Good morning. My name is Cornicia, and I will be your conference operator today. At this time, I would like to welcome everyone to the Third Quarter 2016 Earnings Release Thank you. I would now like to turn the conference over to Mr. Ed Eagle.
Sir, you may begin.
Thank you, Cornicia. Good morning, everyone, and thank you for joining us for our Q3 2016 earnings conference call. With me this morning are David Steiner, Chief Executive Officer Jim Fish, 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 ks this morning that includes the earnings press release and is available on our website at www.wm.com. The Form 8 ks, the press release and the schedule for the press release include important information.
During the call, you will hear forward looking statements, which are based on current expectations, projections or opinions 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 discussed in today's press release and in our filings with the SEC, including our most recent Form 10 ks. David and Jim will discuss our results in the areas of yield and volume, which unless otherwise stated are more specifically references to internal revenue growth or IRG from yield or volume. During the call, David and Jim will also discuss our earnings per diluted share, which they may refer to as EPS or earnings per share, and Jim and David will address operating EBITDA and operating EBITDA margin as defined in the earnings press release.
Any comparisons, unless otherwise stated, will be with the Q3 of 2015. The Q3 2016 results have been adjusted to enhance comparability by excluding certain items that management believes do not reflect our fundamental business performance or results of operations. These adjusted measures, in addition to free cash flow, are non GAAP measures. Please refer to the earnings press release footnote and schedules, 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. This call is being recorded and will be available 24 hours a day beginning approximately 1 p.
M. Eastern Time today until 5 p. M. Eastern Time on November 19. 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 9,000,149,575.
Time sensitive information provided during today's call,
which is occurring on October 26, 2016, may no longer be accurate at the time of a replay. Any redistribution, retransmission or rebroadcast of this call in any form without the expressed written consent of Waste Management is prohibited. Now, I'll turn
the call over to Waste Management's CEO, David Steiner. Thanks, Ed, and good morning from Houston. Our 3rd quarter results exceeded our internal expectations. As we have all year, we saw improving volumes, strong execution of our pricing programs and continued traction in our cost programs. Each of our net income, operating income and margin, operating EBITDA and margin and earnings per diluted share improved when compared to
the Q3 of 20 15.
And during the Q3, we achieved a significant milestone as our operating EBITDA exceeded $1,000,000,000 for the first time. We earned $0.84 per share in the 3rd quarter, an increase of 13.5% from our Q3 2015 results. Our continued growth in earnings translated into strong generation of cash flow from operations, which grew $96,000,000 in the 3rd quarter and drove year to date cash from operations to over $2,200,000,000 That's almost a 12% increase over last year. So we're very pleased with the momentum that we've built in the 1st 3 quarters of the year, which we expect to continue into the 4th quarter and extended in 2017. Our pricing programs are a significant reason for our earnings growth and margin expansion.
For the Q3, our collection and disposal core price was 4.7% and collection and disposal yield was 2.1% with total company yield at 2.6%. Core price improved 70 basis points from the Q3 of 2015. Core price in the industrial line was 8.6%. In the commercial line, it was 7%. And in both our landfill and residential lines, it was 2.6%.
Importantly, we demonstrated our continued ability to increase prices while retaining customers through improved customer service as our churn rate dropped to 8.7%. That's 170 basis points better than last year and 40 basis points better than the Q2 of 2016. This is the lowest churn that we've seen since before 2,005. It's a tribute to our customer service and operations folks who've worked together to create a better customer experience. With respect to volumes, we continued to see positive volume growth in the 3rd quarter, just as we have all year.
In the quarter, we saw volumes in our high margin commercial, industrial and landfill lines of business continue to grow. And we saw an improvement in the rate of decline of residential volumes. Our traditional solid waste volumes were positive 1.6% in the Q3 of 2016, a 170 basis point improvement from the Q3 of 2015 and an 80 basis point improvement sequentially from the Q2 of 2016. And our overall volume was also a positive 1.6% as our national accounts and Recycling segments contributed positively to volume growth in the quarter. Our entire team continues to execute on our strategy
of maintaining price, adding
high margin business and improving customer service and the results continue to impress. Our landfill line of business continues to show strong results too, which Jim will discuss in more detail. However, as we previously mentioned, we've seen a significant increase in the cost of managing the liquids that occur in our landfills. In the Q3 of 2016, the increase in leachate cost was about $23,000,000 or a drag of $0.03 per share. We continue to roll out our wastewater management charge to our landfill customers who are under long term contracts.
However, the charge is fully implemented on our spot customers. So in the Q3, we added approximately 0.2% to landfill yield from implementing the charge with almost no pushback. However, we still have a long way to go before we can recover the full cost. It's important that we pass the cost increases on to our customers so that we can achieve an appropriate return on investment on our landfill assets. But just like when we implemented the fuel surcharge, it will take time to fully implement this charge.
Turning to recycling, we saw a 13.6% increase in average commodity prices at our recycling facilities for the quarter and a 0.9% increase in volumes. Year over year, the recycling line of business contributed almost $0.03 per share to earnings, which helped to offset the $0.03 of increased leachate costs. The improvement in earnings was driven by about $0.01 from pricing and about $0.02 from operational improvements at our recycling plants and our continued efforts to improve our contracts. On the operational side, our recycling employees have done a nice job on improving operational efficiencies, such as reducing downtime events through preventative maintenance practices, educating customers about contamination and charging for contamination overages. This led to gross operating expenses improving 4.5% in the 3rd quarter.
