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Waste Connections (NYSE:WCN)

Q4 2012 Earnings Call

February 21, 2013 8:30 am ET

Executives

Ronald J. Mittelstaedt - Chairman, Chief Executive Officer, Chairman of Special Equity Award Committee and Chairman of Executive Committee

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

Analysts

Hamzah Mazari - Crédit Suisse AG, Research Division

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Corey Greendale - First Analysis Securities Corporation, Research Division

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Adam R. Thalhimer - BB&T Capital Markets, Research Division

Joe Box - KeyBanc Capital Markets Inc., Research Division

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

Barbara Noverini - Morningstar Inc., Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2012 Waste Connections Earnings Conference Call. My name is Shanelle, and I will be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Mr. Ron Mittelstaedt. Please proceed.

Ronald J. Mittelstaedt

Okay, thank you, operator, and good morning. I'd like to welcome everyone to this conference call to discuss our fourth quarter 2012 results and provide a detailed outlook for the first quarter and full year 2013. I'm joined this morning by Steve Bouck, our President; Darrell Chambliss, our COO; Worthing Jackman, our CFO; and several other members of our senior management team.

As noted in our earnings release, better-than-expected pricing growth, disposal volumes and recycled commodity value enabled us to exceed the upper end of our fourth quarter outlook for solid waste, and this strength has continued into Q1.

However, E&P waste activity slowed down sector-wide during the quarter, as many E&P companies have already depleted their drilling budgets for the year. Margins in our E&P segment were hampered by the slower activity and further affected by startup costs at new facilities and R360's continuing use of third parties for certain activities. The good news though, is that we expect revenue and margins for E&P waste to ramp during 2013, as drilling activity picks up, new facilities startup cost abate and we begin to internalize or eliminate some activities currently being outsourced. So put simply, solid waste is doing quite well and performance within E&P waste while off to a slower-than-expected start should improve as the year progresses.

Despite the slowdown in E&P waste activity during the quarter, a strong cash flow characteristics of our strategy is evidenced by adjusted free cash flow in the period, which exceeded our expectations and was about $276 million or 16.6% of revenue for the full year.

More importantly, we believe free cash flow in 2013 remains on pace to exceed $300 million. Our outlook for 2013 already reflects expected double-digit year-over-year growth in revenue, adjusted EPS and free cash flow. Additional acquisitions, any increase in recycled commodity values, improvement in the economy or potential newly permitted E&P facilities should provide further upside.

Before we get into much more detail, let me turn the call over to Worthing for our forward-looking disclaimer, as well as other housekeeping items.

Worthing F. Jackman

All right, thank you, Ron, 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 Harbor from the liability established by the Private Securities Litigation Reform Act of 1995, including statements relating to expected volume and pricing trends, recycled commodity prices, expectations regarding period-to-period comparisons, potential acquisition activity, the contribution from closed acquisitions, timing of permitting activities, the impact of increased regulatory enforcement of the E&P waste treatment and disposal, the impact of the relocation of the company's corporate headquarters in California to Texas, comparative results among our segments and our first quarter and full year 2013 outlook for financial results. 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. Stockholders, 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. 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'll discuss non-GAAP measures, such as adjusted operating income before depreciation and amortization, adjusted net income and adjusted net income per diluted share and adjusted free cash flow. Please refer to our earnings release for a reconciliation of such non-GAAP measures to the most comparable GAAP measure, as we use certain non-GAAP measures to evaluate and monitor the ongoing financial performance of our operations, and other companies may calculate these non-GAAP measures differently.

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

Ronald J. Mittelstaedt

Okay. Thank you, Worthing. As noted earlier, solid waste revenues exceeded our expectations in the fourth quarter, while the contribution from the R360 acquisition was lower than expected due primarily to a slowdown in that sector during the period.

Revenue in Q4 was $448.8 million, up 18.2% over the prior year period. Internal growth in the quarter was about flat, broken down as follows: positive 2.9% from core price; positive 0.3% from surcharges; negative 2.4%, volume; and negative 0.8% from recycling, intermodal and other services. Net pricing, or core price plus surcharges, exceeded expectations in the quarter, increasing sequentially to 3.2% from 2.9% in the prior quarter due to higher surcharges.

Looking at 2013, we expect net pricing in the first quarter to be a little more than 3% and average about 3% for the full year, consistent with the outlook we provided on our October call.

With almost 70% of our 2013 price increases already implemented and 90% implementation expected by April, we believe we have strong visibility and pricing for the full year. Visibility and predictability, along with comparatively higher core pricing and an ingrained culture of accountability throughout our organization, continue to be key differentiators of our strategy.

Volume growth in Q4 was a negative 2.4%, which exceeded our outlook of negative 3% to negative 3.5% for the quarter, due to better-than-expected special waste volumes and C&D volumes, which included about $2 million of disposal revenue from Sandy-related storm debris. Two items accounted for almost 75% of our volume losses in the period. First, our decision in early 2012 to turn away lower-priced volumes at our Chiquita Canyon landfill; and second, the wrongful termination later in the year of a municipal contract in Madera, California that we are now litigating.

