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Waste Connections, Inc. (NYSE:WCN)

Q3 FY08 Earnings Call

October 22, 2008, 8:30 AM ET

Executives

Ronald J. Mittelstaedt - Chairman and CEO

Worthing F. Jackman - EVP and CFO

Analysts

Scott Levine - JPMorgan

Corey Greendale - First Analysis

Bill Fisher - Raymond James & Associates

Brain Butler - Friedman, Billings, Ramsey

Jonathan Ellis - Merrill Lynch

David Feinberg - Goldman Sachs

Operator

Good day, ladies and gentlemen and welcome to the Q3 2008 Waste Connections Earnings Call. My name is Heather and I'll be your coordinator for today. At this time, all participants are in a listen-only mode. We'll be facilitating a question-and-answer session towards the end of today's conference. [Operator Instructions].

As a reminder this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's conference, Mr. Ron Mittelstaedt, Chairman and CEO. Please proceed.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Okay. Thank you, operator, and good morning. I'd like to welcome everyone to our conference call to discuss third quarter results, provide our detailed outlook for Q4 and discuss the unique position we believe we are in regarding capital available for future acquisitions or divestitures.

I am joined this morning by Steve Bouck, our President, Worthing Jackman, our CFO and several other members of our senior management team.

As stated in our earnings release, we are extremely pleased with our performance in '08, especially in light of significantly higher year-over-year fuel costs and weakening economy. Our results in the third quarter met or exceeded the upper end of our outlook provided last month and fell within the original guidance for the quarter, provided back in July. But more importantly we now have over half a billion dollars in cash and are uniquely positioned for additional growth opportunities. The strength of our balance sheet and access to capital are significant differentiators for us in these turbulent markets.

Before we get into additional details, let me turn the call over to Worthing for our forward-looking disclaimer and other housekeeping items.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Thank you, Ron, and good morning. We must inform everyone listening that certain matters discussed in this conference call are forward-looking statements intended to qualify for the Safe Harbors from liability established by the Private Securities Litigation Reform Act of 1995.

Such forward-looking statements are subject to various risks and uncertainties, which could cause actual results to differ materially from those currently anticipated. These risks and uncertainties are set forth in the company's periodic filings with the Securities and Exchange Commission.

Shareholders, potential investors and other participants are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements made herein are made only as of the date of this conference call and the company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances.

On the call, we refer to operating income before depreciation and amortization and free cash flow, each a non-GAAP measure. Management uses these non-GAAP measures as two of the principal measures to evaluate and monitor the ongoing financial performance of our operations. We define operating income before depreciation and amortization to exclude any gain or loss on disposal of assets.

Free cash flow is defined as net cash provided by operating activities plus or minus any changes in book overdraft plus proceeds from disposal of assets and excess tax benefit associated with equity-based compensation, less capital expenditures and distributions to minority interest holders. Where appropriate, we will highlight particular items in certain periods to improve comparability.

Finally, we note that other companies may calculate these non-GAAP measures differently.

Now I'll turn the call back over to Ron.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Okay, thank you, Worthing. As previously stated, we remain extremely pleased with our results in the quarter. Revenue was $272.7 million, up 8.7% over the prior year period and above our updated outlook for the quarter. Organic growth was 3.9% broken down as follows; 5.9% price, and negative 2.1% volume and a positive 0.1% for recycling, intermodal and other services.

Pricing in the quarter increased 50 basis points sequentially from Q2. Core pricing was 4%, which is up about 30 basis points from Q2 and consistent with our focus on core pricing.

Surcharges in selected markets due to spikes in certain costs such as fuel increased from 1.7% in Q2 to go about 1.9% in Q3, due primarily to sequentially higher fuel costs in the quarter. The third quarter was clearly our difficult quarter in '08 for recovering fuel increases. And it does reflect in the lag inherent in how we recover such spikes.

Fuel averaged about $4.45 per gallon in Q3, and as a percentage of revenue rose year-over-year about 315 basis point to 9.2% of revenue. As a reminder we have a hedge in place through the year end that covered about 45% of our fuel needs in Q3, and should provide for 35% of our needs in Q4 at about $4.69 per gallon.

This hedge is above market as fuel we are now buying at market is averaging about $3.35 per gallon. At these prices we would average about $4 in Q4 or around $0.45 per gallon below Q3's rate, providing us a little bit of tailwind into the fourth quarter.

With Q3 now behind us and fuel prices declining, our exclusive market model and focus on core pricing should start to out perform. Remember, core pricing is much more resilient as fuel prices drop, versus the fuel surcharge that must be given up when diesel prices decline.

These declining surcharges are nothing more than negative price, while core pricing better protects long term prospects. Core pricing is more stable and helps us recover costs for future periods. With fuel prices down, we are now in that cost recovery period and in our exclusive markets, we are better positioned in the weakening economy to retain strong pricing without the risk of chasing price down to protect volume.

Our bulk market hedge at $4.69 per gallon expires at year end. To replace this hedge when it expires we have put new hedges and fixed price supply contracts in place over the past two weeks as crude has dipped. These new hedges commence January 1 and cover varying portions of our projected needs over the next two years.

