LKQ Corp (LKQ) 2010 Q2 法說會逐字稿

Greetings, and welcome to the LKQ Corporation second quarter 2010 conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator instructions.) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Sarah Lewensohn, Director Industrial Relations for LKQ Corporation. Thank you, Ms. Lewensohn. You may begin.

Thank you, Claudia. Good morning, everyone. And thank you for joining us today. This morning we released our second quarter 2010 financial results. With me today from LKQ Corporation are Joe Holsten, President and Chief Executive Officer, John Quinn, Executive Vice President and Chief Financial Officer, and Rob Wagman, Senior Vice President of Operations, Wholesale Parts Division. Both Joe and John will provide prepared remarks on results. And then we will open the call up for questions.

In addition to those that are listening by telephone, we're providing an audio cast via the LKQ Website. And both of those forums will have replays available for them after the conclusion of the call.

Before we begin with our discussion, I would like to read the following. Statements made in this call that are not historical in nature are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include 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 or results may differ materially from those expressed or implied in the forward-looking statements as a result of various factors. We assume no obligation to update any forward-looking statement to reflect events or circumstances arising after the date on which it was made, except as required by law. Please refer to our 2009 form 10-K and other subsequent documents filed with SEC and the press release we issued this morning for more information about potential risks.

And with that, I'm happy to turn the call over to Mr. Joe Holsten.

Okay. Thanks, Sarah. Good morning. Thanks for joining us today. As you can see from the results we reported this morning, we delivered a very strong second quarter. Diluted earnings per share from continuing operations were $0.26, an increase of 30% as compared to the $0.20 for the second quarter of 2009. And revenue for the second quarter reached $585 million, benefiting from acquisitions, increased aftermarket parts sales and higher commodity prices. The organic revenue growth for the Company as a whole was 12.2%.

Though stagnant driving trends led to relatively flat miles driven in April and May, we've benefited from a continued increase in the demand for alternative parts. Top-line organic growth reflected in particular an increasing acceptance of aftermarket and refurbished collision parts.

Insurers continue to operate under significant cost pressures. A recent survey by PropertyCasualty.com of the top 100 carriers indicated the net premiums from personal auto lines declined in 2009 for the third year in a row, while the combined ratio -- that's the measure of underwriting profitability -- continued to deteriorate. The net impact was the second straight year of underwriting losses for personal auto coverage. And this environment offers great opportunities for LKQ.

Demand for LKQ's wholesale parts was quite strong during the quarter. Our second quarter organic revenue from the sale of all parts and services increased 5.5%. The greatest beneficiary of the APU trend was our aftermarket and refurbished parts category. Aftermarket and refurbished revenues increased 11.4%, with an organic growth rate of 8.7%.

When we acquired Keystone two and a half years ago, one of the objectives was to accelerate the adoption of aftermarket collision parts. And that is exactly what has occurred. For the past four quarters, organic revenue growth of aftermarket and refurbished parts has run around 9% or better.

Aftermarket and refurbished parts revenue also benefited from a strong used car market, which increases the likelihood that vehicles were repaired rather than categorized as total losses.

Organic revenue growth of recycled parts and services was up slightly during the second quarter, as the quarter reflected some lingering consequences of the Cash for Clunkers Program. In the third and fourth quarters of last year, we bought fewer auction cars. And many of the vehicles we bought had lower parts values than was necessary to support our growth target. I believe we reached the inflection point during this quarter.

And the salvage auction trends have started to improve. During the second quarter, we purchased almost 52,000 vehicles for dismantling at our wholesale operations, which is a 41% increase over the second quarter of last year. The increase in vehicle purchases will clearly help expand our parts inventory.

On the past two calls, I talked about the challenges we face in buying salvage cars. The supply of vehicles was good during the second quarter of the year, but the prices we had to pay were at the high end of what we have historically paid. We have increased our bid prices to ensure we have adequate inventory to support demand. I now believe that at the current run rate, we are acquiring enough cars to fill the backlog of vehicles to dismantle during the third quarter in order to meet our targeted volumes.

Concurrently, we are doing what we can to improve parts pricing to offset the downward pressure from high auction prices on gross margin. We have taken steps to reduce price deviations by our sales reps, and are focused on maintaining gross margin dollars.

Turning to our self-service retail operations, during the quarter we purchased roughly 78,000 lower-cost, self-service and crush-only cars. Current car purchases -- purchase prices are reflecting a little downward stickiness as we move to what we pay for self-service cars closer in line with what we are realizing on the crushed car body. By that, I mean we will likely see a little margin compression in this line of business in Q3 until the cost of cars falls more in line with recent scrap prices.

