Good morning. My name is Richay, and I will be your conference operator today. At this time, I would like to welcome everyone to the Waste Management second quarter 2013 earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' 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. I would now like to turn the call over to Ed Egl, Director, Investor Relations. Thank you, Mr. Egl. You may begin your conference.
Thank you, Richay. Good morning, everyone, and thank you for joining us for our second 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. David will start things off with a summary of the financial results for the quarter, including internal revenue growth from yield and volume. Jim will cover our revenue growth, price and volume trends, operating costs, and the financial statements. We will conclude with questions and answers. During their statements, any comparisons, unless otherwise stated, will be with the second quarter of 2012.
Before we get started, let me remind you that in addition to our earnings press release that was issued this morning, we have filed a Form 8-K 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 that you should refer to. During the call, you will hear certain 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 our filings with the Securities and Exchange Commission, including our most recent Form 10-K.
Additionally, 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 and operating EBITDA have been adjusted to exclude items disclosed in our earnings press release 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 reconciliations to the most comparable GAAP measures and additional information about our use of non-GAAP measures.
David and Jim will also discuss our results in the areas of internal revenue growth from yield and internal revenue growth from volume. Unless otherwise stated, please note that any references to yield or volume results are more specifically referring to internal revenue growth, or IRG, from yield or volume. This call is being recorded and will be available 24 hours a day, beginning approximately 1:00 P.M. Eastern Time today until 5:00 P.M. Eastern Time on August 13th. 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 97883740. Time-sensitive information provided during today's call, which is occurring on July 30th, 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. During the second quarter, our earnings per share grew to $0.54, overcoming $0.03 of unexpected headwinds. We had a negative $0.02 additional headwind from our recycling operations and a negative $0.01 from litigation settlements. Without these headwinds, we would have earned $0.57 per share or close to 10% earnings growth. Our disciplined approach to improving price, reducing costs, and managing capital expenditures is reflected in this earnings growth and in our free cash flow. We're pleased with our results for the second quarter and year to date, which are right on plan despite the negative impacts from our recycling business. The story of our quarter is that we had very strong results in our traditional solid waste operations, overall results were muted by unexpected headwinds in our recycling business.
Even with these headwinds, our operating EBITDA margins grew by 20 basis points. In our traditional solid waste business, we grew income from operations margins by 80 basis points, driven by our yield and cost programs. We expect this margin expansion to continue throughout 2013 and to accelerate into 2014. Volumes improved sequentially in all of our collection lines of business except recycling and roll-off. We offset roll-off volume losses with very strong yield, which drove 90 basis points of margin expansion in our roll-off business. In our recycling business, we expected the second quarter impact to be a negative $0.03 to earnings per share. The actual result was a negative $0.05. Looking out to the third and fourth quarters, we originally expected a positive $0.04 impact on earnings per share when compared to 2012 from our recycling operations.
We now think that the impact from our recycling operations will be flat year-over-year in the second half of 2013. Thus, we now expect a full-year negative impact of $0.08 per share versus the negative $0.02 per share we had originally anticipated. Many of you have heard about the Chinese Green Fence, which is affecting our recycling operations. The Chinese government has recently begun to enforce limits on moisture and non-conforming materials in imported fiber and plastics. The higher quality expectations have translated into additional labor and maintenance costs to remove residual waste from the recyclable materials that we process for our customers. It has also resulted in fewer volumes to sell because of the higher residual material. That, in turn, has reduced revenue and increased residual disposal costs.
You can see why the Green Fence has had a negative effect on the results of our recycling operations. As we've discussed, we've been implementing a business improvement plan in our recycling line of business. First, we'll be working with our customers to improve the quality of the inbound streams of material. Our contracts with many large customers limit the amount of residue in the recyclables they deliver to us. We will be working with them to ensure compliance with these limits, or we will charge them to cover our increased costs. Second, we are modifying our operating procedures to reduce costs and residual waste. Finally, we will also look at each of our recycling facilities and rationalize those that continue to lose money. Our municipal, commercial, and industrial customers want to recycle their waste materials. We have the best assets in the industry to support that desire.
We will do so with a pricing and operating strategy that supports both our customers and our shareholders. Our solid waste pricing programs had a very positive impact in the second quarter of 2013. Yield from our collection and disposal operations was 2.1%. This is the highest yield since the first quarter of 2011, and we've seen yield improve sequentially for four consecutive quarters. If you add in our fuel surcharge and adjust for our South Florida waste-to-energy plants, we achieved yield of 2.6%. We achieved core price of 3.6%, an increase of 110 basis points from the second quarter of 2012. It's worth noting that the uptick in yield more than offset the reduction in volumes. Our pricing program is working very well. During the first quarter, we mentioned the steps that we're taking to improve yield, and in the second quarter, we saw positive results.
Average rates for both commercial and industrial new business pricing exceeded lost business pricing for the second consecutive quarter. Service increases in our commercial business exceeded decreases for the first time since the third quarter of 2010. Price rollbacks are down almost two-thirds from the peak in the fourth quarter of 2011. Our pricing momentum continued to build in the second quarter. In our commercial line of business, we had the highest yield that we've seen since 2011, at 3.1%. Importantly, our pricing actions didn't reduce volumes in the commercial line. In fact, volumes improved slightly over the first quarter of 2013. On the industrial side, we did not see volume growth in our industrial line, with volumes down 1.2% for the quarter. What we did see in our industrial line of business was a yield of 4.8%, which is the highest yield since Q1 of 2007.
