that would be a few percentage points lower than what we saw in Q1. Now, that's, that's fairly normal. We went back and looked at the last few years, it seems we've come out of March, we get a little bit of a low in April. And by the time we ride to May and June we see the momentum swing the other way. And that's exactly what we're seeing so far with April running below the Q1 levels. And if history repeats itself we should see that momentum swing back upwards in May and June.

That's all I have. Thank you.

Thank you, Scott.

Your next question comes from the line of Tony Cristello with BB&T. Please proceed.

Thanks. Good morning guys.

Hey Tony.

Hey Tony.

I guess one question I have is focused on Transwheel. And it clearly seems like the smelter piece cost you about 80 to 100 basis points or so in the quarter. And one is that estimate something that you will consider at some point once you see what the throughput is from your core business into that infrastructure?

Yes, it's fair to say we're certainly, we're currently planning to keep our options open relative to the processor. We really didn't come in to this with any preconceived notions. The management team has set forth their business case of why they think it's important to the company.

We think there is the chance that LKQ plants and the recycling business and through relationships we have with other recyclers that perhaps we can deliver the core product that the business needs. And we need sometime just to let that business case run its course here.

And that kind of leads into the next question is how much investment in terms of time and resources and maybe if you can comment on dollars are going to be needed to get Transwheel to a level that it can handle the capacity or the volumes that youcan put through that system.

Well, we think that the fixed asset investment that exists with Transwheel today can probably generate, I'm going to say, a 50% increase in the wheel production per day. And that can be achieved through some pretty simple kind of double shifting if you will. So there's - I think there's a significant amount of increased throughput that's available to us assuming that the demand develops the way that we think it will.

If we want to think more than a year down the road and if we're please with what we're seeing in the business in the Eastern United States it would probably be our intent to look at putting a production facility up in the Western United States.

I'm assuming when you talk about 50% more throughput what is the run rate now or what was the run rate when you acquired them just to kind of give some kind of a benchmark?

Yes there are various facilities aggregated. We're running I think at about 800 wheels a day.

Okay. Also on an annual basis you're somewhere in the neighborhood of, I don't know, 30,000 or is that 40,000? Have you commented on that before?

We have not. That sounds low.

Okay. So I guess though, but looking at your volume even if you were to double, double say was 50 and you went to 100. If you're buying 100,000 cars a year you're at 400,000 wheels. So is there - and maybe not all those are usable but it seems to me that there is a big opportunity and any incremental throughput you have over a relatively fixed basis is going to be even more profitable.

I think so. And I think our gut instinct tell us that we're going to be able to provide a significant number of those core wheels. But you are correct in that vehicles count or probably 40%, 35 to 40% of cars on the road are riding with steel wheels, [inaudible] piece of the alloy wheels. There just isn't any demand for it. And that's the equation that we have to work through and better understand over the next couple of quarters.

But right now we're very encouraged. Transwheel has been receiving products from the LKQ facilities for a good 45 days at this point. And they're elated with the quality of products that they're seeing come in from the LKQ plant.

Okay. And then I guess one last thing related Transwheel, are the gross margins -- I'm assuming on the core Transwheel business gross margins are much closer to what your core margins are versus the smelter piece side?

Yes, gross margins are probably a little lower. But when you get down to the operating margin which is what we really look at taking out the smelter thing that we talked about and taking out the temporary FAS 141, yes they're pretty close to this.

Okay. Shifting gears real quick to just a few comments on Advanced. Do you expect it to sort of be a balance for this year in terms of rolling out and getting up and running in and sort of learning what is required or what needed. And then you can start to see contribution into 2007. Is that kind of how you're looking at this right now?

Yes, Tony, I think that's a pretty fair assessment. During the first quarter theres probably actually a minor drag in the company. We staffed up the call center, hired people, trained internally gearing up for when the first calls were switched on to off, which only happened three to four weeks ago.

We've seen a nice positive momentum each week we've been active. While small where we're kind of happy after four weeks to reports that right now we're annualizing a little over $3 million year in sales which being 20 days into it, we think it's not a bad place to be. And a fairly low number of stores participating.