And on the contract side, we continued to work with customers on more fair contract terms to allow Waste Management to remain their recycling partner and provide us with a sustainable business model. So we're very pleased with our Q3 results as well as our results through the 1st 9 months of 2016. We are proud of the hard work all of our employees have done to date to cause us to exceed our expectations for yield, volume, earnings and cash flow generation. Consequently, we are again raising our adjusted diluted earnings per share guidance for 2016. We are confident that we can achieve consensus for the Q4, which would put us at $2.91 of EPS for the full year.
Cash flow continues to be strong and we remain confident that we can achieve our free cash flow guidance for 2016 of between 1.6 $1,700,000,000 As we move towards the end of the year, we will do what we have done in the past few years, where we estimate full year cash flow and determine if we want to prepay up to $100,000,000 of our 2017 capital spend or taxes. I want to thank all of our team members for demonstrating once again why they are the best in the business. I will now turn the call over to Jim to discuss our 3rd quarter results in more detail.
Thanks, David. The 3rd quarter was indeed another strong quarter for us. Revenues in the quarter were $3,550,000,000 an increase of $188,000,000 or 5 point 6% when compared to the Q3 of 2015. We saw $110,000,000 increase in our collection and disposal business from the combined impacts of pricing and volume, a $60,000,000 increase in revenues from acquisitions net of divestitures and recycling revenues increased $27,000,000 These increases were partially offset by an $11,000,000 decline related to lower fuel surcharge revenues. Foreign currency fluctuations had no material impact on revenues compared to the Q3 of 2015.
Looking at internal revenue growth for the company. In the 3rd quarter, our collection and disposal core price was 4.7% and yield was 2.1%, with total volumes improving 1.6%. Volumes were positive for the 3rd consecutive quarter. The combined positive price and positive volume led to total company income from operations growing $65,000,000 operating income margin expanding 90 basis points to 18.8 percent, operating EBITDA growing $71,000,000 and operating EBITDA margin growing 50 basis points to 28.2 percent. Our collection lines of business continue to see the benefits improving volume.
Industrial volume was up 1.9% in the 3rd quarter, a 150 basis point improvement from the Q3 of 2015 and a 40 basis point improvement sequentially. Commercial line of business showed strong momentum with volumes up 1.2% in the 3rd quarter, a 250 basis point improvement from the Q3 of 2015 and a 90 basis point improvement from the Q2 of 2016. While our residential business volumes were down 2.9% in the 3rd quarter, this reflected a 70 basis point improvement from the Q3 of 2015 and a 60 basis point improvement sequentially from the 2nd quarter. Overall, our collection income from operations grew $26,000,000 and EBITDA grew $38,000,000,000 in the 3rd quarter. In the landfill line of business, we again saw the benefits of both positive volume and positive yield in the 3rd quarter, just as we saw in the 1st and second quarters of this year.
Total landfill volumes increased 6.9%. MSW volume grew 6.1%, C and D volume grew 22% and combined special waste and revenue generating cover volumes grew 6.7%. More than half of the growth in C and D was due to storm cleanup in Louisiana, but underlying trends remain strong. We achieved core price of 2.6%, an increase of 30 basis points from the Q3 of 2015. The combined positive price and volume in the landfill line of business led to income from operations and EBITDA each growing $12,000,000 in the 3rd quarter.
Moving now to operating expenses. As a percent of revenue, these expenses increased 10 basis points to 62.5%. For the Q3, operating expenses increased $121,000,000 when compared to the Q3 of 2015. Landfill operating costs represented the largest increase, up $29,000,000 $23,000,000 of the $29,000,000 increase were the increased leachate costs, which equated to 60 basis points as a percent of revenue. The remainder of the operating cost dollar increase related primarily to our increased volumes and costs from acquired operations with labor costs increasing $28,000,000 cost of goods sold increasing $25,000,000 and subcontractor costs increasing $22,000,000 These increases were partially offset by savings from lower fuel costs.
Over the next 12 to 18 months, we expect to see operating expense margin improvement as we add wastewater treatment capacity and as our increased fuel fleet purchases and MSTO initiative began to positively impact maintenance costs. For the Q3, as a percent of revenue, SG and A costs were 9.3%, an improvement of 50 basis points when compared to the Q3 of 2015. On a dollar basis, SG and A costs were $330,000,000 a slight improvement compared to 2015. We've done a nice job controlling SG and A costs as increases in wages and compensation have been offset by other improvements. Turning to cash flow for the Q3.
Cash provided by operating activities was $753,000,000 compared to $657,000,000 in the Q3 of 2015. Our operations continue to perform very well as cash flow was driven largely by an operating EBITDA increase of $71,000,000 During the Q3, we spent $333,000,000 on capital expenditures, a decrease of $2,000,000 when compared to the Q3 of 2015. Through the 1st 9 months of 2016, we have spent $962,000,000 on capital expenditures, an increase of $98,000,000 when compared to the 1st 9 months of 2015. We still expect that capital expenditures will be between $1,400,000,000 $1,450,000,000 for the full year 2016. In the Q3, we had $8,000,000 in proceeds from divested assets, a decrease of $28,000,000 from the prior year quarter.
Combined, we generated $428,000,000 of free cash flow, a $70,000,000 increase compared to the Q3 of 2015. Year to date, we have achieved free cash flow of $1,280,000,000 We remain confident in achieving our full year we paid $182,000,000 in dividends to our shareholders. While we didn't repurchase any shares during the Q3, we currently plan to start buying back our stock again in the Q4 when the window opens. We expect that these late 2016 early 2017 repurchases will allow us to completely offset the 2017 dilution impacts of our equity compensation plans. Finally, looking at our other financial metrics.
