Good morning. My name is Janisha, and I will be your conference operator today. At this time, I would like to welcome everyone to the third quarter 2013 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you, Mr. Ed Egl, Director, Investor Relations, you may begin your conference.
Thank you, Janisha. Good morning, everyone, and thank you for joining us for our third quarter 2013 earnings conference call. With me this morning are David Steiner, President and Chief Executive Officer, Jim Fish, Executive Vice President and Chief Financial Officer, and Jim Trevathan, Executive Vice President and Chief Operating Officer. Before we get started, please note that we have filed a Form 8-K this morning that includes the earnings press release as Exhibit 99.1 and is available on our website at www.wm.com. The Form 8-K, the press release, and the schedules to the press release include important information. During the call, you will hear forward-looking statements which are based on current expectations, projections, estimates, opinions, or beliefs about future periods. Such statements are subject to risks and uncertainties that could cause actual results to differ materially.
Some of these risks and uncertainties are detailed in today's press release and in our filings with the Securities and Exchange Commission, including our most recent Form 10-K. David and Jim will discuss our results in the areas of internal revenue growth from yield and internal revenue growth from volume. Unless stated otherwise, please note that any reference to yield or volume results are more specifically referring to internal revenue growth or IRG from yield or volume. Additionally, any comparisons, unless otherwise stated, will be with the third quarter of 2012. During the call, David and Jim will discuss our earnings per diluted share, which they may refer to as EPS or earnings per share on an as-adjusted basis. David will also discuss operating EBITDA as defined in our Form 8-K filed today.
Our EPS, operating EBITDA, operating EBITDA margin, income from operations, income from operations margins, operating expenses, and prior year SG&A expense have been adjusted to exclude items that management believes do not reflect our fundamental business performance or are not indicative of our results of operations. These measures, in addition to free cash flow, are non-GAAP measures. Please refer to the earnings press release footnote and the schedules attached thereto, together with Item 2.02 of the Form 8-K filed today, both of which can be found on the company's website at www.wm.com, for reconciliation to the most comparable GAAP measures and additional information about our use of non-GAAP measures. This call is being recorded and will be available 24 hours a day beginning at approximately 1:00 P.M. Eastern Time today until 5:00 P.M. Eastern Time on November 12th.
To hear a replay of the call over the internet, access the Waste Management website at www.wm.com. To hear a telephonic replay of the call, dial 855-859-2056 and enter reservation code 66496035. Time-sensitive information provided during today's call, which is occurring on October 29th, 2013, may no longer be accurate at the time of a replay. Any redistribution, retransmission, or rebroadcast of this call in any form without the express written consent of Waste Management is prohibited. I'll turn the call over to Waste Management's President and CEO, David Steiner.
Thanks, Ed. Good morning from Houston. We're pleased with our results for the third quarter, as our earnings per share increased 30% on an as-reported basis and 6.6% as adjusted to $0.65 per share. At the beginning of the year, we said that we would get back to basics by focusing on yield and cost controls. Our corporate and field managers have done just that and done it very well. On the cost side, SG&A as a percent of revenue is 9.6%, the lowest it's been since 2005. Our operating cost programs continue to gain traction and should accelerate into 2014. On the yield side, our results again show that focusing on yield works, and we will continue to do so.
Driven by the improved yield, we expanded both income from operations and operating EBITDA margins in the quarter, despite continued headwinds confronting our recycling and waste-to-energy businesses and modestly lower volume. In the third quarter, our overall income from operations grew $33 million, and the overall income from operations margin grew 20 basis points. We also grew overall operating EBITDA by $46 million and overall operating EBITDA margin by 10 basis points. The results were even more impressive when you drill down into our traditional solid waste business, where income from operations grew $71 million and the income from operations margin grew 120 basis points, while operating EBITDA grew by $74 million and operating EBITDA margin grew 90 basis points. This demonstrates the continued strength of our core solid waste business. In our recycling business, we expected the third-quarter impact to be a negative $0.01 to earnings per share.
Recycling operations actually had a negative $0.02 effect on the quarter. In the quarter, we saw a slight improvement in recycling commodity prices that was more than offset by increased costs from the operations of acquired businesses and the continued impact of the Chinese Green Fence. For fourth-quarter recycling operations, we had most recently projected a positive $0.01 impact on earnings per share when compared to 2012. We now think that the impact from our recycling operations will be approximately a negative $0.03 per share in the fourth quarter, which is slightly worse than Q3. That is a result of tougher year-over-year comparisons and relatively flat commodity prices when looking at our full basket of recycled commodities. For the full year, we anticipate that the negative impact from recycling operations will be around $0.13 per share.
The last two years at our recycling facilities have been characterized by low commodity prices and higher operating costs. We've incurred extra costs as we've had to reduce contamination from materials processed in our single-stream plants to improve the quality of our bales to meet regulatory and customer requirements. In addition, recycling commodity prices can be volatile, which leads to volatile earnings in our recycling business. There is no quick, easy solution to these challenges, we're taking a variety of steps to increase earnings and decrease volatility. These solutions require us to change the way that we contract with our customers. Already, our areas are having more direct conversations with customers and are successfully decreasing rebates because of increased contamination levels in the customer's recycling streams. We must do more.
Going forward, our contracts will contain the following protections that we need in order to earn an acceptable return on the capital that we've invested in our recycling business. First, many recycling contracts simply call for a split of the revenue from the sale of the commodities. This approach limits our ability to fully recover our processing costs when commodity prices are low. Our new contracts will call for us to be paid a processing fee before there's a split of revenue from commodity sales. However, when operating costs go up, as they have under the Chinese Green Fence, we still risk losing money unless we can recover those increased costs. The single largest factor driving up processing costs is the level of contamination in the materials that we receive from our customers.
