Heritage-Crystal Clean Inc (HCCI) 2012 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Heritage-Crystal Clean, Inc. third-quarter 2012 earnings conference call. Today's call is being recorded. At this time, all callers' microphones are muted and you will have an opportunity at the end of the presentation to ask questions. Instructions will be provided at that time for you to queue up your questions. We ask that all callers limit themselves to one or two questions.

Some of the comments we will make today are forward-looking. Generally the words aim, anticipate, believe, could, estimate, expect, intend, may, plan, project, should, will be, will continue, will likely result, would, and similar expressions identify forward-looking statements. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from those anticipated by these forward-looking statements.

These risks and uncertainties include a variety of factors, some of which are beyond our control. These forward-looking statements speak as of today and you should not rely on them as representing our views in the future. We undertake no obligation to update these statements after this call.

Please refer to our SEC filings including our annual report on Form 10-K as well as our earnings release posted on our website for a more detailed description of the risk factors that may affect our results. Copies of these documents may be obtained from the SEC or by visiting the investor relations section of our website.

Also please note that certain financial measures we may have used on this call such as earnings before interest, taxes, depreciation, and amortization, or EBITDA, are non-GAAP measures. Please see our website for reconciliations of these non-GAAP financial measures to GAAP.

For more information about our Company, please visit our website at www.crystal-clean.com.

With us today from the Company are the Founder, President, and Chief Executive Officer, Mr. Joseph Chalhoub; the Chief Operating Officer, Mr. Greg Ray; and the Chief Financial Officer, Mr. Mark DeVita. At this time, I would like to turn the call over to Joe Chalhoub. Please go ahead, sir.

Thank you and welcome to our conference call. Last night we issued our third-quarter 2012 press release and posted it on the investor relations page of our website for your review. This morning we will discuss the financial statements and our operations in the third quarter and we will respond to questions you may have relating to our business.

We are pleased to report that our third-quarter sales were $62.1 million compared to $37.2 million in the third quarter of 2011, reflecting a growth rate of 67%. Year-to-date sales increased 79% to $174.8 million compared to $98 million in the first three quarters of 2011.

In the third quarter of fiscal 2012, we continued to ramp up operation of our used oil re-refinery including the production and sales of lubricant base oil and byproducts. I am pleased with our operations during the quarter, which allowed us to produce 6.1 million gallons of really fine base oil. This volume represents 89% of our NIM rate capacity for base oil production. During the quarter we sold 6.3 million gallons of this product.

I have previously spoken about how 2012 is a transformative year for Heritage-Crystal Clean as we start up our re-refinery and expand into the significant new line of business. During the past two years we have overcome many challenges and there are still more in front of us but I think it is important to reflect on the fact that just -- in just two years, we have successfully designed, permitted, built, and started up our re-refinery, the second largest in North America and we are already running it at high rates on a daily basis.

We have grown a used oil collection business from almost nothing to become one of the top 10 used oil collectors in North America. We are well positioned to continue our growth in this segment and we have the team and the tools to add value for years to come. In other words, our transformation is almost complete.

Unfortunately we completed this transformation just as lube oil prices dropped sharply compared to recent norms. When we entered this team, we recognized that we would be exposed to commodity price swings and have ups and downs through the cycle. As we speak with you today, we remain confident that this is a good business that will provide attractive returns over the long run.

Our Oil Business sales and margins for the quarter would have been higher if not for the compression of the lube to crude spread. This spread is the value above the price of Brent crude oil at which lubricant base oil is sold. The reduction of this spread is reflected in the decline in the average stock market prices for group two base oil of approximately $0.44 per gallon from the second quarter until the third quarter.

There are ample supplies in the overall base oil market. Pricing for stock supplies is cyclical and currently remains under pressure even as crude prices rebounded from earlier lows. This resulted in even tighter margins, margins for the industry as a whole.

At the end of the quarter, we had 149 oil collection trucks in service. We were not as productive as we would have liked during the quarter with our internal used oil collection. Now that we have put in place a collection system to supply the vast majority of our used oil requirements and third-party supply is available at economical prices, we intend to slow the rollout of new trucks as we improve the productivity of our existing routes.

Our rollout of oil collection trucks has allowed us to further leverage our established branch network. Without our existing branch network, the incremental costs of our aggressive oil collection rollout would be much higher. Investments we have made over the last decade to develop these locations and the teams of dedicated professionals who manage them have created this opportunity to grow the used oil collection volume that is critical to our success in the Oil Business.