Looking at 2013, we believe volumes on a reported basis will be between negative 0.5% and negative 1%, comparably better numbers in the second half of the year than the first, simply due to uncertain items we anniversary. These items, such as the one final month of the lost customer impact at Chiquita, the wrongfully terminated Madera contract and the loss of a portion of subcontracted volumes from Oakley abate as the year progresses. Net of these items, we believe underlying volumes in 2013 will actually be flat to positive 1%, and we're already off to a good start based on January's results.

Disposal volumes on a tonnage basis in the fourth quarter adjusted for the impact of acquisitions and 1 extra day in this period, were down about 5% year-over-year. More importantly, year-over-year trends improved during the quarter from down 8% on October to down only 2% in December.

In the fourth quarter, construction and demolition debris related to special waste-related volumes rose 16%, with about 40% of this increase related to Sandy.

Special waste volumes were down 1%, although still very strong on a historical basis. And MSW volumes were down around 10%, with 65% of the decline attributed to our turning away of lower-priced disposal volumes at our Chiquita Canyon landfill.

I noted earlier that January trends were favorable. For example, disposal volumes increased about 1% year-over-year over the month -- in the month, but were up about 4%, excluding the loss of the impact at Chiquita, which we've now anniversary-ed as of February 1.

Total of pulls per day in the fourth quarter was down about 0.5% year-over-year on a same-store basis. This decrease was closer to 2%, adjusting for the 1 extra work day in the period. Revenue per pull increased about 1%.

Our Western region, once again, showed an increase in pulls per day for the second quarter in a row after declining quarter-over-quarter for about 4 years.

Recycling, intermodal and other services was a negative 0.8% in the period due to year-over-year decreases in recycled commodity values.

Proceeds from the sale of recycled commodities in the fourth quarter were 3.9% of consolidated revenue, down from 5.5% in the prior year period.

On a same-store basis, revenue from such activity declined $4 million or about 20% year-over-year and at very high margins. This decrease was about a $0.02 year-over-year impact to EPS in the quarter.

Prices for OCC, or old corrugated containers, averaged about $137 per ton during the fourth quarter, down about 10% from the year ago period, but up 17% sequentially from Q3.

For the full year 2012, OCC prices averaged about $138 per ton, which was down 21% from 2011's average. This current pricing at $135 per ton, we expect minimal headwinds in 2013 if these prices hold.

Turning now to an update on the R360 acquisition, which closed in late October. As noted earlier, R360 is off to weaker-than-expected start, with E&P activities slowing down sector-wide during the fourth quarter, as many drilling companies have already depleted their capital budgets for the year. This slowdown in activity, along with startup costs at certain new R360 facilities and the continuing use of third parties for certain activities also dampened margins in the period and is expected to continue in Q1.

The abnormally harsh winter weather in the Bakken has also slowed our start in the year. As a reminder, R360 is the leading provider of non-hazardous, oil-filled waste treatment, recovery and disposal services in several of the most active natural resource-producing areas in the United States, including the oil-rich Permian, Bakken and Eagle Ford basins. We believe R360's existing assets can generate between $240 million and $300 million of annual revenue, and facilities for which we are pursuing permits could add another $50 million to $75 million of revenue per year. While estimating the timing for receipt of new permits is always difficult, we believe we could receive permits for at least 2 new landfills before the end of the year, which would make them operational during the first half of 2014.

These estimates assume no change in the regulatory environment. Any increased enforcement or toughening on the E&P waste treatment and disposal regulations, either federally or by state, would move these estimates higher.

Looking at 2013 in more detail. Our outlook for total revenue is between $1.925 billion and $1.95 billion. Solid waste is fairly dialed in at about $1.675 billion in revenue, and we have assumed between $250 million and $275 million from E&P waste, but it's difficult to forecast the pace of any such ramp in that business.

Our outlook for EBITDA in 2013 is around 34.5% of revenue, which is about 100 basis points below our internal budget of approximately 35.5%, in order to provide some amount of cushion, given the comparably less protectable nature of the higher-margin E&P waste business.

We expect margins within E&P waste to ramp during 2013. As drilling activity picks up, the facility startup costs abate and we begin to internalize or eliminate some activities, which are currently being outsourced.

We expect depreciation and amortization expense, as a percent of revenue in 2013, to increase almost 100 basis points year-over-year due to the impact of acquisition accounting. While such an increase weighs on GAAP comparisons, it has no impact on free cash flow. Consistent with preliminary thoughts we laid out last October, we believe free cash flow in 2013 will exceed $300 million.

Our differentiated strategy produces superior free cash flow margins. It always has. It's the strength of this free cash flow that keeps us well positioned to fund additional growth opportunities, including acquisitions and potential newly permitted E&P waste facilities, reduce debt, as well as return capital to shareholders.

Regarding the latest topic de jure of REITs and MLPs, we believe our strong free cash flow, together with prospects for higher cash taxes once bonus depreciation expires and the qualifying MLP ruling that R360 had received last year, might make a portion of our business attractive for an MLP structure. We intend to look into this possibility as the year progresses.

And now I'd like to pass the call to Worthing to review more in depth, the financial highlights of the fourth quarter, as well as provide you a detailed outlook for both Q1 and the full year 2013.

