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LKQ Corp (NASDAQ:LKQ)
Q3 2020 Earnings Call
Oct 29, 2020, 8:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

[Technical Issues]

Joseph P. Boutross -- Vice President, Investor Relations

Thank you, operator. Good morning, everyone, and welcome to LKQ's Third Quarter 2020 Earnings Conference Call. With us today are Nick Zarcone, LKQ's President and Chief Executive Officer; and Varun Laroyia, Executive Vice President and Chief Financial Officer. Please refer to the LKQ website at lkqcorp.com for our earnings release issued this morning as well as the accompanying slide presentation for this call. Now let me quickly cover the safe harbor. Some of the statements that we make today may be considered forward-looking.

These include statements regarding our expectations, beliefs, hopes, intentions or strategies. 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 statements. For more information, please refer to the risk factors discussed in our Form 10-K and subsequent reports filed with the SEC.

During this call, we will present both GAAP and non-GAAP financial measures. A reconciliation of GAAP to non-GAAP measures is included in today's earnings press release and slide presentation. Hopefully, everyone 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-Q in the next few days.

And with that, I'm happy to turn the call over to our CEO, Nick Zarcone.

Dominick Zarcone -- President and Chief Executive Officer

Thank you, Joe, and good morning to everybody on the call. This morning, I will provide some high-level operating highlights related to the third quarter before discussing some key metrics that are impacting the revenue trends in each of our segments. Varun will then dive into the financials with a key focus on the impact of the measures we initiated in late March across the entire organization to rightsize the cost structure and maximize cash flow.

He will also discuss our liquidity and the strength of our balance sheet before I come back with a few closing remarks. It's hard to believe that just six months ago, in early April, we were facing revenue declines of 40% to 45%, as economies around the world went into lockdown. Today, we are enjoying a material improvement in demand, year-over-year margin improvements in each of our segments and over $1 billion of free cash flow generated in just the first nine months of this year. In light of the challenging environment we have confronted throughout the year, our team delivered a terrific outcome in the third quarter.

These results clearly highlight the true strength of LKQ. This performance was achieved in the midst of having to make mission-critical decisions to protect the business, while simultaneously maintaining the morale of our most-important asset, our people. I could not be prouder of the effort of team LKQ. As noted on slide four, total revenue for the third quarter was $3 billion, reflecting a 3.2% decrease from the level recorded in the comparable period of 2019.

Global parts and services organic revenue declined 4.5% in the third quarter, while currencies and the net impact of divestitures and acquisitions collectively accounted for a 1.1% increase. Notwithstanding the soft revenue environment, our team reached a monumental milestone by delivering the highest level of quarterly earnings in the company's history. During the third quarter, diluted earnings per share on a GAAP basis was $0.64 compared to $0.49 last year, a 31% year-over-year increase. On an adjusted basis, diluted EPS was $0.75 compared to $0.61 or a 23% increase. Now on to the segments.

As you will note from slide six, parts and services revenue in North America declined 12.1% during the third quarter, with organic revenue growth for parts and services declining 11.3%. The lower organic demand is reflective of reduced levels of mobility as evidenced by meaningful year-over-year declines in both vehicle miles driven and fuel consumption. According to CCC, collision and liability-related repairable claims in the third quarter were down 24%. So again, we are clearly outperforming the claims data.

When looking at product-specific data, while both were down, our salvage revenue trends outperformed aftermarket, largely due to the demand of our mechanical parts, predominantly engines and transmissions. Still, our aftermarket collision-based revenue performed materially better than the CCC statistics for repairable claims, suggesting that we continue to experience share gains in the collision marketplace. There was particular strains in our remanufactured product line, as many market participants were disrupted by the component supplier's ability to provide product.

Given the depth and breadth of our remanufactured parts inventory, we were able to keep pace with demand and believe we gained share from our direct reman competitors in the third quarter. I would also highlight that despite the revenue decline, the segment EBITDA margin in North America was 17.6%, the highest quarterly level achieved in the company's history. Also, North America operational efficiency efforts continued to capture the $80 million in annualized permanent cost reductions that we've discussed over the past few quarters.

At the end of the third quarter, over 90% of those cost actions have been completed, with the balance scheduled to be finalized in the fourth quarter. Varun will dig deeper into the puts and takes of these numbers shortly. Regarding the competitive landscape, as many of you on the call know, in August, AutoNation announced that it will be closing its aftermarket collision parts business. This headline is both a commentary on the difficulty of growing a profitable aftermarket parts business and more importantly, a true testament to the strength of LKQ's aftermarket collision parts operations with our market-leading fulfillment rates, service reliability, nationwide coverage and unrivaled depth and breadth of inventory.