So we tried to integrate our training into AAP's planning when they're having regional meetings and regional training sessions with their parts pros. So we'll try to integrate into their schedule and take advantage of those times when their people are all together for other training.

So it's a massive project with 2,900 stores. We think our overlap with Advanced is pretty attractive because obviously their strength is in the Eastern and Central United States which matches up with our strong suit. We [inaudible] seen about the program and the Advance auto parts people are - they're hard charging ,managers. We love the culture. And we couldn't be happier than to be in position we're going to be working with them.

Well, it seems like as this business grows it can contribute 5% plus more in terms of sales growth alone. I mean, I think this could potentially be a very meaningful material piece of business. It that fair?

Yes, we believe so too. We need time to prove that out. The real question, Tony, in my mind and thus I feel we have a better understanding after we get a couple of players under our belt. How much of the revenue that we'll generate through this program is truly incremental revenue to LKQ and how much of the revenue is something that we would have sold to someone else anyway. That's the most critical aspect of the real earnings contribution of this relationship.

Okay. All right, great. I'll let someone else have some. Thank you.

Thank you, Tony.

Your next question comes from the line of Craig Kennison with Robert W. Baird. Please proceed.

Good morning, Joe and Mark.

Good morning.

Good morning, Craig.

Could you review the economics of that Advanced deal from a margin perspective?

The gross margin line should be really no different than our traditional sales. The upside, to the extent, this is -- would be to the extent that, is there an opportunity for us to sell products into the right choice program that otherwise might not have sold. And if that proves out to be the case then there could be a small positive impact on the gross margins of the company. But we need several quarters to really understand, like I said whether these are incremental sales or whether this is just product that we were going to sell otherwise. There will be some savings at the selling expense line in the company. As Mark has pointed out we tend to pay most of our sales reps on a commission rate.

These sales -- some of these sales will be processed through websites and some of the sales will be processed through an LKQ call center which in either case should be a slightly reduced selling cost to the company. I would evaluate programs that we have no bad debt expense exposure, which is certainly a plus.

In terms of delivery the parts that we can deliver on LKQ trucks to the AAP stores we'll do that. So that's really kind of a pretty normal operating cost for the company. There will be those instances where we will be absorbing freight to ship parts into an Advanced Auto Part store and -- in which case there could be a minor deduct.

Okay. Thanks for that. And relative to your inventory balance it grew faster than the pace of sales growth. Is that related to any timing of acquisitions last year or is there something else driving that?

A couple of things. Well, certainly the Fit-Rite acquisition occurred on 12/31/05. So you got a pretty big entries have come in from their inventory investment as well as very reliable year end. The other thing I would note is you may recall from last year during the first 100 or so days of year we tend to tried to build up our backlog of unprocessed vehicles during the winter months when we think the buying season is more attractive. And we did that again in 2006. And within 10 -- probably as we move into May that'll be go flat. And towards the end of May and early June, and it will start to draw down that backlog of unprocessed cars.

And what have you done to control for the margin impact of that backlog to avoid any surprises on the gross margin line in the third quarter?

We inventory our product -- all the major components which we did not do the first year. We did that a couple of years ago. Now, the major components are inventories. That allows our bidders and buyers to have better visibility of exactly what the part types are that are in backlogs so we could avoid any I'll say, excessive duplication.

And then just moving on to a lawsuit by Ford against some of your competitors. Have you seen any change in demand for aftermarket parts on particular Ford products related to that litigation or is it really unchanged?

I -- I can't say that we have seen any change in demand that would be a function of that litigation.

Great. Thank you.

Thanks a lot, Craig.

Your next question comes from the line of Gary Prestopino from Barrington Research. Please proceed.

Good morning, guys.

Good morning, Gary.

A couple of questions. What are you seeing on the pricing side for the salvage that you're purchasing? Are you seeing normalized cost go up 3% or 4% on the price of the cars due to inflation?

Not quite at that level. They did bump up a little over the quarter sequentially. But certainly not at the level that you're discussing.