We continue to make progress regarding future plans to expand our redefining capacity at our Indianapolis, Indiana site. We are hopeful that we will have this permit to expand input capacity to 75 million gallons of used oil near the end of 2012. This expansion once put in place is expected to allow us to improve the profitability of the Oil Business by allowing us to better leverage our fixed costs. This increased profit anticipated from this additional capacity would help us offset the reduced profitability caused by the compression of the lube crude spread.

In the Environmental Services segment, we are pleased that our double-digit same branch sales growth. We expect that the new resources we have invested in over the last year would allow us to continue to meet our growth goals for this segment.

Our growth was made possible by our ability to continually add new customers. As of the end of the third quarter, we have served over 79,000 individual customer sites, an increase of 27,000 compared to just one year ago. We serve those customer sites from 71 Company branch locations compared to 67 branches a year ago.

This is a transformational time for our organization and we see opportunities for cost reduction and margin improvement in our Environmental Services and Oil Business segments.

Our Chief Financial Officer, Mr. Mike DeVita, will now further discuss the financial results, and then we will open the call for your questions.

Thank you, Joe. It's good to be with our investors today for HCCI's third-quarter 2012 conference call. I'm pleased with our third-quarter revenue growth as outlined in last evening's press release. Revenues continue to grow at double-digit rates in both of our segments.

In the Environmental Services segment, sales grew $4.5 million or 16.3% in the third quarter and $13.3 million or 16.4% for the first three quarters of the year. Of the 66 branches that were in operation throughout both the third quarters of 2012 and 2011, the growth in same branch sales was 13.6%. For the first three quarters of the year, same branch sales in our Environmental Services segment increased 13.2%. Our average sales per working day in the Environmental Services segment increased to approximately $555,000 compared to $545,000 in the second quarter of 2012 and compared to $475,000 in the third quarter one year ago.

Operating costs in the Environmental Services segment increased $2.8 million compared to the third quarter of 2011 and $11.7 million compared to the first three quarters of 2011. Our operating margin was approximately 19% during the quarter, which is up from the year ago quarter but was less than our second-quarter margin. The decline in margin from the prior quarter was primarily due to higher solvent and disposal costs.

We continue to work to recover the impact of higher solvent and diesel experienced over the last few years. We expect that our upcoming price increase will allow us to recover some of these costs and help improve our margins in the coming quarters.

In the Oil Business segment, sales for the third quarter grew $20.3 million or 211% as a result of initial sales in base oil products and byproducts from our used oil re-refinery. For the first three quarters, sales in the Oil Business grew $63.6 million or 384%. Our Oil Business experienced income before corporate SG&A of $1.5 million consistent with the year-ago quarter.

As was mentioned earlier, lower base oil selling prices negatively impacted our revenue and operating margin during the quarter. The negative impact of the lower selling price for base oil was approximately $2.8 million or $0.09 per share during the third quarter.

We also continued to experience higher-than-expected transportation costs and internal collection costs for the used oil. We continued to rollout additional used oil route trucks during the quarter. The high percentage of new oil collection routes in our system and the inefficiencies of starting up these routes has opened a higher than expected internal collection comp.

The aggressive steps we have taken to add sales and training resources in this segment have added about $4 million in annual costs, a big investment but one which we calculate to be more cost-effective than the typical acquisitions in this space. We also experienced higher-than-expected costs from the amounts we pay generators for their used oil.

Corporate SG&A was 9% of sales, down from 13.1% in the year-ago quarter. For the first three quarters of the year, corporate SG&A was 10% of sales, down from 14.5% for the first three quarters of 2011. At the end of the quarter, we had $19.8 million of bank debt and $46.4 million of cash on hand.

We incurred $112,000 of interest expense in the third quarter of 2012 compared to $9,000 in interest in the year-ago quarter. In the first three quarters of 2012, we incurred $445,000 of interest expense compared with $23,000 in the first three quarters of 2011.

For the third quarter, we recorded after-tax income of $1 million compared to $600,000 in the third quarter of 2012. Our basic and fully diluted earnings per share for the quarter was $0.06 compared to $0.04 in the year-ago quarter. For the first three quarters, our net income available to common stockholders was $2.5 million compared to $1.7 million in the first three quarters of 2011.

For the first three quarters of the year, our basic and fully diluted earnings per share was $0.15 compared to basic earnings per share of $0.12 and fully diluted earnings per share of $0.11 in the first three quarters of last year when we had fewer shares outstanding. The increased number of shares this year is a result of our April stock offering.

The first three quarters of fiscal 2012 included some important successes. We began operation of our re-refinery and continued to increase the throughput at the facility. We are also producing and selling on spec [crude] 2 base oil. We expect to continue to increase the operating rate of the re-refinery as we approach 100% of nameplate capacity, increase our volume of used oil conducted, and increase our production and sales of base oil over the rest of the year. This growth in our Oil Business will complement our continued growth plan for our Environmental Services business.