From a supply perspective, we have minimal issues sourcing product for our aftermarket crash parts business, and our Taiwanese supply partners are well positioned as we prepare for the winter season. We have seen some tightness getting adequate space on ships for our containers, causing some delay on product coming in from Taiwan and an uptick in freight expense. Depending on the supplier and product, we have witnessed delays anywhere from one week to 30 days. Having said that, our overall inventory is in good shape and heading in the right direction.

On the salvage front, auction volumes are still depressed, but we've seen a slight increase in activity over the past month. We did experience a rapid uptick in pricing during the quarter, as used car prices surged and the exporters resurfaced at the auctions. But our team has done a fantastic job at combating these price increases by harvesting more parts per vehicle and executing our price optimization strategy. When combined with the rise in precious metals prices, our efforts have allowed us to recapture a significant portion of the increased pricing at auction.

As we enter Q4, we have seen little change in pricing, but we are optimistic that this trend will reverse over the next few quarters as volumes return to historical level. While these pricing dynamics may put some pressure on salvage margins in the near term, when taken together with our productivity gains, over the longer term, we believe North America EBITDA margins will settle out well above 2019 levels. Now let's turn to Europe. Total revenue for our European segment during the third quarter rose 2.2% compared to the prior year.

Organic revenue for parts and services in the third quarter decreased 0.7%, while the negative impact of acquisitions and divestitures was a negative 1.5% and currencies added 4.5%. Throughout the quarter, most regions witnessed stronger-than-anticipated volumes, a very encouraging trend. As I stated in our second quarter call, not all regions were impacted by the COVID pandemic at the same time or to the same degree, creating a different growth profile for each of our European businesses. This difference in growth profile continued in the third quarter, but the variability in growth across the businesses were not as disparate when compared to Q2.

Importantly, certain key markets such as the U.K., Germany and the Netherlands posted single-digit organic revenue growth on a per day basis, with September generally reflecting the best month of the quarter. Italy continued to be the softest region posting the largest year-over-year declines, followed by the Central and Eastern European operations, which collectively were also down on a year-over-year basis. In the U.K., we have completed the restructuring of the Andrew page branches, with nearly 30 unprofitable branches closed and all remaining branches running on ECP's IT infrastructure.

While this branch restructuring likely cost us bit in terms of revenue growth, it enabled ECP to post double-digit EBITDA margins for the first time in the last 17 quarters. As the leading aftermarket mechanical parts distributor in the U.K., we believe ECP has the best margins in the market given the scale advantages and the operational efficiency as a result of our investments. Local management has done a terrific job of delivering on the key operational initiatives of profitable growth and enhanced and margins. Additionally, our Brexit contingency plan is in place and being thoughtfully executed, despite the significant uncertainty around the Brexit negotiations.

The team continues to effectively manage any safety stock risk in the U.K. Our European team continues to rightsize their inventory levels in the midst of the lower demand. As of late, we have seen softness in sourcing products broadly across our supply chain. And daily, we actively review, line by line, our inventory levels to assure our customer service and fulfillment rates continue to be industry-leading. I am happy to report, at this time, neither of those has been impacted largely because of our levels of safety stock. Lastly on Europe, the execution of our one LKQ Europe program remains on track.

As mentioned at our September 2020 Investor Day, we have pulled forward some activities relative to the original plan and have seen slight delays in other areas. Again, we've accelerated our platform rationalization, innovation and shared services development, talent acquisition efforts and the build-out of our digital strategy; while our ERP harmonization projects, procurement and product and yield management activities have been delayed by a quarter or 2. In total, we remain comfortable with both the magnitude and the cadence of the margin improvements set forth in the comprehensive review that Arnd and Yanik provided last month during the Investor Day event.

Moving on to Specialty. During the third quarter, our Specialty segment had total revenue growth of 1.4% composed of organic revenue growth for parts and services of 1.1% and acquisitions and currencies making up the balance. Given some industrywide inventory challenges, our organic growth rates were clearly hindered by the low availability of product to meet the robust demand, and we believe the lost revenue due to significant gaps in the supply chain. That said, we believe that our market-leading position allowed us to fare better than our competitors.