We also saw the highest new business pricing that we have ever seen in our roll-off line of business. There are all sorts of roll-off customers. Some value service and quality, and some value price. We are clearly more focused on obtaining higher-margin customers that value service and quality, and we simply won't chase low-margin roll-off business. The trade-off is very positive. In both our commercial and industrial lines of business, we saw margins expand by 100 basis points. We've focused on core price increases, and we've moved core price close to 4%. In future quarters, we will continue that focus, but we will also turn our attention to fees and surcharges. When you look at our average customers over time, the combination of fees and surcharges is between 20%-30% of the total bill.
Every time we waive the fees and surcharges, it's the equivalent of giving a 20%-30% price decrease versus the opportunity. Increasingly, we've seen our competition offer to waive fees and surcharges, particularly in the roll-off line of business. When we match that action, it equates to a 20%-30% rollback of prices, which dwarfs a 4% core price increase. In the second half of 2013, we will focus on obtaining the fees and surcharges. With fuel and environmental compliance costs growing drastically over the years, this is the only way that we can ensure we cover our increasing costs so that our other programs can drive margin expansion. Overall, volumes were negative 0.6% in the second quarter. It's important to note that one of the main drivers of the decline in volume was in the recycling business.
Recycling volumes were down almost 1%, a notable swing from recent increases in the range of 6%-8%. Volumes have been impacted by China's Green Fence initiative, and we've also seen several large new plants pass their first-year anniversary. In both our commercial and residential lines of business, we saw a sequential improvement in the rate of decline in volumes for the third consecutive quarter. For the second half of the year, we don't expect volumes to change much from the second quarter. That assumes slightly negative collection volumes, but our increase in yield should more than make up for the lower volumes. In our waste-to-energy business, average electricity pricing improved almost 5% in the second quarter when compared to the second quarter of 2012. We also saw improved SG&A expenses. These improvements basically offset an increase in repair and maintenance costs due to the timing of outages.
Overall, the waste-to-energy business was basically flat for the quarter and the first half of 2013 when compared to the second quarter and first half of 2012. We still expect the full year impact on earnings per share from our waste-to-energy operations to be approximately a -$0.02 per share compared to 2012. In summary, we had greater than expected recycling headwinds in the second quarter, but we overcame them. Consequently, we're on plan through the first two quarters of 2013. We overcame the headwinds through good cost controls and an IRG that is more weighted to price than volume. We expect that our continued execution on yield and costs will help us manage against the $0.08 per share of recycling headwinds that we anticipate for the full year.
Accordingly, we still expect to achieve full year guidance of between $2.15 and $2.20 of adjusted fully diluted earnings per share, and free cash flow of between $1.1 billion and $1.2 billion. This quarter clearly shows how well our field operations can perform when they're focused on the right items. In the past few years, we diluted some of the messages to our field operations. This year, we asked them to focus on two things, yield and costs. In the second quarter, they delivered on both. Our overall IRG was right where we expected it to be, but weighted more toward price than volumes, which is a very positive fact. Jim will talk about our cost programs, but when it comes to yield, we've put the plans in place, and our corporate and field leaders are doing a superb job in executing the plan.
We are focused on adding volumes in the higher margin lines of business, like our landfill and commercial lines. In our lower margin lines of business, we're either going to improve their profitability or we're going to disinvest in them. Given cost inflation, we must have better pricing to drive sustainable margin expansion in these lower margin lines. We simply will not chase volumes at inadequate prices. For example, we've not bid on a number of residential contracts. In those that we do bid, we're generally bidding higher prices. This may cost us some volumes, but losing volumes in a low margin line of business can be a very smart move to drive returns on capital. This is particularly true in the residential line of business that, on a non-integrated basis, contributes about 15% of our collection earnings, but takes up over 40% of our fleet capital spend.
In the temporary roll-off business, many competitors are willing to put their cans to work at a low price. We will not do that. As I mentioned, our new business pricing in our roll-off line has hit its highest level in the history of our company. The 100 basis point improvement in margins in our collection business reflects the success of this trade-off of price versus volume. Obviously, if we're going to charge higher prices, we need to provide greater value by being the service leader. We have a number of programs designed to give great value to those higher priced customers. We are constantly trying to improve the value delivered for the prices we charge. We will continue to add programs for those customers to make their experience the best in the industry.
I'll now turn the call over to Jim to discuss our second quarter results in more detail.
Thank you, David. I will start by discussing our strong SG&A and cash flow performance. I will expand on David's comments about the results of operations from our traditional solid waste business and yield and volume in our various lines of business. I will conclude with a discussion of our financial metrics. In our SG&A cost category, we continue to see the results of our restructuring and focus on controlling cost. SG&A costs were $353 million in the second quarter and 10% of revenue, an improvement of $21 million and an 80 basis point improvement compared to the second quarter 2012 as a percent of revenue. The two biggest areas of savings came from labor due to our restructuring last year and our focus on lower controllable costs. These savings were partially muted by a $30 million incremental compensation plan accrual that did not occur in 2012.