The motivation of our team to expand our business remains strong and we have confidence in our ability to take advantage of the exciting opportunities we see before us.

Thank you for your continuing interest in Heritage-Crystal Clean. At this time I will turn control of the call over to our operator and she will advise you of the procedure to submit your question.

(Operator Instructions). Ryan Merkel, William Blair.

Thanks, good morning, everyone. So we did a very nice job on the revenue side of things but I just want to dig in a bit to the profitability and I want to start with the Environmental Services segment. So the margin there was up year-over-year nicely but I was a little surprised that sequentially it was down as much as it was. Can we just walk through why that -- what drove that?

There are two main pieces, Ryan. This is Mark. There are two main pieces to that. Most of it revolves around solvent and there were higher disposal costs. One of the things did not get too deep in the weeds is every quarter we make an adjustment for the solvent that is actually out at our customers and our [custom oil] machines and we adjust that based on not only volume but the value of the solvent from quarter to quarter and that had a net impact, a negative net impact of about 1% on the margin.

And then there was also another write down in general of other solvent aspects of another percent and the disposal cost was a littlest than 1% impact on margin. So those I guess -- two if you count the two solvent areas and then with disposal, as I alluded to in general, were the main drivers.

Okay, so some of that stuff normalizes and you push through another price increase. Is it fair to say that those margins will go back above 20 next few quarters?

That's what we expect. We believe that the price increase will help us obviously top line all the way through to the bottom line and the fourth quarter is the time of year when we would traditionally do that. We've talked about that throughout the year, so that has been our track record and we would expect to see improvement there and being at 19% getting to the number you just mentioned should be a reasonable expectation.

Okay, then moving to the Oil Business, you kind of point out three reasons why the profitability was a bit light and it looks to me like the biggest reason is the spread just got a little bit worse this quarter. So kind of walk through that with me for a minute and then what needs to change in order for us to have that moving in the right direction?

The spread is market-driven. There's obviously some variations from what posted prices are and spot prices and what we actually sell at. But it is primarily driven by the posted price and Brent crude oil pricing which we control neither of those things. And we need to focus on -- or what we are going to be focusing on is the other areas we mentioned that were responsible for the shortfall to where our expectations are and that is in the area of transportation, various aspects of used oil collection, whether that be the actual amount we pay the generators, our current inefficiencies on truck. So getting the gallons collected per route truck higher, that's really where we are going to focus.

I don't know, Joe or Greg, if you want to talk more about the price side of it.

Yes, I think it's important that -- this is Joe here -- that we understand that this industry -- the lube pricing is cyclic and driven by many factors -- imports, exports and the margins, specifically the margin of the spread between crude oil and the selling price of lube is driven by a few players in major oil companies that produce lube oil. We have seen it cycling historically.

Unfortunately it hit us here at the time where we are just starting to get strong with strong production out of the refinery. We don't expect this to remain tight on the long-term. We know that. There's pressure, we have -- we hear there's pressure from the producer of lube oil that operate out of -- produces out of crude oil and it's known in the industry but when will that change? It's pretty hard for us to predict this.

Okay, maybe just last one and I will turn it over to others. How much VGO did you sell this quarter if any?

Very little of VGO, nothing really to speak of.

I don't believe we have done much at all, if any.

Yes, maybe less than 100,000, almost 200,000, sorry.

Okay, thank you.

David Manthey, Robert W. Baird.

Good morning. First of all, in terms of the effect on margins in the ES business, Mark, you mentioned the higher solvent adjustment, which I get, and I want to just get deeper into that in a second. You said something about 100 basis points due to other solvent issues and maybe if you could talk about what those are? And higher disposal costs, did you say that was also 100 basis points roughly?

A little less. I talked a little specific about our custom oil machines and our process for reevaluating that every quarter but the other half of it or roughly other half of it really is due to market write-downs, lower cost to market, certain aspects of our solvent, even though some costs are going up. Other aspects of it aren't going up and a lot of it is based on the solvent we resell, what we can resell the used solvent for and those went negative quarter-to-quarter, so we took a write down in that area as part of that.

Okay, I know in the third quarter of last year, we had a similar effect here. Is this something to expect in every third quarter? And along the same lines, was there any -- it sounds like this piece you just referred to is sort of an accounting catch up. Is that the same case here and were there any positive or negative benefits on the prior two quarters?

There was positive on the custom oil machine. About 0.5% I think it was in Q2, so we kind of ate through that and then some on that custom oil machine thing I described.