Changing the focus to our heavy-duty truck operations, we're moving forward with the expansion of our network. We currently -- we purchased approximately 900 units for resale or parts during the quarter. And today we have 11 facilities. And we are starting to see the locations benefit from being a part of the organization. For example, we recently had several export buyers who were able to find what they needed by offering them our entire inventory across the country while they visited a single location.

During the quarter, we purchased two heavy-duty truck locations, one in West Monroe, Louisiana, and the other in Jackson, Mississippi. We also acquired a couple of wholesale recycled auto parts operations that provide important platforms for entry into strategic markets. The wholesale auto recycle businesses will allow us to serve the Winnipeg, Manitoba, and the Seattle, Washington metropolitan areas and beyond. Winnipeg provides an important entry into Manitoba and Central Canada. And the Seattle operation will allow us to create a stronger presence in that city and its surrounding markets.

Collectively, the acquisitions we made in the second quarter reported 2009 annual revenue of about $14 million. As of today, we have made a number of acquisitions that will be recognized as third quarter transactions. These include an automotive paint distribution business in the Boston, Massachusetts area, a wholesale recycling operation near the Tennessee border that will serve the Huntsville and Birmingham, Alabama and the Nashville, Tennessee markets and, finally, a wholesale recycling operation in one of our nation's major markets, Philadelphia, Pennsylvania.

Additionally, we have re-purposed two of the properties we took on with the Greenleaf acquisition, a wholesale recycling operation in Monroe, Georgia was reopened with specialized high-end European brand vehicles. And the former Greenleaf facility in Wilson, North Carolina has opened as a heavy-duty truck operation.

Finally, our marketing efforts to increase our service levels and the comprehensiveness of our parts offerings to the insured repair community continue to pay dividends, as we now have four of the top 15 carriers signed to our parts program, along with a number of smaller carriers with very modest market shares. We've also seen recent successes in our offering of parts supply programs to three national rental car companies and a half-dozen fleet management companies. And we recently appointed a small team of people to have responsibility to develop a government agency marketing effort.

I'd like to turn our conversation over to John now so he can provide more detail on our financial results.

Thanks, Joe. And good morning, everybody. As Joe mentioned, we are very pleased with the way the Business performed in Q2. Hopefully, everybody has had a chance to look at our 8-K, which we filed with the SEC earlier today. And, as normal, we are planning to file our 10-K in the next few days.

Our revenue for the second quarter increased approximately $98 million to $585 million, compared to $486 million for the same period last year, an increase of 20%.

For Q2, our organic growth was 12.2%. And acquisitions accounted for 7.6% growth. We had a small favorable foreign exchange impact of 0.5%. Organic growth of our parts and services revenue was 5.5%. And organic growth of other revenue, which is where we record our scrap commodity sales, was up 81% as commodity prices were higher on a year-over-year basis.

For Q2 2010, our same-store sales growth for aftermarket and refurbished parts was 8.7%, while our growth rate for recycled was 1%. Our year-to-date growth rates for same-store sales for aftermarket and refurbished crash parts was 8.4%, and recycled parts was 1.4%. The total same-store sales growth rate for parts overall is at 5.5% for the quarter and 5.6% year-to-date.

We spent a fair amount of time, and after analyzing the recycled revenue growth, we know that the expensive salvage auction market earlier this year resulted in lower purchases by us during the first months of the year. And that led to recycled parts sales being unfavorably impacted in Q2.

We also commented on calls dating back to Q3 of last year that we were concerned that the Cash for Clunkers cars would also adversely impact overall recycled part revenues due to the substantially lower value of the parts on a clunker car as compared to a typical salvage auction car. Our review of detailed parts sales by mechanical part type as well as the average selling price per unit has confirmed this belief.

During the quarter, due to the legal restrictions against selling the engines from a clunker car, revenue from engine sales actually declined during the quarter compared to last year. Similarly, we were negatively impacted due to the lesser value of clunker car transmissions when compared to the value of a normal auction car transmission. It's our belief that our same-store sales for the quarter for recycled parts were negatively impacted by at least 2.2% due to these two factors alone, let alone the lower value of other clunker car parts.

As most of you realize, we operate our management structure in a way that a single management team has responsibility for the sale and distribution of recycled parts, aftermarket parts, paint and body supplies, re-manufactured mechanical parts, as well as refinished crash parts. We view this business as a single segment for our SEC and GAAP reporting.

Moreover, we are consolidating warehouses and delivery routes to co-locate and co-deliver these products. And we are encouraging and incenting our sales reps as well as our customers to view recycled aftermarket and refurbished parts as substitutes for each other. All of which is to say as we've grown and expanded our profit offerings to a full array of alternative parts, the lines of distinction we're reporting on these parts types has become somewhat arbitrary. And we're giving strong consideration to combining the reporting in these two lines -- that is, recycled and aftermarket -- at some time in the future, possibly by year end.

