美國廢棄物管理公司 (WM) 2016 Q3 法說會逐字稿

Good morning. My name is Cornisia, and I will be your conference operator today. At this time, I would like to welcome everyone to the third-quarter 2016 earnings release conference call.

(Operator Instructions)

Thank you. I would now like to turn the conference over to Mr. Ed Egl. Sir, you may begin.

Thank you. Good morning everyone, and thank you for joining us for our third-quarter 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-K this morning that includes the earnings press release and is available on our website at www.WM.com. The Form 8-K, the press release and the schedules 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 risk 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-K.

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 third quarter of 2015.

The third quarter of 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 1:00 PM Eastern time today until 5:00 PM 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 90149575.

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 express written consent of Waste Management is prohibited. Now I'll turn the call over to Waste Management CEO, David Steiner.

Thanks Ed, and good morning from Houston. Our third-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 third quarter of 2015. And during the third quarter we achieved a significant milestone, as our operating EBITDA exceeded $1 billion for the first time.

We earned $0.84 per share in the third quarter, an increase of 13.5% from our third quarter 2015 results. Our continued growth in earnings translated into strong generation of cash flow from operations, which grew $96 million in the third quarter, and drove year-to-date cash from operations to over $2.2 billion. That's almost a 12% increase over last year. So we're very pleased with the momentum that we've built in the first three quarters of the year, which we expect to continue into the fourth quarter and extend into 2017.

Our pricing programs are a significant reason for our earnings growth and margin expansion. For the third quarter, our collection and disposal core prices 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 third quarter 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 second quarter of 2016.

This is the lowest churn that we've seen since before 2005. It's a tribute to our customer service and operations folks who have worked together to create a better customer experience.

With respect to volumes, we continued to see positive volume growth in the third 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 third quarter of 2016, 170 basis point improvement from the third quarter of 2015 and an 80 basis point improvement sequentially from the second quarter 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 third quarter of 2016 the increase in leachate costs was about $23 million, 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 third quarter 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 onto 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 operation 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 third 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 third-quarter results, as well as our results through the first nine 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 fourth quarter, 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 billion and $1.7 billion. 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 million of our 2017 capital spend for 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 third-quarter results in more detail.

Thanks, David. The third quarter was indeed another strong quarter for us. Revenues in the quarter were $3.55 billion, an increase of $188 million, or 5.6% when compared to the third quarter of 2015. We saw $110 million increase in our collection and disposal business from the combined impacts of pricing and volume, a $60 million increase in revenues from acquisitions net of divestitures, and recycling revenues increased $27 million. These increases were partially offset by an $11 million decline related to lower fuel surcharge revenues. Foreign currency fluctuations had no material impact on revenues compared to the third quarter of 2015.

Looking at internal revenue growth for the Company, in the third 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 third consecutive quarter. The combined positive price, positive volume, led to total Company income from operations growing $65 million, operating income margin expanding 90 basis points to 18.8%, operating EBITDA growing $71 million, and operating EBITDA margin growing 50 basis points to 28.2%.

Our collection lines of business continue to see the benefits of improving volume. Industrial volume was up 1.9% in the third quarter, 150 basis point improvement from the third quarter of 2015 and a 40 basis point improvement sequentially. Commercial line of business showed strong momentum with volumes up 1.2% in the third quarter, a 250 basis point improvement from the third quarter of 2015 and a 90 basis point improvement from the second quarter of 2016.

While our residential business volumes were down 2.9% in the third quarter, this reflected a 70 basis point improvement from the third quarter of 2015 and a 60 basis point improvement sequentially from the second quarter. Overall our collection income from operations grew $26 million and EBITDA grew $38 million in the third quarter.