Bad debt expense improved SG&A costs by $8 million due to the partial collection of a receivable at our Puerto Rico operation. DSO improved sequentially. In fact, we've improved DSO sequentially for three consecutive quarters. We are pleased with the second quarter SG&A results. We still have a lot of work in front of us to achieve our full year goals. In the third quarter, we expect approximately $45 million of headwind in SG&A from incentive compensation accruals. We only had $30 million in the second quarter of 2013. For the full year, we still anticipate achieving our goal of flat SG&A costs when compared to the full year of 2012. Turning to cash flow, second quarter 2013 net cash provided by operating activities was $545 million. This is a decrease of $124 million compared to the second quarter 2012.
In 2013, we had $117 million increase in taxes paid based on higher income and the timing of estimated tax payments. In 2012, we benefited from $72 million of proceeds from swap terminations. Cash from operations was very strong. Net of those two items, cash from operations would have been up $65 million. Our capital expenditures for the second quarter were $235 million, an improvement of $116 million compared to the second quarter of 2012. We remain disciplined on ensuring that we spend capital on assets that fit within our long-term strategy. As we've mentioned in the past, we are also looking at rationalizing our asset base. For instance, during the quarter, we recorded an impairment charge on a disposal facility that was cash flow negative. When we close the facility, we will move the volume to another Waste Management facility so that we maintain the associated revenue.
Putting all of this together, our free cash flow for the quarter was $347 million, an increase of $15 million compared to the second quarter 2012. Year-to-date, free cash flow increased $261 million to $695 million. If you exclude proceeds from sale of assets, free cash flow is $621 million year-to-date and puts us well on the way to achieving our goal of generating between $1.1 billion and $1.2 billion of free cash flow for the year. We returned $171 million to our shareholders through our second quarter dividends. We invested $30 million on acquisitions, and we repaid $290 million in debt. Our pricing programs are improving each of our collection lines of business, as well as our overall results. Yield on our collection and disposal operations grew 2.1% in the second quarter.
Our yield growth for the second quarter of 2013 would have been 2.6% if you include the fuel surcharge and adjust for the change in pricing at our waste energy plants in South Florida. In the third quarter, we will see a portion of our contracts reset price again on tip fees in our South Florida waste energy business, where a competitor took some volumes at about a 40% per ton reduction from our rates. Combined internal revenue growth from yield in our collection business was 2.9% in the second quarter, with 4.8% growth in industrial, 3.1% growth in commercial, and 1.5% growth in residential. The industrial yield is the highest that we've seen since the first quarter of 2007, and for the commercial line of business, it's the highest since 2011.
The increase in yield has not had a significant impact on collection volumes, as the commercial and residential lines of business saw sequential improvement in the rate of decline of volume loss. In the landfill line of business, we achieved MSW yield of 1.8%. Moving to volumes, internal volume growth was -0.6% in the quarter. The decline was primarily driven by a decrease in recycled volumes, as David mentioned. We saw collection volume decline by 1.4%, although the rate of decline on collection volumes slowed. More specifically, commercial volumes declined 2.7%, industrial volumes declined 1.2%, and residential declined 1.1%. In the landfill line of business, volumes were a positive 6.6%. MSW volumes grew by 6.3%, primarily from increased Oakleaf vendor hauler volumes, and special waste volumes grew 5% as our pipeline for jobs remains strong. We also saw strong volumes from revenue-generating cover and C&D tons.
When you look at our overall operating results, our income from operations margin was flat at 14.8% when compared to the second quarter 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 $47 million, and income from operations margins increased 80 basis points. The collection lines of business drove most of the income from operations increase. Both our commercial and industrial lines of business improved when compared to the second quarter 2012. The residential business continues to be a challenge, primarily in the south, where contract changes in Florida related to the waste energy business drove a slight decline in income from operations. The 80 basis point improvement in the traditional solid waste business was offset by a decline in the recycling business.
We've been very clear with our field operations that we must pass through the recycling increases to our customers in the coming quarters. Turning specifically to operating expenses. The improvement that we saw in our traditional solid waste business was muted by an increase in operating expenses, primarily from increased costs in our recycling operations and the timing of repair and maintenance at our waste energy facilities. These items were $35 million of our $51 million increase. We remain focused on controlling costs and expect to see improvement as we progress through the remainder of 2013. In fact, when you look at our traditional solid waste business, our maintenance costs were essentially flat when compared to the second quarter of 2012.
Looking at our other financial metrics, at the end of the second quarter, our weighted average cost of debt was 5.1%, and our debt to total capital ratio was 58.9%, consistent with our target ratio of about 60%. The floating rate portion of our total debt portfolio was 10% at the end of the quarter. Overall results are proceeding as expected, as our pricing and cost control programs have allowed us to overcome the recycling headwinds in the first two quarters and remain on plan. The results of the first six months of 2013 have put us in position to achieve our yield, SG&A, earnings per share, and free cash flow goals. We continue to take a strong stance on controlling SG&A costs. We've saved $38 million year to date when compared to 2012. Our stated goal for SG&A is to remain flat with 2012.