Got it, okay.

So it's swung the other way basically.

Okay, then when you talk about exploring ways to improve profitability, I guess we understand that some of this is just pure accounting. Some of it is market-driven and that's what happens. But when you talk about exploring ways to improve profitability, it's sounds bigger than that and it sounds bigger than just sort of price increases, which would be common for you around the turn of the year here.

So could you talk about what those might be, if there's something you are thinking about, what the magnitude or timing of those potential actions might be?

There are several areas that we are looking at and have started implementing on cost containment. We basically over the last two years have doubled the sales of the Company and our first target in here was to get the construction of the re-refining on and get the supply to fit the plant and develop the markets. Now as we went through this rapid expansion, we have picked up some typical startup inefficiencies we want to now focus on to sharpen up our -- improve our margins.

And I will give you -- I can give you some examples in here. And one area of this is our transportation costs into the re-refining plants. We have gone in from basically very low volume to having to get in rail cars into our existing branches and we have incurred (inaudible) in some cases. We have had shipments at lower than full rail cars because of the lower productivity in our oil trucks and over a period of time as we improve our efficiencies through the branches, we should see these transportation costs come down.

In the description of our rollout of the Oil Business, I think Mark had mentioned that we had been spending about $4 million a year of additional sales and support, better marketing support to increase the number of customers we have and a rollout of these oil trucks. Now that we have these to a large extent in place, we have already started to cut down the number of people involved in this (inaudible) rollout, so we are going to see some savings.

The oil productivity, the route trucks are going to continue to build productivity. Now this is going to take some time but we expect these based on our past history that productivity should increase significantly.

On the Environmental Service aspect outside of the price increase that we look at doing every year, over the last year and a half, we have added significant resources at the branches. These are basically sales resources and that will help us carry this through. We intend to start slowing down since we have these already in place.

And these resources are not like a sales and service rep that becomes -- that the ramp up is quicker on the productivity where they are doing service and generating revenue for us that way. They are simply sales resources. It's not long, but you don't start to see productivity usually until at least six months or six, seven periods in our world for these extra sales resources that Joe mentioned.

And we started adding them end of the third, beginning of the fourth quarter last year period -- or excuse me, last year.

We have Greg, our Chief Operating Officer. Maybe if you want to comment further, Greg?

I wanted to add just a little bit of color about the impact of the decline in the lube margins and put it in a historical context relative to what we have told the Street in the past about our Oil Business. And in 2010 when we announced our plans to invest in this business, we put out financial projections, which said at that point in time we envisioned that when the business was up and the plant running at capacity and we had a developed collection business that we expected sort of 20% operating margins were the target for the business and the justification for our capital investments.

Early this year when conditions were even better and when lube oil prices and margins or spreads are much higher, we provided a reforecast that suggested that the margins could be better than 20%, I think in the mid-20% range. And the decline in oil prices we have just experienced if it's sustained and doesn't change doesn't take us off of that original 2010 plan. It just means that the numbers we had earlier this year can't be realized because we've seen the spread compress back to the original kinds of spreads.

And so we are still convinced that this business when the plant is running at capacity and when we have a well-developed mature collection infrastructure should be a 20% margin business for us. We're not backing off of that and we don't think it's the spread situation has suddenly gotten catastrophic. We are okay where the numbers are right now but clearly we would have been happier if we had stayed with lube prices and spreads where they were six to nine months ago. That was a really extremely strong market condition and it's just not there right now.

Got it. Thanks a lot, Greg. Just one more question in terms of values here. What is the theoretical captive used oil capacity that you have within the Company based on the number of trucks you have right now? And then second, did you buy any used oil from third parties in the third quarter?

In terms of the theoretical capacity, I think the easiest way to think about it is based on the number of trucks we have, when they were fully at capacity, they would probably be in the ballpark of able to collect or handle 70 million, 75 million gallons a year. Is that right, Mark?

Yes.

What that means is I think we have indicated that we are running at -- in the high 30 million gallon range, so our fleet is really underutilized. It's all intentional. That's how we are ramping up our volume to not only feed our plant at the current capacity but to try and build or add in place some of the growth capacity that we are going to need, assuming that we are successful in the permit process that Joe mentioned earlier that we're optimistic about for this year.

So we've got a lot of available capacity that we are filling up over time and that is part of sort of the drag on earnings if you will and another part of it is I think Mark talked about, we have been spending at a particularly high rate in order to try and rapidly fill up that volume, a decision that's sort of on the make or buy equation, something that we think is worth making those investments rather than making acquisitions, but it is coming out of the bottom line of the P&L.

Dave, I know you had another part to the question, sorry.