In Q2 2010, revenue from our self-serve business was $53 million, or 9% of LKQ's total revenue. Approximately 36% of this revenue was parts sales included in recycled and related products, and 64% scrap and core sales included in other revenue.

Our acquisition revenue growth was driven primarily by the acquisition of Greenleaf, which was completed on October 1, 2009. This transaction accounted for approximately 5.5% of acquisition-related growth.

Gross margin for the second quarter of 2010 was 44.7%, which was down 60 basis points from the 45.3 in the same period of 2009. This decline is primarily related to the higher costs incurred for acquiring salvage cars at auctions, higher costs for self-service cars and a lower margin percentage on scrap aluminum sales. You may recall, in the first quarter, I indicated the higher-priced cars would be putting pressure on gross margin.

Our facility and warehouse expense for the quarter increased $7.5 million or 15.7% as compared to the same quarter of 2009. Approximately $3.6 million of the growth was related to business acquisitions. Facility and warehouse expense as a percentage of revenue for the quarter showed an improvement to 9.5% from 9.8% last year.

Distribution expenses for the quarter increased $8.5 million or 19.7% from Q2 2009, with $2.3 million of the growth related to business acquisitions. The remaining growth is primarily fuel of $2.4 million, labor of $1.2 million and $2.2 million of volume-related items such as freight and truck rentals. As a percentage of revenue, distribution costs were essentially flat year-over-year at 8.8%.

Selling, general and administration expenses grew $9.3 million or 13.9% over the second quarter of 2009, with $2.1 million of the growth related to business acquisitions. We also had higher labor costs to support the increased business of about $5 million. As a percentage of revenue, selling, general and administrative expenses were 12.9% in Q2 2010, compared to 13.7% in 2009.

Our operating income was $70 million in Q2 2010 compared to $55 million in Q2 last year, an improvement of $15 million, or 27%.

Net interest expense of $7.2 million was slightly lower than the last -- the second quarter of last year due to lower average debt balances and a slightly lower effective interest rate of 4.93%. We had a floating fixed hedge of $50 million, which rolled off in April and has not been replaced at this time.

Income from continuing operations for Q2 was $37.9 million, a 33.2% increase compared to the $28.5 million in the prior year. And diluted earnings per share from continuing ops for the quarter was $0.26 in 2010 compared to the $0.20 in 2009, an improvement of 30%.

Year-to-date through six months, we've experienced strong cash flow from operations of $101.2 million compared to $87 million in the same period last year. During this quarter, we built inventories by a little over $20 million. I had mentioned last quarter that we were exiting Q1 with our salvage inventory a little lighter than we would have liked. And you can see that we've picked up the buying in that area.

Capital expenditures for the quarter were $9.9 million, excluding acquisitions, which we spent about $10 million on.

During the quarter, we issued 436,000 shares of stock related to the exercise of stock options that resulted in $4.4 million in cash, including related tax benefits.

Debt at the end of the quarter -- $594.4 million, including $587.8 million under our secured credit facility. Cash and equivalents were $190.5 million at the quarter end.

As I've mentioned in the past, we pre-paid the final 2010 mandatory terminal payment. So we have no further scheduled terminal debt repayments for the balance of the year. Today we have no draw on our $100 million revolving credit facility and approximately $20 million of letters of credit that are back-stocked by the facility, leaving $80 million of availability for future borrowings. Combined with our cash balances and the fact we have pre-paid the mandatory terminal payments for 2010, we believe we have adequate liquidity.

Now I'll turn to guidance, which, as always, excludes restructuring charges or gains and losses related to acquisitions or divestitures.

As we noted in our press release, we're easing our guidance. We increased our -- we are increasing our previous EPS from continuing operations estimate of $1.06 to $1.12 to a revised estimate of $1.08 to $1.14, and income from continuing operations from a previous $154 million to $163 million to a revised estimate of $158 million to $167 million.

We've not revised the balance -- we've not revised the balance of our guidance. Cash flow from operations is still expected to exceed $160 million. Capital expenditure is still expected to be in the range of $85 million to $95 million, and organic growth of 6% to 8% for parts and services revenue.

Last quarter, I laid out some potential headwinds and tailwinds that could impact us for the rest of the year. And I thought I'd give you an update on where we see these items today.

In Q1, we talked about scrap prices moving lower in Q2. What we ultimately saw was that they rose early in the quarter, but fell in the back half of Q2. And today they stand about as low as they have been all year. But we are seeing some indications that they may tick up a bit in Q3. So on this front, while we continue to see some risk, the bias is more favorable than when we exited Q1.

Secondly, in Q1, we described the difficult buying environment for salvage vehicles. During the quarter, we saw prices at the auctions stabilize and actually come down a bit. And we've had some of the best buying weeks ever in terms of volume over the past month. To characterize it, I would say we saw the downside risk of higher prices at the auctions abate. But we haven't seen the upside case of materially lower auction prices manifest itself yet. Obviously, what -- we're doing what we can to improve prices to offset the increased costs. But it'll take a little time to see those efforts.