Even though the third quarter comparison will be tough with $45 million of compensation accrual headwinds, we still expect to meet our full-year targets. Similarly, we're applying a very disciplined approach to capital management. Combining this with our focus on yield, SG&A, and our improvement in working capital and earnings, we've already generated $621 million of free cash flow, exclusive of the sale of assets. This puts us more than halfway to our goal. We will continue this disciplined approach in order to achieve our free cash flow goal of between $1.1 billion and $1.2 billion for 2013. With that, Richay, let's open the line for questions.
At this time, if you would like to ask a question, please press star, then the number one on your telephone keypad. Again, press star, then the number one to ask a question. Your first question comes from the line of Hamzah Mazari with Credit Suisse.
Good morning. Thank you.
Good morning, Hamzah. Happy birthday, by the way.
Hey, thanks a lot. I appreciate it. The first question, David, is just on volume. It seems like the recycling business is 12% of revenue. It's not that big. You guys said that it's 1% down on volume. Is all of the volume loss or below volume relative to expectations, given what you're seeing with the rest of the sector? Is that all you guys just walking away from lower margin roll-off business, or is there something else in that as well?
Yeah. No, I think that's basically it, Hamzah. As we mentioned, we've got the highest new business pricing that we've ever seen in the roll-off line of business. When you think about it, if you look at the roll-off line of business as call it a 20% margin business, every time you get a new can, 20% of it drops to the bottom line. Every time you get 1% price, 100% drops to the bottom line. You have to get 5% volume in order to make up for 1% price. What we saw in this quarter was basically, the quarter-to-quarter change in yield was 1.3%. In order for that to equate to a fair trade-off, we have to get 7% volume. You can't do that in this business.
We went around and talked to our folks out in the field, and they said, "Look, we can go get roll-off volumes if you want us to, but what we're going to do is we're going to mess up the market at a lower price, and we're going to get low margins on it." We would much rather go out at higher price, offer good quality for what we're doing, and get that higher priced roll-off volume. As you can see, the trade-off worked very well with 100 basis points of margin expansion.
Okay. Maybe if you could give us a sense of the lag that it may take the field organization in making the adjustments on the recycling business to get the surcharges and fees. How much of a lag do you think it's going to take the field to get the recycling business from sort of not being a margin headwind? Is this more of a two quarter lag or any sense of expectation there?
There's sort of two pieces to the recycling business. There's the commercial recycling that is as close as we can get to spot recycling, if you will. On those types of transactions, we can change the price today, and we've got folks and teams out in the field doing just that. In other cases, we have long-term contracts with municipalities and other folks, and we need to get through those contracts. We need to understand what our rights are under those contracts, and we need to go and talk to the customers. There are pieces of it that we can do quickly. There are pieces of it that take time. I would say, frankly, Hamzah, overall, it's going to take a little bit of time, but what we've told our field operations is we don't have the luxury of time right now.
We are losing money in most of our recycling operations. We've got to turn that around, and we've got to turn it around now.
Okay. Just last question from me, I'll turn it over. The landfill pricing, it seems like that decelerated at 1.8% relative to sort of the mid 2% it was running. Could you maybe comment on that? Thank you.
Actually, it was up in the quarter from prior quarters. The last time we saw a yield that high was Q1 of 2012 on the MSW line. Look, we've talked about it very vocally that we need to get that sort of 5%-7% price increase at the landfill. That is like the recycling business in that you've got a lot of long-term contracts, so you have to work through those issues. We're absolutely working through those issues. We will not back down on our 5%-7% price increases.
Great. Thanks a lot.
Sure.
Your next question comes the line of William Fisher with Raymond James.
Good morning.
Morning, Bill.
Hey, first one, Jim, you mentioned, I think, I just want to make sure I have the numbers right, of the operating costs increase of like $30 million of it was Wheelabrator maintenance and recycling. Is that roughly right?
About $35 million was a combination of the one-time Wheelabrator events, maintenance events, and recycling.
The rest of it, if you do the math roughly, the cost was only up, say 1% or so. You had good cost control on the rest of it?
One thing, Bill, that we've talked a bit about in previous quarters was maintenance costs. We actually, on our core business, maintenance costs improved by 11 basis points. While it's not where we want it to be, we're starting to move it in the right direction.
Okay, great. Just quickly on acquisitions and divestitures. I thought I saw in the Quebec papers, did you guys, were you able to close that RCI transaction?
Are you able to read the Quebec papers?
Yeah, I had to translate it, but that's what it looked like.
Yes, we did. We closed it in early July.
Okay. Any rough handle on what the annualized revenues of that could be?
Yeah, the annualized revenue is roughly $170 million.
Okay.
Bill, we had actually intended to close that. We had an agreement to close that for quite a while. When we gave our full year guidance, we actually expected to close that at the beginning of the year, not in the middle of the year. It is baked into our guidance. It'll be a great acquisition for us. Lucien Rémillard ran a spectacular business up there, and we're looking forward to leveraging the great company that he built.
Okay. You have some decent overlap on the hauling side, too, or do you not in that market?
Well, frankly, this is sort of the minnow swallowing the whale. We have a fairly small presence from a collection point of view in the Montreal market area. RCI had a much bigger presence. We're going to keep the RCI brand in Montreal.