At the end of the Q3, our debt to EBITDA ratio measured based on our bank covenants was 2.56 and our weighted average cost of debt was 4.17%. The floating rate portion of our debt portfolio was 13% at the end of the quarter. The effective tax rate was 33.7% in the 3rd quarter. Adjusting for the impairments, the tax rate was 33.5%. We still expect that our full year as adjusted tax rate will be approximately 35%.
In summary, year to date 2016 has been a very successful year, driven by the exceptional performance of our employees. I want to thank them for their efforts through the 1st 9 months. I know they're working hard to improve our operational and financial performance for the remainder of 2016 and end of 2017, and we are confident that they will be successful. And with that, Garnetia, let's open the line for questions.
And your first question comes from Noah Kaye.
Yes. Thank you and good morning.
I would just like to start
with maybe your thoughts on the general environment. We've seen commentary around maybe macro longer term on the other hand, there continues to be some optimism around housing growth. But maybe, David, you could just sort of tell us how you're seeing the picture these days and maybe the sustainability of some of this very impressive growth that you've been seeing.
Yes. We obviously can't look out a number of years, but we've said very often that the best indicator for our business is new housing starts. And as you know, we've been running a deficit on new housing starts in the United States since 2009. So we still haven't gotten to the point where we're meeting annual demand for new housing starts. And so everything I've seen says that that's going to continue to be strong through 2020.
Now obviously, you saw there are some labor challenges in the housing markets. But once those get evened out, I think you're going to start to see those new housing starts move up that $1,100,000 to $1,200,000 to sort of the $1,400,000 to $1,500,000 And you can run at that rate for a good 3 to 4 years before you actually catch up with demand. So and following those new housing starts, you'll see commercial businesses come in. And so we see the commercial business remaining strong. And then I think our other lines of business like our industrial and our oilfield services, I think oilfield services has bottomed out.
We should see I think, So absent any big political event or big regulatory event, I would expect that we'll see continue to see good volume growth over the next few years.
No, I might add one thing, Wynn, and that is that while it's sometimes hard to see what the macroeconomic climate holds, demographics are kind of set in stone. And when you look at housing starts, as David talked about, you've got a big generation that kind of millennial generation that's coming into their own in terms of moving out of parents' homes and buying their own houses. So we feel pretty good about housing starts, which is a direct correlator for us going forward for the next 5 to 10 years.
Okay. Thanks for that. Getting the churn rate down to its lowest level in over a decade, again, very impressive. Can it go further from here? And where do you see as the levers continue to drive churn rate lower at this point?
And also how do you think about some of the pricing stickiness benefits of the churn rates being at this level now?
Yes. Our pricing programs quite frankly have always been premised on providing better customer service. I always use the cable model, right? We all get an offer to get lower cable or lower TV service once a week, we'll get something that will promise us a lower price. But we don't switch because the pain of switching is high and the cost differential is not dramatic.
And so you've got to keep that good customer service because you don't change your TV provider until you start having service issues. And that's when you take those lower priced offers and you say, I'm going to listen to these and actually get this done. And so customer service is pivotal to the long term sustainability of our pricing programs. And I would say it's 2 things that really drive it. 1 is technology, I mean, in the use of technology, the use of data.
And I would tell you in that, we're probably in sort of the 2nd or 3rd inning. But the more important part of customer service is making sure that our customer service folks, our sales folks and our operations folks are all working hand in hand to make sure that we give a great customer experience. And frankly, that's where we've made a lot of progress over the last 2 years. Jim Trebathen and his team have done a phenomenal job of creating better connections between our sales folks, our customer service folks and our operations folks to make sure that we're all driving to the same goal. So, yes, it can go lower.
Probably about 4% to 5 percent of that churn is systemic, people going out of business and moving businesses, different things like that. But we think we can continue to get it lower and we expect to
do so. Noah, with a couple of specific examples of that, Jim Fish and I visited with our national account team last week. And we've rolled out in the last year some very specific tools that help us provide for our largest customers some online and real time information that helps them manage their business more aggressively. And it's led us, as Dave and Jim mentioned earlier, it's led us grow national account revenue in total this year where it's been a negative drag on our volume in previous years. So we're trying to differentiate that service offering very specifically.
The other thing without getting into any specific metrics and it ties to exactly what Dave said, we've added some operating metrics that tie directly to service to our customers rather than just that internal efficiency look. And that's really helped us focus on the right things that we think adds that specific value. And I guess the last thing I'd mention there is that we've gotten much more aggressive in the process in how we handle service challenges with our customers. And occasionally, we fail. And when we do, we want to correct it quickly and adequately.
But we also want to make sure that we renew contracts when we every opportunity we get. So we've added some real process changes that let us renew those agreements once an issue either positive or negative happened. And I think it's added to that decreasing churn number.
Okay. Thank you all. I know there are a lot of other analysts waiting, so I'll jump back in queue.
Thanks.
Your next question is from Andrew Buscaglia with Credit Suisse.
Hey guys, thanks for taking my question. Can you talk a little bit more about on the volume side? So that definitely was stronger than we expected. I thought moving into the second half of the year, you guys would see more of like a flatter up slightly number. But can you talk about why where things surprised you?
Obviously, C and D was pretty strong, but what exactly happened and how surprised were you with these numbers?