Worthing F. Jackman

All right, thank you, Ron. In the fourth quarter, revenue of $448.8 million increased 18.2% over the prior year period due to acquisitions. Adjusted operating income before depreciation and amortization in the quarter was reconciled in our earnings release, increased 18.8% to $142.3 million. As a percentage of revenue, this was 31.7% or about 20 basis points above the year-ago period.

Strong pricing and contribution from higher-margin acquisitions helped us more than offset the estimated negative 200-basis-point year-over-year margin impact from lower recycled commodity values and are pushing out to the one customer at our Chiquita Canyon landfill, adjusting for the items reconciled in our earnings release, the following are certain line items that moved a notable amount from the year ago period as a percentage of revenue, primarily due to a change in revenue mix resulting from the R360 acquisition.

Fee-based, revenue-sharing and pass-through fees and expenses decreased 90 basis points; labor expense decreased 80 basis points; fuel expense decreased 40 basis points; third-party equipment rental expense increased 40 basis points; subcontracted cost and utilities expense increased 40 basis points. In addition, SG&A increased 35 basis points year-over-year as an increase in incentive and equity-based compensation and a number of smaller items were somewhat offset by a reduction of bad debt expense. Medical and risk-related insurance costs increased 30 basis points.

In the quarter, fuel expense was about 6.1% of revenue, and we averaged approximately $3.57 per gallon for diesel or about $0.08 a gallon above the year-ago period, and up $0.02 sequentially from Q3.

Depreciation and amortization expense in the fourth quarter increased $12.7 million year-over-year, and were 12.5% of revenue, up more than 100 basis points year-over-year due to higher acquisition-related depletion and, to a lesser extent, amortization costs. About 2/3 of the R360 purchase price will be expensed through the P&L, primarily through noncash depletion expense given the landfill-oriented nature of their assets. A significant increase in D&A as percent of revenue due to acquisition-related accounting further widens the difference between this end CapEx, which runs about 9.5% of revenue. This 300-basis-point difference is noncash, which does not impact free cash flow, but it does dampen reported net income to GAAP EPS.

Net interest expense in the quarter increased $4.4 million over the prior year period to $16.8 million due to higher outstanding debt balances resulting from the R360 acquisition.

Our outstanding year end was about $2.2 billion and our leverage ratio, as defined in our credit facility, was about 3.25x debt to EBITDA. We expect this ratio to improve to below 3x at the end of 2013. We currently have about $350 million of available capacity under our credit facility.

Effective tax rate for the quarter was 43.2%, which equates to a normalized rate of a little more than 39%, also onetime $2.6 million increase due to provision associated with an increase in deferred tax liabilities, primarily resulting from the R360 acquisition completed in the period.

Our fully diluted outstanding share count for Q4 was 123.7 million shares, an increase of about 11.3 million shares or 10% in the year-ago period due to the impact of our equity offering in early 2012.

GAAP and adjusted EPS in the fourth quarter were $0.29 and $0.37, respectively. Adjusted net income on the comparative periods now includes an add-back for acquisition-related intangibles that helped certain investors raise a portion of a significant difference between GAAP net income and free cash flow, especially following the R360 transaction.

Adjusted free cash flow in 2012 was $275.8 million or 16.6% of revenue, exceeding our original $250 million to $260 million outlook for the full year.

Our recognized E&P waste will introduce a bit more volatility in period-to-period P&L results. We believe our annual mid-teens free cash flow margin remains the more important metric.

I will now review our outlook for the first quarter and full year 2013. Before I do, I would like to remind everyone, once again, that actual results may vary significantly based on risks and uncertainties outlined in our Safe Harbor statement and our various SEC filings. We encourage investors to review these factors carefully. Our outlook assumes no change in the current economic environment, excludes the impact of any additional acquisitions that may close during the year, potential newly permitted E&P facilities, expensing of acquisition-related transaction costs and any remaining costs incurred in connection with the relocation of the company's corporate headquarters from California to Texas, including a charge for the write-down of our prior corporate office lease.

Looking first at the full year 2013. Revenue in 2013 is estimated to be between $1.925 billion and $1.95 billion, up about 16% over 2012 with, as Ron noted earlier, between $250 million and $275 million expected to be E&P waste-related. Organic growth is expected to be between positive 2% and 2.5%, net pricing around 3%, volume growth between negative 0.5% and negative 1%. Recycling, intermodal and other is expected to be flat to slightly down at current commodity prices. Operating income before depreciation, amortization and accretion in 2013 is estimated to be about 34.5% of revenue, an increase of almost 300 basis points over 2012, due primarily to rollover contribution in the higher-margin R360 acquisition.

As Ron noted earlier, this margin outlook is about 100 basis points below our internal budget of approximately 35.5% in order to provide some amount of cushion, given the comparably less protectable nature of the higher-margin E&P waste business. Margins within our solid waste business are expected to be up slightly year-over-year.

Depreciation and amortization in 2013 is estimated to be about 12.5% of revenue, closure and post-closure accretion expense, as a percentage of revenue, is expected to be approximately 15 basis points in 2013. Operating income for the year is expected to be approximately 22% of revenue. Net interest expense in 2013 is estimated to be about $75.5 million. Our effective tax rate for the year is estimated to be about 39.2%. Non-controlling interest is expected to reduce net income by about $1 million in 2013.