The second change we will make is that going forward, our customer contracts will have contamination limits. We will also require a mechanism to audit the inbound materials to ensure compliance with those limits. If the materials contain too much contamination, either we will recover a higher processing fee, or we will reduce the rebate to the customer to cover our increased costs. We will also continue to educate our customers about the proper materials to place in their recycling bins through our Recycle Often. Recycle Right. program to try to reduce contamination rates. Third, our contracts need to have some flexibility to increase the processing charge or decrease rebates when outside business factors drive up our processing or other costs. For example, if regulations like the Chinese Green Fence increase our costs, we should be able to pass through incremental pricing to cover those costs.
Finally, we need to do a better job of working with our customers to ensure that we can earn an acceptable return on commodities that are, or that may become, low-value commodities. For example, today, we lose money recycling glass. In most locations, we have to pay a third party to take the glass. For those types of materials, our contracts need to contain language that either allow us to pass along those increased costs to our customers or allow the customer to make a decision to remove a low-value commodity from the recycling stream until such time as the commodity can be economically recycled. As you can see, there is no easy fix in the recycling business. Our recycling contracts are generally 3- to 5-year contracts.
Over time, as more and more of our contracts contain these protections, we should see recycling return to being a more stable income producer that consistently earns a fair return on capital. Turning back to yield, our yield from our collection and disposal operations was 2.3%, the fifth consecutive quarter of sequential yield improvement and nearly triple the yield we saw in the third quarter of 2012. If you add in our fuel surcharge and adjust for our South Florida waste-to-energy plant, we achieved yield of 2.8%. We achieved core price of 3.9%, which is an increase of 160 basis points from the third quarter of 2012. This is our best core price performance since before 2010. We also saw the highest core price in over 10 years in the commercial and industrial lines of business, and the second highest in the landfill line of business.
Our yield increase in the quarter more than offset the loss in volumes, resulting in overall growth in revenues and margins. The benefit of strong yield is most evident in our industrial line of business, where we achieved the highest ever income from operations and income from operations margin despite negative volumes. This industrial income increase was driven by yield of 5.5% and core price of 8.4%, which is the highest in nearly a decade. We've also intentionally shed low-margin roll-off volumes and avoided adding low-margin new business. As we've said repeatedly over the years, the yield versus volume trade-off always favored yield. In the third quarter, we proved this once again. Of course, we want to retain our current customer base, but we want to do so using tools other than price.
We will focus on improving retention by providing customers with better service and higher-value solutions, we will not chase volumes with low prices or large rollbacks. In our commercial and residential line of business, we had the highest yield that we've seen since 2011. Commercial yield was 3.4% in the quarter, and residential yield was 2%. Finally, MSW yield was the highest since 2010 at 1.9%. Taken alone, the yield story is a great one. The bigger story is the increased income from operations and margins in each of these lines of business that are driven by increased yield. The commercial business saw increased margins of 40 basis points. Industrial margins increased 130 basis points. Residential margins increased 60 basis points, and our landfill margins increased 80 basis points.
We saw this margin growth even though volumes were down 0.6% in the quarter and down 1.3% on a workday-adjusted basis. However, the lower volumes were more than offset by higher yield. For the quarter, recycling volumes declined 1.2% versus last year's high single-digit growth. Our waste-to-energy volumes were down 3.2%, primarily due to lower third-party volumes at our South Florida plants. We also saw a modest sequential decline in volumes in our collection and landfill business. On the positive side, we're encouraged to see that the service increases in our commercial business exceeded service decreases for the second consecutive quarter. In summary, we maintained our disciplined approach to improving price, reducing costs, and managing working capital and capital expenditures, which is reflected in our third-quarter results.
We remain confident that we will achieve our goals despite an expected $0.13 per share of full-year headwinds from our recycling operations, which is $0.11 per share more than we anticipated at the beginning of the year. Based upon our year-to-date results, we are confident that we can achieve our guidance range of between $2.15 and $2.20 of adjusted EPS. With our strong free cash flow, we are raising our free cash flow target by $100 million to between $1.2 billion and $1.3 billion. We've laid a solid foundation in 2013, a foundation built upon yield and cost control and driven by our corporate and field management, who continue to perform at an extraordinary level. That foundation is serving us well in 2013, and we expect this foundation to continue to drive high single-digit earnings growth in 2014.
I will now turn the call over to Jim to discuss our third quarter results in more detail.
Thank you, David. I will start by discussing our SG&A costs and cash flow performance. I will expand on David's comments about the results of operations and volume in our various lines of business. I will conclude with a discussion of our financial metrics. Our SG&A as a percent of revenue was 9.6% for the third quarter. This is the lowest it's been since the third quarter of 2005. We improved SG&A as a percent of revenue by retaining the savings from our restructuring and focusing on controllable costs. We did so despite a net increase of $50 million in accruals for our annual incentive plans. The $50 million change was driven by a reversal of the 2012 bonus accrual and a normal accrual in the current year for incentive compensation.
SG&A costs were $349 million in the quarter, an increase of $17 million compared to the third quarter of 2012. In the third quarter, we saw improvements in bad debt, litigation settlements, and professional fees, which were offset by the compensation accruals that I mentioned earlier. Without those accruals, SG&A costs would have improved $33 million. On a year-to-date basis, SG&A costs were lower by $19 million, despite an increase of $93 million in compensation plan accruals over 2012. Turning to cash flow, third quarter 2013, net cash provided by operating activities was $736 million. This is an increase of $162 million compared to the third quarter of 2012. The strong performance on working capital, yield, and cost control were the primary contributors to the almost 30% increase in net cash provided by operating activities. Working capital improved during the quarter as we tightened up on our receivables and payables.
This is particularly evident in our DSO, where DSO has improved for three consecutive quarters and improved more than two days when compared to the third quarter of 2012. Our capital expenditures for the third quarter were $323 million, which is $79 million lower than the third quarter of 2012. Through the first nine months of 2013, capital expenditures were $824 million. We still anticipate capital spending of between $1.3 billion and $1.4 billion for the full year of 2013. We remain disciplined on ensuring that we spend capital on assets that fit within our long-term strategy and generate acceptable returns. Putting all this together, our free cash flow for the quarter was $452 million, an increase of $272 million compared to the third quarter of 2012. Free cash flow in the quarter was $413 million if you exclude divestiture proceeds.