Finally, we talked about some potential pressure on aftermarket margins as a result of freight increases. We continue to face this pressure and have seen some increases. But again, we're doing what we can to improve our pricing.

And with that, I'll turn it back to Joe.

Okay. Thanks, John. I just want to share a few closing thoughts. A little more than a year ago on our first quarter 2009 conference call, I shared with you some thoughts about our opportunities or the opportunities that might arise for LKQ as a result of the economic conditions we saw at the time.

And my reflection of those opportunities are coming true today, first of which is that the collision insurance industry continues to face significant price challenges. And in response to this challenge, they have increased their use of alternative parts for collision repairs, driving the 3-point increase of APU that we saw over the last 12 months. The organic growth of our parts and services revenue, we believe, reflects those actions.

Next, we've expanded our product line by adding new aftermarket products. And we've broadened the revenue base through the diversification of our operations to the expansion of heavy-duty trucks, the acquisition of paint distributors, shifting -- and shifting the inventory of select wholesale recycle facilities to focus on high-end vehicles.

And finally, as we commented on our first quarter 2009 call, the strength of our balance sheet has provided us with the capital to finance our organic growth and make strategic acquisitions when our competitors are shrinking their businesses.

Results of the last six quarters have demonstrated the benefits of LKQ's position as a leading distributor to the collision and mechanical auto repair industry. We believe our unique competitive position and the actions we have taken in response to the economic environment have translated into consistent, sustainable earnings growth.

During what is likely to be a slow economic recovery, by maintaining our focus, we will continue to deliver solid growth in 2010 and beyond.

And, Claudia, at this point, I think we'd like to open up for questions, please.

Thank you. Ladies and gentlemen, we will now be conducting the question-and-answer session. (Operator instructions.) Our first question is coming from the line of John Lovallo with Bank of America-Merrill Lynch. Please state your question.

Hey, guys. Thanks for taking the call. The question -- the first question is on the recycled business. And I know you spoke of an inflection point, Joe. Is that largely attributable to the clunkers effect kind of running off and some supply improving? Is there anything else going on there?

No, I think you nailed the two -- the two issues that will kind of drive a better result in the second half of the year. As we indicated on the last couple of calls, the impact of the clunkers surprised us, as I think we estimated that the kind of average loss of revenue on a clunker car compared to a normal salvage auction car is about $2,500. And just to confirm that, we did a little deeper dig on that over the last 90 days, because we'd indicated in some of our comments we were able to very noticeably see the impact in our engine and transmission sales. And those are our two leading part revenue generators for the whole Company. So the clunker cars are really -- I'd say at this point they've pretty much bled through the system as we're -- as we're headed into Q3.

The other item I think you put your finger on, I think the real kind of tightest times that we have seen in the buying market on salvage auction vehicles was kind of in the March to May time frame. We've enjoyed -- over the last eight weeks, we've enjoyed the highest volumes of product purchases that we've ever bought as a Company. We've -- and in the non-holiday weeks, we've bought over 4,000 vehicles every week. And as I indicated, part of Q2 last year, of course, has a bit of a Greenleaf factor in it.

But total purchases in the second quarter, with the strength related to back end of the quarter, were up slightly over 40%. So the volumes are very healthy right now in terms of the incoming product growth, and a little more than we have seen historically. But, you know, we accept that. We think we're good enough in terms of our management skills. We get the right pricing, dig a little deeper in the cars that we'll sustain or come very close to sustaining the gross margin dollars we have enjoyed over the years.

So again, we think the back half of the year will show a lot better picture in terms of the same-store sales growth and the recycled product line.

Okay, great. Second question is, we've had some pretty hot weather, particularly in July. Have you guys seen any increased demand for mechanical parts?

That's somewhat seasonal. The things we see generally this time of year is that the mechanical parts requests come up. And I wouldn't say that this year's atypical by any stretch of the imagination.

The other thing we typically see this time of year is the competitiveness on the aftermarket parts sales comes up a little bit. As the volume of the work in the shops decreases, the shops will negotiate a little harder on their parts pricing. So we're seeing that predominantly on the aftermarket parts side of the Business. But once again, nothing out of -- out of the barn either way.

Okay, great. And last and final question here, the acquisition market -- is that continuing to gain steam here heading into the tax law change?

The acquisition environment is absolutely the strongest deal market we've seen in the -- probably hasn't been this good since 1998 when we first got started in the business. And I would say the -- overhearing two things in terms of seller motivation. One is certainly the lack of clarity of what capital gains rates are going to be next year. I think most people we talk to think it's a dead cinch that they move to 20%. And there's a lot of fear in the market right now that for some taxpayers that rate will be even more than 20%.