Two principal components of our 2013 free cash flow is expected to be as follows: Net cash provided by operating activities for the full year is estimated to be approximately 25.5% of revenue; capital expenditures are expected to be about $185 million. This puts estimated free cash flow for 2013 at a little more than $300 million.

As discussed on prior calls and noted in our public filings, we expect to take a one-time charge to write down our prior corporate office lease in California. This charge is now expected to occur in either the second or third quarter of 2013 and is still estimated to be between $8 million and $10 million.

Turning now to our outlook for Q1 2013. Revenue in the first quarter is estimated to be between $448 million and $450 million, up about 19% over Q1 2012. Organic growth is estimated to be between 0.5% and 1%, with the components as follows: net price, a little over 3%; volume growth, between negative 2% and negative 2.5%; and recycling, intermodal and other, slightly negative. Operating income before depreciation, amortization and accretion in Q1 is estimated to be between $143 million and $144 million, reflecting a margin of about 32%. Depreciation and amortization for the first quarter is estimated to be almost 13% of revenue, up about 160 basis points over the prior year period due to the impact of acquisition-related accounting. Amortization of intangibles in the quarter is estimated to be almost $6.5 million or about $0.03 per diluted share.

Operating income for the first quarter is estimated to be about 19% of revenue. Net interest expense in Q1 is estimated to be about $19.2 million. Our effective tax rate in Q1 is estimated to be about 39.2%. And non-controlling interest is expected to reduce net income by about $250,000. Our diluted share count in Q1 is assumed to be about 124 million shares.

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

Ronald J. Mittelstaedt

Okay, thank you, Worthing. Again, we believe we are well positioned in 2013 for double-digit year-over-year growth in revenue, adjusted EPS and free cash flow. Our solid waste business is fairly dialed in for the upcoming year and we have been cautious in our outlook for both revenue and margins from E&P waste as we wait to see how that sector ramps during the year.

As we see it, sector-leading pricing growth and a mid-teens percent free cash flow margin are hallmarks of our differentiated strategy. These attributes, along with acquisition rollover growth and easier recycling commodity price and MSW landfill volume comps will produce more favorable comparisons for '13 over the prior year period versus what we experienced in 2012.

The outlook for 2014 could also be shaping up nicely if our continued pricing strength gets combined with positive volumes from an improving economy and more importantly, growth and higher-margin revenue, both from increased disposal volumes in the LA basin, once the Puente Hills landfill closes later this year and for potential, newly permitted E&P facilities. We appreciate your time today. I will now turn the call over to the operator to open up the lines for your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Hamzah Mazari of Crédit Suisse.

Hamzah Mazari - Crédit Suisse AG, Research Division

The first question is just on your comments on the MLP structure. Could you maybe share some color as to what stage in the process are you? I assume it's early stages. And does this pertain to adjust the E&P legacy landfills you have? Or how are you thinking about the process?

Worthing F. Jackman

Hamzah, it's very early stage. We're trying to get our K filed, get our proxy done, get our annual report mailed. Once we get through and get the bandwidth to turn to MLP structures, that would likely be sometime during the second or third quarter. With regards to what assets are we looking at, obviously, the private letter ruling already addresses the applicability of E&P assets within an MLP structure. We also -- we note that there's at least one other landfill -- MSW landfill within an MLP structure. So what we don't know is whether or not it will just be limited to E&P or whether or not we could pull in the other landfills because obviously, the more mental assets you can pull within such a structure, the more potential benefit you get on tax yielding.

Hamzah Mazari - Crédit Suisse AG, Research Division

That's very helpful. And then just second question. Maybe if you could describe what you're seeing in the underlying volume trends across commercial, industrial. And as muni regi is still weak, I've realize you're guiding negative volume, but that's due to clearly, some moving parts there specific to your business. So just wondering, underlying volume trend, whether you're seeing still flattish or how should we -- how would you describe that?

Ronald J. Mittelstaedt

Yes, Hamzah. I mean, I think, as you accurately said, if you were to take out the 1 month rollover of the Chiquita customer we pushed out, the contract loss that in Madera and the Oakley volumes that Waste Management internalized, if you were to -- those were all gone. So if you were to exclude those, we really were seeing the business flat to nominally up. And it's really across all business lines. The commercial business line is very stable in the fourth quarter. Our increases and our decreases in service were about dead equal. Our new business and our closed businesses and loss business were about dead equal. And the same trend has continued in January. So commercial is very stable. The residential business is up about 1.5% or 2%. So what it really tells you is that, our landfill and our rollout business is just nominally down, maybe a percent. And that's what brings you back to about flat. So we would tell you that things continue to improve very slowly. They're certainly not deteriorating in any manner that we see, in any system or in any geography. But the rate of improvement is very slow. But certainly, flat to positive.

Hamzah Mazari - Crédit Suisse AG, Research Division

Okay. And then just last question. How should investors think about your leverage right now and where you can get that leverage to -- on debt to EBITDA by year end? And does that leverage procure you from share repurchase or dividend increase?