For 2009 we have locked almost 75% of our needs at approximately $3.35 per gallon. This assumes we use about 24 gallons in 2009, excluding the impact of any additional acquisitions or divestures. We had noted on our previous call that we would start looking at multi-year hedges for diesel once it sells between four and $4.25 per gallon. Patience paid out and we did better than our initial target. We continue to watch the market and would opportunistically hedge a greater percentage of our need in 2010 and 2011, if multi-year pricing approaches $3 to $3.25 per gallon.

Back to organic growth; volume growth in Q3 was a negative 2.1%, which is slightly better than our updated outlook a month ago. Declining temporary roll-off activity accounts for about 50% of the reported volume decrease, with the remainder split evenly between lower special waste activity in the Northwest and a reduction in commercial activity, primarily related to customer closures and bankruptcies, due to the weakening economy.

Landfill volumes on a same-store basis declined about 2% over last year in the same quarter. Looking again at roll-off; pulls per day in the quarter declined almost 6% on a same-store basis. Sequentially lower than the 4% decline we saw in Q2 and 2% decline in Q1. Although temporary roll-off activity is decelerating, the good news continues to be that revenue per pull has been increasing enough to offset lower activity.

Revenue per pull in the quarter was up about 6%. While that's good for the quarter, we've note that revenue per pull in the first half of the year had been increasing at a greater plus than the decline in pull. Weakening conditions have now converged these two metrics.

We believe the recent turmoil in the equity and credit markets, along with growing concerns about a deep recession and higher unemployment may have placed the U.S. economy in hibernation. My conversations with CEOs in other sectors suggests consumer and overall economic activity has slowed dramatically in the past four to six weeks.

We believe this cycle has now eclipsed the depth of the '01 to '03 contraction. As such, our outlook for both volumes and commodity prices going forward will be much more cautious. We believe conservative assumptions to be prudent in these uncertain times.

The flipside though is that guaranteed price in about 55% of our markets. Productivity improvements and cost reduction should continue to drive strong margins and solid financial performance despite a potentially deteriorating macro environment.

Back to the third quarter results; operating income before depreciation and amortization was $81.1 million or 29.8% of revenue, consistent with the upper end of our revised outlook and within our original guidance for the quarter.

On a year-over-year comparison our margin in Q3 for operating income before depreciation and amortization as a percent of revenue declined 180 basis points. An almost 60% year-over-year increase in fuel prices drove fuel as a percentage of revenue higher by about 315 basis points. While acquisitions completed since the year-ago period accounted for an additional 10 basis point impact in the quarter.

This combined 325 basis point negative margin impact in Q3 was offset by almost a 150 basis point improvement in other line items. Worthing will review those details later in the call. Margin comparisons going forward should be more favorable as we began anniversaring higher fuel costs and as current diesel prices trend lower.

Earnings per share in the quarter was $0.41 on a reported basis. This EPS includes the $0.03 impact from non-cash items related to equity based compensation cost and the amortization of acquisition related intangibles.

We continue to highlight such non-cash items since new acquisitions and upcoming changes in accounting principles will significantly increase non-cash expenses and weigh on reported EPS in future periods. But we'll have no impact on free cash flow.

The LeMay acquisition is a perfect example, since the long term contractual nature of that business will result in good portion of the purchase price being allocated to amortizing intangibles associated with customer contracts, rather than being allocated to non-amortizing goodwill.

Turning now to acquisitions; we currently expect our previously announced LeMay transaction to close in November. LeMay Enterprises is the largest privately owned solid waste services company in the Pacific Northwest providing collection, recycling and transfer services, a majority of which are under exclusive G-certificate for the counties of Gray's Harbor, Lewis, Pierce and Thurston in the State of Washington.

And currently with that transaction, we also agreed with entities affiliated with LeMay to acquire the remaining minority interest in Pierce County Recycling, Composting and Disposal and Pierce County landsfill Management, Inc. which provides solid waste Transfer, Disposal, Recycling and Composting services in Pierce County. These entities currently are majority owned subsidiaries of ours that will become wholly owned on closing in November.

From a P&L standpoint, these acquisitions provide about a $100 million in revenue and an approximate 25% EBITDA margin and eliminate all, but about 500,000 of our annual minority interest expense. We also benefit on our free cash flow basis from the elimination of the minority interest distributions that were about $12.5 million in 2007 and almost $9 million through Q3 of this year.

Well, this deal should be solidly accretive to both cash EPS and GAAP EPS, the contractual orientation of this business results in a good portion of purchase price being allocated to amortizing intangibles, resulting in between $4.5 million and $5 million increase in annual amortization expense, or almost a $0.04 non-cash impact to reported GAAP EPS accretion on an annual basis.

We will continue to highlight these non cash items to help investors better understand why our growth in free cash flow will exceed our growth in reported earnings in 2009 and beyond.

In addition to the LeMay transaction, we believe we will sign or close in Q4, acquisitions with an additional $15 million to $20 million of annualized revenue, primarily in exclusive West Coast markets. If so, this would make 2008 a record year for acquisitions, all of which would be done in what we consider the more attractive exclusive markets of the West Coast, bringing us to a total approximately $135 million to $140 million of acquired revenue in 2008.

Divestitures resulting from the potential merger between Republic Services and Allied Waste may provide additional growth opportunities for us as well. Based on our analysis over the past four months, we believe this merger could result in the divestiture of assets worth between a $100 million and $150 million of EBITDA, about two thirds of which we believe would fit our strategy. And the remainder of which we could potentially slap [ph] with other companies or markets that's fit our longer term strategy.