Right. And then could you elaborate on this last look program and this pilot you're doing in Michigan. Could you just talk a little bit about that?

Yes, love to. There are other electronic parts -- search engines that are available in the market. We have never been big components of those programs because we feel they shortchange the insurance industry and shortchange us because the search engines aren't really - for lack of a better word, they're not good enough to really identify all of the recycled parts that are available in the repair process.

So we have linked with a third party software provider who's developed a search engine, if you will. And we're coupling that with some additional phase of review that no one else really provides. And that's where we would have someone physically make a fairly quick review of the parts manifest, looking for those part opportunities that -- and the electronic interchange search just won't find. And by that I mean things like rocker panels, cross beams between the front rear doors, quarter panels. And sometimes just assemblies that aren't easily recognized by an electronic search engine.

So we think that will be -- well we think it will be the best product on the market. And as opposed to predominantly marketing this into the insurance industry, it's our intent to market this heavily to the collision repair shops and provide them tools that will allow them to prove to the insurance -- their insurance partners that they have really the best capability in the market to seek out alternative parts.

And we'll be showing all of our parts in the system. So this is a search engine that can find recon wheels, aftermarket parts as well as of course our recycled parts.

And then what about - that was last quarter, correct -- what about the pilot with AAA?

That, I believe, is going to move toward a full kind of a full scale utilization in the Michigan market.

It's an estimate review.

Yes, it's a full scale estimate review.

Full scale estimate review? Okay. And then lastly what you -- are you seeing any of the cars coming out of Louisiana or the Gulf Coast now being -- have the ability to be sold? Have they been titled and is there any economic value to some of these automobiles?

Yes, that's a better question for the [co-part] guys. But from our perspective there's still a pretty -- very healthy log jam down there.

Okay. Thank you.

All right. Thanks a lot.

Your next question comes from the line of Bill Armstrong with C.L. King & Associates. Please proceed.

Good morning. I've got a couple of follow-up questions just on the smelter and on the Advanced Auto Parts deal. So just to clarify the $4.4 million in, in third party sales is that from the entire Transwheel business or is that just the filter or whatever the melted down aluminum from the smelter?

Yes, that's, the third party revenue that smelter received selling the melted aluminum.

Okay. So the actual while sales of Transwheel would be in your, just there's more obviously --

Yes.

-- than that? Okay. Can you -- can you tell us what that number was?

It's -- in general, we've been trending about $28.5 million a year. So somewhere around $4 million or so. We only had this company two months.

Right. All right. Okay.

Not a major change from what they did in '05.

So I get it. It sounds like you're trying to figure out if there is really any value added or economic value in this, in this smelt, in keeping the smelter in operation?

Yes, I mean the value to us is getting more cores in and setting those out first. And then the rest of them you melt. That's what the value is.

Can you just ship out the cores that you don't need - just ship them out as is to third party smelters?

Oh no. The ones that we need, we recondition and sell those back to broadly into the collision repair industry. The ones that we don't need, do not need, those are the ones that are processed through Transwheel's aluminum smelter. So they're melted poured into aluminum ingots and sold back into the automotive manufacturing industry.

Yes. I guess my question was those wheels that you can't use for your recycling business, instead of melting them down why not just sell them to some third party smelter operation. Would that make sense?

Mark Spears You could but you'd probably make them, it would probably be less economically advantageous to do that. That's why these guys got the smelter.

Okay. On the Advance Auto Parts. So Joe in your initial comments you mentioned that you may have to adjust your procurement practices in order to raise your fillweer rate. Could, could you flesh that a little bit, what does that actually mean?

Yes we just, as I indicated we're just few weeks into the -- so we're getting our first kind of appetite, if you will, the type of products that we're receiving demand for through the right choice customers. So we will just as we do within our request from our whole sale accounts. Those requests will be logged in our system and as our buyers are evaluating the value of the damaged vehicle, there maybe some parts that we formerly had no demands for but under the right choice program we do have demand for. But we'll, start to place value on those parts when we bid cars.