In the landfill line of business, we again saw the benefits of both positive volume and positive yield in the third quarter, just as we saw the first and second quarters of this year. Total landfill volumes increased 6.9%. MSW volume grew 6.1%, C&D volume grew 22%, and combined special waste and revenue generating cover volumes grew 6.7%. More than half of the growth in C&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 third quarter of 2015. The combined positive price and volume in the landfill line of business led to income from operations and EBITDA each growing $12 million in the third quarter.

Moving now to operating expenses. As a percent of revenue, these expenses increased 10 basis points to 62.5%. For the third quarter operating expenses increased $121 million when compared to the third quarter of 2015.

Landfill operating costs represented the largest increase, up $29 million. $23 million of the $29 million 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 million and cost of goods sold increasing $25 million and subcontractor costs increasing $22 million.

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 fleet purchases and MSDO initiative begin to positively impact maintenance costs.

For the third quarter as a percent of revenue SG&A costs were 9.3%, an improvement of 50 basis points when compared to the third quarter of 2015. On a dollar basis, SG&A costs were $330 million, a slight improvement compared to 2015. We've done a nice job controlling SG&A costs, as increases in wages and compensation have been offset by other improvements.

Turning to cash flow for the third quarter. Cash provided by operating activities was $753 million compared to $657 million in the third quarter of 2015. Our operations continue to perform very well, as cash flow was driven largely by an operating EBITDA increase of $71 million.

During the third quarter we spent $333 million on capital expenditures, a decrease of $2 million when compared to the third quarter of 2015. Through the first nine months of 2016 we have spent $962 million on capital expenditures, an increase of $98 million when compared to the first nine months of 2015. We still expect that capital expenditures will be between $1.4 billion and $1.45 billion for the full year 2016.

In the third quarter we had $8 million in proceeds from divested assets, a decrease of $28 million from the prior-year quarter. Combined we generated $428 million in free cash flow, a $70 million increase compared to the third quarter of 2015. Year to date we have achieved free cash flow of $1.28 billion. We remain confident in achieving our full-year 2016 free cash flow guidance of between $1.6 billion and $1.7 billion.

In the third quarter we paid $182 million in dividends to our shareholders. While we didn't repurchase any shares during the third quarter, we currently plan to start buying back our stock again in the fourth quarter when the window opens. We expect that these late 2016 and 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 third quarter 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 third 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 first nine months. I know they're working hard to improve our operational and financial performance for the remainder of 2016 and into 2017. And we are confident that they will be successful.

And with that, Carnisia, let's open the line for questions.

(Operator Instructions)

Your first question comes from Noah Kaye.

Yes. Thank you and good morning.

Good morning.

I would just like to start with maybe your thoughts on the general environment. We've seen commentary around maybe a moderating macro longer term. On the other hand, there continues to be some optimism around housing growth.

But maybe David, you could 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's going to continue to be strong through 2020.

Now, obviously you saw there's 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 from that 1.1 to 1.2 million to sort of the 1.4 to 1.5 million. You can run at that rate for a good three to four years before you actually catch up with demand.

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 a recovery. I don't think that will be a huge, robust recovery in 2017. But I think we'll see a good, steady recovery over the next couple of years.

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.

I might add one thing. That is, while it's sometimes hard to see what the macroeconomic climate holds, demographics are set in stone. 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. Thank you 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.

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 two things that really drive it. One is technology and the use of technology, the use of data. And I would tell you in that we're probably in sort of the second or third 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 two years.

Jim Trevathan 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% 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 helps 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, and Dave and Jim mentioned earlier, it's led us to grow national account revenue in total this year where it's been a negative drag on our volume in previous years. We're trying to differentiate that service offering very specifically.

The other thing, without getting in 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.

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. 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 every opportunity we get. So we've added some real process changes that led us to renew those agreements once an issue, either positive or negative happened. And I think it's added to that decreasing churn number.

Okay. I thank you all. I know there a lot of other analysts waiting. So I'll jump back in queue.

Your next question is from Andrew Buscaglia with Credit Suisse.