We currently have over $525 million of cash on hand and about $375 million of available revolver capacity. We have pre-positioned our balance sheet with the requisite capital to pursue any divestitures resulting from the potential merger between Republic Services and Allied Waste.

We believe this available capital puts us in a unique position within the solid waste sector for future growth opportunities arising out of this transaction or other opportunistic growth platforms.

And now I would like to pass the call to Worthing to review more in depth our financial highlights of the third quarter and provide a detailed outlook for Q4.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Thank you, Ron. In the third quarter, revenue increased 8.7% to $272.7 million; 3.9% from internal growth and remaining from acquisition activity. Operating income before depreciation and amortization for the quarter was $81.1 million or 29.8% of revenue, which compares to $79.2 million or 31.6% of revenue in the year ago period.

The theme we saw in the first half of the year continued through Q3. One line item fuel increased a notable amount year-over-year as percent of revenue. As we had forecasted this negative year-over-year impact peaked in Q3 as fuel expense increased about 315 basis points to about 9.2% of revenue.

For the fourth quarter, we averaged about $4.45 per gallon, which was up about a $1.65 per gallon, almost 60% above the prior year period. This 315 basis points margin hit from fuel was reduced by about 135 basis points from improvements in the following areas: Labor and related costs declined about 40 basis points due to price driven revenue growth; SG&A declined almost 40 basis points primarily due to reduced incentive compensation, partially offset by higher equity-based compensation costs.

Third party transfer, disposal and the intermodal drayage expense declined about 35 basis points, again due to a price oriented topline growth. And finally, worker's comp and auto insurance cost declined about 15 basis points, due to continued improvements in incident frequency rates and reduction in severity.

Acquisitions closed since the year ago period accounted for about 10 basis points of reported year-over-year margin dilution in the current year period. Depreciation and amortization expense increased about $2.2 million year-over-year to a little more than 8.9% of revenue in the current quarter, up almost 10 basis points from the prior year due to an approximate 10 basis point increase as a percentage of revenue in CapEx related depreciation and a 10 basis point increase in amortization of intangibles as a percentage of revenue associated with acquisitions completed since a year ago period, offset by about a 10 basis point reduction in completion [ph] expense as a percentage of revenue.

Net interest expense in the quarter remained relatively flat at about $8.7 million. We ended the quarter with about $643 million of outstanding debt, and reduced our leverage ratio to about two time debt to EBITDA. We also had about $366 million in cash. So the net debt or debtless cash was about $277 million, or less than one times debt to EBITDA.

Our cash and debt balances both increased by about $175 million, when we closed our previously announced private placement of seven year notes. We have prices tranche back in June at 6.22%, and our timing was fortuitous, given the recent event in the credit markets. The note will allow us fees [ph] for the issuance of up to an additional $325 million of notes, under the same master agreement, at pricings subject to market conditions

Our effective tax rate in the quarter was 35.3% which was up about 40 basis points in the year ago period. Again it's not uncommon to have some volatility in Q3 rate due to the expiration of tax contingencies and a reconciliation of the provision following tax returns each September. Free cash flow was $26 million in the quarter. Timing pushed some Q3 free cash flow into Q4 as we have already seen record collections so far in October.

Free cash flow through nine months was $105.2 million or 13.3% of revenue, up almost 30% over the prior year. We remain on target for full year free cash flow to be at least 13% of revenue, which will reflect a dollar increase of 13% or more over 2007, and exceed the expected 20% year-over-year increase we have provided in our initial outlook for 2008. Again, despite hard cash outlaid for fuel.

I will now review our outlook for the fourth quarter of 2008. But before I do we'd like to remind everyone once again that actual results may vary significantly, based on risks and uncertainties outlined in our Safe Harbor statement in our various SEC filings. We encourage investors to review these factors carefully.

Our outlook for Q4 assumes the LeMay acquisition closes November 1. And as Ron noted earlier; we are much more cautious in our outlook for the economy given the recent volatility in the markets and growing fears about further weakening in the economy. We believe it prudent to be conservative regarding volumes and recycled commodity prices, given this macro-environment.

Revenue in the fourth quarter is estimated between $270 million and $273 million, up about 9.5% over Q4 '07. We expect pricing growth of almost 6%, volume growth of about a negative 3.5%, and recycling, intermodal and other to be a negative 1.5%. The assumed sequential increase in negative volume from Q3 to Q4 is primarily favorable to further reductions in roll-off, special waste and related transfer revenue, and commercial activity due to customer closures and bankruptcies.

We have assumed that our special waste project totaling about $2 million of revenue that we had previously expected in Q4, pushes into early '09. That said, it's still possible that this project will start December 1 and that about a half of the project or $1 million in additional revenue could still occur in Q4.

The decline and recycling, intermodal and other is primarily related to decrease in commodity prices, which have dropped about 30 to $50 per ton in the past three weeks on most commodities.

Operating income before depreciation and amortization is estimated between $77 million and $78 million, reflecting a margin of about 28.5%. As a percent of revenue, this represents about a 90 basis point decline from the prior year period and assumes that a 160 basis point margin impact of higher fuel cost and the lower margin LeMay acquisition are offset by about a 70 basis point improvement in the underlying business.

Regarding time for the LeMay closing, again our outlook assumes closing November 1, and we have assumed about $8 million in revenue and $2 million of operating income before depreciation and amortization for each of the two months.