So this is just a -- it's a process that'll take several quarters for us to understand what the exact part price that we're [getting] requests for. And in some cases that may lead us to buy a slightly different product mix to meet that demand.

Okay. But you're not talking about paying more just so you can get more -?

Absolutely not. And quite frankly if anything, the product that we would need to meet the demand from the right choice customer base is probably a lower end and less expensive product than what we buy today to supply the needs to the professional collision repair shop.

And the right choice customer's these -- these are just individual do-it-yourself guys?

The - Bill we have both a retail component that you just described. But they also have I think maybe close to 20% of their business is what they term commercial business which is -- you should probably think of as kind of a mom-and-pop one or two, one or two bay mechanical repair shop. And their part pros sell to that piece of the customer base. And that's - their demands for product from us is most likely going be engines and transmission.

And so your delivery to them would basically be on a just-in-time sort of, they call, they see if you've got what the part they're looking for. If you do, you ship it out to the stores rather than to one of their distribution centers?

Right. We ship it right to the Advanced Auto Parts store, that's correct.

Okay. And then finally what's the rollout schedule? You just started -- they've got 2,900 stores -- that's a lot of stores. When -- are you planning to roll out to all 2,900 stores or just some portion and when do you think that will be completed?

Our target would be to have 2,900 stores actively seeking to buy products from us and to kind of run to the cycle and it probably means a couple, a couple of visits and maybe three visits. That's probably the balance of this year.

So by the end of this year you figure you should have pretty much full coverage with these guys.

I would hope so yes.

Okay. All right thanks.

Okay. Thanks Bill.

Your next question comes from the line of John Lawrence with Morgan Keegan. Please proceed.

Mark, would you comment just for a minute on the fuel cost and just sort of break down a little bit the difference of how much of additional runs versus just the actual pricing of gas would mean?

Yes, if you look at diesel prices which is really what we mostly run on they went up about to 21%, okay? We kind of then tracked that by area and everything. So diesel prices went up 21% if you look at Q1 to Q1, okay? We then on top of that added another 8% more routes -- local delivery routes. And it happened to be 8% more transfer run at the same time so that was added on top of it. And of course labor comes up with that as well. I don't know that helps you a little bit. That's kind of your price increase for the fuel and a contract delivery that we do. It's like 21%.

All right, thanks guys.

Thanks, John.

We now have a follow up question from Tony Cristello with BB&T. Please proceed.

Hey, thanks. I just wanted to follow up one question. This retail opportunity with Advanced seems like something that could potentially be used with other retailers if it proves successful. Is that something that you envision?

We'd certainly keep our options open on that. I think right now our focus is to engage as effectively as we can to the right choice program planning. And as far as it appears on the surface to be an enormous opportunity and I think we just want to do a great job for Advanced Auto Parts and prove that we're worthy partners of them in what we think it's really a fantastic opportunity for both companies.

Okay. One other question. I've met --there's been a lot of talk of late of [Snitzer Steel] and Greenleaf and I notice that they converted yet two more or are in the process of converting two more facilities to their sort of pick and pool type format. And if -- when you look at that concept versus yours I mean there's clearly - it seems like any competitive threat is very minimal especially as they continue to sort of go in a different direction then you would. Is that something you would agree with?

Yes I guess I would agree with that. We don't currently see snifter [inaudible] in the acquisition market. We don't think that the business today that they have, it doesn't - there's not enough density to it to allow for the type of networking of inventory that we're able to achieve. It appears to us that at least on the surface that maybe they're gravitating toward a slightly lower end product even at their wholesale stores than what we tend to buy.

Okay that's great, that's helpful. Thank you guys.

Okay, Tony, thank you. I guess I'd like to thank every one for joining us today for the call. We'll probably be looking at the last Thursday of July I'll assume for Q2 call but we'll certainly put out a formal announcement well in advance of that call.

And again thanks for joining us. I apologize for the delays upfront -- I know some of you had difficulties getting into the system, so we'll keep working on that to see if we can come up with a little better solution there. Thanks again and have a good day.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.