And as you would expect, we are in constant communication with our suppliers to work with them and help wherever we can to get more product out on the road. Over the past few weeks, we have seen an increase in product receipts, and we have finally started to increase our Specialty inventory levels, with sales growth rates increasing as a result. In particular, we are encouraged by the extended RV season, with this particular product group continuing to perform well. From a corporate development perspective, during the quarter, we acquired a mobile diagnostics business that provides our existing diagnostics business entry into the Virginia market and also add some technicians that will serve key markets throughout North Carolina.

Also during the quarter, STAHLGRUBER entered into an agreement to divest its 51% ownership stake in two small businesses located in Poland. These transactions represent our ongoing effort to rationalize our asset base through the divestiture of noncore, lower-margin businesses and finding new opportunities to grow our customer offerings. The net consideration related to these transactions was negligible. From an ESG perspective, during the third quarter, our recycling businesses processed 209,000 vehicles, resulting in, among other things, the recycling of 990,000 gallons of fuel, 581,000 gallons of waste oil, 542,000 tires and 191,000 batteries.

During Q3, we also processed approximately 286,000 tons of scrap steel. You can see that our businesses help preserve significant levels of natural resources, reduce the demand for scarce landfill space and reduce air and water pollution, all of which helps protect the environment. So where do we go from here? Similar to the second quarter, we have clearly benefited from a solid rebound in demand during Q3. But as widely publicized, there has been a resurgence in COVID cases across the globe, with positive test rates reaching all-time highs.

It is impossible to predict how the recent surge may impact our business, as it depends on how the governments around the globe react. Some countries are headed back to strict lockdowns, but most appeared to be focused more on curbing certain activities such as attending sporting events and other group functions, limiting in-restaurant dining and utilizing virtual schooling, all of which will continue to dampen mobility. While the horizon of the overall market demand remains foggy, we are hopeful that the industry will not return to the extreme market conditions experienced early in the second quarter.

With that as a backdrop, we do not expect any material improvement in mobility or overall industry demand in the fourth quarter, as there are no catalysts apparent to drive meaningful increases in miles driven. Until improvement is evident in our business, we remain intensely focused on controlling our cost and generating significant levels of cash flow.

And at this point, I will turn the call over to Varun.

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Thank you, Nick, and a very good morning from the LKQ offices in Chicago to everyone joining us today. I'm very excited to speak with you this morning on our third quarter results. When I joined LKQ in October 2017, I saw a market-leading business with an opportunity to become even stronger by becoming disciplined and more rigorous in the application of key management principles. Since then, following a very successful consolidation phase in the company's evolution, we shifted our focus to operational excellence with an emphasis on pursuing profitable revenue growth and generating high-quality, sustainable free cash flow.

Our 2020 results and especially the third quarter are an indication of the success of these multiyear efforts. I want to acknowledge the work of all our teams across the business in producing a record quarter of earnings per share and over $1 billion in free cash flow through nine months, while navigating a pandemic. That is truly outstanding performance. In my remarks, I will cover the progress we've made with margin expansion and cash flow generation and a brief recap of the segment results and our thoughts about the fourth quarter.

I'll start with slide seven, which shows the consolidated margins achieved over the last three years. You can see how prioritizing profitable revenue growth has played out in gross margin in the last couple of years. Each quarter in 2019 and 2020 has shown year-over-year improvement, except perhaps the third quarter of 2019, which was adversely impacted by 60 basis points from restructuring charges. Taking away that impact, it would have been seven consecutive quarters of year-over-year improvement.

Listen, I can't guarantee that The Street will continue uninterrupted, as we know there are positive and negative shocks that can pop up such as the effect from fluctuations in precious metal prices. However, I fundamentally believe that we are in a stronger and more resilient position today than a few years ago, linked to rightsizing and productivity actions and margin initiatives implemented across each of our segments that recognize the world-class fill rate, service and value that we provide to our customers to help them achieve their goals.

Additionally, with the portfolio deep dive that we initiated in line with the operational excellence program, an integral part of our ongoing efforts to rationalize our asset base, the divestiture of lower-margin and noncore businesses is increasing our margin profile and improving returns on invested capital, all of which is a sustainable development. Shifting to segment EBITDA. We recognize that the benefits of our gross margin improvement initiatives were being partially or fully offset by changes in overhead expense leverage.