Depreciation and amortization is estimated to be about 9.5% of revenue, about 50 basis points of which are related to non-cash amortization of intangibles related to acquisitions including LeMay. Operating income for the fourth quarter is estimated about 19% of revenue.

Net interest expense for Q4 is estimated at approximately $8 million. This assumes about $10.4 million of interest expense is offset by about $2.4 million of interest income on cash investments. Any decreases in short term reinvestment rates, as credit markets begin to loosen up with reduced interest income and increased reported net interest expense.

In these times, security and preservation of cash is more important then chasing short term yield. Minority, interest and other expense are estimated to be a combined 0.5% of revenue, a decline from previous quarters as it reflects just one month of minority interest expense associated with the LeMay acquisition before its assumed closed on November 1. In conjunction with the LeMay closing, we also expect to report a one time pre-tax charge in Q4 of approximately $2 million related to transaction cost.

Our effective tax rate for the quarter is assumed to be 39%. And finally we estimate our Q4 diluted share count to be about 81 million shares, which reflects the increase resulting from our 12.65 million share common stock offering that closed September 30.

Now let me turn the call back over to Ron for some final remarks before Q&A.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Okay, thank you Worthing. In closing, again we're extremely pleased with our results in Q3 and our prospects for the future. We're well positioned for both the weakening economy and additional growth opportunities. Our differentiated strategy focusing on exclusive markets should comparably better protect pricing into '09. Put simply, there is no price volume trade-off in those markets. And with almost 75% of our '09 fuel needs hedged, we are well positioned to recover cost that did not pass through in '08 and deliver solid financial performance.

By year end, we could already be positioned for about 10% revenue growth in 2009 and margin expansion despite the dilutive margin impact of the LeMay acquisition. In addition, we believe the strong get stronger in a difficult economy. We currently are uniquely positioned with over $0.5 billion in cash, along with access to additional debt capital to fund future growth opportunity. While '08 has been a record year for acquisition activity, we believe continuing dialog with private company owners and the potential for divestitures from the Republic Services and Allied Waste merger could make '09 another record acquisition year for us.

We appreciate your time today. And at this time, I will turn this call over to the operator to open up the lines for your questions. Operator?

Question And Answer

Operator

Thank you, Sir. [Operator Instructions]. You first question comes from the line of Scott Levine with Waste Connections [ph]. Please proceed.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Welcome to the company.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Welcome to the company.

Scott Levine - JPMorgan

Thanks. Good to be here, JPMorgan. Could your talk a little bit about the trends with regard to pricing in your competitive markets versus your franchise markets and whether any of those trends have been surprising in your view, given the sharp downturn here over the last four to six weeks and also talk to month-on-month trends in the quarter, both price and volumes?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Okay, Scott. First with regard to price, the price in the competitive markets has held up very well, especially the core pricing in the competitive markets. We've really seen no change in that. That has remained in the 5% to 7% plus range on the core pricing. We... now, the core pricing in the exclusive markets continues to stay strong, obviously at a lower level because that is indexed to a CPR of other [ph] measure that's staying in that 3% to 4.5% range.

The difference is that obviously as fuel declines particularly in the competitive markets, the surcharge piece of pricing will come down because it's indexed to one or more different indexes regarding diesel or crude. So that has come down obviously, so has the cost, so it should come down.

And that is the different between both competitive and exclusive. In the exclusive market it has not come down nearly as much because we only get it either perhaps once a year or twice a year. So there is a much greater much lag going on and a much greater lag coming off on the surcharge in the exclusive. So there has really been no change to the pricing environment, whether you look at it as exclusive or competitive in our model.

On the volume side; I think your question was how that compared, we've obviously given macro volume for roll-off and for length of volumes in the quarter. How that compared in the quarter? The basic trend was it was down in July. It actually improved a little bit in August. And then came down much more precipitously in September, particularly the last two weeks of September. And October, at this point has stayed inline with the last two weeks of September.

So it actually moved around a bit in the quarter. But got worst as the quarter wore on.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Yes, Scot. I'll remind you for pricing standpoint we've got a Q4 price consistent with the strength we saw in Q3.

Scott Levine - JPMorgan

Got it. One last one on acquisitions. Can you talk a little bit about the pipeline increase in... this is beyond really divestitures in our public allied transaction. What you're seeing in terms of the pipeline, what you're seeing in terms of multiples and prices paid? And also if you could remind us what your expectation are, in terms of how the acquisition pipeline would play out in a slowing economic environment, both generally, and what you are seeing today?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Got it. Well, with regard to the acquisition pipeline and as you said excluding any potential divestitures that may or may not occur, so just private company opportunities; that continues to be very robust.

I mean our pipeline has always sort of remained somewhere between a low end of about 100 million or high end about 200 million of companies in active discussion at one level or another. And I'd say we're... have stayed at it for the middle of that range here over the last two to three quarters. Nothing has really changed there.

As far as multiples, we're also not seeing any material change. Obviously we believe the multiples will be coming down overtime because the reality is from this credit crisis, I think anywhere you shake it, that across the capital, both debt and equity is going up for all companies in corporate America. So I would expect that to translate overtime to lower multiples for acquisition, whether it be from us or anyone else. I would remind you we will not do acquisitions on a multiple basis, we do it on a return on capital. So, the multiple is a forced outcome of the process. And so... what was the last part of that question?