Year-to-date, free cash flow was $1.15 billion as compared to $614 million for the first nine months of 2012, an improvement of $533 million. Excluding divestiture proceeds, year-to-date free cash flow was $1.03 billion. As David said, based on strong year-to-date free cash flow driven by yield, SG&A savings, working capital improvements, and capital spending discipline, we're raising our 2013 free cash flow target from between $1.1 billion and $1.2 billion to between $1.2 billion and $1.3 billion. We returned $171 million to our shareholders through our third-quarter dividend. We invested $488 million in acquisitions, primarily the acquisition of RCI in Montreal. Yield on our collection and disposal operations grew 2.3% in the third quarter. We believe that on average, we need about 2% of yield to cover cost inflation. Over the last few years, our yield has not been enough to recover cost inflation.
Over the last three quarters, we've shown sequential growth in yield, and in the third quarter, we fully offset the cost inflation in our business. Moving to volumes. Internal volume growth was -0.6% in the quarter and -1.3% if you adjust for the one additional day in the current quarter. We saw overall collection volume decline by 2%, a modest deterioration from the second quarter level of -1.4%. More specifically, commercial volumes declined 3.1%, industrial volumes declined 2.2%, and residential declined 1.4%. In the industrial line of business, we continue to see tough competition for both temporary and permanent roll-off work. For example, we've seen temporary roll-off hauls decline 3.1%, while our rate per haul has increased by more than 5% as we emphasize price over volume gains. We will continue our focus on improving yield and on pursuing higher margin roll-off business.
This trade-off was very profitable for us in the third quarter, as our industrial line of business achieved the highest income from operations and income from operations margins that we've seen. In the landfill line of business, volumes were a positive 4.1%. MSW volumes grew by 4.3%, and C&D volume rose 9.3%. Combined special waste and revenue-generating cover volume were a positive 1.9%. That growth is a reflection of the growth we've seen in our energy services business. When you look at overall operating results, our income from operations margin increased 20 basis points to 16.8% when compared to the third quarter of 2012. As David mentioned, our traditional solid waste business collection, landfill, and transfer stations, had a very good quarter. Income from operations in those lines of business increased $71 million, and income from operations margins increased 120 basis points.
The collection lines of business drove most of the income from operations increase as all three lines of business increased when compared to the third quarter of 2012. These improvements were partially offset by a combined 70 basis point decline in our recycling and waste energy operations. In our waste energy business, average electricity pricing improved almost 3% in the third quarter when compared to the third quarter of 2012. The price improvement was offset by lower volumes and an increase in repair and maintenance cost due to the timing of plant turnarounds. Overall, the waste energy business earnings per share were almost $0.01 lower than the third quarter of 2012, and we expect a similar headwind in the fourth quarter, which is consistent with our annual guidance of negative $0.02 per share given at the beginning of the year.
In the recycling business, we've seen increased costs related to the Chinese Green Fence and from acquired operations. In addition to the structural contract changes that David mentioned, we are also focused on operating cost improvements. We are looking at ways to reduce the 10% increase in operating costs at our recycling facilities. This will take some time, we have to take decisive action to generate an appropriate return on our investments in recycling assets. Turning specifically to operating expenses. The acquired operations of RCI and Greenstar accounted for almost $60 million of our $97 million increase in operating expenses. The majority of the remaining increase related to other recycling costs, the timing of repair and maintenance at waste energy, and the timing of repair and maintenance at waste energy facilities.
Finally, looking at other financial metrics, at the end of the third quarter, our weighted average cost of debt was 5.06%, and our debt to total capital ratio was 58.9%, consistent with our target ratio of 60%. The floating rate portion of our total debt portfolio was 13% at the end of the quarter. Our disciplined approach to yield management, cost control, and capital spending is working. Despite significant projected headwinds for the full year from our recycling operations, the results of the first nine months of 2013 have put us in a position to achieve or exceed our yield, SG&A, earnings per share, and free cash flow goals. We're not going to change our focus. We thank all of our employees who worked hard to achieve these excellent results. With that, Janisha, let's open the line for questions.
At this time, I would like to remind everyone, in order to ask a question, please press star then the number one. Your first question comes from the line of Hamzah Mazari of Credit Suisse.
Good morning. Thank you.
Good morning.
Hey. The first question is just on how should investors think about your ability to buy back stock given higher free cash flow guidance, but also given some other moving parts like higher CapEx spend. Next year, you're presumably going to pay out bonuses which aren't in cash flow this year, but your cost control is better. Maybe help us think about the moving parts, leverage on the balance sheet. How do we think about buybacks here? You haven't been in the market for a while.
Sure, Hamzah. A couple of things here. First of all, in 2014, we expect to allocate free cash flow to dividends as we always do, about $100 million-$150 million in acquisitions, and the remainder to go towards a combination of debt repayment and share repurchase. In fact, we have proceeds from divestitures and the proceeds from the exercise of stock options this year that we plan to use to buy back some shares in Q4. We'll determine how much of that we will use once we see October free cash flow. When you think about what you talked about, which was a couple of the headwinds that we have on free cash flow, we've got the bonus payout. We have the expiration of bonus depreciation, which will negatively impact us by about $230 million.
On the other side, we have the drivers of this year, which we would expect to continue, of course, yield cost control, capital discipline, and working capital management. Of course, we intend to drive operating costs next year as well. I expect 2014 to be a solid year for us, even with a little bit of headwind from those two items.
Okay. Just on the recycling side, could you give us a sense of the timeframe in renegotiating these contracts? Do you have to wait for these to expire? You said they were three to five years. Does that Greenstar acquisition earlier this year, how does that mix differ from your legacy business? Does that complicate the process further, in terms of fixing the recycling business?