As you will recall, we implemented a global restructuring program in 2019 to drive operating efficiencies, along with the ongoing one LKQ Europe program. When the global pandemic struck in early 2020, we took tough and decisive actions to accelerate the cost savings initiatives. We acted immediately to align overhead expenses with revenue changes through actions such as furloughs, salary reductions and bypassed discretionary and other non-mission-critical spending.

Further and more importantly, we made permanent reductions through another restructuring program that targeted inefficient operations that had built up over years of relentless revenue growth. These cost actions have been critical to the margin success we've seen in the last two quarters during the pandemic, including the 210 basis point year-over-year improvement in the third quarter. Looking at slide eight, you can see the effects of our cost structure actions, with the largest cuts coming in Q2, followed by some increase owing to operational activity in Q3, as revenue recovered.

Importantly, we've layered back expenses at a lower rate than the revenue increase. Sequential revenue in the third quarter increased by 16%, while overhead expenses grew only by 10%, thus creating positive operating leverage. We are encouraged by these results and the level of permanent cost savings being achieved across the business. On slide 10, you'll see a summary of the consolidated results for the quarter, highlighted by impressive profitability increases on the segment EBITDA and EPS lines. Moving to segment performance.

We are very pleased with the North America results, as shown on slide 11. The segment EBITDA margin of 17.6% is the highest we've seen in the history of the company and merits additional praise for coming in the third quarter, which traditionally runs at a lower margin than the first two. The gross margin remains strong due to pricing and rightsizing actions and was further enhanced by favorable impacts from scrap steel and precious metal prices. It's difficult to forecast how long the precious metals benefit will last. The current prices support a continuing benefit into the fourth quarter, although at a diminished level, as car costs adjust for the increase.

We expect some downward pressure on gross margin in the fourth quarter from higher salvage car costs, and the team is working to mitigate those effects. North America has done an exemplary job of leveraging operating expenses as evidenced by a 5% sequential increase in opex in Q3 to deliver a 15% revenue increase. Personnel costs are the biggest driver of improvement, reflecting reduced headcount, lower medical claims, improved safety performance, lower overtime and limited travel expenses.

With gross margin expansion and operating expense leverage, North America delivered an incredible result. As you heard at our Virtual Investor Day last month and see in these results, the North American management team has embraced the operational excellence mindset and is delivering outstanding performance. Europe also produced a strong segment EBITDA margin in the third quarter, coming in at 9.2%, which is its highest figure since the second quarter of 2017.

As shown on slide 12, the gross margin remains solid at 37.1% and generated most of the year-over-year improvement in segment EBITDA, largely due to margin enhancement initiatives implemented to pursue our profitable revenue growth objective. Overhead expenses are down in local currency versus last year as a result of permanent and temporary headcount reductions, limited travel expenses and aid from government programs in Europe. We know that there is more work to do in Europe to realize the full benefits of the one LKQ Europe program, but we now have the right team in place, and we are confident that they're positioned to meet or exceed the segment EBITDA margin target for the second half of 2020 that was presented during Investor Day.

Turning to slide 13. Specialty continues to perform well through the pandemic, producing a 60 basis point improvement in segment EBITDA. There is some year-over-year mix shift impacting gross margin and freight expenses in offsetting directions, leaving personnel expenses as the primary driver of the improvement. Specialty made significant reductions in 2019 but was able to identify additional opportunities to drive efficiency and productivity. We've seen this benefit come through in the operating expense leverage.

So in summary, Q3 was an excellent quarter for all three of our segments. Each faced challenging conditions and yet produced year-over-year improvements. Reflecting upon the journey we've taken over the last few years, I vividly recall Q1 2018 when, as a newbie to LKQ, the business generated $5 million of incremental segment EBITDA on a revenue increase of $378 million, and contrast that against this quarter with a $52 million increase year-over-year in segment EBITDA despite a $100 million decrease in revenue. There's a lot of hard work and difficult decisions that got us to this position.

A massive thank you to all of my LKQ colleagues who have helped make this happen. Now on to cash flow and liquidity. Q3 was another successful quarter for cash flow generation. We added $222 million in operating cash flows, as we continued to benefit from reductions in trade working capital, especially inventory. As expected and stated on the second quarter earnings call, some of the tax payment deferral that boosted cash flow in the first half reversed this quarter as we caught up on income tax and VAT payments, which partially offset the trade working capital benefit.