Well, look, I think the trend has been there now for about 5 quarters. So I would tell you the move up in the volume number was not surprising at all. What I would tell you is where we've made the most progress, I would say, is on the commercial line. We finally flipped last quarter the commercial line to positive volume. And those are the volume and those are the customers that stay with you on average somewhere between 7 9 years.
And so they are they're long term customers. We can create that route density. And so adding that 1.2% volume on the commercial line, I think, is tremendous. I would say I wouldn't say that we are that we're very happy to see the landfill continue to be so robust and it really doesn't look like that's going to slow down dramatically. Now we may not continue to see that 22% on the C and D line, but we fully expect to continue to see sort of that 4% to 7% increase at the landfill.
We don't see that slowing down. And so we've created some good volume momentum and we'd expect that to continue into 2017.
Andrew, I don't think you can overstate also the importance of that churn number that Jim just talked about. I mean, when you when our churn is at 8.7% and it wasn't too long ago that we were in the 11s, That is a big contributor. And it comes, as Jim said, largely from a focus on customer service, which doesn't cause you to lose yield. You just you keep a good solid customer through improved customer service.
Yes. And Jim, on the addition rate itself, we talk more about the defection side, but on the addition side, we were up 50 basis points there providing another quarter that was net positive in number of customers, not just dollars.
Okay. That's helpful. And yes, near C and D seem to have benefited. You mentioned Louisiana, some work down there. How about in Q4 with storm cleanup from Hurricane Matthew, do you expect volumes to just kind of continue at this level here?
Yes. Like any big storm event, the initial issue is that we have increased operating costs. We were actually as a company hit particularly hard by the flooding from the hurricane. We lost probably 20 brand new CNG trucks that were flooded out. And so we have to move other trucks in to cover for those trucks.
And so the initial will actually be a cost for us, but obviously you'll see some additional volumes. But it really was not a hurricane that hit in very populated areas and that caused a lot of damage in populated areas. And so if I had to guess, I would say it will be about a wash for the Q4.
Okay. Thanks guys.
Thank you.
Your next question is from Al Koshawk with Wedbush Securities.
Good morning, guys.
Good morning, Al.
Solid performance. David, I want to just drill down on 2 topics. First, on the volume side, you called out the special waste piece. And if I'm not mistaken, that's really more fly ash directed. So could you talk about maybe the duration of that and what it means more for your broader outlook as it relates to volume?
I know you've said a few things earlier, but is this more a comment that there's reacceleration in the economy from your perspective and therefore this landfill and transfer volumes revenue should be continue to remain strong for a couple of quarters?
Yes. The ash is actually a very small part right around 10%. A little
less of 10% of the
to continue to see good growth in that area. As far as the special waste goes, my view of it, Al, is that we never really saw the industrial slowdown. And I think people talk about an industrial slowdown and they focus on a particular there's there's an industrial slowdown. We cover all the sectors and we service all of the sectors. And we really just haven't seen when you look at it on that basis with all of the industrial business, we really haven't seen the slowdown.
So we'll see a slowdown maybe in an oilfield sector, but we'll see a pickup in the chemical corridor. And so overall, we really haven't seen the industrial slowdown, and we don't see it on the near horizon.
I was going to say, yes, part of that answer is because we are so well distributed with our asset base across so many geographic areas, but also as Dave said, specific industries, we are so well positioned along the Gulf Coast with all of the capital being spent to improve petrochemical industry that we picked up quite a bit of volume, those hazardous sites along the Gulf Coast, while other places showed maybe a little bit of weakness and that's the strength of our company.
Yes. I would have thought with the government spending, the election, housing sort of shaking around a little bit, mixed data here, that the volume would not have been as strong. Although, look, I'm not taking anything away. I'm just trying to tease out the duration or the tenor of what you see, it looks like to be 2% volume growth for the next several quarters. So that's where that one was heading at.
Yes. And we just don't see at this point in time, we certainly don't see that momentum stopping.
Well, and actually now a piece that's been weak for us has been energy services and we're starting to see we're starting to hear a little bit from drillers that they may be looking to add capital expenditures in drilling in 2017. So we're not banking on that, but that would be a benefit to us at the landfill too.
Okay. My second one is a follow-up, if I may. I wanted to talk a little bit, I know it's $20,000,000 it was $23,000,000 in terms of cost for the quarter. But just on a bigger picture standpoint, the leachate cost seems to be something that's maybe going to stick with you for a while. But maybe you can add some color as to how broad based that is?
Is it just a few sites? Is it regional? Is there weather issues that are going on? What's the future what's the future expense there that we should be thinking about?
Yes. I would say that it's obviously 2 factors. It's the volume of leachate and then the cost to dispose of the leachate, right? And there's not a lot we can do about the volume of the leachate. When it rains, we get more leachate.
But there is something that we can do on the disposal side and that is the bigger part of that $23,000,000 of expense is the disposal side. And so we're building wastewater treatment plants. We're going to look at doing some deep well injection at various sites. And so if we can reduce that disposal cost, we think we can bring that cost down pretty dramatically. Now that takes a little bit of time.
So we would expect these increased leachate costs to be with us at least through mid year of next year and probably throughout 2017. But in 2018, we ought to be able to attack it pretty well.
Now I would say that it is somewhat regional, but we've seen an increase in transportation, not just in kind of the East Coast, Mid Atlantic and New England. We've seen it in the Michigan area. We've seen it in Texas. Not obviously so much on the West Coast. I don't think you guys have had rain there for a couple of years.
