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Executives

Ronald J. Mittelstaedt - Chairman and Chief Executive Officer

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

Analysts

Scott Levine - JPMorgan Chase

Justin Maurer – Lord Abbett

Hamzah Mazari - Credit Suisse

Joe Ritchie - Goldman Sachs

Michael E. Hoffman - Wunderlich Securities

Adam R. Thalhimer - BB&T Capital Markets

Al Kaschalk – Wedbush Securities

Corey Greendale - First Analysis Securities

Tony Bancroft – Gabelli & Company

Waste Connections, Inc. (WCN) Q2 2012 Earnings Call July 24, 2012 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2012 Waste Connections earnings conference call. My name is Deanna, and I'll be the operator for today. At this time all participants are in a listen-only mode. Later we will conduct a question and answer session. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to host, Ron Mittelstaedt, Chief Executive Officer. 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 second quarter 2012 results and provide a detailed outlook for the third quarter as well as few updates for the full year.

I'm joined this morning in by Steve Bouck, our President; Worthing Jackman, our CFO; and several other members of both our corporate and region senior management team.

As noted in our earnings release, the first half of the year has played out about as expected as revenue, adjusted EBITDA, and adjusted free cash flow tracked within or ahead of our expectations. In the recent quarter, revenue slightly exceeded our outlook and adjusted EBITDA hit the midpoint of our guidance. More importantly, we have now delivered almost 60% of our full year free cash flow guidance for the year.

Year-over-year margin comparisons are difficult. As expected due primarily to decreases in recycled commodity values and our decision to turn away lower price disposal volumes at our Chiquita Canyon landfill. And as we've been communicating for the past several months, these negative comparisons should be most pronounced during the third quarter.

Likewise, year-over-year EPS comparisons are impacted by the negative drag from the increase share count resulting from our equity offering earlier this year. This drive will continue until that capital is deployed. With this year fairly well dialed in, we are focusing on the unknown. More specifically, to what extent, to a tepid economy, and further decreases in commodity values cause additional margin and volume headwind and what might be the timing of our capital deployment for acquisitions or share repurchases.

Industry and investor dialogue more recently has focused on a volume-less recovery and potential increasing price competitive emphasis and churn rate, especially in urban markets. We believe our results in this environment once again highlight the benefits of our differentiated strategy and disciplined deployment of capital.

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

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, including statements related to expected volume and pricing trends, recycled commodity values, expectations regarding period-to-period comparisons, potential acquisition activity, share repurchases, the impact of the relocation of the Company's corporate headquarters from California to Texas, comparative results among our regions, and our third quarter and full year 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. 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 will discuss non-GAAP measures, such as adjusted operating income before depreciation and amortization, adjusted net income and adjust net income per diluted share, adjusted free cash flow. Please refer to our earnings release for a reconciliation of such non-GAAP measures to the most comparable GAAP measure. Management uses certain non-GAAP measures to evaluate and monitor the ongoing financial performance of our operations. Other companies may calculate these non-GAAP measures differently. Now I'll turn the call back over to Ron.

Ronald J. Mittelstaedt

Okay. Thank you, Worthing. As noted earlier, revenue in the second quarter slightly exceeded our expectations. Revenue was $410.7 million, up 5.3% over the prior-year period. Internal growth in the quarter was a -0.2%, broken down as follows: +3.0% from core price; -2.2% volumes; -1% from recycling, intermodal and other services; and surcharges were flat. With the vast majority of price increases already implemented core price for the balance of the year should remain around 3%, and surcharges should be flat at current fuel prices. This strong core pricing has thus far offset the dollar impact from year-over-year declines in recycled commodity values, and our turning away of lower priced disposal volumes at Chiquita Canyon.

Volume growth in Q2 was -2.2%, or slightly ahead of the midpoint of our -2%-2.5% outlook for the quarter, due to nominally better-than-expected special waste and exploration and production, or E&P disposal volumes. As expected the negative volumes were due primarily to three factors, which accounted for over half of this volume loss. Our decision to turn away lower price volumes at our Chiquita Canyon landfill, tougher year-over-year comps for special waste jobs, and increasing competitiveness within our more urban-like markets of Denver and Houston. This third factor while only affecting a small percentage of our markets reminds us of the benefits of our exclusive and our secondary market focus.

From a macro standpoint, the necessary drivers for volume growth are increased consumption, increased construction activity, household formation, and new business starts. All of which are disappointing at this stage of the recovery. This tepid economy has made us a little more cautious on our volume outlook for the second half of the year.

Changes in special waste activity will be the most notable driver of volume decreases in the second half of the year, especially in Q3. We are expecting a sequential decline in such activity Q2 to Q3, which contrasts with the more typical seasonal ramp normally expected between those periods. This is exacerbated this year by the fact that we're comping a record amount of special waste activity in last year's third quarter.