Okay, great. Thank you.
Your next question comes in the line of Corey Greendale with First Analysis.
Hi, good morning.
Good morning.
First, just wanted to ask about the price. Given, obviously it's moving in the right direction, would you say that you have most of the pricing actions kind of fully baked in in Q2, so we should expect a similar level of price growth in Q3, or could there still be some acceleration as you keep implementing that stuff?
The regulatory cost recovery fee, we didn't get a full quarter benefit out of it in this quarter because we implemented it sort of mid-quarter. We will also have some headwinds coming in the back half of the year from CPI, from the resets of the contracts in Florida. All in all, I'd sort of call it a wash. We said at the beginning of the year that we would be at sort of 1%-1.5% yield. For the first half of the year, we're at 1.7%. I now expect that for the full year, we'd probably be at that 1.5%-2% type of range. There are a couple factors that come into the second half of the year that lead me to not try to say we're going to see dramatic acceleration.
I can promise you from a total dollars to the bottom line, we aren't taking our foot off the pedal.
Can you give a sense how much of that 2.1% yield was from the regulatory recovery fee?
Just about $8 million in the quarter.
Right. Okay. Then in your commentary, David, you talked about the non-compliance in some cases with the fees and surcharges.
Right.
Can you put some kind of parameters around that? Like what percentage of the customer base is compliant with that? What's the opportunity to get closer to 100% compliance?
Yeah. Look, the opportunity is tremendous. What I talked about, it's basically a 20%-30% price decrease when you waive fees and surcharges. On our commercial line of business, we're at about 85% compliance. On the roll-off line of business, we're only at about 55%, because basically what you've got, the roll-off line of business, it's a little bit baffling to me that in a low margin line of business, you'd see folks out there waiving fees and surcharges on the roll-off line of business. So it's very competitive. In the roll-off line of business, our compliance is about at 55%. So just take 20%-30% price rollback and add it back into that, and you can see the dramatic effect that that has on earnings.
On that front, are you starting to see new entrants into that business? Is it primarily the entrenched players that you're seeing being more aggressive in waiving fees?
Well, I think that one's sort of across the board. There's obviously a lot of competition in the roll-off line that's very low barrier to entry. I would say that it's sort of across the board. Generally, what you've seen is that the smaller players sometimes don't even have the fees and surcharges. The larger players, generally, are the ones that will roll it back.
Okay, just a quick housekeeping one for Jim. What would you suggest is the tax rate for the back half of the year?
Yeah, we always say we're going to approach the statutory rates of 35%. I would stick with that.
Okay, great. Thank you.
Your next question on the line of Alex Ovshey with Goldman Sachs.
Good morning. This is Ashutosh Guntupalli on behalf of Alex Ovshey. How are you?
Good morning. Doing well.
Great. On some of the topics, expectations for full year 2013, the run rate so far seems to be below your initial guidance. How do we think about a lower bound?
Well, I would say that we're still on track to hit our guidance of $1.3 billion-$1.4 billion. Typically, we see an acceleration of capital spending in the second half of the year. While it may look like, if you straight line it, that we're going to be close at $1.3 billion-$1.4 billion range, we'll more than likely see an acceleration in the second half as we always do and end up right within range.
Got it. One more. On rollbacks in second quarter, they were lower by 45% year-on-year without increasing the churn rate. Does this imply improved pricing discipline in the industry generally?
I don't think there's any doubt. Look, we can't particularly speak for the industry. We can only speak for what we do. I can promise you that there's absolutely no doubt there's been increased discipline with our folks as far as rolling back prices. Look, it's a tribute to our sales folks and to our training folks. This doesn't happen just by putting an edict out that we're going to not roll back prices. There's a lot of training that goes into it. There's a lot of preparation that goes into it. There's a lot of work by our customer service reps that go into it, and they've done a phenomenal job turning it, frankly, that fast.
Got it. Any expectations for second half on roll-off rates?
Yeah. On roll-off or rollbacks?
Rollbacks, sorry.
Yeah. Generally, rollbacks do pick up a little bit in the back half of the year. We've done a nice job of holding the line, and I wouldn't expect to see it materially change. It could tick up a little bit, but I wouldn't expect to see it materially change.
Got it. Thank you.
Thank you.
Your next question comes from the line of Joe Box with KeyBanc Capital.
Really nice job on the SG&A front. I understand you guys reiterated your flat year-over-year guidance, and I guess that makes sense with comps getting tougher in 3Q and accruals sequentially ramping. I'm just curious if you could maybe give us a little more color on how much flexibility you have towards that flat guidance. Is that a stretch, or are you thinking you could actually put up better SG&A margin given the improvement you've seen so far?
Joe, I would say it's not a huge stretch, but it's also, I don't think we have a whole lot of room there either. I think we're probably pretty comfortable with flat year-over-year, which is saying something considering the comp headwinds that we've faced. I think we're probably on track to hit the flat guidance with 2012 that we've given.
Okay. Switching gear to the recycling side, I'm sure we could probably back into this. I just want to check. Can you just flush out with the swing in recycling volumes ended up contributing to the 60 basis points of volume degradation that you had?
Yeah. We'll run that calculation for you and check it and get the number to you.