So we haven't seen much in the West or the Rocky Mountains. But definitely, the rest of the country has seen an increase not only in volume but in transportation costs.
Are there any I appreciate all the color. Is there any 1 or 2 sites that I won't say a problem child, but could be or are working their way there?
Well, the biggest issue we had was in Virginia when we got basically we were transporting the leachate to a water treatment facility, municipal water treatment facility, a POTW. And they shut off the leachate not just from our landfill, but from all landfills. And so, it's not an issue that is unique to us. We just happen to have 2 large landfills fairly close to that POTW. And so and by the way, that's happening a little bit more throughout the country.
I wouldn't say it's a trend, but that's the biggest part of what's driven our transportation costs is now instead of transporting it to a local POTW, we've got to put it on trucks and barges and ship it 100 of miles. And so, if you can build the wastewater treatment facility on-site, obviously, you eliminate that transportation cost and that's exactly what we're doing.
Excellent. Good luck guys and thanks for the color.
Thank you.
Your next question is from Hazza Mazari with Macquarie Capital.
Good morning. Thank you.
Welcome back. Thank you. I appreciate it. Good to be back. The first question is just on free cash flow.
Is $1,600,000,000 to 1 $700,000,000 the new normal for Waste Management? 5, 10 years ago was 1,100,000,000 dollars Just trying to get a sense of is the free cash flow profile sustainable given that divestitures don't seem like a big part of the number at least this quarter?
Yes. Hops, as you recall back a couple of quarters ago, we kind of said the new normal was 1.4 percent. And it feels like that number is going up. It feels like more like a 1.5 percent. If you look at kind of how we get to our range of 1.6 percent to 1.7 for this year, I'll kind of walk you through a little bit of it.
But most of it comes from the single biggest component, which is EBITDA, which is, in my mind, kind of the best proxy for how the business is doing overall. So if we think about finishing 2016 with about $365,000,000 in EBITDA and then you back out CapEx kind of in the middle of that range that I gave on earlier, So back out CapEx of $1,425,000,000 less kind of the sum of interest taxes and working capital of about 6 $50,000,000 And then you add in proceeds, and you're right, proceeds are kind of a small number this year compared to prior years, but add in proceeds of about $50,000,000 and that puts you at about $1625 finishing points for 2016. And then in order to get to kind of a new normal, you probably have to kind of normalize cash taxes a bit. We haven't decided exactly what we're going to do, but the last 2 years, we've actually prepaid some cash taxes. 2 years ago, we prepaid $200,000,000 and last year, we prepaid $150,000,000 And as we said when we did it was really in an effort to try and kind of smooth out cash flows a bit so we don't have these big lumps.
But we'll look at that as we get to the end of the year. And to the extent that we're kind of over the top of that low end of the range, maybe look to prepay some cash taxes in December. Yes.
So Hamzah, I would completely agree with Jim that I think the business is about a $1,500,000,000 free cash flow business. I think that's sort of the baseline. And then you look at what happens with working capital, right? If working capital goes positive, this year it goes positive because of the prepayments, that's how you get to that 1.6% to 1.7%. And so I would say that I'd agree with Jim, the baseline is sort of 1.5 and then you have a couple other moving items within working capital that could drive it
above that. That's very helpful. And then second question on commercial volume, we saw a nice recovery there, But aside from the last 2, 3 quarters, it's been negative since 2008. And I realize that you've been getting rid of low margin business. But maybe just frame for us where are we in that commercial volume cycle?
Is it the 2nd inning, the 3rd inning? And can commercial see the same cycle industrial volumes have? Just curious on any thoughts there. Thank you.
Yes. I would tell you, Hamzah, that I think we're in the early innings still. I talked earlier about housing starts and how housing starts are the demand is there. The problem right now is that it's hard for the housing companies to get labor. And I would say that's sort of where we are in this cycle, right, that the demand is there.
But getting drivers, mechanics, getting the labor, getting the trucks in place is something that we've got to work to be able to meet the demand. And so I'm encouraged that I think we're in the early innings because the demand is there. Now it's a matter of us getting the labor and the equipment there to meet
the demand. But Jim, I'll let Jim. Completely agree, Dave. It's been a little more of a challenge. You saw that and a little bit of a compression in the operating margin.
Although it would move forward, it was smaller than previous quarters. And we think that's primarily related to some new routes, trucks that were not routed before. We spent a few dollars in maintenance costs to get them up and running and servicing customers correctly. And it's a good problem to have that we see continuing, but we're getting our arms around how to do that quicker and faster and better as that volume moves forward. And I think, I mean, the economy, that kind of late cycle economy that I've read that you all have talked about, it definitely is helping volumes.
And then I think our processes and some of the additions that we've made on how we go out and find that volume. We're targeting volume, especially on the commercial side, but also industrial, much more specifically to MSAs that have growth and where do we put the right resources in place, both human and physical resources in place, how do we target it correctly, price it correctly. Those tools have been out there. We're just using them much more consistently across all areas, sharing best practices and you're starting to see the benefit of that.
Great. I appreciate it guys. Thank you.
Thank you.
Your next question is from Michael Feniger with Bank of America.
Thanks for taking my question. If we're in a 1.5% to 2% volume growth next year, what can we reasonably expect for margin expansion? Is there still work to do? I know we have leachate cost, but are there other areas that we could look at for the cost side to make sure we get that margin expansion?