But I think the other -- the other thing we're starting to hear, John, in terms of why people are at the table -- and it really goes back to the comment I made in terms of LKQ's balance sheet and our unique position in our industry as really being the only publicly traded company in the market in our space -- is the fact that the liquidity of many owner-operators has really been choked. And the owner-operator who used to be able to borrow say $0.60 on the dollar on the basis of his inventory or inventory and receivables, his bank saw him the day that that's 20% or 25%. So these people, for probably the first time in the last decade, if they're going to grow their business, there's only way to do it. And that's to write a personal check. And thus, their personal funds enter the business. I think that's the other driving factor of why we're seeing a lot more people at the table.

Another really encouraging thing, and what I think is so stimulating about the deal flow right now is that it's really in every sector that we touch. You know, we're seeing owners of the late-model recycling yards at the table. Some of the aftermarket businesses are at the table as well. We're seeing people in the re-manufacturing or refinishing businesses interested in selling. Certainly, I think our more vocal interest in the paint business has drawn people into being interested in selling those businesses as well. So it's a very -- and, of course, the truck and the self-service yards -- but it's really kind of on all fronts.

The -- our deal team is stretched thin right now. We're trying to add resources to that. We're -- because I don't see this just as a 2010 phenomenon. I think this'll continue for a couple of years.

Great. Thanks very much, guys.

Thanks, John.

Thank you.

Our next question is coming from the line of Craig Kennison with Robert W. Baird.

Good morning. Thanks for taking my questions. First question -- how do you see the mix of recycled and/or -- and aftermarket growth trending in the balance of the year?

Certainly, based on the comments I just made to John, it's our view that the recycled product same-store sales growth in the next year is going to gain some steam. Because the seasonality of the third quarter is generally not one of -- one of our strongest quarters as demand, especially for crash parts, tends to ebb a little bit. But I guess I would see aftermarket staying pretty steady in terms of our usual trends that we've seen from year to year, but a little more robust environment for the recycled products.

Thanks. And then, as you face a little gross margin pressure on the cost side, could you address just what pricing opportunities you think you may have, and put that into the context of how OEM prices have trended recently?

Sure. As John mentioned, we're still seeing about historical costs for salvage. I mean, we did see a little bit of reduction here in late Q2. We have taken various steps, correct, to address that. One Joe mentioned was the monitoring of deviations. We have the ability to look at our reps reducing prices. And we're at the point now where we have the ability to lock down a price for a high-demand product that may be low in quantity. So we are watching our reps a lot closer than we ever have.

And as you mentioned correctly, we do price in relation to the OE part. We do track that daily, watching for any kind of trends that may go one way or the other. And in recent months, we've seen a slight increase in the OEs, a little bit more than a point of price increase. So we do watch that very closely and react to that when we can.

One of the other things that we are doing is locking down some of the reps' ability to bypass certain charges that we -- core charges, for example, where we sell a used engine and we expect the old one back to sell to a re-manufacturer. So we are in the process of really tightening that to make sure we get the proper price for the proper parts.

One last thing I will comment is that we do have pricing teams in each of our divisions. We have a separate price team for aftermarket and a separate price team for salvage. That monitoring certainly trends with the OEs as well as our competition. We expect our competition to have to address the same concerns we are at the auction. So we constantly monitor their activity as well.

And then lastly, Joe, just on the acquisition front, you added I think $14 million in revenue, which would annualize to about a $56 million run rate. Do you see that trend accelerating as you conclude the year, given prior comments that you'd hoped to maybe add as much as 10% to organic growth through acquisitions?

Yeah. First we should probably correct the run rate of the deals that were closed during the quarter. The $14 million was the annual run rate. They were very small deals, the ones that were closed during the quarter, and the ones that have been closed subsequent to that, slightly larger. But, yeah, I think we've said that we believe -- and the deal flow will typically be lumpy in the Company, and -- the ones you can't really forecast or when the more significant deals are going to hit.

But I think the guidance we've provided over the last several years, I would say, remains unchanged in terms of our view that the same-store sales growth of the business should fall somewhere in the range of 6% to 8%. And on a kind of three to five-year trajectory, there'll be enough deal flow that will move the overall revenue growth probably right up to the vicinity of high teens to 20%, which ironically is exactly where we hit in the current quarter that we're reporting in.

So I continue to feel very confident in that amount of deal flow over the next few years, and certainly plenty on the table. There's a chance we could out-perform that a little bit next year. But we look at this more on a three to four-year basis. I would continue to think we're looking at 10%, a little over 10% growth from acquisitions.

Great. Thank you.

Thanks, Craig.

Our next question is coming from the line of Tony Cristello with BB&T Capital Markets.