Okay. Yeah, that'd be helpful.
I'm not a CPA, I don't know how to do that complicated math.
Was there any difference then between your internal MRFs, what you saw from a volume basis there or your broker volumes, or was it basically one and the same?
It was basically one and the same.
Great. That's all for me. Thanks.
Thank you.
Thanks, Joe.
Your next question comes on the line of Michael Hoffman with Wunderlich Securities.
Good morning, thank you for taking my call.
Hey, Michael.
Morning, Mike.
How you doing, David? Jim.
Great.
Can we just push on the volume subject a little bit? I get the model. You're going to push price, and you're willing to push some less marginal volume away. If I looked at the business that you've gotten price and kept the customer, what's happening on the volume in those customers?
Oh, you mean as far as weights or service?
Yeah. It's like in your front-end loader business, are you seeing container rates starting to rise?
Yeah.
I wouldn't think you would push this price thing forever if you didn't think the macro volume environment was gradually improving as well.
Yeah, I don't think there's any doubt that we're seeing improvement in the commercial line of business. Again, it's not dramatic, but it's consistent. We saw weights up, frankly, across all of our collection lines in the quarter. Obviously, it was a very wet quarter, so that added some to the weight. The other thing that is very encouraging for me is what we mentioned about service increases and service decreases. For the second quarter in a row, we've seen service increases outpace service decreases, which tells you that, yeah, there was some wet weather in the second quarter, but we are seeing the customers start to move up to the larger containers. Again, like we've said in the past, we're not going to declare victory. It's certainly a long slog for us to get there.
In the commercial line of business, we actually are seeing some very good signs.
If I were parsing the customers at the landfill, third party delivering C&D, is that on a rise, which would be consistent with the sort of improving construction environment?
Yeah, we saw C&D volumes up in the quarters. I recall around 4.5%. Sorry. Yeah, 4.5%.
Okay.
Across the landfill, we're seeing actually very good volumes. We saw volumes up nicely on the MSW side, special waste, C&D were both up. Look, it comes back to what I said in the script. If you're going to add volumes, let's add them in the right line of business. If you're going to be aggressive on pricing, let's be aggressive on pricing in those low margin lines of business where the only way you're going to drive look, it takes a long time to drive costs out of a system. You're never going to get margin expansion if all you're going to try to do is drive costs. In those low margin lines, you absolutely have to raise price. Like I said, the five to one trade-off in a 20% line of business is well worth it.
When you think about a residential line of business, call it a 10%-15% margin. If it was a 10% margin customer, you can gain 1% price and lose 10% of your volume and still be equal. By the way, price comes without any capital investment. Look, Michael, this is not any different than what we did from 2004 through 2008. It's what I said in my script. I think we got the message to the field a little bit mixed up the last couple of years, we got them unfocused on price and costs. We got it back. You saw some progress in it this quarter. We still got a long way to go, I think you're going to see it accelerate throughout 2013 and 2014.
Where I would connect the dots between your comments and my questions are there's a point of operating leverage that should start to accelerate as macro volumes continue to improve, you continue to be successful on this price, as well as the discipline around the G&A. What's your thoughts about the visibility on that? Where are we, a year away from that? Are we six months away from that? Where is that?
Look, I'm encouraged that we saw the EBITDA margins turn positive this quarter. Look, I will tell you, Jim talked about the flat SG&A guidance for the rest of the year. Jim Fish and Jim Trevathan have done a phenomenal job on holding the line on SG&A costs. I don't expect to see SG&A costs go up materially this year or next year, frankly. We've got to drive operating costs out of the system. We're starting to get a little bit of traction on that, and I think what we saw was, look, the biggest leverage is always going to come from yield in this business, and I think you saw us start to get some traction back in that in the quarter.
All we need is for the economy to continue to improve so that we don't see the dramatic volume drop-offs that we saw in 2009, and I think you've begun to see the leverage in the operating model. I think you should see that accelerate in the next 18 months.
Michael, just one quick point, Michael, on operating expenses that David talked about. I mentioned that a big slug of that operating expense increase was related to recycling. I think when you think about the leverage going forward, if we can't squeeze that operating cost out that's related to this quality control measure from China, then we plan to pass it through to our customers. And that, in and of itself, helps us reduce operating expenses as a percent of revenue.
It's a great point. Every penny that we improve in recycling drops straight to the bottom line, and there's a lot of room for improvement there right now.
Okay, my last dot connection on this, it sounds like if I take the bonus accruals for this year, plus the headwind from bonus depreciation, but netted against the successes you're having on G&A pricing and operating leverage, you should be able to produce a flat year-over-year free cash flow, maybe even a teeny bit of growth, given those two cash headwinds for 2014.
Michael, we'll wait until 2014 to give the guidance. Look, I've said all along, this is a business that should generate $1.1 billion-$1.2 billion of free cash flow come hell or high water. Look, we didn't do that last year. That's not going to happen again. The other thing that I can say that Jim and Jim have been phenomenal at is the capital discipline. We're going to manage the capital such that we make this at least a $1.1 billion-$1.2 billion free cash flow company every year, come hell or high water. I wouldn't expect that to change next year.
Michael, did you say flat for 2014 versus 2013? Are you saying flat?