I got that.

As far as our third-party purchases, we did see that decline. It went down under $2 million to -- went down from quarter-over-quarter by about 17%. So we are as we grow our collection hopefully able to rely less and less on that although it has been pretty economical. Joe mentioned in his part of the call or his comments earlier, so it is something that we are opportunistic within the framework that we long-term want to still control the feedstock or input capacity, but if we're having situations like we have now, we are at least flexible enough to take advantage of that.

What is that in gallons, Mark?

That is about 1.9 million.

Okay, great. Thank you, guys.

Sean Hannan, Needham & Co.

Thank you, good morning. So just to go back to the talk on the spot pricing, if there is a way you can perhaps talk through the average in September for the spot pricing you saw perhaps starting with -- I'm assuming lower pricing earlier in the quarter, the degree of change perhaps -- perhaps toward better pricing toward the end based on recovery or better stability in crude -- Brent crude.

Then what you have seen since in that spot pricing realizing in general context that it's a bit under pressure versus what we had seen earlier in the year.

What I would tell you kind of month by month with spot pricing of lube is that -- and we probably have shared with you before -- historically in the lube oil business, lube prices if you don't see changes in the spread, lube prices tend to follow the movements in crude but with a lag of three or four months. And so as crude prices came down this summer, we saw lube prices come down as we would've expected. As crude prices rebounded in the fall and we are talking about Brent crude being our relevant crude index here, it came back up. It started at $125, it went back down to like $95 a barrel and then it came back up into the $115 to $120 range. And we would've thought and I think the market, the lube market would've expected that lube base oil prices would have moved up around now to come back up tracking that earlier improvement in crude and that has not happened.

So I can't forecast for you. I think the consensus in the lube industry is that the next movement in lube oil prices if they were to be one soon would probably be up tracking crude but we haven't seen that move yet and we commented that there seems to be ample supply and so the spot market isn't sort of signaling that prices are about to come back up.

So we are sort of -- that explains why that spread we talked about has moved sort of in a negative direction and hasn't come back yet and if we got another bump up in lube base oil prices we might get back to the better spread environment. We just haven't seen it as of today.

Thanks, Greg, and then you actually gave me a good segue into my next question. So we got comments from you, Joe, we are not expecting the pressure on the spread to be as tight long-term and it seems that the logic would provide us with some recovery around the General pricing.

But given the ample supply out there affecting all of this, can you elaborate a little bit more on that in terms of the dynamics, the logic, why perhaps that ample supply resolves itself or doesn't become even more of an issue?

Even more of an issue becomes quite a difficult situation for the major producers of lube oil. We track the vacuum gas oil postings as well as you know we were producing and sending some of this, our vacuum -- our products we sold in the vacuum gas oil and vacuum gas oil can refer to in the refining industry to make gasoline and make distillates. These are fuel and other distillates. Or you can make lube oil.

But at some point in time, if the spread between crude or/vacuum gas oil and lube gets very low, the refiners start diverting some of this product to make gasoline and distillate fuels. And so it's quite compressed at this stage and we hear noises that some of the refiners are looking at moving more into the fuel and gasoline and it's pretty hard to give you a clear picture on that. But there is a limit how far these -- that spread can go down before some of the older capacity lube plants come out of service.

And now how far this compressed cycle will last? It's very hard for us to forecast. We usually just follow the cycle. We have had a couple of good years of improving spread between Brent crude and lube and unfortunately it started to come down in the last couple of quarters but really this last order was a major drop for us.

Okay, let's see if I can switch over to the Environmental Services side. I know there was an aspect of this that was already asked a moment ago but in terms of getting back to a 20% margin, is that an opportunity that we can get in 4Q with some of the pricing changes? Do you need basically a full quarter? Is that really not more of an opportunity until we get into 2013?

We certainly won't feel the full effect based on our parts cleaning business is the biggest piece of Environmental Service and that is a business that is driven by certain service frequencies or intervals, as you know, Sean. So we certainly won't feel the full effect to gain one more percent. I think that's possible depending on just when the services fall, but certainly I would stick to what I said earlier I think when Ryan was asking the question that it would be realistic at the end of the cycle of price increase that we would be able to get back to margins in that business before the probably third quarter of last year is when we first started to experience a lot of the negative impact before that. And we'll start to see some of the benefits and the things Joe mentioned as well. So it's possible.

It sounds like possible but not probable.

I wouldn't say that.

All right, fair enough. Thanks for answering my questions.

Rich Wesolowski, Sidoti & Company.

Thank you. Good morning, everybody. According to the math you laid out on your April update for the oil profit forecast, a $0.44 per gallon reduction -- and basically the prices about 10% would translate to a 40% or 50% cut to the plant's profit on that increased forecast that you had given.