Yeah. We do have to wait for those contracts to expire. Even in our existing contracts, we've got plenty of contracts right now that have contamination level clauses, so we need to go back and enforce those. That's why we say, today, we're having conversations with our customers about that, we're seeing some movement. We just can't see a movement across 100% of the base. It's going to take that three years as we see the contracts roll off. As far as the mix from Greenstar, we inherited a couple of bad contracts in that deal. As far as the mix, no, it's not a dramatic mix different than our current recycling business.
Okay, great. Lastly, could you remind us how much of your business now resets on CPI in Q3 traditionally? Thank you.
Well, about 40% of the entire business resets, and that's generally about 50/50 between January 1st and July 30th.
Okay, great. Thanks a lot, Dave.
Sure.
Your next question comes from the line of Corey Greendale of First Analysis.
Hey, good morning.
Morning. Morning.
A couple questions. First of all, it sounds like underlying volume trends are positive, but could you just speak to that a little bit more specifically, given it sounds like you're pushing some volume away because of the focus on yield. Just speak to broadly what you're seeing in the economy, any regional variation, what you're seeing in terms of customer service levels, any increases yet?
Yeah. What we're seeing, I think you characterized it correctly. I would call the volume environment very stable. On the industrial side, we aren't going to chase that low margin business, right? Other folks are going to chase that low margin business. They're going to fill up their capacity, and we're going to go on the other side, and we're going to get yield on the industrial side rather than volume. As we said that trade-off was pretty spectacular with margins on the industrial line moving up 130 basis points. The residential line, I would say pricing and volumes are fairly stable, but there's always some interesting bidding on the residential side. Look, I will tell you in the last few years, we've probably had some interesting bids on the residential side.
We've gotten much more disciplined on making sure that we don't go after residential business, which is generally low margin, low return on capital, and high investment of capital. We're just not going to chase those kind of volumes unless we can get sufficient returns. Then I guess, the one that's really popped up the most recently is on the recycling side. We recognize that we have to make a systemic change in the way we approach the market on recycling so that we can get long-term, stable earnings. I talked about the four things we're going to do to change the way we approach the market. You still see some folks that are out bidding large recycling contracts with a low processing fee or a simple split of the revenue.
My guess is that the market will adjust to these environments of high operating costs and low commodity prices. My guess is the market will adjust, but we can't control that. All we can control is what we do, and we're going to take a much more disciplined approach to the recycling market.
Actually following up on that point, some of the changes that you're talking about, have you had any feedback from the market, either from customers or from your people in the field on the receptivity to that kind of stuff? Then what's involved in managing some of these things like the auditing the recycling stream? What's involved operationally in doing that and in terms of dealing with any customer complaints when people come back and say, "Hey, I didn't actually have that much glass in there," or anything like that?
Well, these are mostly large municipal contracts where you're doing these audits. It's a real interesting situation that you've got going on in the recycling markets. We've pushed, and everybody's pushed single stream recycling throughout the U.S. What we haven't pushed is educating the consumers as to what can go in there that can be recycled and what goes in that causes processing costs to go up. We have to do a better job of educating the public, and we can do that in conjunction with our municipal customers. As far as how are those conversations going, look, I liken this to what happened in our company about 10 years ago when we put in a fuel surcharge, right? When we first put in the fuel surcharge on residential contracts, there was a lot of pushback from municipal customers.
There were plenty of municipal customers that said, "We're not going to put a fuel surcharge in because we've never done it before." We said, "Fine. That's fine." We're not going to bid those residential contracts. Over time, as fuel became more important to everybody, the market basically reset, and now you don't see contracts that are put out without a fuel surcharge. I would expect that same thing to happen in recycling. Look, the recycling business has not been economically viable for anyone over the last few years. We want to recycle as much as we can. We want to help our customers recycle, but we obviously can't do that unless what we have is a long-term sustainable business model. We're going to reset our business practices to do that. I wouldn't be surprised to see the market do the same.
Okay, last quick one from me. I think, David, at the beginning of your comments, you said something about your operating cost program accelerating in 2014. I was hoping you might just elaborate on that. What kind of cost savings you're talking about, where you might find those cost savings?
Yeah, Corey, Jim Trevathan here. We are doing very well with our collection business that we're focused on the operating side. We're making real headway, especially at some of our certified locations. We've touched about half of our areas to date. We've got a couple of dozen sites that we have certified as meeting the goals. We're not ready yet until guidance next year to begin to talk about those dollars, but we're excited about the opportunity, Corey, and see real improvement on the operating side, both efficiency and cost per unit.
Thanks, Jim.
What Jim and his team have done on the operating cost side is nothing short of remarkable. It really is a culture change in the way we treat both our efficiency and our service, right? It takes a long time to change that culture. We've been doing this for a while. We're going to continue to do it. It's going to be the way we do business forever. We fully expect to see that continue to accelerate into 2014.
Thanks, David.
Corey, it really is adding the technology that we put on trucks, those onboard computers, and adding a real defined management process, along with an accounting process to get the value out of the onboard computers. We've seen other industries do it. We're leading ours, and we'll get it done over the next couple of years.
Thank you.
Your next question comes from the line of Michael Hoffman of Wunderlich Securities.
Good morning, congrats on the nice quarter, gentlemen.
Thanks, Michael.
On capital spending, can we talk about that from a philosophical standpoint? You clearly have this objective of driving better returns and one of the three value drivers you've got your hands around, you're driving better price. The other is your cost side on margins, but the third one's capital efficiency. Can you frame where your head is with regards to maintenance capital spending, how we should think about that as a percentage of the business if your company's growing sort of organically 3%-4%?