Ronald J. Mittelstaedt

Well, let's take them all separately. Right now, leverage is about 3.2x. We're comfortable with it going higher than that for the right strategic and appropriately priced deals. In the absence of that, I think, you would see us use free cash flow this year to reduce debt, which would bring leverage down to probably about 2.9x -- 2.85x to 2.9x by year end. And we would suspend share repurchases, which we've done right now, but you would still see us obviously, continue with the dividend and of course, look to increase the dividend in October as well.

Operator

Our next question comes from the line of Michael Hoffman with Wunderlich Securities.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

With regards to the solid waste business and the deal activity, I suspect there might have been some effort by some sellers to try and get things done at the end of the year due to cap gains. It doesn't look like it happened. So how do you think about that normal number you talked about of $40 million to $60 million, as it relates in this year? Does it end up back in there? Because if they were selling, they would have and if they're not, they wait?

Ronald J. Mittelstaedt

Yes, Michael. I think, that certainly for the first half of the year, you're going to see things be more quiet because -- than normal because of the fact that, just what you said, that they were going to do something. They probably got it done last year. But again, people continue to die, get divorced, have illnesses, have estate issues. And as you know, that drives a lot of what we do. I'm still very comfortable with that $40 million to $60 million number in the solid waste side alone, let alone what we'll do on the E&P side. So again, that $40 million to $60 million number is a number we could do pretty routinely, and I don't see us having anything impairing us from that this year.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Okay. And then on that vein, in the legacy companies, they used to talk about sort of a pipeline of potential. Can you frame that from the E&P side?

Ronald J. Mittelstaedt

Yes, I can. It's not as refined as the solid waste side because we haven't owned it as long, we don't know it quite as well and we don't have the track record on the deals. So with all those caveats, yes, I can. I'd say that we're looking right now at about $100 million in potential E&P deals.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Okay, perfect. And then, can you frame for us what's in your in your guidance in November, December when Puente Hills closes? What are you thinking happens?

Ronald J. Mittelstaedt

We put nothing -- no incremental improvement in our guidance.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Okay. There is -- that's upside if the market corrects back to a rational pricing?

Ronald J. Mittelstaedt

Yes. If either pricing or volume picks up from that, we have not made that assumption in our guidance.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Okay. And then, you mentioned this in your prepared remarks, I apologize. Special waste trends at this juncture, what's your thoughts about as you're entering '13 in sort of the patterns through the year?

Ronald J. Mittelstaedt

Well, we had very strong special waste year in both '11 and '12, driven by a lot of federal cleanup money being allocated to states. We are not sure if that money will be out -- or actually, we are sure that, that much money won't be allocated, but there's more private activity occurring. This is always a slow quarter for special waste in the special quarter because of the frozen ground in many parts of the country, but we are still expecting -- it was down 1% in the fourth quarter, but on a very, very high comp. So it was still extremely strong in the fourth quarter.

Worthing F. Jackman

And January was actually up year-over-year.

Ronald J. Mittelstaedt

And there you go, January was up. We still expect it to continue to be fairly strong.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Okay. And then last question, since linear fee drilled matters more about E&P waste, can you share a little bit about that -- where your activity -- the new growth activity, like the new capacity you think about adding? Because like the Bakken, you drilled at 25,000 feet versus the Permian, you're at 10,000 feet.

Ronald J. Mittelstaedt

Yes. So right now, the capacity we're looking at adding is in Eagle Ford, in the Oklahoma and as well as some in the Bakken in different geographies.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

And that where you're spending this $1 million a month in the start up? Where is that located?

Worthing F. Jackman

Well, that is in the Eagle Ford, in the Permian and the Bakken, all 3 places.

Operator

Your next question comes from Corey Greendale, First Analysis.

Corey Greendale - First Analysis Securities Corporation, Research Division

I just want to understand a little bit better. I think, R360 driven reasons for the change in the outlook versus kind of the preliminary outlook you gave last quarter and how much of it is driven by -- on the revenue side and how much there are incremental costs that were not factored into the prior outlook?

Worthing F. Jackman

Well, the prior -- again, the prior outlook was preliminary setting in the budgets. I have the good news that budgets confirmed what our expectations were, which was an expectation of around 35.5% for the business this year. Again, that the biggest delta is, A, putting in some cushion as we talked about with regards to, how do you discuss things publicly versus your own internal expectation? Also, you've got some added cost, as we talked about, about $1 billion a month. That $1 million a month in that business should be out of the P&L by the middle of this year. And so that will help make better for a ramp second half of the year versus first half of the year. Obviously, in the -- the amount of revenue -- the dollar revenues slowed down. It actually flows through at a very high margins, similar to special waste. And so that hits us as well, it just makes us more cautious about how the year will play out.

Ronald J. Mittelstaedt

Yes, and it's also geographies, Corey. I mean, it's not unlike solid waste, where in the Washington area, we take solid waste to $100 a ton, in Denver, we take it at $10. In the Bakken, volumes come in at $60 to $80 per ton, but in the Permian and the Eagle Ford, they come into at $20 and $40. And we've had a shift for more rigs in the Permian and the Eagle Ford and less in the Bakken. So that just gives you less revenue per ton, even if you're handling similar tonnage.