Is that still a valid translation and is that the type of leverage we should expect to see throughout the life of the plant?

Well, there are other factors, Rich, that effect the profitability of the business outside of that spread. If the lube price is down because crude is down, then we have an opportunity to reduce the payment for the used oil that we collect and recover a significant piece of the decline in margin. What has happened here for this quarter is we had within the last few periods, four-week periods for us, we have had crude coming down, the price of base lube end up coming down, then crude went up and lube oil didn't go up. So we had to squeeze in margins and unfortunately when that happens, we cannot go and reduce -- or continue to reduce what we pay the generator for the used oil. We have done some of it. But we haven't done it as much as much as we would like to restore some of these margins.

Understood. You are getting hurt from both sides, it seems.

That's right and it's a little bit unusual but it has happened before. It's happened for this quarter.

Maybe this is a question that reflect me being a little green in the industry but as you look at a traditional refining business, there's spreads for gasoline and virtually every other product, they change constantly. Why does it take the base oil market so long, three or four months to respond to a change of Brent?

That's historical. It's historical because it's not as much. We still look at it as a commodity but it's not as much of a moving commodity as gasoline and distillate because every refiner or every refinery produces gasoline and distillates but not every refiner or every refinery produces lubricants. Lubricants is a specialty line for the refiners and it's a very small percentage of the total (inaudible) and there are many refineries that don't have any lube production.

Historically refineries have moved very quickly with the distillates and gasoline and it's typically 90 days to six months for the lube to rise and fall as a function of crude.

But then you have the other factor which is the margin between crude and lube oil and that supply and demand if the refinery major producer of lube oil has a hiccup, they're going through a shutdown, a turnaround, or that export from the US refiners are strong, then these margins expand.

There may be a few other factors to talk about why the market is structurally somehow different for gasoline and for lube oil and that doesn't explain all the why, but if you are trying to kind of understand that, I think an awful lot of gasoline is sort of sold at the rack and delivered to the gas station the next day. A lot of lube oil is sold via rail cars and barges that take a week or two weeks to get to the destination. There's a lot of import and export of base oil that comes across the ocean, so there's a longer time involved in the delivery on average.

Pricing is usually sort of set between a buyer and a seller for the upcoming month or a couple months or even on a longer-term basis on contract and so there's just a longer cycle time that sellers typically use to adjust pricing than with the shorter supply chain on fuels.

Makes sense. Would you mind discussing if you haven't already how far along you are in the process of getting your product additive companies? And second maybe even qualitatively, the difference in the profitability on your base lube product today versus what it would likely be when it's used to make motor oil versus today I imagine it's going into mostly burner fuels.

It's not going into burner fuels today. The base oil that we are selling is we would expect entirely going into the formulation of lubricants. But if you think about our typical customer who is a blender and compounder, they are really a firm that makes their money by mixing up a variety of different types of lubricants and they will make gear oils and compressor oils and hydraulic fluids and passenger car and motor oils and truck oils and they buy base oil already from several different suppliers. There's very few that are sort of sole-source, so they buy different weights of base oils from different suppliers and have different recipes to make different products.

As we started up our plant, we only could give them recipes for a few different finished products they could make with our base oil that didn't require a wide range of certifications and approvals. And as we get more and more approvals, our menu, their utility of our product in a broad range of finished product just keeps widening so that they can buy more and use our product more fully. And of course that also has a relationship with how many customers would carry our product if we could only go into a single one or two products for a particular customer, they are less likely to even want to buy a rail car from us than when we're widely usable in a full range.

I believe that there really have been four major additive supply companies that we have been most interested in that represent the vast majority of additives and formulations and they basically end up testing our product in different mixes with their additives in order to decide how we can be used, what the recipes are, and provide certifications. And I think that we have the certifications now just recently from three of the four big firms if I'm not mistaken and I think the fourth firm is actively working on testing us for a variety of products.

It's still not a case where when we are done with all of that, it's sort of an end game and you've got every possible approval for everything, there's a huge number of products. But when we have the four main suppliers with formulas for the main things that we want related to passenger car motor oils and truck oils, then we will be pretty well situated to tell our customers that they can use our product widely.

So lastly, when you put it all together with today's spread or perhaps a rebound in base lube prices in response to Brent over the third quarter and your current encouraging progress in developing the collection, is 20% a good oil operating margin for 2013 or is that too aggressive a timeline?

It's going to be a gradual move towards that. And basically quarter by quarter as we get some of these efficiencies in place and quite frankly, a big factor is what's going to happen with the price of lube.