Sure. I'll take that one, Michael. First of all, when you think about capital spending for the year to date, we're about $476 million under the low end of our guidance for the year. We've got to spend $476 for the fourth quarter. We've averaged about $400 the last two years, and we've also accelerated, just recently, some truck and some HE purchases, some heavy equipment purchases into Q4. We think we will be at or near the bottom end of that guidance range that we originally gave. With that said, we think that 9%-10% of revenue is the appropriate level of capital spend for Waste Management, and we think we'll finish the year within that range. Basically, the bottom line here is that Jim and I have put some discipline into the process this year by trimming out some of the nice-to-have requests.
We've probably, Jim, approved 90% of the rest of the requests that have come across our desk.
Especially in the second half of the year, Jim, as we instituted the discipline in the first quarter.
Yeah. I think this is really cutting out those requests that we kind of categorized as nice to have and are approving all of the must-have requests. Mike, we've also kind of redefined what we consider to be maintenance capital versus growth capital. We used to think of a contract renewal where we had the business and the renewal required new trucks. We used to think of that as being growth capital, and we've redefined that. That really isn't growth capital because it doesn't add any top-line dollars. That's maintenance capital, and that has to pull out of that area vice president's fleet plan.
Okay. If I'm hearing this correctly, we should see growth capital, one, come down proportionally, also there is maybe a new level where maintenance is even managed tighter. While 9%-10% in the aggregate, maintenance is not 9%-10%, it's going to be less than that.
I am saying overall, total capital in the 9%-10% range. I would say that on the growth capital side, look, if it has the appropriate returns, we have not turned it down. We have invested capital in our energy services business, which we consider to be a nice growth business. I think you are right about maintenance capital. We are narrowing the definition a bit and putting some discipline into the process.
By the way, Michael, when you grow revenue through yield, it takes absolutely zero capital.
Right. Exactly. Okay. For you, David, on fees and surcharges, how much money are you leaving on the table by having rolled back or waived fees and surcharges, and where are you in bringing new discipline around that?
It is a significant dollar amount. When we look at all of our charges.
If we were at 100% compliance, obviously you're never going to get to 100% compliance, but if we were at 100% compliance, that would be roughly $360 million. Look, we aren't going to back down from our yield programs. What we're trying to do is drive a lot of different parts of the yield program, not just raising prices, but driving other pieces that can drive yield and you hit the nail on the head. One of our key focuses in 2014 will be driving environmental fee and fuel surcharge compliance up.
That's an existing, it's already in the invoice. I'm still going to see improving the reported to us, the reported yield should still continue to improve because you've got a discipline there, but also capture an incremental revenue dollar that was already in the invoice, you've just rolled it back, right? Is that the right way to think about it?
No, what's going on right now is that, depending on the fee of the surcharge, only 55%-75% of the customers actually even have the surcharge. Just to give you an easy example, on the fuel and environmental surcharge, in the past, if a salesperson went out and either waived the fuel surcharge or the environmental surcharge, or both of them, if they waived it for a customer, there was really no oversight about that. What we've done now is we've put rules in place that if you waive them, you've got to get a higher level of approval. You can imagine just that focus on fuel and environmental raises the compliance rates.
On new business, we're going to make sure that we get it more often, and on existing business, we're going to go back and, in every case where we can get it, we're going to try to get it there. Obviously, we've got other folks that aren't at full fuel and environmental, and that's what you're talking about. When they are not at full fuel and environmental, we can raise them up to get them closer to or at the full fuel or environmental surcharge.
Now what I'm hearing is two bites at that apple, which is even more interesting. David, you've kindly offered in the second quarter that free cash flow would be flat year-over-year. Having raised the guidance, will we still be flat in 2014? It sounded like, Jim, you alluded to, without saying it specifically in your opening comments, that would in fact be the case. I just want to get a feel for how we should think about 2014's free cash.
Jim talked about it earlier, that there's a lot of ins and outs in 2014 with bonus depreciation, with the cash going out from the compensation accruals that we're having this year, the movement of working capital. Look, we've always said that this company is first and foremost a free cash flow generating machine. Our guidance this year was $1.1 billion-$1.2 billion. We've now raised that to $1.2 billion-$1.3 billion. Michael, you and I have had this conversation many times. I've always said this company, at a very minimum, every year should generate $1.2 billion in free cash flow, come hell or high water. With the focus that Jim and Jim have put on capital, I'm very confident that we can do that, not just in 2014, but going forward.
Okay. Collection prices, lots of success. Landfill price seems to be more muted. What can be different in 2014 about the depth of which you can, or breadth of which you can raise landfill price?
There's two things. One is the contractual nature, right? Those are different types of contracts, longer term contracts. Two is just the visibility. Just this year, we've started to get reports on sort of the top 10 customers at every landfill. Every quarter, we will get what the price action has been with those top 10, top 20 type customers. Look, pricing is all about discipline and accountability. You can't have accountability without visibility. It's the same approach we've taken, whether it's pricing or cost. We've said, you know what, we're going to get the visibility so that we can hold people accountable, and once you hold people accountable, it's amazing what this organization does. Look, this is an execution organization. Once we set the right direction, they will execute.
If we're holding our field managers accountable and they're holding folks accountable down the line, it's truly amazing what this organization can accomplish.
Okay. Thank you very much for taking my questions.
Certainly.
Your next question comes from the line of Alex Ovshey of Goldman Sachs.
Good morning. This is Usha Guntupalli on behalf of Alex. How are you?
Good morning.
Good morning.
Doing well.
Awesome. Any updated thoughts on the divestment pipeline for 2013 and any potential for 2014?
Can you repeat the question for me?
What does your divestment pipeline look like for 2013 and anything going into 2014?
This year, we've divested somewhere in the neighborhood of $100 million. That's probably about where we typically are through the year. I wouldn't expect it to differ dramatically in 2014.
Okay. That's helpful. Was there any noticeable change in construction-related volumes inter-quarter and any early read on the fourth quarter trend?