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. Can you talk about why -- where things surprised you? Obviously C&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 five 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 customers that stay with you on average somewhere between seven and nine 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 lining is tremendous.

I would say -- I wouldn't say surprised, but I would say that we are very happy to see the landfill continue to be so robust. 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&D line. But we fully expect to continue to see sort of that 4% to 7% increase in 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. When our churn is at 8.7%, and it wasn't too long ago that we were in the 11%s, 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 keep a good solid customer through improved customer service.

Jim, I want to -- the addition rate itself, we talked more about the defection side. 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, your C&D seemed 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 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 C&G trucks that were flooded out. 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. So if I had to guess, I would say it will be about a wash for the fourth quarter.

Okay. Thanks, guys.

Thank you.

Your next question is from Al Kaschalk with Wedbush Securities.

Good morning, guys.

Good morning, Al.

Solid performance. David, I want to just drill down on two topics. First on the volume side, you called out the special waste piece. And if I'm not mistaken, that's really more FlyAsh 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 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 quarters?

The ash is actually a very small part, right around 10%.

A little less than that. (Multiple speakers).

It's really a pretty small part. But we continue to see good growth in that area. We expect to continue to see good growth in that area.

As far as 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 sector, like they might focus on the automobile sector, they might focus on the housing sector, they might focus on a particular sector and say, well, that shows that 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 pick-up in the chemical corridor. 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, Al, part of that answer is because we're 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 show maybe a little bit of weakness. And that's the strength of our Company.

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 I'm not taking anything away. I'm just trying to tease out the duration of 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.

Yes, well, we just don't see -- at this point in time we certainly don't see that momentum stopping.

Actually, Al, a piece that's been weak for us has been energy services. 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 follow-up, if I may. I wanted to talk a little bit -- I know it was $23 million in terms of costs 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. 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 expense there that we should be thinking about?

I would say that it's obviously two factors. It's the volume of leachate and then the cost to dispose of the leachate. 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 million of expense, is the disposal side. So we're building wastewater treatment plants. We're going to look at doing some deep well injection at various sites.

So if we can reduce that disposal cost, we think we can bring that cost down pretty dramatically. That takes a little bit of time. We would expect these increased leachate costs to be with us, at least through midyear of next year and probably throughout 2017. But in 2018 we ought to be able to attack it pretty well.

I would say that it is somewhat regional. But we've seen an increased 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 years. 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 cost.

Are there any -- appreciate all the color. Is there any one or two sites that, I won't say are problem child but could be or are working their way there?

The biggest issue we had was in Virginia when we got -- basically we were transporting the leachate to a water treatment facility, a municipal water treatment facility, a POTW. And they shut off the leachate, not just from our landfill but from all landfills. So it's not an issue that is unique to us. We just happened to have two large landfills fairly close to that POTW.

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 cost. Now instead of transporting it to a local POTW, we've got to put it on trucks and barges and ship it hundreds of miles. So if you can build the wastewater treatment facility on-site, obviously you eliminate that transportation cost. And that's exactly was we're doing.

Excellent. Good luck, guys. And thanks for the color.

Thank you.

Your next question is from Hamzah 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 $1.6 billion to $1.7 billion the new normal for Waste Management? 5, 10 years ago it was $1.1 billion. 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?

As you recall, back a couple of quarters ago we sort of said the new normal was $1.4 billion. And it feels like that number is going up. It feels like more like a $1.5 billion.

If you look at kind of how we get to our range of $1.6 billion to $1.7 billion for this year, I'll kind of walk you through a little bit of it here. The encouraging part is that 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. If we think about finishing 2016 with about $365 million in EBITDA. And then you back out CapEx, kind of in the middle of that range that I gave earlier. So back out CapEx of $1.425 billion less kind of the sum of interest, taxes and working capital of about $650 million. 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 million. And that puts you at about $1.625 billion 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 two years we've actually prepaid some cash taxes. Two years ago we prepaid $200 million and last year we prepaid $150 million. As we said when we did it, it was really in an effort to try and 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.