Thanks. Good morning, gentlemen.

Good morning.

Hi, Tony.

First question I had is, when you look at sort of the organic growth -- and you kept your 6% to 8% range the first half of this year -- you were sub-6% in both the first two quarters. I'm just wondering, is there something in July? I mean, you talked about the inventory. You talked about some of the sort of headwinds that you had in the first half of the year. But is there anything else in terms of your visibility into the second half that gives you confidence that the 6% to 8% is a very achievable range? Or are there some things that have to go your way to sort of move meaningfully into that? And then, maybe can you just comment on how July has looked relative to where that range is currently?

I think we've covered the factors of what we think will impact the second half of the year. The -- we have discussed the fact that we think the recycled parts inventory is certainly looking stronger than it has for almost a year at this point. And the buying continues to come in week after week at pretty impressive levels. As I said, are we paying a little more than we'd like? Yep, you bet we are. But the volumes are there. And I think we've always said that the constraint on growth in the Company is supply, not demand. And I remain comfortable with that comment.

On the aftermarket side of the business, I think our inventories are in very good shape. As a matter of fact, it's our intent to probably inventory up a little earlier than normal in 2010, just to try to avoid any shipping lane congestion. And we're starting to see some reports of container shortages. And it looks like a lot of shipping capacity has been dry-docked. So we're moving to get ahead of that in terms of bringing volume on a little sooner than we normally would. So I think it's probably more salient things that I comment on regarding the second half of the year.

And when you look at the activity in terms of fill rate, is that sort of still on that 65% level? Or are you starting to see that pick up here now that you've added some inventory?

Yeah, I think that'll be slow. But the not-in-stocks continue to be, I think, pretty impressive for the industry. But we did give up some ground in the not-in-stocks on recycled parts over the last couple of quarters. And I think that'll be a very gradual correction over the next 180 days. Fill rate on aftermarket parts, very impressive performance there. I think we're hitting levels as high as we've ever seen in terms of aftermarket product fill levels.

And on the gross margin, then, should we think that the run rate you've experienced this quarter is probably a normalized rate, at least until the pricing at auction gets a little bit more favorable and/or the pricing in general from a price increase pass-through, you get more benefit from that? I mean, how should we think about what is impacting that -- the ability to improve gross margin versus what could be a headwind?

Well, obviously, we're working on the pricing side, as Rob mentioned. The inventory, the way that it works is as we pay higher amounts for the cars, it bleeds through the next couple of months.

Now, Joe mentioned that we are seeing auction prices coming down a little bit. We probably won't start to turn those cars through the inventory, though, until Q4. So my -- although I don't want to get too granular here, because there's a little -- it's going to be a little bit dependent on what happens with the combination of scrap prices and auction prices. But as we see it today, probably Q3 will be a little bit soft. And then Q4 will bounce back, is the way I'm going to anticipate it.

Okay. And one last question, and maybe for Rob. And there's again been some noise out of Ford, and I know you've in the past had some issues, but have settled and some things went your way. Is that just again more noise? Or is there a bigger issue going on in the industry today with the regulation of aftermarket parts? And how do you see that sort of evolving as the increase in alternative parts continues to act as sort of a tailwind for you?

Well, we certainly do view it as noise right now. It's just an extension of the test with the Sawzall blade. As we mentioned last quarter and so on, and we did do the crash test on three late-model vehicles, with all passing. We then were asked by some about why we tested at 35 miles an hour. And we made it clear that we tested because of the safety requirements, the [SMVS] laws for occupant safety. So what we did is, we then set out to take 16 rebars and five absorbers and test those at 5 miles per hour. And every one of those passed.

We certainly take this very seriously, the activity that's going on. And that's really part of what -- our quality assurance program that addresses this stuff. We're at over 8,000 parts in the program were traceability is available on every one of those parts. And that was one of the concerns. So I think we've taken all of the necessary steps to take it to where we have comfortability in the fact that our parts are quality and meet the standards of the federal government.

At the end of the day, I think one of the best outcomes of this -- all of this activity is the fact that we have two certification bodies that are now going to start certifying these types of products. So we are actively supporting them. And we'll continue to buy those products and put them on our shelves to make sure we have the right products.

Okay, great. Thank you.

Thanks, Tony.

Our next question is coming from the line of Rod Lache with Deutsche Bank.

Hey, guys. Good morning. This is actually Dan, in for Rod this morning.

Okay, Dan.

Hi, Dan.

I know you've covered this in pretty good detail so far. But I was just wondering if there was any way to gauge if there's any difference in actual demand for recycled parts versus aftermarket parts? And it would seem that aftermarket growth be higher than recycled for about a year now. But you've also talked about your inventory being kind of down for a year. Is there any way to tell in terms of fill rates or inquiries like where demand stands between the two segments?