Yeah. Like we said earlier, I think that we can certainly say that the volume trend for us is very stable. When we look at the construction-related volumes, we've got very good volumes at our landfill, which is very high margin. We don't have as good a volume in industrial line. It's what we were talking about earlier. We basically intentionally shed some low margin industrial business, and we're not going out and chasing new industrial business at low margins. We've got the highest new business rate that we've had in the industrial line, goodness, probably since I've been here. We aren't chasing collection volumes on the construction side. The good news is, we're not chasing those at low margins. If we can get the right margins, we'll chase them, but we're not chasing them at low margins.
The good news is we're still seeing that volume come into our landfills at very high margins. I would say that we've seen a nice uptick on the construction side. For us, it manifests itself more at the landfill. Last year, we had some industrial volumes from Hurricane Sandy that obviously won't repeat in the fourth quarter, but other than that, we see the volumes on the construction side being pretty robust.
That's helpful. Obviously you are focused on pricing growth, but in the medium term, what's the upside you see from changing your recycling contract structure and surcharges?
Yeah, look, like I said, there is no quick and easy fix on the recycling front. That's going to take some time. We've got some plans in place to see improvement, but frankly, it's modest improvement in the near term. In the medium term, I'd like to sort of see how the program plays out a little bit before we make a call on what we're going to see in the medium term. Look, again, this is no different than what we did with the fuel surcharge 10 years ago. We sort of led the industry, and it became an industry standard.
Look, if customers want to have recycling for the long term, which is, look, that's what all of our goal is to have recycling for the long term, we all need to make it a more stable and profitable business. That's what our programs are designed to do.
Thank you.
Thank you.
Your next question comes from the line of Al Kaschalk of Wedbush Securities.
Good morning.
Hi, Al.
I just wanted to follow up on this recycling concern or issue, David touched a little bit upon it. To me, if you're calling yourself the leader, why wouldn't we start to think about doing something more of a larger scale or more, I say, inflection point in how the business is maybe being run? That is, have you looked at third-party processing or outsourcing of this? Is this something you can get an economic value on doing some of the things you're talking about doing, and can you do it sooner versus later? Back in the '90s or maybe even earlier than that, recycling was a bust for a lot of companies. With commodity prices down, it doesn't seem to be generating the cost of capital returns that you'd like. Pricing is something that you're never going to control.
To me, as I look at this business, are we going to continue to have headwinds on this relative to your ability to drive returns in other areas?
Right. Look, short term, I think you're absolutely right. We're looking at everything we can look at short term to improve the business. For example, we shut down two recycling facilities, and we moved that volume to third-party processors. What you see in recycling is basically the same thing you see in the solid waste side, which is it is a market-by-market analysis. In California, where you're supported by fees to support recycling, we've never really seen profitability wane. I think you're absolutely right, Al. In the short term, we can do some things to change that. In the long term, we need to make the entire business more profitable and more stable. I think the four actions we talked about will do just that.
How many facilities, David, do you have that are recycling oriented by-
Yeah, we've got about 120 total, about 40-ish, 35, 40 single stream.
Okay. I think I may have misplaced my second question here, but bear with me.
Al, while you're looking for your second question, I think it's important to say that the recycling business, as difficult as it's been for us over the last 2 years, the recycling, it's imperative that we be in this business for our customer needs. Customers require it. We need to provide it. We just have to improve the business at this point. That's why we're tackling these issues as David went through.
Yeah, I agree 100% with that. My concern is at the end of the day, it appears not only for you but for the industry, that this is almost a loss leader in the short term because of the education process and change in habits that needs to take place to drive better than corporate average return on the business.
Yeah, again, Al, I go back to the fuel surcharge on the residential contract that occurred probably 10 years ago. At that point in time, our residential business was low single-digit margins. Now what you see is sort of mid-teen type margins. A lot of that is driven by the fact that what used to happen is you'd enter into a long-term contract, fuel would go up, your cost structure went up, before you knew it, you were losing money on a residential contract that when you originally bid it, you made some money on, then if the municipality had a 5-year renewal, they'd renew it for 5 years, you'd continue to lose money on it.
Basically what we did is we said, "Look, we've got to find out what are the drivers of profitability in the residential line of business, how do we fix this from our point of view so that we don't get stuck in this constant low double-digit margin business?" Recycling's in the exact same spot here. Jim's absolutely right. We've got to meet our customer demands, we fully expect to meet our customer demands, our customers need to realize that if they want us to meet their demands long term, we need to make it a more viable business. We need to do that by ensuring that when times are good, everybody's happy, right? When times are good, we're having a revenue split with our customer. They're making money, we're making money.
The problem is, when commodity prices go down and processing costs go up, our customers don't lose money. We lose money on the recycling side. We just need to make them understand that in order to make this business work long term, we have to make some structural changes. I would expect that over time, you'll see exactly that happen. What you'll find is that we are certainly the leader in recycling. I would like to be the leader in a business that has predictable, solid returns.
Yeah. I agree. I think sometimes it's also constructive and healthy to fire clients or customers. My second question is this. I'm trying to appreciate, obviously, your comments have been focused around pricing. To me, you can only continue to get pricing when you see the volume trend being positive as well. Are we at a spot here where you're going to be offsetting top line, maybe a net positive because of the pricing, but at some point, your customer base starts to push back on a little bit more aggressive pricing in the marketplace?
Well, look, we certainly haven't seen that point. Look, obviously pricing gets better as volumes get better. I would characterize the volume environment right now as very stable, but it's not growing like it did in the 2005-2007 timeframe. I think if we continue to see housing starts above 1 million, you'll also see new business starts pick up because you have to build new businesses around those new subdivisions. We expect the volume trends to not get dramatically better, but we certainly don't expect them to get dramatically worse. What we've found is that, since I've been CEO now for 10 years, what we've found is that our churn rate doesn't change dramatically, regardless of the level of pricing program that we put in place.
I think there's still a lot of runway to go from a pricing point of view, you're absolutely right. I would much prefer to see a robust volume environment. That would certainly help both from a leveraging volume point of view and from a price point of view.