The vendor financing program in Europe continues to ramp up with an increase in supplier participation, which we expect to yield benefits in 2021. During the fourth quarter, we give back some of the year-to-date trade working capital-related benefits as we plan to increase our inventory levels to support the service and fill rate requirements of our businesses based on the revenue trend and expectations for 2021, including normal seasonality as we approach the winter. As previously mentioned, while we expect to be able to operate effectively at a lower inventory balance than we exited 2019, the September figure isn't sustainable in the long run for us to continue our best-in-class fill rates.

As shown on slide 14, operating cash flows were $1.1 billion through September, and capex cash outlays were $110 million. The resulting free cash flow was used to pay down over $1 billion in debt. We are very pleased with the trend in EBITDA to free cash flow conversion, as presented on slide 15, though we know that the 2020 ratio of 108% just isn't sustainable. However, the strong conversion this year demonstrates the ability of the business to generate significant cash during periods of extreme volatility. On slide 16, you can see the progress we've made this year to strengthen our liquidity position. I want to highlight the net leverage ratio, which has decreased to two times from 2.6 times at the end of 2019.

We've targeted to maintain our net leverage around the two times level, as I stated at the Investor Day last month. And reaching this level creates flexibility in our capital allocation decisions, while continuing to pursue investment-grade metrics. We will still opportunistically pay down debt when appropriate. And the target net leverage ratio, combined with a solid total liquidity position, gives us confidence to restart the share repurchase program. As you recall, we voluntarily halted the program in March to preserve cash as we worked to understand the pandemic's effect on our business.

No different than before, we will repurchase shares when we feel market conditions are favorable under our remaining authorization. Finally, I will close with a couple of thoughts on the fourth quarter. As COVID uncertainties remain, we are not providing full financial guidance for 2020. However, our experiences obtained from operating in the pandemic over the last seven months gives us comfort in making the following statements, which assumes extreme mobility restrictions, I repeat, which assumes that extreme mobility restrictions are not reimplemented in our major markets.

One, we believe that the full organic parts and services revenue recovery will come through sometime in 2021. Though near term, our fourth quarter revenue will be lower than the reported 2019 figure. Two, with the ongoing benefit of our focus on cost and productivity actions and margin improvement efforts, we expect our fourth quarter adjusted diluted earnings per share to be above the comparable figure for 2019. And finally, we project that free cash flow for the full year 2020 will be a minimum of $900 million, up double-digit year-over-year despite the lower revenue. So once again, thank you for your time and attention this morning.

And with that, I'll turn the call back to Nick for his closing comments.

Dominick Zarcone -- President and Chief Executive Officer

Thank you, Varun, for that detailed financial update. In closing, our performance in the quarter clearly illustrates the strength of our business, which is driven by a tremendous team that is focused on our key initiatives of driving profitable revenue growth, enhanced margins and free cash flow. Regardless of the operating environment and hurdles confronted, our team once again delivered on each one of these initiatives in the quarter. No one at LKQ takes for granted how hard we work to create our market-leading positions, and all levels of the organization are laser-focused on maintaining and growing these positions each and every day.

The strength of our three reporting segments is based on our geographic, customer and product diversity, unmatched inventory levels and the high levels of fulfillment rates across all of our segments, which is all supported by a proud culture of putting the customer at the center of everything we do. With these key initiatives in place and the best operating teams in the industry, we are confident that we will continue to drive long-term value for our shareholders.

Operator, we are now ready to open the call to questions.

Questions and Answers:

Operator

[Operator Instructions] Our first question is from Daniel Imbro of Stephens.

Daniel Imbro -- Stephens -- Analyst

Hi, guys. Congrats on the quarter.

Dominick Zarcone -- President and Chief Executive Officer

Thanks, Daniel.

Joseph P. Boutross -- Vice President, Investor Relations

Thanks, Daniel.

Daniel Imbro -- Stephens -- Analyst

Varun, I wanted to ask one on opex, specifically on the personnel. I think in the slide, you mentioned personnel was down 12%. That included some portion of permanent costs but also some portion of like lack of merit-based expenses -- or merit-based increases, which should come back eventually, I would think. Over what kind of time frame do you expect that to normalize? And can you help us think about what that 12% looks like by segment? Is it more concentrated in North America or Europe? Any kind of color there would be helpful.

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Absolutely, Daniel.Good morning to you and everyone else joining us this morning also. So yes, in terms of when you look at the personnel costs, that's really the one area which is a significant portion, in fact, by far, the largest key element of our operating expenses. With regards to some of the temporary cost savings that we had implemented in the second quarter, I think, as we've mentioned, in the third quarter, those pretty much came back. So if your question is in terms of what level of the bypassed merit or the salary trims that had taken place, those are currently running on a normal basis as of now.