Yes. When you look at the margin expansion, I think that we still have that 50 to 100 basis points. And let's so when we look at 2017, we will probably expect to not get a big benefit from recycling even though we've seen commodity prices up. We've been bitten by that before. And so when we put together our plan, we probably won't expect to get a large benefit from recycling.
So that won't contribute to the margin. Obviously, we've got this leachate expense, which will restrain the margin. But what we need to do is get efficiency gains by adding route density. We need to get more dollars of price as we see the construction season beginning next year and we need to do I think a better job of planning for the construction season and meeting the increased demand that we would expect to see. And to me that's what's going to drive the margin.
Obviously, the gyms and our other operations folks keep a great eye on SG and A. And as you see revenue go up, obviously, we pick up basis points there because we'll hold SG and A relatively flat. And so I think that 50 to 100 basis points of margin expansion next year sort of comes probably 40% from SG and A and about 60% from the operating side.
That's perfect guys. And just my follow-up, if we do see volumes come in a little bit light next year, is there any way to move in terms of maybe stepping up the acquisition side? I was curious if you guys could talk about the pipeline there and what you're seeing on the M and A front?
Yes. The last 3 years we've sort of done that $50,000,000 to $70,000,000 EBITDA acquisition starting with RCI in Canada and then Deffenbaugh in Kansas City and then SWS in South Florida. And we really don't see one of those type of acquisitions in the pipeline for 2017. So we're going to have to go back to doing it one acquisition at a time, doing those $5,000,000 to $25,000,000 type of acquisitions and get our business developers to really go out and start getting some folks to build up those type of acquisitions so that we can reach. We'd like to add somewhere between $25,000,000 $40,000,000 of EBITDA next year, but we've got some work to do
in order to get that done.
Perfect. Thanks guys.
Thank you.
Your next question is from Corey Greendale with First Analysis.
For Corey, thanks for taking my question. So just looking at yield being a bit softer in Q3 relative to Q2, just wondering what do you attribute this to and what do you see as the sustainable rate going into 2017? Yes.
As you know, we've always said, we think that that yield should be somewhere around 2%. The overall company was 2.6%. We actually got some positive from recycling and some other areas where we've sort of been negative lately. And so it's pretty much right where we expected it to be. Now we knew that in the back half of the year and I think we said on the first two quarter conference calls that it would probably abate in the second half of the year between CPI and mix that we would see it come down closer to that too.
But when I look at pricing, increasingly we're looking at core price not yield because yield has those mix issues in it. Yield has some of the CPI issues in it. But core price is the actual dollars that we're putting out on the street and holding on to, in pricing. And as you saw, that was up 70 basis points this quarter. What we've said is that we think core price should be sort of at that 4% number, year in and year out.
We'd expect that to continue. And so if we continue to get that 4% core price, 4% plus core price, yield should continue at around 2%, but we're not going to get too worked up over a few basis points of movement here or there based on CPI or on mix.
All right. That's helpful. Thank you. And just looking at commodity prices, which have been on an upward trajectory, what kind of impact are you expecting for your recycling revenue over the next few quarters? And, does this have any impact on your efforts to change contracts?
No. I mean look we've got to get you can't fall into the trap of saying prices are going up. So let's go back to the old style of doing business in recycling. We absolutely will never do that as long as I'm breathing. And so it won't affect our contracts.
It will affect we will continue to weed out those contracts that are under the old form and basically we're about 80% through with that. When you look at the pricing, it's up, but it's not dramatically up. And it's been fairly volatile over the last few years. And so we're not declaring victory. We're going to continue to go after all the operating costs that we can on the recycling side.
And like I said, we won't expect to get a benefit from it in 2017, but if we get a benefit that will help to offset some of those increased leachate costs.
We finished when you think about where we to put it into historical perspective, we finished the quarter about $98 in our average commodity price for us and the 10 year historical average is kind of 103 ish. So still slightly below that. And as David said, we're we've fallen into the trap before of saying we think this trend continues and we'll build it into the guidance for 2017. At this point, we while we haven't put any guidance out, we're probably not going to set high expectations for commodity prices for 2017.
Thank you. And by the way, to the volume issue, because I think you did ask about the volume too. Most of the increase that we saw and we did see positive volume in the quarter, but most of that volume was brokerage volume, which obviously is very low margin volume. When you look at the core processing business, we've as you know, we've shed a lot of unprofitable contracts over the last 3 years. And so the core business is still seeing some negative volume on the recycling side, but we had really strong brokerage volume.
All
Your next question is from Joe Fox with KeyBanc Capital.
Hey, good morning guys.
Good morning Joe.
David, if I heard you right, I think you said you're looking for about 50 basis points to 100 basis points of margin expansion next year. And I think you called out 40% of that being SG and A and 60% being operating. Maybe if we just drill into the SG and A, which it was basically at the lowest level that I could find in my model going back to at least 2,003. When you look at that going forward, are there any big items that you expect to cut out of SG and A? Or is this more a function of just watching your costs and getting good leverage on that revenue growth?
Yes. I do think it is watching the costs and the gyms and the operating folks have done a spectacular merit increase merit increase every year. So they've done a nice job of keeping the dollars flat. And then as the revenue goes up, that's where you get expansion. I mean, look, we've always said, if we can start putting volume onto this sort of high fixed cost structure that we have, that's how you generate margin expansion.
And we feel like we've got the right level of SG and A in order to meet the needs of the business whether it's in today's environment or in next year's environment where we see the volumes go continuing to go up. And so we don't think that we're going to have to add a lot of dollars of SG and A. We've done a nice job on SG and A over the last 5 years of taking out costs. I would tell you there's not any big dramatic decrease in SG and A. It's just a matter of making spectacular job of looking at operating guys do a spectacular job of looking at every dollar of SG and A we spend and making sure that it's justified.