There's no question as we run at capacity and get route trucks more efficient, sharper on our payment on how much we pay for the used oil, we are going to see some improvements from where we are as long as the spread doesn't compress further and we think it's pretty compressed.

So it's pretty hard to give you a clear answer from a timing point of view but we are confident that we should sustain a 20% margin on a long-term basis.

I would add that when I think about the timing for us in the coming year, the one thing that sort of potentially the good news/bad news story is that if we are successful in getting the permit to expand our plant, then that will sustain the pressure on us to keep growing the collection business and we won't be able to get as dense and efficient there as quickly as if we didn't have that expansion opportunity and we were just trying to get to the 50 million target.

I don't think there's any question when we look at the models in economics that it's worth it for us to keep pushing and get more throughput at the plant and get a better return on the capital and on fixed costs of the site but that just may slow down how quickly we can get to sort of a highly dense fully utilized fleet which even if we don't think about sort of the expansion case, takes several years on a single truck to get it up and started and running and building the density on a route so that it's productive. And we are trying to do that 150 times by quickly putting these trucks out.

And so if we have more pressure to get more volume, you may think it will on the surface help us improve density but it will also put pressure on us to keep some resources in place to be selling, having a more aggressive sales program, and it will keep some pressure on us to perhaps keep our prices paid to generators higher than we otherwise would feel was necessary in the market because we really need that feedstock to run the plant.

Appreciate your time. Thanks a lot.

Kevin Steinke, Barrington Research.

Good morning. I just had a follow-up question related to the lubricant formulation approvals and this I believe may be more of a longer-term proposition. But as you see base oil production ramping up, you have referred to in the past I believe an opportunity to produce and sell your own lubricant and how far away would that be and what do the economics of that look like compared to selling it to customers?

This is something that remains in our horizon. We like -- we say this is a downstream market. We like a downstream market because it improves -- brings additional margin but more important, it reduces these bigger fluctuations with the base oil. And we have talked about it in the past, we had plans to do some rollout actually earlier this year. Last year we are thinking about rolling out some blending and sale of the blended lubricants in some of our branches as part of the program. We have decided to postpone this and really focus on customer obtainment on the used oil side.

We just have plenty of stuff on our plates and decided to focus on tying up what we consider our own crude oil, our used oil and we continue to look at opportunities for people that have capabilities of blending. We call it blending and compounding these -- this stuff into finished lubricant.

But there's nothing imminent but I think on the long-term, this is where we want to be for at least some of the production, not for all of the production, but some of the production out of our plant in Indianapolis. It will be a good strategy for the Company to add blending and compounding capabilities and sale of blended lubricants.

Yes, I think in margin dollars, it's a positive impact for the blended material and then it does add a little bit -- or is a little less volatile, and Joe and Greg can comment further if they want -- but a little less volatile in general in selling because you are customizing the product a little more so it is a little less volatile on the pricing side of things than regular base oil.

Okay, thanks. That's very helpful. I wanted to talk a little bit more about used oil feedstock and you talked about the cost being higher than you expected this quarter but I believe on your last conference call, you also talked about you are actively working to try and reduce the cost of feedstock. Is there anything you can do longer-term to do that or are you pretty much captive to the market? I would assume mostly in the short term.

We can definitely -- the big chunk of it is collecting more gallons per truck and getting more efficient there and you are leveraging all your -- a lot of your collection costs other than your pay, what you pay on the street to generators. There we have had some improvement. Joe mentioned that we had brought that down in the last several months. I think we have added $0.06 a gallon or so improvement there.

So we have done it. We can continue to do it. It's something we need to focus on. Greg did mention though those things can change if your demand or your capacity increases by 50%, sometimes that can put pressure the other way, so it is something we can affect but it's also driven by the residual fuel market. And when Brent crude stays high or crude stays high and residual fuel is based on that, our competitors that aren't re-refiners but are maybe acceptable of lower margins in their business, they might not necessarily be lowering their price of what they would be paying in a competitive fashion versus us.

So there are challenges but I think on both of those sides, we can move it. I don't know if you gentlemen want to add?

Historically sort of the used oil, the cost of used oil is very much a competitive market and we are operating out of 60 or 70 branch locations now in our oil collection business and every one of those markets has different competitors and different dynamics. We know that there's a price volume relationship and if we get out of the boundaries of the market we can lose share and if we go the other direction as we have been in the last couple of years and we are trying to gain share, we can do that with competitive pricing as well.