So the-
How about, one quick thing here. When you think about volume, one sure way for us to create shareholder value in really what is a mature industry here is through price increase. If we're going to make collection pricing increasing or increases sustainable, we've got to get price increases on the disposal side, and I think Michael asked a question earlier about that. That is going to be important for us in 2014, is to make sure that we are mirroring the success we're having on the collection side of pricing with success on the disposal side. If we do, and we think that that's a long-term sustainable model for growing shareholder value.
Finally, the volume decline, it was most noticeable or meaningful on the industrial side. Going over the next near term, should we still expect, should we think about volumes comping negative, or are we back to flat line here?
Just in the industrial line, you mean?
I'm trying to appreciate, I think I heard volumes were, you reported down 0.6 and down 1.3 day adjusted. I thought I heard industrial was where you were pushing some volumes away.
Yes.
Maybe that was a major component to the decline. Going forward, do you still have a few quarters where you're sort of pruning the volume base, and therefore we should expect a negative volume comp near term?
I wouldn't be surprised by that. It's not just that we're pruning unprofitable business. We also aren't chasing the low margin roll-off business. Like I said, if you give me the option of getting negative on a workday adjusted basis, the industrial volumes were -2.2%. If we can get 5.5% yield and 8.4% core price, I'll take that trade-off every day. What's really going on here is that we are shedding some volumes intentionally, but we're also not just taking the cans and throwing them out on the street. As other folks throw their cans out on the street and their capacity gets maximized, we're then able to go in and get selective hauls at higher prices, which, for us is a spectacular trade-off.
Like we said, this is the highest income from operations we've had in our industrial line since I've been here, and that's with a 2.2% volume decrease. The price-volume trade-off for us is working very well, and we don't anticipate changing that.
Thanks a lot.
Thank you.
Your next question comes from the line of Joe Box of KeyBanc Capital.
Hey, good morning, guys. Question on your SG&A savings program. Now that you guys are about a year in and it looks like waste fundamentals are starting to turn, can you just maybe give us a sense of the type of leverage that you're thinking we can get on SG&A as volumes do come back? Ultimately, do you think that the 100 basis points of expansion from 2012 levels are still generally doable?
What I would say on SG&A is that the comps get more difficult, but what we've said to the field for 2014 is that not only were we going to be flat from 2012 to 2013 in absolute dollars, but we said we're going to be flat from 2013 to 2014. We're in the process of going through budget reviews right now. As you can imagine, that's a difficult message for not only the field, but for corporate to hear. We think that it's achievable. At some point, obviously, as your business grows, you're not able to hold flat in absolute dollar terms. We do think over this three-year period, we can hold flat on SG&A and work our way through the increases, the headwinds that we face each year from compensation.
By the way, SG&A is just exactly like what I said about capital before. If you add yield, you don't have to add SG&A. If you add volume, you do.
That's really helpful. I guess, Jim, just to be clear, if you hold SG&A flat, does that include the acquisitions, or is that excluding the acquisitions that you've done?
Well, it's a good question. We have basically held it flat, including the acquisitions this year, which has been quite a task. We expect, as we said at the beginning of the year, we said we would hold flat. We are on track at this point to hold flat. We will run a little negative in the fourth quarter. We've got about $26 million worth of comp-related headwinds in Q4. As I mentioned, we had about $50 million in Q3. We still think even with $26 million in comp-related headwinds, we will finish at or below last year's levels.
Perfect. That's helpful. Then just a question on the industrial roll-off side. Clearly, you guys are taking a more disciplined approach there. Can you just give us a sense of, 1, where your utilization is at for these assets? And 2, what is your view on the pricing market going forward? Does it ever improve to the point where it actually makes sense to put these assets back to work?
Yeah. I can't give you an exact utilization number, but I will tell you, we just went through our business reviews with our market areas 2 weeks ago. You don't hear anyone that says that they're missing volumes because they don't have equipment, right? I would characterize the market as fairly tight from an equipment point of view. Look, that bodes well, right? That bodes very well for us, both from a volume and from a pricing point of view. Like I said before, we'd expect to see some stability there. I would not be surprised if we see housing starts continue at over a million starts, that we see both price and volume on the industrial side. We'll wait to see it before we declare victory.
Perfect. Thanks, guys.
Thank you.
Your next question comes from the line of Adam Thalhimer of BB&T.
Hey, good morning, guys. I would also say congratulations on a nice quarter.
Thank you.
David, as it relates to pricing, I don't hear you saying a lot, "Hey, we're going out there and we're pushing price." I hear you talking about a mix issue. You're not going out and chasing low margin work. I hear you talking about surcharges, I mean, to what extent are you actively out there pushing price?
Yeah. Well, look, our core price was the highest, again, that we've seen in a long time. I think it's a great point. Look, when we did our first cut of our pricing programs in sort of the 2004 to 2008 time frame, the primary weapon that we had were price increases. We're a much more sophisticated pricing company at this point in time, and we look at a number of different areas. One of the areas where we end up giving away dollars is on new business pricing versus lost business pricing, lost business versus new business, right? You lose business at a high margin, and if you gain business at a low margin, you're going to lose EBIT dollars. We've sort of changed the way that we look at pricing from, quite frankly, we don't look at yield.
I mean, obviously yield is an indicator, but what we look at is total dollars dropped to the bottom line from all the actions we take on pricing, whether it's core price, which includes the fees and surcharges, rollbacks, new business pricing, lost business pricing. We take a look at all of it to understand the bottom-line effect of our pricing program. Getting a 2.3% yield and dropping $0 to the bottom line is not what we're looking to do. We're looking to see yield go up only as an indicator of dropping more dollars to the bottom line. The short answer to your question is, I think you're being very perceptive, which is this is much more than just core price increases. It's about pulling a lot of different levers in pricing and dropping dollars to the bottom line, not just a reported number.
Okay. I guess, can you get more aggressive as the volume recovery plays out?