So from that perspective, that's going to come back. But I think more importantly, what you should think about is the permanent cost reduction that we've called out exactly seven weeks ago by segment at our Virtual Investor Day on the 10th of September. North America and Europe, both of them are driving hard on that front. North America is ahead with regards to the execution of that program, and we're certainly seeing that benefit come through. So all in all, I'm happy with the way we're managing our cost structure, given the extreme volatility there is out there in the market.

Operator

Our next question is from Scott Stember of CL King.

Dominick Zarcone -- President and Chief Executive Officer

Good morning, Scott.

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Good morning, Scott.

Scott Stember -- CL King -- Analyst

Again, thanks for taking my question. Congrats on a great quarter.

Dominick Zarcone -- President and Chief Executive Officer

Thank you, Scott.

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Thank you.

Scott Stember -- CL King -- Analyst

You talked about, obviously, some certain caution regarding the increased infection rate throughout the world. I'm just trying to get a sense of what we've seen so far in October. Have you seen any material difference from the trajectory of recovery in Europe, particularly in the U.K. and the Netherlands and Germany?

Dominick Zarcone -- President and Chief Executive Officer

So, obviously, we had a -- what we think was a pretty good third quarter across the enterprise, given where we are with miles driven and the like. Importantly, in Europe, while we were down 0.7% organic for the quarter, some of the key markets were up kind of single digits, particularly the U.K., Germany and the Netherlands; and September was the best month, generally of the quarter, so that was encouraging. The -- we haven't seen a significant move in the first couple of weeks of October, either up or down, quite frankly. But the spikes in the cases have just -- they've just started.

And the governments are just beginning to think about what their action plans are going to be. Actually, since we've been on this call, I saw a note that France is going into pretty much of a severe lockdown. Now we don't have much business in France, so that won't have an impact on us. The key, Scott, is how are the governments around the globe going to react to the current spike in positive cases. And we just don't have any clarity as to how that's going to be. But thus far, we're OK.

Operator

Our next question is from Brian Butler of Stifel.

Dominick Zarcone -- President and Chief Executive Officer

Good morning, Brian.

Brian Butler -- Stifel -- Analyst

I just wanted to maybe go in a little bit more on the working capital, and if you could provide a little bit more color. I know you said that it was going to -- you're going to give back some of that, but maybe a little bit of color in the fourth quarter, where that comes. Is that a couple of hundred million dollars in inventory? Or anything that could help us get that fourth quarter number right.

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Yes, absolutely. I think it's a great question. And as I kind of called out in the second quarter and then also at invents to the last month and then earlier this morning, the working capital conversion as of now is running significantly higher, essentially proving that the business model that LKQ operates has the ability to generate significant amounts of free cash, as we've proven yet again. With regards to the fourth quarter, given as to how revenue trends are coming through, we do see ourselves investing in inventory, specifically.

And again, it's broad-based but largely within our specialty segment, which essentially has been constrained up to a certain point to -- with regards to inventory availability. It is flowing at this point of time, but that clearly is the one key priority that we are pushing pretty hard on. And so, really, it will be the inventory build for a few reasons, Brian. One, we are significantly lower than where the revenue is currently trending. We do expect the balance sheet to also flex based on revenue. But as you know, revenue is running a little bit better than where the inventory levels are.

We do not have any fill rate issues. We do not have any stock-outs, but we certainly want to maintain our best-in-class and class-leading fill rates and service levels. So that is something that we're not willing to compromise on. So really from that perspective, as I called out this morning also, we will be delivering at least a minimum of $900 million of free cash flow for the full year. A year ago, it was roughly about $800 million.

So that certainly makes sense with regards to a double-digit conversion. And then the final piece really is, as you think about our key selling season. It's the first and the second quarter. And so, now is the time when we need to rebuild the inventory levels for that seasonal uptick as we head into the winter. So yes, we will see some trade working capital giveback, and really, it will be within the inventory side.

Operator

Our next question is from Craig Kennison of R. W. Baird.

Craig Kennison -- R. W. Baird -- Analyst

Hey, good morning. Thanks for taking my question.

Dominick Zarcone -- President and Chief Executive Officer

Good morning, Craig.