Scott Levine - JPMorgan

I guess the question would be that forced outcome, you expect that reality to ultimately coming around to reality and you're expecting activity next year in a recessionary environment on the acquisition side.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Yes.

Scott Levine - JPMorgan

Be relatively healthy?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

I do. I think it will be relatively healthy giving tax consideration I think that has a lot to do as we've stated depending on the outcome of the upcoming presidential election, which candidate prevails there. And then what their capital gains or other tax policy are and how quickly those come in or do not come in within '09 or beyond, I think will have something to do with certainly private sellers.

I would say to your question that you asked earlier that generally in a declining economic environment where you have lowering interest rate, generally that has not boded well in the acquisition environment. And I think we've said that historically in both the '01 to '03 period and at the beginning of this contraction because of the fact that; A, sellers businesses begin to weaken and so they're afraid of not getting full value.

And B, as they cannot redeploy their proceeds into a fixed income investment that provides them a yield for a lifestyle that's anything close to the cash they are taking out of their business. The combination of those two things tends to put people on the side line. I think the offset this time could be what may or may not happen with regard to the tax rate that they will see in selling those companies.

Scott Levine - JPMorgan

Okay, thanks guys.

Operator

Your next question comes from line of Corey Greendale with First Analysis. Please proceed.

Corey Greendale - First Analysis

Hi good morning.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Hey, good morning Corey.

Corey Greendale - First Analysis

Couple of questions, ask you to look [ph] for a little bit, I realize we're in some what unprecedented territory in terms of the economy. But is there reason to think that your geographies do better than say Mid West, East coast this time around because of weak construction activity, do you think your volume comp could be similar to the large national players this time?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

No I mean in what I think Corey if you look back to the '01, '03 contraction or if you look back to this contraction, which people would argue started in over the last part of '06. I mean if you look at the large national players, that are Waste Management, Allied and even to lesser extent Republic, they have been negative volumes now for seven quarters. This will be their eighth quarter, this quarter. And that volume has approached in some cases 4% to 5% plus negative. This is the first quarter and being Q3 we've actually broke through more than 1% negative, being 2.1, and now we're guiding for about 3.5 and in Q4 or up to 3.5 in Q4.

So, I mean we're still probably only at 52% may be 65% of what the nationals have been experiencing for quite some time. And I would expect that for two reasons. One is that our exposure not being in urban America and their being considerably more construction activity both residential and commercial, in their model. If you look at it the national companies model has about two to three times the amount of construction volume in it, in both their landfills and their roll-offs than we do.

So I would expect that, whatever the economic environment that our volume decrease would continue to only be half at most two-thirds of what you would see in the other companies. And if you go back to the '01 there were pre-contraction, that was exactly the case then as well.

Corey Greendale - First Analysis

Okay, thank you. And then, looking out to next year and again I know the crystal balls probably a little bit murky given what's going on in the economy, but do you think for '09 you could end up posting a volume number similar to the guidance that Worthing just suggested for Q4, or do you think with easier comps it's not quite that negative in '09.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

It's obviously the crystal ball's clarity when it comes to '09. But you would think that on sequential basis, volume growth should be improving from Q1 to Q4 as we begin the comp... better comps in the second half for the year.

Corey Greendale - First Analysis

Okay. And then another economic question, Ron. Could you put in perspective, you were talking about customer... commercial customer closings and bankruptcies. Is the magnitude of that similar to what you saw in past downturns, or is that looking more severe?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

At this point... and I would emphasize that this is only really predicated [ph] on the third quarter and the fourth quarter projected right now. This would certainly equip the '01 to '03 contraction at its depth; we certainly would have eclipsed this by the data we're seeing now.

So, using that measurement, I would say it's certainly more severe and in my 21 years in the business, I would say that this is certainly the worst that I have seen.

Corey Greendale - First Analysis

Okay. And then one on the acquisition front, if I could. In your commentary, in your script you had said something about some of the divested assets from Republic and Allied being good swap material potentially. Is your expectation that it possibly could end up acquiring the entire basket that they are looking to sell and then find swapping partners or would we expect some announcement that would say, we're acquiring this piece and simultaneously that we are going to swapping with some other geography?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Well, I think anything on that Corey would be very premature since we don't even know what those assets are specifically going to be yet. Through our own analysis, which I think will get us pretty accurate because there is... this is not really an audit survey, it's much of a science in terms of concentration indexes.

So I think we can get very close, but it would seem to us that about two-thirds of the assets fit sort of our strategy very well or what we can replicate our strategy, the other third of those I would think that there would be or I believe there is both regional companies... public and private regional companies we can enter into either sale or swap arrangements with and end up with an equivalent amount of EBITDA that fits our strategy.

I have no real thought right now, whether that would be simultaneous. I think that would take sometime, post closing. Again, if we were able to acquire all of those divestitures and again that's going to be that's not our decision but we just participating in the process.

And Republic may choose to do all of this with a company, they may choose to do multiple things. So we really don't have that, that's not our unilateral decision by us by any means.

Corey Greendale - First Analysis

Okay so just in terms of setting expectations for your strategy as possible, you would theoretically be willing to acquire assets that are not ones you intend to keep long term. And then you would look for buyers or swap partners after that.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Yes, if I mean if we need to acquire the totality of the basket, we have positioned ourselves to do that to assure that we can get the assets that we think fit our strategy and we're very comfortable about rationalizing the balance and making it work for our strategy. So yes, absolutely.