We have had success sort of helping move market pricing when we have felt that that was necessary or justified in our business based on the costs or economics and we think we will continue to be able to do that. We don't view it as sort of a rigid monolithic market. We are also able to focus on specific customer sets or types that have different I guess ideas about pricing or value than others. We're obviously as a full-service integrated company that does a really good job out there of taking care of customer needs. We're looking for people who value that and as a result, we probably tend to have customers who don't demand to be paid quite as much for their used oil because they are valuing the service component as part of that compared to the accounts some of our competitors serve.

And so we can shift within that market and look for the people that are best aligned with our program and that's another way for us to sort of extract value and reduce our costs. I think that's something we've been doing well in the last year and I think we can aspire to do even better.

Great, thanks for all that color. Just a couple more from me. You referred to the fact that you continue to work through logistical and operational challenges that are typical with a new re-refinery and you have prepared us that that is going to be the case here in the first year.

Were there -- does any of those issues leads to perhaps higher costs or lower production in the plant which affected the Oil Business margins this quarter that might dissipate going forward?

The logistics did not affect our production capability. It was just a cost factor to bring in the materials to the plant. But it has not slowed us down as far as reduced throughput. We have tankage at the refineries to give us a cushion on the supply side and to also on the product -- finish the product that we re-refine.

Okay, last one for me. I noticed that corporate SG&A was actually down by almost $700,000 sequentially. Were there any one-time items last quarter that may have skewed SG&A any higher? Is this a good run rate going forward or how should we think about SG&A trending in the next couple quarters next year?

It might not stay as low as it was this last quarter but in general if you look at the general trend over the first three quarters, it's around where expected. We did have some adjustments for bonus accruals for this quarter that improved our -- or brought it down -- our percentage of SG&A. But in general, that 10% range based on where we are at is -- where we are pacing is good as we continue to grow our used oil business and depending on capacity additions and running more through the plant generating more revenue, then we could see that continue to go lower but there was some impact in the quarter due to the one bonus accrual adjustment.

Okay, great. Thanks for the update.

Thank you, I have no further questions at this time.

We do now have a follow-up from Rich Wesolowski, Sidoti.

Excuse me, just a quick one. I apologize to extend the call, but I'm curious if you are pushing price increases throughout the year for the vacuum and the container services or is that something that you had tried earlier in 2012 and maybe waiting to take another swing in 2013?

And secondly on that, are you still convinced there's an opportunity to raise pricing environment outside of the parts washing? Thank you.

We typically will -- maybe not all in the same period -- but would typically even with things like vacuum and the other parts of the Environmental Service, do institute our price increases all at the same time. We varied it a little bit last year. We delayed the containerized waste pricing increase implementation because we were trying some new things. But we tend to coordinate them and our plan would be to coordinate them all at the same time in this round and that has been the norm over the many years that we have been doing that.

We see actually -- we are optimistic I should say about getting more out of some of the other non-parts cleaning service segments in Environmental Services this time around. We are at least focusing more effort on that and we are hopeful that we might see more than we traditionally have seen because typically most of our success has been in the parts cleaning service area. And we haven't been as effective in containerized waste or drum waste or the vacuum.

Again, there is a piece to that this year. We have had some but we think we can do even better this year with some more focus.

I understand your environmental margin will bounce around. There was some accounting puts and takes here but looking out past this quarter or even 2013, what is the satisfactory environmental operating margin for Heritage?

We've been up in the mid-20s before. It is our continued aggressive rollout in branches and routes and investment over the last year, we mentioned in new sales resources that have from an investment or operating expense standpoint helped exacerbate commodity effects of solvent increases and diesel fuel. But we really think that getting back up to that low to mid 20s range is doable and certainly that's our expectation. Then longer term, potentially be on that.

I want to make a distinction between where we are now and what we think we want to do in the business and Mark is right. In the short term, we would like to get the margin on a before corporate SG&A basis up into the low to mid 20s and we think that that's certainly realistic.

But that's not where we are going with the business. The easiest way to think about the business long-term is to think about our unit model and we really want to see a typical branch have -- as it gets scale and maturity 10 years in and it's doing $5 million, $6 million at a branch, get to where the same measure of profit before corporate SG&A is in the 30% to 35% range. And then after applying a 10% corporate SG&A rate that we are at right now, then we would like to see the business at a 20% pretax margin.

And we know that it will be a long time until we get all of our branches there because we are still opening new branches today and I talked about a 10-year runway, but eventually we think that we will have the majority of our branches in that mature mode and they will be generating that kind of return. And as we get that development in the business, the overall Company average will just keep moving closer and closer to those kinds of numbers. That's the way we think about it.

Exactly what I was looking for, thank you.

Thank you for your time and interest. We are grateful for your support. We invite you to join us for our next conference call. Participants, you may now disconnect.