Wow. We do -- we do measure the request activity on our recycled products. That's easy to do, because when we have requests for parts, our systems automatically kind of allow you to look up. And that's something I monitor weekly personally, looking at request activity, quotes issued and inbound phone traffic. And that is -- that's stronger than it was a year go. It's remained strong. And it's strong year over year.

The aftermarket, the way our systems work, we really don't have that insight into the demand activity. The -- a lot of the demand's coming in over Websites. And our IT and that piece of our business doesn't really -- isn't recording some of the demand. So I don't know how we could really reflect on demand on the aftermarket parts, short of the fact that we're -- we continue to see the kind of 8%, 9% year-on-year growth. Some of that's obviously coming from, I think, a stronger inventory.

But I think it's also safe to say that with the number of carriers who are expanding their interests in programs like our AQRP program and are broadening the scope of aftermarket products, that they're willing to consider in the repair process, we know the demand is up. But I can't say that we can modify it.

Dan, it's John speaking. Maybe to supplement a little what Joe said, if you think about the aftermarket where we have 90% plus fill rates, we're essentially filling most of the calls when somebody comes in and asks for it.

On the salvage side, where the fill rates are probably 70%, obviously there's a lot of demand that we're not able to fill. And some of that manifested itself, as an example, in the engines that we talked about in Q2. I have no doubt in my mind that had we had those engines, we would've sold them in Q2. So the demand was there. We just can't fill it if we don't have the re-sellable parts.

And so, we -- in Q1 we talked about we were going into Q2 with a little bit lighter inventory. Joe mentioned that last quarter we bought over 50,000 cars, which was up 41% year over year. So in terms -- regardless of what happens with demand, I think the availability of supply will increase the sales, which is giving us some of the confidence in the prior question with respect to the back half growth rates.

I --

I appreciate -- yep, go ahead.

I guess one other little just comment is that if you think about a headlight, we sell a recycled headlight. We also sell a comparable aftermarket headlight. We also sell a comparable refurbished headlight. And those three products, when we talk about them today, we bifurcate where they came from. But from a customer point of view, they're being sold to the same customer. They're filling exactly the same function. They're priced incomparable. So as we're somewhat agnostic between the two product lines, in terms of the source, we're really looking at the demand side. And that is some of the comments that we talked about wherein we said we're considering amalgamating these two things. Because we view it as a single segment. And we think our customers -- we'd like them to be indifferent among these parts.

I appreciate the color on that. One more, if I could. I was interested to hear the comments on -- excuse me -- signing out -- signing deals with rental companies and fleet management companies. Can you give us a little more color on how these types of companies generally acquire their parts? And is this an opportunity for you to raise your penetration of their purchases significantly here? What's the -- and any kind of -- if you could put any kind of a range of the market out there?

Yeah. Historically, these have been buyers of new OEM parts, pure and simple. The rental car companies over most of the last decade have re-purchasing agreements with the manufacturers. And it's my understanding that part of those re-purchasing agreements were that the cars would be repaired with new OEM parts.

Now that the rental car companies are in positions that they actually own more of their own fleet, that parts -- replacement parts decision has -- there's more flexibility in it. And we believe our -- especially as the rental car companies are keeping their fleets closer to a three-year turnover now as opposed to 12 to 15 months, that's I think also putting those maintenance managers in a position of questioning whether or not all of their part replacements should be with new OEM parts.

So I -- that's a very, I think, rich market for us. It's not a huge market. But certainly we wouldn't be cannibalizing any parts that we already have today. Those are really new parts sales opportunities for us. And I would venture to say that the same is basically true of the fleet managers that we're experiencing gains with. And typically those repairs have been made almost exclusively with new OEM product historically.

And the answer to the other half of your question, Dan, is how they order the parts. It is coming through e-commerce. They're not picking up the phone and calling us. They're using our key list strategy, where they write an estimate and it scrubs against our inventory. So it's a B-to-B function that's worked out really well for us.

Okay. Thanks very much. And one other one, sorry. The Philadelphia market, is that a new market for you guys? Are there any kind of revenue synergies you can point to between that and other facilities in the area?

There certainly will be. We do service the Philadelphia market today. But our market share there is insignificant. I don't think we probably have even more than a $2.5 million recycled parts business in the Philadelphia market today. We're servicing the market essentially out of the Hunts Point Business in the Bronx. And, quite clearly, the product that we have in the Bronx, it's staying in the Bronx, because it's another market where we really need more capacity. But it's -- we've been chasing this market for a decade. I've personally been chasing this market for a decade. So we're really happy to have production and distribution capacity right in the heart of the Philly market now.

Okay. Thanks a lot. I appreciate the answers.

Hey, thanks.

Thanks.

Our next question is coming from the line of Nate Brochmann with William Blair. Please state your question.

Good morning, everyone.