Yeah.
Okay. All right.
Yeah, in 2014, you should do $1.1-$1.2 again, even with those two headwinds, given the leverage from your price and your cost controls.
Yeah, I just want to make sure, because 2012-2013 is going to be a dramatic improvement in free cash flow.
All right, Michael, you snuck some 2014 guidance out of us, but I'll give it to you. We're going to do at least $1.1-$1.2 in 2014.
There you go. Thanks a lot.
Your next question comes on the line of Adam Thalhimer with BB&T Capital Markets.
Hi, thanks. Good morning, guys.
Good morning.
Are the Green Fence costs, do you think those are permanent? How long should it take to pass those costs on to your customers?
We've looked a lot at this, as you can imagine, it's been a big topic of conversation. There's so much international trade involved that it's hard to get really good visibility. We've sort of decided that we need to take the approach that it is going to be, if not permanent, at least long term. We can't sit back and say, "Well, we're just going to let the business continue the way it's been in the past and wait for the Green Fence to clear and everything's going to be all right." We're not going to take that approach. If we're not going to take that approach, we absolutely have to start driving costs out of the system and going back to our customers and getting our customers to pay for the increased costs that we're incurring and for the reduced commodity prices.
I will tell you, I don't even want to try to put a guess on the timeframe to when recycling gets back to where we want it to be. All I can tell you is that we need to see incremental improvement every quarter, and we've got the plans in place to do that.
How are the recycling contracts structured? Do they only come up once every five years, so it's hard to push price, or how hard is it to push price, I guess, is the question?
Yeah, it depends on the type of customer, right? We've got plenty of commercial recycling customers that are just like our regular commercial customers, where we can change the price immediately, right? We've got other customers that are municipal customers, where the contracts are going to be more the three- to five-year type traditional municipal contracts. What we've done is we've asked every one of our operations to get their top contracts. Let's go where the dollars are first, and let's go to our biggest contracts in every one of our market areas and start going to those customers, and most of those contracts are going to allow us, in some manner, to either pass on increased price, lower rebates, or higher processing costs.
Let's go after the big ones first, and let's make sure that we go out and talk with those customers to cover our increased costs. On the other side, the non-contracted customers, like our commercial customers, we've run a couple of pilots to look at what we can do from a pricing point of view there, and we're going to spread those across the country. Look, from a commercial recycling customer point of view, there's going to be a lot of places where they're going to have a decision to make. They're either going to have to pay us more to recycle, or they're going to have to move back away from recycling and just use their one disposal can. We've got to do that. It's certainly not something that we relish doing.
We need to have the customers make the decision on what they want us to do from a recycling their materials point of view.
Adam, one quick point here on these contracts. While it may sound difficult to change the price, many of these contracts have residual percentages in them. Many of these contracts have composition components to them. We'll hold these customers to their contracts. If their residual percentage is 10% and we're getting 20% out of their contract, then we're going to go back to them and have a discussion. Similarly, if we expected to get a certain percentage of glass by weight out of a municipality, and we're getting a much bigger percentage of glass, then we'll also go back and have a discussion with them.
Well, I hope you're successful, right? That doesn't seem like the trend is going to slow down. I imagine your commercial customers are going to continue to recycle. It's just a matter of you being able to push price, right?
Absolutely. They're going to continue to recycle, and we look forward to helping them recycle.
All right. One more question. I hate to ask it because I know you're not focused on this, but for us analysts trying to plug numbers into a model, what would be your thoughts on volume growth in the back half?
Yeah. Obviously, no one knows what the future holds. At the beginning of the year, we said we were going to have positive volumes. Obviously, in the second quarter, what you saw in the second quarter was recycling driving the bulk of the I don't know if we've got that number yet, but we saw recycling driving the bulk of the decrease in volumes. The only other line of business where we saw negative volumes was on the roll-off side, where volumes were -1.2%. About half of that was the anniversary of a large national account that we brought on. It's not like you're seeing volumes fall off the face of the earth or anything of the sort like that.
We didn't expect a volume decline in recycling, and we don't expect to see our roll-off line bounce back to where we're getting hugely positive volumes because we're just not going to chase low-margin business. For the back half of the year, I think we're looking at volumes similar to what we saw in the second quarter. Look, basically what you saw in the second quarter is our volumes went down half a % and our price went up half a %. If I can get our price up a half a % and our volume down a half a %, I'll take that trade-off six ways to Sunday.
Okay. Great color. Thank you.
Thank you.
Your next question comes from the line of Jeff Osborne with Stifel.
Good morning. I just had two quick questions for you, David. On the Green Fence side, the rule's been in place for quite some time, to my understanding, but has the enforcement from China stepped up over the past couple of months? Is that part of the issue at play here?
Yeah. With the change in premiers in China, early this year, you saw basically a declaration by them across all sorts of type environmental initiatives. Even though the regulation's been on the books, they finally just passed, I mean, not just passed, but they just mandated that they're going to enforce those regulations, basically in February of this year.
Understand. On the M&A side, just what are you seeing out there in terms of either tuck-ins or potentially getting into oil and gas, which I think you had talked about at the WasteExpo conference?