So Hamzah, I would completely agree with Jim that I think the business is about a $1.5 billion 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 the prepayment, that's how you get to that $1.6 billion to $1.7 billion. So I would say that I'd agree with Jim. The baseline is sort of $1.5 billion. And then have you 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 two, three quarters, it's been negative since 2008. 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 second inning? The third inning? And can commercial see the same cycle industrial volumes have? Just curious on any thoughts there. Thank you.

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's 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. Jim. I'll let Jim -- .

I completely agree, Dave. It's been a little more of a challenge. You saw that in a little bit of the compression in the operating margin. Although it moved 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. It's a good problem to have that we see continuing. But we're getting are arms around how to do that quicker and faster and better as that volume moves forward.

I think 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, 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?

And 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 costs. 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 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. 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 Jims and our other operations folks keep a great eye on SG&A. And as you see revenue go up, obviously we picked up basis points there because we'll hold SG&A relative flat. And so I think that 50 to 100 basis points of margin expansion next year sort of comes probably 40% from SG&A and about 60% from the operating side.

That's perfect, guys. 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&A front.

Yes. The last three years we've sort of done that $50 million to $70 million EBITDA acquisition, starting with RCI in Canada and then Deffenbaugh in Kansas City and then SWS in South Florida. We really don't see one of those types 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 million to $25 million 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 million and $40 million 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.

(Technical difficulty) 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?

As you know, we've always said we think that yield should be somewhere around 2%. The overall Company was 2.6%. We actually got some positives from recycling and some other areas where we've been negative lately. 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 2%. 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 on the street and holding onto in pricing. 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. 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. 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 in 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'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 a the core processing business, as you know, we've shed a lot of unprofitable contracts over the last three years. And so the core business is still seeing some negative volume on the recycling side. But we had really strong brokerage volume.

All right. That's very helpful. Thank you.

Absolutely.

(Operator Instructions)

Your next question is from Joe Box with KeyBanc Capital.

Good morning, guys.

Good morning, Joe.

David, if I heard you right I think you said you're looking for about 50 to 100 basis points of margin expansion next year. And I think you called out 40% of that being SG&A and 60% being operating. Maybe if we just drill into the SG&A, which it was basically at the lowest level that I could find in my model going back to at least 2003. When you look at that going forward, are there any big items that you expect to cut out of SG&A? Or is this more a function of just watching your costs and getting good leverage on that revenue growth?

I do think it is watching the costs. And the Jims and the operating folks have done a spectacular job of keeping SG&A flat, despite the fact that we give a 2.5% to 3% merit increase every year. They've done a nice job of keeping the dollars flat. As the revenue goes up, that's where you get the expansion.

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&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&A.

We've done a nice job on SG&A over the last five years of taking out costs. I would tell you there's not any big dramatic decrease in SG&A. It's just a matter of making sure that you're not adding people that you don't have to add. And that you're not adding other expenses that you don't have to add. And Jim and the operating guys do a spectacular job of looking at every dollar of SG&A we spend and making sure that it's justified.

Got it. And maybe switching gears to the coal ash side, can you maybe talk about what the coal ash contributions was in the quarter, either if a revenue or a volume standpoint? Where are you putting that? Is that primarily in the special waste bucket? 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?

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 customers' 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. 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 site 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.

You bet.

So Jim Fish, on SG&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?

I think for Q4 we'll probably -- it will 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 it 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's sort of about 10 -- .

Let me say this. Not in the absolute percentage but in percent of revenue versus prior year. 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.

Those two metrics have done well. As a result, we've had to increase the accruals there. 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. Okay. That helps there.

So then to get to your revised guidance on earnings would suggest that the gross margin in the fourth 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 maybe some gross margin improvement that has to come in the fourth quarter in order to be able to hit that $2.91 or better number?

You've also got the volume improvement continuing into the fourth quarter.