Hi there.

Hi.

Good morning.

I'm wanting to see if you could put a little bit of extra color on the buying environment? John, you kind of mentioned that it's starting to improve a little bit. But, Joe, you were talking about still paying a higher, above-average price for the cars. Can you just talk about kind of a little bit more color in terms of what you're seeing there?

Yeah, certainly. The main measurements that we look at are just the overall volume of product at the auction. We're not sophisticated really enough to quantify kind of the value or the quality of what's there at the salvage auctions. And I monitor pretty closely kind of our activity levels of how much product we actually evaluate. And I consider any week when we see more than 50,000 vehicles at the auction pools to be relatively healthy, particularly when you consider the number I just gave you a few months ago. And we've been buying a little over 4,000 per week. So we've in fact consistently -- probably up to the last week, we're still seeing the auction volumes in the low 50,000 range. So we consider that to be a very healthy level.

And I've been very impressed with our field activity. A lot of our regions have brought additional scouts and additional buyers into the process, realizing that we need to evaluate more product. So, for example, last week I think we wrote up -- excuse me -- we evaluated about 45%, 46% of the product at the auction. That's up -- a year ago at this time we were probably evaluating around 33% to 35% of the vehicles at the auctions. So you can see that teams are digging a lot deeper, looking, evaluating significantly more product at the auction pools. And based on that, our win rates have come up quite a bit over the last two to three months.

That said, kind of the only -- the negative here is the beacon pricing. As I would see, it would have been in the March through May time frame as it would appear to me at this point right -- today that pricing probably peaked during that three-month time frame, came down in June and the pricing we've seen so far in July is showing a few more percentage points reduction over where we were in the June time frame.

I do think that the correction's going to be gradual. There's no snap-back sort of adjustment time in terms of the auction prices. It continues to be our belief it's largely -- not exclusively, but largely -- the used car market that's driving the high salvage prices. I think everything that we've seen relative to the used car market is that it remains to be a very strong market. And it's probably going to be a market that adjusts very gradually over the next one to two years.

That's great color. Thanks, Joe. And, Rob, maybe this is a question back for you. But you talk about pushing some pricing through and doing a little bit better job eliminating some of the discounts with some of your sales reps. How's the market acceptance of that kind of progressing?

I think the insurance industry is aware of the fact that we're paying more for the salvage, and certainly expect that to be passed on. We believe we're still competitive. And again, pricing to OE, we're still a price alternative to that number. So we always keep in mind the pricing of the OEs in the aftermarket world, as well. So we're still a price alternative to the OE in the aftermarket -- to the OE with the aftermarket and salvage. So I think we're maintaining a nice, comfortable margin for the carriers to make it worthwhile to run our parts.

Okay, great. Hey, thanks a lot.

Thanks, Nate.

I think we're going to do one more question. We're coming up on the hour and certainly want to be respectful of everybody's time. I know a lot of companies are releasing today. So let's do one more question, please, Claudia.

Okay. Our last question is coming from the line of Bill Armstrong with CL King & Associates. Please state your question.

Good morning. You had a -- obviously, a big increase in your other revenue category. Could -- would you be able to break out how much of that was volume versus the higher scrap metal prices?

We don't have a good breakdown of that. So -- pricing was up about 77%, though. As you can see, the organic growth was 81%, if I recall. A little bit more volume.

Got it. Okay. Your distribution expenses were essentially flat as a percentage of revenue, despite higher freight and fuel. Is that just kind of offset by more volume efficiencies?

Yeah.

Okay. And then, on the auction side, prices are still kind of high. Is that -- I think in your last call three months ago, you mentioned that it was really more an issue of maybe more buyers in the auctions rather than a lack of supply. Would you still characterize the auction conditions like that? Or are you seeing anything changing in the buy -- in the supply-demand equation there?

I think you've summarized that very accurately. The -- I think the volume of the products is in very good shape. It's our belief that the high used car price market has brought more buyers. People who would normally be buying at the wholesale auctions are also buying at the salvage auctions right now. And it's our belief that when used car pricing is -- gradually adjusts and the volumes of used cars come back up, those buyers will revert to buying in the wholesale auctions again.

Got it. Okay. And then, finally, the organic growth -- and I know you've addressed this already on the call -- organic growth for recycled has been pretty slow. And it sounds like it's your belief that as supply starts to ease up, you don't have the clunker vehicles, you're getting more parts revenue per vehicle. Is that what we should expect to see starting to happen in the third quarter and the fourth quarter?

That's our belief. Absolutely.

Yeah. Okay. All right, great. Thanks a lot.

Thank you.

All right.

Thanks, Bill. I appreciate everybody joining the call today. I'll look forward to getting back to you in 90 days to report on our third quarter progress. Thanks again.

Thank you.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. And we thank you for your participation.