The the coal ash contribution was in the quarter, either from a revenue or a volume standpoint? Where are you putting that? Is that primarily in the special waste bucket? And I'd be curious to know how the margin is coming in for coal ash, if it's accretive to the overall margin or if it's dilutive?
Yes, Joe. Overall, as we said earlier on the call, coal ash, the disposal portion flows into the special waste revenue generating cover category, and that was up almost 7%. The coal ash part is less than 10% of that total. So it's still a small part of our overall revenue but a growing component of our revenue. We also have some on-site activities.
We've done work on those customer sites where we're moving materials from one location to another, helping them operationally manage both their generated waste materials, but also their historic materials that are stockpiled and need remediation. So there's an on-site component. That on-site component is without a doubt a lower margin. It is accretive to our company. But it also it has a very low capital cost associated with it.
The disposal side, much higher margin when we go off-site, higher margin, but it's typical to our landfill margins. So it is a good part of our business, but it's not a substantial part yet, Joe, but we expect it to be over the coming years to continue to grow as those regulations take effect and companies decide what they're going to do on their side to meet those new regulations.
Got it. Thank you.
Thank you.
Your next question is from Michael Hoffman with Stifel.
Hey, thank you, David, Jim and Jim for taking my questions.
Absolutely.
So Jim Fish on SG and A, you started the year targeting a flat year over year in dollars. To do that, you would actually be down again in 4Q. Is that still the right trend in dollars?
Excuse me. I think for Q4, we'll probably it'll probably look a little bit more like the first half of the year. But the goal is always as it is when we talk about 2017 planning right now to try and hold flat in dollars and then get the benefit as revenue increases. I think Q4 will probably be a little bit more like the first half of the year than Q3 itself.
In percentages or dollars?
In percentages.
Percentages, okay. So the midpoint of that sort of about 10 points?
Yes. Let me say this, not in the absolute percentage, but in percent of revenue versus prior year. So we were for the first half of the year, we were basically flat on a percent of revenue basis. We were up a little bit in dollars. And a lot of that came from the increase in our stock based compensation the accruals for our stock based compensation programs, which are driven obviously by total shareholder return and then also free cash flow.
And those two metrics have done well. So as a result, we've had to increase the accruals there. So I think you may see that again in Q4, which would mean that as a percent of revenue, Q4 versus prior year will probably be about flat dollars, it may be up a bit.
Right. Okay. Well, it would definitely be up a bit. So that puts you up for the year. And okay, that helps there.
So then to get to your revised guidance on earnings would suggest that the gross margin in the 4th quarter has to improve. So while you had gross margins leak a little bit sequentially, this is a sequential issue. And you noted the leachate issue. I'm hearing there's some maybe some gross margin improvement that has to come in the Q4 in order to be able to hit that 291 or better number?
So you've also got the volume improvement continuing into the 4th quarter?
Yes, but that's I mean that's the operating leverage into the gross margin is what I'm assuming is that volume improvement is going to help drive gross margin improvement in the 3rd Q4?
That's absolutely correct.
Okay. So it would be realistic to assume gross margins will be better in the Q4 than they were in the Q3?
Yes, absolutely.
Okay. And then with regards to the volume, well, let me ask a different question on churn first and then operating leverage. Given if you were to run all next year at the same rate of churn, I would think that your reported price that yield number trends up by definition because you're not replacing as much business at lower rates. So that 4 point something core price, you're keeping more of it. That's part of the answer of why you're able to do 2% ish is because you've structurally going to have a whole year of lower churn.
That's exactly right. And when you look at the effect of new business pricing, lost business pricing, you're exactly right. If we can have less lost business, that drops straight to the yield number.
Got it. Okay. All right. So that's support for that pricing in this. And then Jim Fish on working capital, do we get some help in working capital in the Q4 for on the to the free cash?
Should that be a positive you'll get you'll collect more of your bills?
We do get a little bit
of help from working capital in Q4.
Okay. And then, David, you started talking about industrial activity. I think Jim Trevathan you did too and then you didn't quite close the loop on it. I mean, clearly the industrial economy has slowed. That's not disputable.
But you're not seeing incremental deterioration. It's slowed to a now sustained rate of a lower rate of growth. And you're not seeing any further deterioration.
No, I'd agree with that. And the last time I saw the numbers, they're still above 50. So we're still seeing a little bit of industrial growth.
Yes. It's just that a slower rate of growth than everybody had been. I mean, folks were looking for 3% 4% industrial production growth starting the year. We're really sort of in a 1% to 2%. So it's a long term low growth rate.
Yes. No, I'd agree with that.
Okay. And then on free cash flow, all things being equal, we would be you'd be down year over year because of the cash tax issue and then grow that number. I guess, I mean, that's the comment of the baseline of $1,400,000,000 to $1,500,000,000 and grow that number some rate is the right way to think of it because of the noise of cash taxes.
That's right, Michael. I mean, there's 2 things really that are potential headwinds for us and then we overcome those with growth of the business. Those two things, as you mentioned, one is cash taxes, the other is CapEx. And right now, it looks like CapEx for 2017 could be higher. We've had a couple of projects that we originally had in 2016.