Corey Greendale - First Analysis

Okay, great, thank you.

Operator

Your next question comes from line of Bill Fisher with Raymond James. Please proceed.

Bill Fisher - Raymond James & Associates

Good morning.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Hey, good morning Bill.

Bill Fisher - Raymond James & Associates

Hey Ron just on the franchise market you touched on the CPI and have been and I know it's not uniform in those markets, but if you look out to '09 with fuel coming down here, do you still feel that some of those adjustments could be higher if you look at CPI '08 versus '09 or how that kind of shake out.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Yes I mean for the most part our build the CPIs that we get exclude food and energy. So fuel coming down is not going to affect the CPIs we've been getting. Some of our contracts have a PPI and in that one we have been getting 5.5 to 6%. Those will come down because food and energy is in those. But the vast majority of CPI base and if you take food and energy out up till recently every other driver has still been positive.

So, we're still expecting strong CPIs, perhaps not as strong as we're experiencing right now but certainly very nicely positive 2.5% to 3.5% type CPIs, because they do not include diesel.

Bill Fisher - Raymond James & Associates

Okay. And those more weighted to the beginning of the year, just kind of off middle, beginning at middle [ph], when you get those increasing.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

The vast majority Bill of our pricing about 70% to 75% will come in Q1.

Bill Fisher - Raymond James & Associates

Okay. And then totally from the cost side, Worthing touched on a lot of the items. But again, as you look, next year, outside of fuel, when you look at things like subcontract hauling and some of third party things and even labor, do you think some of those may ease with fuel, or... and how do you deal with labor hours, as volumes are down 2, 3% or so?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Well, first-off obviously, anything that has had a component driven by petroleum, such as subcontractor and other inputs in capital for that matter, on the landfill side, we expect those to be... those costs to be coming down. As far as labor; we are working very hard right now to drive our labor as a percent of revenue, particularly in a negative volume environment, down to what it was on prior basis. So that we recapture those labor savings. And that involves a number of things. It involves a reroute across the company, it involves schedule changes. We're implementing a number of different changes right now throughout fourth quarter, and in to the first quarter that I think will allow us to keep variable costs inline throughout '09 in the event of negative volumes.

Bill Fisher - Raymond James & Associates

Okay, great. And just a quick one if could on recycling. Is that the commodity part about $13 million or so revenue a quarter, and then if you just think about it in terms of the change, do you pretty much share half of that roughly with the municipality or how does that work?

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

We think about it as a between a 50% and 60% incremental margin. And so the difference on that is what you re-bear your share with the providers or municipalities.

Bill Fisher - Raymond James & Associates

Okay. And it's about $13 million or so total revenue, on the gross side?

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

That's right. It's between 4% and 4.5% of total revenue.

Bill Fisher - Raymond James & Associates

Okay, great. Thank you.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Thanks Bill.

Operator

Your next question comes from the line of Nicole Debrace [ph] with Deutsche Bank. Please proceed.

Unidentified Analyst

Good morning guys.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Good morning.

Unidentified Analyst

A couple of quick questions for you. Looking at 2009 CapEx, we have seen a lot of firms cutting back on their spending plan. How are you guys thinking about this?

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Well we looked at '09 as likely to be flat to down normally. And again that would be on 10% higher revenue. Obviously some rental capital is not variable. We have to spend money on that. And obviously on the fleet side we do pre-commit to a portion of our fleet needs, but since we're controlling fleet deployment given declining in volumes and you should see a less spend on container capital as well as volumes come down, so again flat to down on a dollar basis year-over-year despite 10% higher revenues.

Unidentified Analyst

Okay, great, thanks. And than specifically on the M&A, I mean what markets are you like targeting here from Allied and Waste Management? I mean what are you interested in keeping? So are you interested in expanding to different parts of the country or are you going to maintain that West Coast bucket?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Well, I think you mean Republic and Allied?

Unidentified Analyst

Oh, yes, sorry.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Since Waste has withdrawn its offer. That overlap is throughout the country between those two companies. We happen to be in 24 states right now, those combined companies are going to be in 40 plus states.

So the vast majority of assets will come in states that... just if you look at a map, will come in states that we are in today but there will be some tangential and some other states that we are not in. There will be assets in that we would either go in or look to go in on a temporary basis until we either swap or sold that, if it didn't make sense for our strategy.

I think what's important is; we are not looking to change our strategy. We are looking to stay an exclusive market provider, which is predominately a West Coast phenomenon in this industry. And we are looking to stay a suburban and rural provider.

So to extent that their assets that are heavily urban, if we cannot position ourselves to make it look like or function like our model that would not be something we intend to do long term. So I would not get overly hung up on what states the assets are in, but whether or not we intend to deviate from our strategy and we do not plan to.

Unidentified Analyst

Okay. And then one more, if I may. There is a lot of concern right now around municipality tax revenues coming down. Are there any risks to your pricing increases based on lower tax receipts or is that pretty much flat, no matter what happens.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

That's pretty much set no matter what happens, because I think one or... and that's a very good questions you've asked, because, I think a policy of a lot of investors that follow our space don't understand. We are not paid by the municipality, in almost all cases we are paid by the individual.