Craig Kennison -- R. W. Baird -- Analyst

One of the -- Hey, Nick. Good morning. I wanted to ask about just the pandemic here. I mean, it's been particularly hard on small businesses. I'm curious what you see as your competitive change in position here. I'm sure you've got some small competitors that are struggling, but then also, you've got some customers here who are also small businesses, who also may be struggling. And just wondering how all of that dynamic plays out maybe in 2021 as things hopefully normalize.

Dominick Zarcone -- President and Chief Executive Officer

Yes, I wish I had a crystal ball, Craig. The reality is, it's all going to depend on what the governments around the globe do, not only as it relates to kind of controlling the pandemic B2B restrictions on mobility, which obviously, as we saw in the second and third quarter, have a negative impact on the overall demand in our industry. And that hits not only distributors like ourselves, but it also hits our customers. And also, what they do from an economic stimulus perspective.

The reality is we saw some of our competitors early in the pandemic shut their doors for a couple of weeks. And almost as soon as the Payroll Protection Plan monies got distributed, they opened back up. But that tells you kind of how much on the line some of those smaller businesses are in being able to keep the doors open. If there are significant restrictions on mobility, such as demand for repair services and related parts is down, and there is no government support, well, that's going to really put the smaller businesses at risk. If the governments come along with another big funding, if you will, to help businesses stay afloat, that will obviously mitigate.

What we've seen across the globe is not a rash of people going out of business. But we know, for a fact, like in the U.K., market demand in the third quarter was down. Our organic revenue in the U.K. was up, so we're taking share. And we believe that the larger, well capitalized businesses are doing OK in this environment, and the smaller undercapitalized businesses are going to continue to struggle. So, the answer to your question, Craig, it all depends on how deep the restrictions are in mobility and what kind of programs are in place, particularly for smaller businesses by the government to keep them going.

Operator

Our next question is from Bret Jordan of Jefferies.

Bret Jordan -- Jefferies -- Analyst

Hey, Good morning, guys.

Dominick Zarcone -- President and Chief Executive Officer

Good morning, Bret.

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Good morning.

Bret Jordan -- Jefferies -- Analyst

With another quarter of accounts payable experience under your belt, Varun, I guess, could you give us a feeling where you think you might be able to get your payables ratio in Europe? And obviously, I guess your aggregate AP is like 37%. But what do you think your total payables ratio could be companywide, as you sort of run this program forward?

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Yes. Listen, great question and very happy with the way the payables program is coming along in Europe, both the formal vendor financing program but also the ongoing discussions with our supplier community. We keep ramping that piece up. We've seen some benefit in the current fiscal year. But really where we expect to see a lot of those negotiations come to fruition will be in 2021. And again, it's not everything going to the formal vendor financing program. In a number of cases, Bret, we actually have our supplier basically giving us what we're looking for from an extended payment term perspective in any case.

So, overall, things are moving in the right direction. All I'll say is there is still a tremendous opportunity within our European segment. Our teams are working hard on that front. We have prioritized the top 40 suppliers, and those discussions have come through really strongly. There is still a large portion of the remainder of COGS in Europe to actually come through. In terms of giving you an absolute number, listen, this is a multiyear program.

And despite that fact, I know folks would be clamoring to try and to get a target number that we are chasing. Listen, it's one step at a time. In many ways, this is the first time it's been done across the European continent in our industry, and I'm glad with -- we now have a partner that's also pushing hard on that front in the two largest protagonists across the European continent. So we know we're not alone on that front. Great progress being made, and we keep resetting the bar with regards to where we expect this program to end up.

Operator

Our next question is from Stephanie Benjamin of Truist.

Stephanie Benjamin -- Truist -- Analyst

You guys have noted, firstly at your Analyst Day, but again today, that you reshuffled some of your margin improvement initiatives in Europe, delayed some like ERP, but accelerated others. Is this updated strategy kind of less reliant on the top line improvement? I'm just trying to get a sense of, OK, worst-case scenario, Europe does see a meaningful lockdown, how these initiatives can still be realized even at a tougher top line environment.

Dominick Zarcone -- President and Chief Executive Officer

Good morning, Stephanie, and good question. The reality is it's a combination of both, right? I mean, some of the things that we're doing, clearly, we are going to be moving toward a shared service center. That's really not dependent on revenue flow in any given quarter. That's all about just trying to really get rid of some duplicative costs that are being incurred across the platform currently, and pool them all together in a single spot. And again, that's one of those items that we mentioned back in September 10 that we're pulling forward in the overall plan.