That's why our range has come down a little bit. We were originally $1,400,000 to $1,500,000 We're now $1,400,000 to $1,400,000 So we brought the top end of the range down by $50,000,000 that's just simply because a couple of the projects that we had originally thought would show up in 2016 look like they will show up in 2017. So none of it do we feel like we can't overcome, but those are the 2 things that work against us a little bit in 2017.
Okay. And I was going to sort of tease on that given the strength of volume, do we see the mix of CapEx maybe move a little bit to help this tax issue too, which is you pull forward some trucks and containers, get them in service before the end of the year and capture the bonus depreciation?
Yes. So Jim and I kind of manage the capital committee pretty along those lines. And we look at bonus depreciation. We look at how do we kind of smooth CapEx a little bit. And so as we think about CapEx, though, really maybe to answer your question this way, we've said all along that we thought CapEx should fall in the 9% to 10% of revenue range.
In 2014, it was below that. It was in the 8s. 2015, it was just above 9%, kind of like 9.1%. Percent. And 2016, it's going to be closer to 10%.
But we'd still think in 2017 and on a go forward basis that, that range of 9% to 10% is a healthy range. It's a good range for us. Keep in mind that if you look at things like fleet purchases, in 2012, 2013, I think 2012, we bought around 900 to 9.50 vehicles. We're going to buy 1300 vehicles this year. So when we think about OpEx, and we talked about it a little earlier, eventually that has to start affecting our maintenance costs as we've increased the number of trucks that we buy by almost 40%.
Hopefully, that answers
your question. Yes. Michael, I'd just add one other thing to that. Although we have, the last few years, moved a few dollars of capital into the current year. The one thing that Jim and I are very focused on and that's making sure we support the business and the growth.
We're not doing that other than to support growth, where can we add value by moving trucks forward or backward or any other capital project. It's got to align with where the opportunity is and how we want to grow our business.
Okay. And that's a good
news in order to one of the things we've talked about is, look, talking to individual area of managers and vice presidents and saying, look, here's what your capital requests have done over the last 3 years and here's what your earnings have done. So when we think about return on invested capital, maybe you're doing well, maybe you're not, but we're having those individual conversations.
Right. And then last question on volume. So lots of hand ringing in the last month about data regarding the consumer and the economy. If you look into your database and start looking at very consumer centric businesses, restaurants, especially retail. My sense is based on the MSW trends and the landfill volume trends in MSW that consumer is still plodding along there and you haven't seen any pullback in activity.
They're participating in the economy and restaurants may be complaining about having to cut price and do all that. That's a fundamental issue for them. It's not the consumers not shopping.
No, I completely agree with that. And we've seen, to your point in the restaurant sector, we've seen weights come down slightly, but we haven't seen service levels change. And so, we continue to see service increases outpace service decreases. And so and for us, that's really sort of on the commercial side, that's the leading indicator that we look at and we still see that very strong.
Okay. Thank you very much.
Thank you.
Your next question is from Tony Bancroft with Cadeli Cat and Company.
Thanks for taking my call. Good morning, gents. Real quick, just give us an update on the waste CPI transition and progress there?
CPI transition, so Yes.
As we look at it, I think the number that we've always said is about 25% to 35% of our customers are on some type of modified index, whether it's a particularized index for us or a government index like the wastewater and sewage. That's one where like a lot of things we do, you have to have sort of an industry backing, right? I mean, look, too many times we see I'll go back to the recycling business. Too many times we saw a lot of people bid rational contracts like we do and then one party comes in and says we'll do it under the old type of contract and before you know it they're winning business and losing money. And I would tell you we haven't seen as much sort of industry acceptance of a different CPI based residential or franchise type model, we have not seen widespread enough acceptance to move the needle.
I mean, when bidders go in and say, we're going to bid on a modified CPI and then the 4th bidder comes in and says, we'll take whatever you have on the table, it's hard to see things change. And so we've had better success in our large franchise areas like California. But I think that's going to be a long slow slug that we just have to we have to there's only one thing we can do at Waste Management and that's stiffen our backbone and say we're not going to bid these contracts
when it's not good for our business. We've proven that on the recycling side. We need to continue to have that same type of firm backbone on the residential and franchise side. And Tony, you've seen that. That's why our residential volume has stayed negative is that we have lost some volume, but we look at it, as Dave said, on the long term basis with our return on invested capital is a real focus and we're just not going to take business long term that doesn't give us the ability to manage our cost structure, but also get some margin improvement.
Right at that.
Thanks. And I know you mentioned in the call bottoming of energy potentially. I wondering if you could maybe elaborate a little. Obviously, rigs have been up recently. Any green shoot, anything you're seeing as far as your in your line of in your business right now?
Yes. The last report I saw, which was last week, I think, showed rig counts across the U. S. And the shale plays up 11, which is very small on a percentage basis. And the majority of those were in the Permian Basin where we don't have a presence.
But we are starting to see a little bit of indication that maybe some of those shale plays where we do have a presence are thinking about drilling next year, which is a change from the past 2 years for sure. So but nothing yet.
Tony, in real business, we're still down versus prior year. We're getting closer to anniversarying that reduction, but it's still not at anywhere close to the previous level and without significant movement forward, but we see signs of it.
Right. Thank you so much.
Thank you.
At this time, there are no questions.
All right. Well, thank you all for joining us as we move into the holiday season. We wish you all the best as we move toward the end of the year. And hopefully everyone on the phone takes a little chance to spend some time with the families and live what the holidays are about. So we'll see you when we release next quarter.
Thank you.
This concludes today's conference. You may now disconnect.