Corey Greendale - First Analysis Securities Corporation, Research Division

And that $1 million per month, is that just startup costs? Or does that include the third-party activities that you talked about?

Worthing F. Jackman

That includes the third-party.

Corey Greendale - First Analysis Securities Corporation, Research Division

Okay. So that part of it dissipates as well in the second half?

Worthing F. Jackman

It should. Yes.

Ronald J. Mittelstaedt

Yes.

Corey Greendale - First Analysis Securities Corporation, Research Division

And I apologize if you gave this and I missed it, but I think you said a couple of times that there was an extra work day in the quarter. Do you have the -- what was the overall volume number was excluding extra work day?

Worthing F. Jackman

Well, we gave the data excluding the extra work day.

Corey Greendale - First Analysis Securities Corporation, Research Division

So the negative 2.4 is x?

Worthing F. Jackman

Yes. Everything is -- everything we've given you is adjusted for the work day.

Ronald J. Mittelstaedt

For the work day.

Corey Greendale - First Analysis Securities Corporation, Research Division

Okay, good. And just to give us a sense -- and I know you're not probably heavy -- you're not trying to massively predict what the economy is going to do, but just what you're assuming generally on the E&P front in the guidance as far as activity levels?

Worthing F. Jackman

Well, the guidance includes $250 million to $275 million of revenue from E&P activity. If you look at it kind of first half versus second half of the year, it's almost an inverse of what you saw in 2012, where 2012 was a very strong first half of the year and weaker second half of the year. Many folks in the E&P industry expected second half of '13 to be stronger than the first half of '13.

Corey Greendale - First Analysis Securities Corporation, Research Division

What was R360's revenues for the 2012 full year?

Worthing F. Jackman

About $275 million or so.

Corey Greendale - First Analysis Securities Corporation, Research Division

So you're assuming conservatively kind of flat or to maybe slightly down?

Worthing F. Jackman

Yes, we'll see how it plays out.

Operator

Our next question comes from the line of Al Kaschalk, Wedbush Securities.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Just to continue on, since we are all beating up on R360. Ron, could you maybe -- I know it's only been 4 months, but -- since you've closed it or approximately. Could you take a step back and just give us some of the -- your initial observations on the acquisition and maybe, some of the -- what it sounds like more plans for further M&A to leverage these assets?

Ronald J. Mittelstaedt

Yes. I mean, I don't think anything has really changed, Al. I mean, when we announced the acquisition, when we looked at it all throughout the summer and into early fourth quarter, I mean, R360 has, what we believe, is a very unique set of disposal and processing assets for predominantly oil-filled, but also natural gas waste. It is a business that is solid for 70% of the business and 30% is fluid. They have a leading position in 6 of the 7 major shale and petroleum-rich basins in the U.S. We believe their asset base is virtually impossible to replicate. There is a fairly high barriers to entry in most of the disposal market. They have a group of executives and personnel that understand the business better than anyone. And it is a business that, I think, over the next 5 years, grows at an organic growth of 8% to 12% a year, excluding any acquisition growth. It's going to be a $250 million to $300 million business this year. It's going to be a $450 million to $500 million business 5 years from now at a 50% EBITDA margin. So those were our thoughts going in. Those are still our thoughts. We don't get quite as hung up as everybody on this phone about a $25 million revenue shift in a high-margin business. It's not optimal, but this business has much greater organic growth characteristics than the MSW business will ever have. It's got more organic growth than the MSW business will have organically and externally. And so, would I want it to be 50% of our revenue mix, no. But I'm comfortable at 15% to 20% of our revenue mix because of the stability of the other 85% of our business and its predictability. So I think it augments our business very well. It's margin-accretive. Our operating margins are starting to exceed some public company's EBITDA margins. So I think, the business is a good business, but it comes along with volatility that is greater than MSW business that you've -- that we've all experienced.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

No, I appreciate the color. I guess, the one thing -- just trying to tease out, and part of this may be just inherent, particularly when you compare it to MSW. But it sounds like it's not the timing, or your adjustments are reflecting the inherent nature of the E&P market as opposed to anything -- a slowdown or concentration of -- in certain shale regions.

Worthing F. Jackman

Certainly. And then again, I think, we try to differentiate this as -- like, it has a period-to-period volatility within the P&L that might move GAAP EPS a $0.01 or $0.02, here and there. Is that important or is cash more important? And we point back to the strength of the cash flow in 2012 at 16-plus percent of revenue. The outlook again, for this year at over $300 million in free cash flow. I mean, that is -- that's across the strategy. And despite the volatility, the cash is there in the space.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

I appreciate that. And then one final -- just in terms of special waste trends, I know you talked a little bit about strong trends in '11 and '12. What's the underlying volume in here that's driving what we are -- what the company is calling special waste. I mean, is it commercial activity? Is it industrial activity? Is it more E&P-oriented waste? What's...

Ronald J. Mittelstaedt

No. It's more both commercial and industrial, Al. It is -- I mean, E&P excluding the R360 E&P, but -- the special waste, excuse me, that we categorized as special waste, is 95% contaminated slower mediation projects that occur generally due to either development, which would be on the commercial or the industrial side or clean-up activity and infrastructure expansion activity, such as river bottom dredging to increase ship canal depth, such as improvements for overpasses and tunnel systems for transportation where soil has to be remediated upon dig up. The -- with large jobs where freeways are redone on the West Coast, there's a lot of some of that going on right now. And that's soil, that concrete has to be either handled as special waste or remediated. So that's what is in that special waste strength.