Other items like procurement benefits, there is a direct or a relatively direct connection to revenue because as revenue goes up, our procurement and our inventories need to go up to support that higher level of revenue, which means our supplier rebates and the like go up. If revenue goes down, we're buying a little bit less from the suppliers, and our rebates go down. And so that's -- so some of it is not impacted by revenue.

And the things that are totally under our control, we're trying to move forward. Other things have a connection to revenue. So it's a little bit of a mixed bag. As of now, like I indicated, we are comfortable with both the magnitude and the cadence of the margin developments and forecast that we provided during the Analyst Day about 50 days ago.

Operator

[Operator Instructions] And our next question is from Daniel Imbro of Stephens.

Daniel Imbro -- Stephens -- Analyst

I have a follow-up, guys. Varun, I wanted to touch on the cost side of the equation. You mentioned in your segment discussion that freight costs are also increasing. I think in the slide, you said you increased your third-party freight exposure. Can you talk about what potential offsets you have to mitigate that risk? And maybe can you compare where you're at today versus where we were at in the last freight cycle in 2017, when it was a pretty big headwind to margins for you guys? Maybe just compare the two situations.

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Yes, absolutely. And yes, we are seeing an increase in freight. Freight is actually impacting both our COGS. So, if you think about North America, aftermarket supplies coming in from Taiwan, Daniel, we have seen a spike in the spot rates for ocean freight. So that has spiked. We're still able to get our product delivered, so no issues from an inventory availability. We're actually getting it through. But yes, we have seen a spike in spot rates on that front.

I think the other piece I'd probably -- I'd point you toward is, see how the big freight forwarders and carriers here in the United States, but also the same folks in Europe. The UPS and FedExes of this world, I mean, they essentially are also doing incredibly well, and they have taken their charges up. The final one really is we are seeing an uptick in e-commerce and online purchases. So, from that perspective, there is some tightness in demand out there. The ongoing challenge of finding delivery drivers, it's no different to others within our industry or for that matter, anyone else within the distribution space per se.

And so from that perspective, what we have done from, call it, the first quarter 2018 where we saw this piece initially, we obviously did become more efficient with regards to the amount of product that was being shuttled around. And where it was being transported on a cross country basis, for example, to kind of keep our fill rates up. The example I gave was from Q1 2018, where revenue was up like just under $400 million, and all it really kind of got us was about $5 million of incremental segment EBITDA. We've obviously put those learnings into place.

And yes, there are certain charges that we do apply as and when those are necessitated. So we're certainly mitigating a lot of it through the learnings of the past couple of years. But clearly, there is an uptick on that front. And our teams with regards to route optimization, our road map proliferation across the network or for that matter, the number of deliveries that end up taking place, all of that piece is being worked into the equation. So, I'm really happy with the way our segment teams, in fact, all three segment teams are dealing with this spike in freight and delivery costs.

Operator

[Operator Instructions] And we have no further questions. I'd like to turn the call back to Nick Zarcone for any closing remarks.

Dominick Zarcone -- President and Chief Executive Officer

Well, thank you, everyone, for joining us on this call. Again, we believe we reported just terrific results during the third quarter of 2020. We are working hard to make sure that we can do everything under our control to deal with the impact of the pandemic, both, obviously, what's occurred thus far and what may ever lie ahead for the globe going forward. You can trust that we are going to be extremely focused on our cost structure and continuing to generate cash.

On that, I want to give a huge thank you to everybody on the LKQ team because it has absolutely been a huge team effort to get us where we are today. And lastly, we started off, right before this call, with a piece of birthday cake for none other than Joe Boutross, whose birthday is today. So, Joe, happy birthday to you. I know most of the folks on the call, and I know you well, and I'm sure they extend their best wishes. So, we will talk again after fourth quarter results, and we appreciate your attention. Take care.

Operator

[Operator Closing Remarks]

Duration: 55 minutes

Call participants:

Joseph P. Boutross -- Vice President, Investor Relations

Dominick Zarcone -- President and Chief Executive Officer

Varun Laroyia -- Executive Vice President and Chief Financial Officer

Daniel Imbro -- Stephens -- Analyst

Scott Stember -- CL King -- Analyst

Brian Butler -- Stifel -- Analyst

Craig Kennison -- R. W. Baird -- Analyst

Bret Jordan -- Jefferies -- Analyst

Stephanie Benjamin -- Truist -- Analyst

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