So declining individual customer, we are overseen by the municipality, but we are paid by the individual customer. So declining revenues to the municipality due to drop in property tax and sales tax revenue does not affect how we are paid.

Unidentified Analyst

Okay, great, thank you.

Operator

Your next questions come from the line of Brain Butler with FBR please proceed.

Brain Butler - Friedman, Billings, Ramsey

Good morning, guys.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Hi, Brian,

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Hi. Good morning, Brain.

Brain Butler - Friedman, Billings, Ramsey

Just a couple of housekeeping ones here. On the hedge side; you talked about '09, can you give us a little detail on what you haven't placed for 2010?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Yes, we've got right now about 25% or so of our needs in 10, hedged at a wholesale price of around $3.55 or so. We'll be looking to put more hedges in place, once it crosses below $3.25 and supplanting that down to get another closer to 3 bucks as we build the position. I think a 10 and 11 hedge price right now is about $0.20 above that or $3.45 based on this morning's close with crude moving down to about $3.60 [ph] right now a barrel.

Brain Butler - Friedman, Billings, Ramsey

And kind of the max you guys look at a kind of 75% of your needs is kind of a high end of what you did hedge?

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Yes that's from the base business that's correct because what we're guidance to now [ph] is the fact that increased acquisition activity will dilute that percentage back closer to 55 to 60%.

Brain Butler - Friedman, Billings, Ramsey

Okay. And then on the cash flow side, the book overdraft you have I might have missed this one on your comments, but can you give a little detail on that, that was kind of a big number at the $9 million level.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Yes, that's more of a timing issue with checks clearing that are outstanding. You will see that number bounce back up again near the $5 million or $6 million figure mostly likely by year end.

Brain Butler - Friedman, Billings, Ramsey

On the positive side, the other way.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Right, that's right.

Brain Butler - Friedman, Billings, Ramsey

Also on, I was going to say also on working capital, you had mentioned that you had record collection in the fourth quarter, that kind was pushed. So we should... should we be looking at the working capital side of the cash flow, statement looking to be positive again in the fourth quarter?

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

That's correct.

Brain Butler - Friedman, Billings, Ramsey

Okay, great. Thank you very much guys.

Operator

Your next question comes from line of Jonathan Ellis with Merrill Lynch. Please proceed.

Jonathan Ellis - Merrill Lynch

Thanks, good morning guys.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Good morning.

Jonathan Ellis - Merrill Lynch

Why don't you just talk a little more about volumes, first off you mentioned that the lands [ph] are under down 2%? Can you carve out the changes in C&D volumes and MSW during the quarter?

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

When we look... we look at it on a... on volumes on an average basis primarily, when we talk about the 2%. And obviously you got some sites that are down year-over-year and those sites have been more on the higher priced fifty markets in the North West, and those sites that have been up year-over-year are in the lower price markets at Southern California and the plain states?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Well, Jonathan, what I can tell you is this, of that negative 2% a little more than 50% of that is in special waste on a dollar basis. And the vast majority of the differential would be construction related. So the actual MSW volumes were down certainly sub 1%.

Jonathan Ellis - Merrill Lynch

Okay. Great, and then just on the volume trends in your franchise versus competitive markets, how did those trend in this quarter? In the last quarter you mentioned that franchise had gotten incrementally weaker relative to competitive markets, how did that play of this quarter?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

The same, we saw the West Coast, which is predominantly... well, which is almost exclusively franchised dip by a greater amount than the central portion of the country or the southern-- South-East portion of the country. So, on a volume basis, so that did not change in Q3. And I think that would be indicative of what we've seen in this cycle, which is that where the weakest residential housing pockets have been with the greatest amount of decline is on the west coast.

Jonathan Ellis - Merrill Lynch

Okay. And on the roll-off business and I know this maybe somewhat difficult to break out, but even if you can give us some qualitative insights into this, revenue per force you mentioned has decelerated over the course of the year. And I'm wondering, to what extent is that a function of just a little weight per container versus something going on perhaps with pricing, are you seeing some pricing pressures in the roll-off business now?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

I think our commentary on that would be more... would be more subjective than objective right now. And I would tell you that, the pricing pressure in roll-off is really driven by supply and demand on a local basis, Jonathan. It... so it's really a function of declining activity, leading to lower pricing, more than it is, less weight per pull, if you will, leading to lower pricing.

So I would tend to actually tell you, it is more on the competitive side of being a supply and demand driven business in a local market than it is less weight per pull, accounting for lower price per unit.

Jonathan Ellis - Merrill Lynch

Okay. All right, great. And then just... maybe if you could, Ron talk a little bit about independent companies and specifically what I am interested in is, given that fuel costs have come down here fairly precipitously. Are you starting to see them get perhaps little bit more aggressive in pricing on contracts given at the data [ph], perhaps a little bit more flexibility in the cost structure now due to lower fuel costs?

C: Ronald J. Mittelstaedt: Well, the good news for us, John, is that in almost now 60% post LeMay... 58% post LeMay, it doesn't matter, because there is no other competition and there is no independent. So it really comes down to that 42% of our business that's competitive.