Albert Leo Kaschalk - Wedbush Securities Inc., Research Division

Are you willing or have you shared percentage of your total volume -- special waste volumes?

Worthing F. Jackman

If you look at landfill, again, the average breakdown over the course of year is about 70% of the volume, by weight, is MSW, about 20% is special waste and 10% is C&D.

Operator

Our next question comes from the line of Adam Thalhimer, BB&T Capital Markets.

Adam R. Thalhimer - BB&T Capital Markets, Research Division

Are you seeing any improvement in municipal budgets that will make you think that the contract negotiations on that front would get any easier over time?

Ronald J. Mittelstaedt

No. No, they were as broke as they were last quarter.

Worthing F. Jackman

But again, it's not -- the nature of our contracts in the West Coast, they're not coming up for renegotiation year in, year out.

Adam R. Thalhimer - BB&T Capital Markets, Research Division

Right. And then on the margins in the quarter, I've hopped a little late, so sorry if I missed this, but what were pressure margins in Q4?

Worthing F. Jackman

Just what are pressure margins on a year-over-year basis or relative to what?

Adam R. Thalhimer - BB&T Capital Markets, Research Division

Well, I mean, margins were down year-over-year in Q4, but with R360, you'd think that might be higher, so...

Worthing F. Jackman

Yes, well, margins were up year-over-year, about 20 basis points, and that was our ability, as we said in the script, to offset about 200-basis-point impact since we lower recycling prices year-over-year and the loss of the volume at Chiquita Canyon. That's our landfill in the LA market. So again, had it not been for the contribution of acquisitions, you would've seen margins down year-over-year versus up year-over-year.

Adam R. Thalhimer - BB&T Capital Markets, Research Division

Okay. And then margin trajectory next year, it sounds like, again, kind of weak-ish in Q1 and then rising throughout the year.

Worthing F. Jackman

Right. Well, I mean, Q1, as you know, is always the seasonally weakest period for the business. As you look at the full-year outlook, we're basically guiding solid waste at about 31.5% to 32% on an EBITDA basis, and guiding E&P waste between 50% and 55% for the full year.

Adam R. Thalhimer - BB&T Capital Markets, Research Division

Got it. And then, on the -- with regards to the potential MLP conversion, I mean, really high-level, but could you kind of give us a sense for how that might impact EPS and cash flow?

Worthing F. Jackman

To -- no. Just like initial budgets, no. It's too early to tell. We've not -- as we said in the prepared remarks, we'll turn our attention to that at some point in time later in the year.

Ronald J. Mittelstaedt

Yes. Adam, it's all a function of what assets would be able to get into and qualify into that structure, how much revenue that will produce, how much earnings that would produce. Obviously, therefore, then you could calculate the tax benefit, what kind of overhead you're able to allocate, et cetera. It's -- there's way too many assumptions to make any reasonable estimate right now.

Worthing F. Jackman

And even Mike knows, it's not just net people need to focus on. I mean, as you move assets around, does that require municipal consent, yes or no? And that obviously, that's not a can of worms you want to open for a lot of assets. Now it's inter-company relationships between -- on disposal holding side. It's an assessment of what the stock equity is worth for the collection side of the business. So there are a lot of qualitative aspects, execution considerations that go into this, such as the math on -- with the EPS or that nature.

Operator

Our next question comes from the line of Joe Box, KeyBanc Capital Markets.

Joe Box - KeyBanc Capital Markets Inc., Research Division

Ron, just a clarification, and I apologize if I missed this earlier. But I think, you said that disposal volumes were up 1% in January? Was that including or excluding the lost customer in Madera?

Worthing F. Jackman

That was including.

Joe Box - KeyBanc Capital Markets Inc., Research Division

Including. Okay.

Worthing F. Jackman

Right. That's why we said, net of that, it was even stronger.

Joe Box - KeyBanc Capital Markets Inc., Research Division

Great. And then how has the growth change, I guess, so far in February, now that you guys have grandfathered your lost customer at Chiquita?

Worthing F. Jackman

Yes. As that closes in February, we'll let you know. I think it will be on April.

Ronald J. Mittelstaedt

Yes. A little too early to know yet, obviously. I mean, we're 20 days into it, or 21 now, but I would say there's been no change from January per se. Things have continued on that trajectory. So it would be north of 1% is what we would expect right now, excluding those items you said.

Joe Box - KeyBanc Capital Markets Inc., Research Division

Okay, fair enough. Just a high-level question for you in some of your competitive contracts. Historically, you guys have been able to push price annually. And I'm just curious if some of the contracts that have been signed over the last few years, if they include some of the same flexibility to push rates up or are there some, maybe, new restrictions that might limit the upside over the next few years?