Yeah. We just closed, as we mentioned, our RCI deal in Montreal. That was obviously a fairly large deal for us. Other than that, we're just looking at sort of our typical smaller tuck-in acquisitions. On the oil and gas side, we closed a small acquisition there. We're constantly looking for further acquisitions, but that's been a fairly pricey market. I don't anticipate that we'll spend a lot of money there. At this point in time, I'd say we're sort of through the largest acquisitions that we had in the pipeline. RCI was basically the final one of those. We'll be back to sort of our typical $100 million-$200 million of tuck-in acquisitions.
Very good. Thanks much.
Thank you.
Your final question comes from the line of Al Kaschalk with Wedbush.
Morning, David. Good morning, team.
Al.
David, in terms of I apologize, I joined the call late. Have you commented on how the integration of RCI is going? I know it's one month, could you just comment?
Yeah. We didn't specifically comment on it. What we've got in Montreal is that we have fairly small collection operations, we're basically tucking operations into RCI. So far, that's gone very well. RCI had some very high-quality management there, they've done a great job of tucking our operations into theirs.
The interest of the acquisition was largely predicated on what, in terms of the opportunities that you see going forward besides not previously having a lot of collection operations there?
Yeah. Montreal was a fairly unique market for us in that we had a lot of disposal capacity, very little in the way of collection operations. We've tried to build up those collection operations over time, frankly, they have one spectacular company there in RCI that made it difficult for us to get into the collection business. We had a landfill that pre-recession was actually fine because there was an excess of tonnage in the market and our landfill was fine. After the recession, frankly, there wasn't enough tonnage in the market to fill all the landfills, we had a choice to make. We could either get deeper into the collection business to help feed our landfill network, or we were going to see volumes deteriorate at our landfill, and we were going to be at the mercy of other collection companies.
It was a perfect tuck-in acquisition for us. It's a great market. We've been looking at it for a long time. Lucien Rémillard, as I said earlier, ran a great business and we look forward to continuing his successes.
This is an MSW landfill, David, or is there other waste streams it can take?
Yeah, no, it's MSW.
Okay. Finally, if I may, and sorry if this has been a topic that I missed, but on the SG&A front, you have talked about cost savings on the gross side of $120 million. You did 10%, I believe, as a percentage of revenue in the quarter. How much of that benefit, for lack of a better word, is due to the lower recycling volumes? How much are you really on track to hit that gross target number?
Due to the lower recycling volumes, I wouldn't say any of it's due to the lower recycling volumes. It's really due to two things. There's several things in play here, but certainly the restructuring has had a big impact. We've kind of gone over and above the restructuring by taking out a chunk of non-labor SG&A as well throughout the year. Those are the two big components of our SG&A, and we've talked about not only holding flat from 2012 to 2013, but looking to hold flat from 2013 to 2014 in absolute dollars.
A $353 run rate is what you're suggesting we should think about in terms of Q3 and forward?
Well, so Q3 has, and we talked about this a little bit earlier, but Q3 and Q4 have a bit of headwind with respect to compensation accruals year-over-year. While we're up for the first two quarters of the year, we expect that we'll have a little bit of headwinds, and that's why I think we're comfortable with saying that we'll be flat year-over-year.
Okay. Jim, my point about recycling is that if prices are down, then I would think that that would hurt the operating margin on that business. There may be some, I won't say idle cost, but let's say not fully utilized cost. That's what I'm just getting at, trying to triangulate. You're getting to an EBITDA margin of 25%, I think above that is the easy hurdle, and we just didn't see the progress in the quarter. I'm trying to decipher out whether that was an SG&A or an operating cost issue.
It was operating cost at our recycling operations. Remember, that had a 90 basis point effect on margin.
Okay.
Well look, when it comes to recycling, basically the breakdown you had is that the bulk of the problem with the $0.05 headwind was in pricing. Commodity pricing's down 12.5% for the quarter. Next was operating costs. Operating costs are up because we have to get lower residue. Then you have the volume and the integration of the acquisition pieces, a little bit small pieces in there, too. Look, the two biggest things are price and operating costs. Those are two things that we can affect in recycling. You can affect price by going and looking at rebates. You can affect operating costs by driving the inefficiencies out of the system. That's where we're focused on recycling. When we talked about margin expansion, we got 20 basis points of EBITDA margin expansion.
Obviously, that would have been back over 100 if we had gotten just flat in recycling. Once we get to the point where we're positive from the recycling operations, that's when you'll really see the leverage appear.
Okay. What's the assumption on commodity price, David or Jim, for the back half of 2013?
We expect it to be pretty much flat for the rest of the year.
Got it.
You had the midyear run up, and we're expecting it to sort of be flat for the rest of the year.
Okay. Thanks for taking my questions.
Not a problem.
Thank you. Mr. David Steiner, do you have any closing remarks?
No, thank you all for joining us in the quarter. I know Jim and Jim will be out on the road in New York next week, look forward to seeing you out on the road.
Thank you for participating in today's Waste Management conference call. This call will be available for replay beginning at 01:00 P.M. Eastern time today through 11:59 P.M. Eastern time on August 13th, 2013. The conference ID number for the replay is 97883740. Again, the conference ID number for the replay is 97883740. The number to dial for the replay is 1-800-585-8367 or 1-404-537-3406.