And I will say at this point we have not seen a lot of that. We have not seen a lot of that either from other public companies or independent private companies, and probably because most of this cost decrease has been very precipitous in a short period of time. And that's going to take time to flow through. I would tell you as those probably know [ph] I would be very cautious in assuming that, that wouldn't become an issue going forward because I believe in a contracting environment with declining input cost, such as fuel and interest rate that independent companies have historically used that as an opportunity to gain share and companies have to respond on price. That has historically been the cycle.

Jonathan Ellis - Merrill Lynch

Okay great. And on some of your guidance for a 3.5% volume decline next quarter relative to which you recorded in the third quarter of 2.1% decline. And you say that couple of markets specifically there going to be source of weakness. But can you maybe give in qualitative returns sort out which ones you think are going to have the most drag in the fourth quarter versus the third quarter where you are seeing more incremental deceleration.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

The west coast. Or continuing to see

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

They come off... comes of in a higher [indiscernible].

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Yes and the real issue John there especially on the disposal site because the West Coast and particularly the North West is a $90 to a $100 a ton tip fee market, I mean you lose 10,000 tons at a $1 million. And a $1 million is a 0.5% in our model. And that's why we don't want people to read too much in because the difference between 2.1% negative volume and $3.5 million is $3 million. I'm rounding $3 million to $3.5 million.

That's 30,000 tons if it's coming out of the North West. Because it's a $100 a ton.

Jonathan Ellis - Merrill Lynch

Right.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

So it's really the North West where that has been a little bit weaker than the previous quarter. No, I'm not and that would be misleading to say we're not also seeing that. Nominally and incrementally in other parts of the country. But it's most pronounced there because of the pricing.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

And John, I'd say that 3.5% that regarding for Q4, that's almost better than the other larger companies reported in Q2. Those guys were 3.5% to negative 5%. And so those guys have been reporting negative volume now for several quarters as Ron pointed out, and their P&L has never been better.

I think our guidance for Q4 will strengthen the margins and EBITDA holding up in the face of 3.5% negative volume, just tells the same story. And the guidance we provided or the indicative directional guidance we gave [ph] for '09 suggest that; hey, this is a bad economy, which is bad for us, pales in comparison with [indiscernible] other sectors. With respect to... and especially us, given our market model will hold up quite nicely.

Jonathan Ellis - Merrill Lynch

Okay great, just my final question. Assuming that you don't make any acquisitions of divested assets from the Republic Allied merger. Should we be at this point assuming that next year share buybacks would be fairly consistent with what they have been prior to 2008?

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

That's a good assumption as well as we've take excess cash and pay down some revolver and reduce our interest expense well below $30 million plus.

Jonathan Ellis - Merrill Lynch

Okay. Thanks guys.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Thank you.

Operator

[Operator Instructions]. And your next question is from the line of David Feinberg from Goldman Sachs. Please proceed.

David Feinberg - Goldman Sachs

Good morning.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Hey, good morning, David.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Good morning

David Feinberg - Goldman Sachs

Most of my questions were answered. One follow up question though, as it relates to recycling business. I am trying to understand the sensitivity to the collection side, as it relates to those following prices. Are you finding that volumes are somehow being hampered by the fact that the commodity prices are being hampered, or are the two independent? In another words your collection of recycled materials is independent of what you ultimately get on the back half.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

They are independent.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Yes.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

I mean the volume of recycle materials has in this business and particularly in our model and I would say it's the exact same for the other larger players has zero correlation to pricing for those commodities.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

You got middles [ph] that are per load and dump capacity on the market place, you've got importers and exporters having better credit issues trying to do international trade right now. And so you've got less exporting going on. I mean those kind of issues are independent of what's going on the hauling side?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

There is some nominal decline in volumes on recyclables, David that comes from commercial customers, industrial customers whose volume of business is down and therefore the amount of recycling, recycled commodities they're producing for us to collect is down. But that's not because the pricing of commodities, which is I think what you are asking is that?

David Feinberg - Goldman Sachs

Yes and then as a follow up though, do you end up having to sit on any access inventory, if in fact the price is come down we heard reports of folks stock piling inventories in the hopes that the commodity prices would increase and they could sell at a later date?

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

No, we really don't, I mean, it certainly if there is a known driver that will increase commodity values in a relatively short period, David, two weeks, four weeks, we may stockpile to take advantage of that. But we are not in the business of warehousing recycled commodity, we don't have that type of facility capacity to do that in most cases and it's pretty much a product turn that we recover and move out in very short order.

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

Some allocations [ph] get commitments early every month, lock in the pricing for that month as well the volume off take.

David Feinberg - Goldman Sachs

Got it and one last question as it relates to hedging you've done pretty well in terms of fuel hedging. What efforts if any have you taken in terms of commodity pricing for your recycled business and hedging prices in the out years, if at all possible?

Worthing F. Jackman - Executive Vice President and Chief Financial Officer

We have not hedged commodity prices at this point.

David Feinberg - Goldman Sachs

Thank you.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Thank you.

Operator

As there are no further questions in queue at this time, I'd like to turn the call back over to management for closing remarks.

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

Okay. Well, if there are no further questions on behalf of our entire management team, we appreciate your listening and interest in the call today. Worthing, Steve and I will be in the office for the remainder of the day. If there are any direct questions we did not cover, that we are allowed to answer under Regulations FT and Regulation D, we will be happy to do so.

We thank you and we look forward to speaking with you on our next call.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Have a great day. .

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Source: Waste Connections Inc. Q3 2008 Earnings Conference Call Transcript
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