Ronald J. Mittelstaedt

No. There really has not been any change to our ability to increase rates on an annual basis in our contracts. Again, I think that's why you're seeing us guide '13 at pricing that is effectively at were '12 was, at 3% or so. So if there had been, you would be seeing it in our pricing. So the answer is no. Sometimes you trade off a contract extension and you give -- and you get greater time on your contract maybe for a flat price in that year or even a reduction in the current year. But I would say rarely do we or really anyone in the industry, from the public standpoint, give up or forgo their ability to increase in outyears.

Joe Box - KeyBanc Capital Markets Inc., Research Division

Okay, great. That's helpful. Maybe switching gears to the E&P side. It sounds like there's some level of improvement that's baked into the guidance. I'm just curious, if you don't see a reacceleration in rig count, what could E&P revenues and EBITDA margins look like relative to your guidance?

Worthing F. Jackman

Again, we will see how the year plays out and provide periodic updates.

Operator

The next question comes from the line of Alex Ovshey, Goldman Sachs.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

For your solid waste pricing. Can you talk about what the impact of CPI will be in '13 relative to what it was 2012?

Ronald J. Mittelstaedt

Yes. CPI, we are running between 1.8% and 2.2%. That is down about 20 basis points from 2012.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

And on the E&P revenue outlook. Are you guys implicitly baking in an assumption for a change in rig count and then you'll feed drilled for '13 relative to '12?

Worthing F. Jackman

We try to bake in like we baked in solid waste, some seasonal improvements in the business, as well as an overall sector assumption. But again, as you're coming out of a slower start to the year, that activity will increase in certain areas.

Alex Ovshey Ovshey - Goldman Sachs Group Inc., Research Division

That will work. And last question. Did you guys say what your C&D volumes were up in January 2013?

Worthing F. Jackman

We didn't.

Ronald J. Mittelstaedt

We didn't, but give us one sec, Alex.

Worthing F. Jackman

So C&D was up about 11% in January at the landfill.

Operator

Our next question comes from the line of Michael Hoffman, Wunderlich Securities.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Just to be clear on E&P. I mean, the upstream cap spending estimates in the market are -- it's -- will be down the first half up and the second half, flat year-over-year. But the activity level, say, for instance, in that Bakken x to weather, the rig count might be down, but they're still drilling about 185 to 200 holes a month. So it's the activity level of permits that's actually more relevant at this point.

Worthing F. Jackman

Well, in the Bakken, it's also a look at whether or not the state will get more aggressive and proactive in enforcing open-pit rules. You've got -- you still have, right now, close to 70% of rig that are being rigged out there that are used in open-pit disposals.

Ronald J. Mittelstaedt

Yes, Michael, from Q3 of '12 through the projected Q1 of '13, there has been an increase from open pits from going from 55% of rigs in Q3 to 70% of rigs in Q1. Well, effectively, you've lost, if all rigs drill equally, 15% of linear foot drilled in the Bakken just due to regulation of non-enforcement.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Okay. And the same thing, I mean, in Oklahoma, for instance, there's a huge amount of permits that have been issued. They only land farm, they don't do pits and tons, and there's not enough acreage to land farm the number of permits that have been issued for drilling.

Worthing F. Jackman

Right. And in Oklahoma, we're still waiting for the rigs to move into the market. There's high expectations that they will start moving in January, but that got pushed to March and April, and so we're just waiting to see if that timing pans out.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Right. So that's not in your guidance, for instance?

Worthing F. Jackman

Right.

Michael E. Hoffman - Wunderlich Securities Inc., Research Division

Okay. So that -- those are the points to leverages that there's a lot of permits issued in Oklahoma, there's a lot of conversion from vertical to horizontal drilling going on in the Permian, so it would just increase the level of activity of volume. So that -- none of that is in your $250 million to $275 million?

Worthing F. Jackman

Well, the key drivers to any ramp the business is going to be again, the increased drilling in Oklahoma, increases that we're starting to see in Gulf of Mexico, any increase we can get back on-shore in Louisiana, and look back at the Bakken with regards to how the Bakken enforces or not reserved pits.

Operator

Our next question comes from Barbara Noverini, Morningstar.

Barbara Noverini - Morningstar Inc., Research Division

Would you be willing to share what percent of the R360 waste is internalized towards your existing asset base? Or maybe I should ask, will the 2 new permits you're waiting for substantially improve that internalization rates?

Worthing F. Jackman

Yes. I think, it's less of a discussion of internalization, as we think about it. I mean the way we look at it is, how much E&P waste are we generating or we're receiving really at our other landfills, our traditional MSW landfill or industrial waste landfill. Again, that was running last year between $20 million and $25 million for the full year. And internalization is really a metric about how much waste on your own trucks are you putting into your own disposal sites. And again, in E&P waste, very little of the trucking is done in-house. A lot of that is done by third parties.

Operator

[Operator Instructions] And at this time, there are no further questions.

Ronald J. Mittelstaedt

Okay. Well, if there are no further questions, on behalf of our entire management team, we appreciate your listening to and interest in the call today. Worthing, Marianne, Steve and I will be here today to answer any direct questions that we did not cover that we are allowed to answer under Regulation FD and Regulation G. Thank you, again. We look forward to speaking with you at our upcoming investor conference or our next earnings call.

Operator

Ladies and gentlemen, that concludes the presentation. Thank you for your participation. You may now disconnect. Have a great day.

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