I don't think there's any doubt. Again, we can get more aggressive both on, if you will, net price increases. That means we can also get more aggressive on rollbacks. That means we can also get more aggressive on new business pricing. There's a lot of ways you can drop dollars to the bottom line over and above just raising prices on current customers.
As I said earlier, Adam, it's really important that we address it on the disposal side, too. In order for us to continue down this path of success on collection pricing, we have to be equally successful on the disposal side.
Okay. Jim, is that harder, or how would you characterize that versus the collection side?
Well, yeah, I think it is harder because typically you have fewer customers that are bigger customers, there's a little more perceived risk in the manager's mind there. Increasing a small restaurant has relatively low risk to an area vice president versus a big disposal customer. Yeah, it is probably more difficult, but I think it's equally critical.
Okay. Just in terms of industry volumes, having been in this industry for decades, what's your sense of the environment out there, what you're seeing, how sustainable it is, et cetera?
Again, I would say, we're not seeing dramatic volume growth. What we're seeing is good, steady volume growth. Where we're seeing the best volume growth, frankly, is at our landfill, which obviously is our highest margin business. That's a good thing. Again, when you look at it from our point of view, the industry volumes, I would say right now, are doing more to support our pricing programs than providing volume leverage. Obviously, at negative 1.3% volume, we're not providing a lot of volume leverage. What it's doing is it's filling up capacity for the rest of the industry at lower margins. That's able to support our pricing program. We're not going to go after I think the industry is actually growing volumes faster than we are.
By the way, we are perfectly comfortable with that because, if the industry wants to chase, there's always going to be someone that's going to chase those low-margin volumes. As long as they fill up their capacity chasing those low-margin volumes, we can take the higher-margin volumes. When they collect it, they're still going to show up with it at our landfills.
It seems like almost everyone else is. Kudos to you guys for being so disciplined. Thanks for the time.
Thank you.
Your final question comes from the line of Barbara Noverini of Morningstar.
Good morning. Nice job on the core business improvements.
Thank you.
Should we expect increased investment into your existing recycling plants in order to more efficiently handle contamination? For example, can increased automation make a dent in processing costs at this stage? If not, what more can you do to reduce operational costs as you work on educating your customers and improving those contract terms?
Yeah. There really isn't a lot that we can do from a technology point of view to make the processing easier. You can't really do it inside the plant. You really have to do it outside the plant with the materials, right? We've got plenty of contracts that have maximum contamination levels, call it, at 10%. When recycling prices are high and everybody's making money, you don't go in and audit it and go back to your customer. Once you start to realize that you're getting 20%-30% contamination, and your processing costs go up and the commodity prices go down and you start losing money, that's when you need to say, "Look, we need to go back in where we have these clauses in the contracts.
We need to go back in with the customers and say, 'We need to do a better job of helping you get these contamination rates down. In the meantime, we need to either charge a higher processing fee or reduce the rebate to cover our increased processing costs.'
Got it. What's involved in that auditing process? I assume that happens at the recycling plant as the waste arrives. How do you go about providing that feedback back?
Yeah, I mean, that's a pretty Yes. I mean, you do it as the waste arrives, and you go through sample loads.
Barbara, I was also going to mention that there are specific things we can do in addition to the structural changes that Dave mentioned. This business has grown fairly dramatically in the number of recycling facilities over the last handful of years, and it probably has exceeded the experience base of managers that have manufacturing-like experience. We're moving people around that have great experience and have managed costs to locations that have the largest need, and we're having real success there. You'll see that little by little as we drive down that 10% increase we've seen in the operating cost per ton. We'll start cutting into that in Q4 and especially into next year.
Barbara, I guess, when I look at the recycling business, what happened, someone referred to it earlier on one of the prior questions, what you've had in the past are some dramatic price dips on the commodities. Back in the 90s you had it, and then back in the Great Recession you had it. Those were always V-shaped drops in price, right? They dropped dramatically and fast, but then they came back dramatically and fast. You said, "Okay, well, we can live with a little volatility now and then." What you've seen lately is a more sustained period of low commodity prices. We looked at it, with low commodity prices in 2009, 2010, we said, "Okay, we've got low commodity prices.
Let's do something to fix that." We put in floors and different things like that, not thinking that our processing costs could go up because of regulations imposed by China. Go up from the regulations in China, and we addressed that. What I'm saying is we can fix some of that short term, just like we fixed the pricing or the low commodity price short term. We can take some actions to fix it short term, but what we need to do is fix it long term. If we don't fix it long term, what you're going to see is that there's not going to be recycling facilities anymore. Look, we want to help our customers, but we also want to do it by earning a decent return on the capital that we've got invested in this business.
We need to make some systemic changes so that we can both continue to recycle, but then also recycle even more for our customers.
Yeah, it's great to see you digging into those issues. Just on the Chinese restrictions, have you seen any of that becoming less stringent? I know this was supposed to be a temporary measure, but do you have any indication that it's going to lift any time soon?
Yeah, they recently extended it into 2014. I would say that in certain locations you've seen a little bit of easing, certainly not enough to make a dramatic difference.
Got it. Thanks for the additional details.
No problem. Thank you.
There are no further questions.
Thank you all for joining our call. We get the honor of reporting the results to you, but I can guarantee you that we don't drive the results. We've got 45,000 people at this company that are working hard every day to drive the results. In the third quarter, they did another spectacular job. I wanted to say personally to them, thank you very much, and we'll see everybody on the phone out on the road, and we'll see some of our 45,000 employees out on the road to give them a personal thanks. We'll see you next quarter. Thank you.
Thank you for participating in today's third quarter 2013 earnings release conference call. This call will be available for replay beginning at 1:00 P.M. Eastern Standard Time today through 5:00 P.M. Eastern Standard Time, Tuesday, November 12th, 2013. The conference ID number for the replay is 66496035. Again, the conference ID number for the replay is 66496035. The number to dial for the replay is 1-800-585-8367 or 1-404-537-3406.