Yes, but 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 fourth quarter.

That's absolutely correct.

It would be realistic to assume gross margins would be better in the fourth quarter than they were in the third quarter?

Yes, absolutely.

Okay. And then with regards to the volume -- let me ask a different question on churn first and operating leverage. 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're structurally going to have a whole year of lower churn.

That's exactly right. 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 the support for that pricing (inaudible).

Jim Fish, on working capital, do we get some help on working capital in the fourth quarter to the free cash? Should that be a -- you'll collect more of your bills?

We do get a little bit of help from working capital in Q4.

And then David, you started talking about industrial activity. I think Jim Travathan, you did too. And then you didn't quite close the loop on it. Clearly, the industrial economy has slowed. That's not disputable. But you're not seeing a incremental deterioration. It's slowed to a now sustained rate of a lower rate of growth. And you're not seeing any further deterioration.

I'd agree with that. 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 at a slower rate of growth than anybody had been -- folks were looking for 3% and 4% industrial production growth. Starting the year we're really in a 1% to 2%. So it's a long-term low growth rate.

I'd agree with that.

On flee 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. That's the comment of the baseline of $1.45 billion to $1.5 billion and grow that number some rate is the right way to think. Because the noise of cash taxes.

That's right, Michael. There's two things really that are potential headwinds for us. And then we overcome those with the growth of the business. Those two things, as you mentioned, one is cash taxes, the other is CapEx.

Right now looks like CapEx for 2017 could be higher. We had a couple projects that we originally had in 2016. That's why our range has come down a little bit. We were originally $1.4 billion to $1.5 billion. We're now $1.4 billion $1.45 billion.

We brought the top end of the range down by $50 million. 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 two 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 IM, do we see the mix of CapEx maybe move a little bit to help this tax issue too, which has pulled forward some trucks and containers, get them in service before the end of the year and capture the bonus depreciation?

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 8%s. 2015 it was just above 9%, kind of like 9.1%. And 2016 it's going to be closer to 10%. But we still think in 2017 and on a go-forward basis 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 950 vehicles. We're going to buy 1,300 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 cost as we increase the number of trucks that we buy by almost 40%. Hopefully that answers your questions.

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 could 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.

(Multiple speakers). We've talked about is talking to individual area managers and vice presidents, and saying look, here's what your capital requests have done over the last three 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 wringing 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, specialty retail, my sense is, based on the MSW trends and the landfill volume trends at MSW, that consumer is still plodding along there. And you haven't seen any pullback in activity.

They're participating in the economy. Restaurants maybe complaining about having to cut price and do all that. That's a fundamental issue for them. It's not the consumer's not shopping.

I completely agree with that. We've seen, to your point, in the restaurant sector we've seen weight come down slightly. But we haven't seen service levels change. And so we continue to see service increases outpace service decreases. For us, that's really 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 Gabelli & Company.

Thanks for taking my call. Good morning, gents. Real quick. Just give an update on the way CPI transition and progress there?

CPI transition.

Yes. As we look at it, I think the number that we've always said it's 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.

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.

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.

When bidders go in and say, we're going to bid on a modified CPI. And then the fourth 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 -- 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 type of firm backbone on the residential and franchise side.

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 return on invested capital as 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.

Thanks. And I know you mentioned in the call bottoming of energy, potentially. I was wondering if you could maybe elaborate a little. Obviously, rigs have been up recently. Any green shoots, anything you're seeing as far as in your line -- in your business right now?

The last report I saw, which was last week I think, showed rig counts across the US in 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 two years, for sure. But nothing yet.

Tony, in the real business we're still down versus prior year. We're getting closer to anniversarying that reduction. But it's still not anywhere close to the previous level. And without significant movement forward, but we see signs of it.

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 gets a little chance to spend some time with the families and live what the holidays are about. So we'll see when we release next quarter. Thank you.

This concludes today's conference. You may now disconnect.