In the upcoming quarter, we expect this year-over-year decrease in special waste activity together with lower volumes at Chiquita Canyon landfill to contribute a -2.5% to reported volume growth. Given the economy, volume growth within our base business continues to be fairly stable at between approximately a -0.5 to a -1%. As a result, we believe volume growth on a dollar basis could be between -3% and -3.5% in Q3 and then improve to about -2% in Q4.

Disposal volumes on a tonnage basis in the second quarter adjusted for the impact of acquisitions were down about 1% year-over-year as nominal increases in special, E&P, and construction related volumes were more than offset by reductions in MSW volumes. Special waste and E&P Volumes increased 10% year-over-year with 50% of landfills reporting year-over-year increases in special waste volumes. Construction related volumes increased about 11% compared to the year ago period with only 40% of landfills reporting increased C&D volumes. Construction activity remains spotty.

MSW disposal volumes were down 7% primarily due to our turning away of lower priced disposal volumes at our Chiquita Canyon Landfill. As noted throughout the year rather than chase prices down and consume Chiquita Canyon airspace at lower prices, we have made the decision to hold the line on our prices in the short term as we expect a significant increase in market pricing on the LA Basin once Puente Hills closes on October 31st, 2013. Overall, about 60% of our landfills reported year-over-year increases in MSW volumes.

Roll off pulls per say in the second quarter were down about 1% year-over-year on a same-store basis. But revenue per pull more than offset this increasing 2%. All three regions reported increases revenue per pull per day. But only our central region reported increased pulls per day. We believe the comparative improvement within our central region is due to stronger local economies in that region tied to the oil and gas industry.

Internal growth in the quarter from recycling, intermodal and other services was a -1%, primarily due to year-over-year decreases in recycled commodity values. Proceeds from the sale of recycled commodities in the second quarter were 4.8% of consolidated revenue, down from 6.1% in prior year period. This translates into a 4.3 million or 18% year-over-year decrease in such revenue on a dollar basis and at very high margins.

Prices for OCC or Old Corrugated Containers averaged about $155 per ton during the second quarter, down about 22% from the year-ago period and down 7% sequentially from Q1. Prices declined over the course of Q2 and further in early Q3 and currently average about $135 per ton, or a little more than 30% below the epic high of $197 per ton we average in the third quarter of 2011.

At current prices we believe this translates into almost 7.5 million year-over-year decrease in such revenue on a dollar basis in the third quarter, or about $3 million higher reduction year-over-year than we experienced in Q2. As a reminder, each $10 move in OCC prices is between a 25-30 basis point impact to margins and a little more than a half of a penny impact to EPS per quarter.

Looking at acquisition activity. We are pleased to announce the acquisition on July 1st of SKB Environmental, a leading provider of solid and industrial waste transfer and disposal services, primarily in Minnesota's Twin Cities region. With annual revenue of approximate $30 million, we believe SKB provides an attractive platform for entering into this market, given the large number of complementary, privately owned collection companies in that region.

In June, we also completed a $5 million revenue tuck-in in Louisiana near Alexandria. Although the amount of potential acquisition under active dialogue remains very high, our disciplined approach to market selection and valuation remains unchanged. While we expect the pace of acquisition activity could remain strong over the next 18 to 24 months, the strength of our free cash flow and balance sheet enables us to fund our growth strategy and increase the return of capital to stockholders.

As such we have resumed our share repurchase program targeting to buy-back between 4% and 5% of outstanding shares annually and would expect to maintain that pace of buy-backs unless we though acquisition cash outlays within each 12 month-month period might significantly increase.

And now, I'd like to pass the call to Worthing to review more in depth the highlights of the second quarter and provide a detailed outlook for Q3 2012. I will then provide an update on expected full year results in my closing remarks.

Worthing F. Jackman

Thank you, Ron. In the second quarter, revenue increased 5.3% from the prior year period to $410.7 million, 5.5% of which from acquisitions and -0.2% from organic growth. Adjusted operating income for depreciation and amortization in the quarter is reconciled in our earnings release, increased 2.7% to $131.5 million.

As the percentage of revenue, this was 32%, or about 80 basis points below the year-ago period. Year-over-year, we estimate that about 55 basis points of this 80 basis point margin decrease was attributable to lower recycled commodity values.

On a reported basis, the following are certain line items that moved a notable amount from the year-ago period as a percentage of revenue:

Tires, repairs, and maintenance increased 50 basis points. Insurance expense increased 35 basis points. Labor expense increased 25 basis points. Leachate expense increased 20 basis points, and facilities and other property costs also increased 20 basis points. Almost half of these increases is percentages of revenue were offset by 35 basis point in decrease in fuel expense, a 35 basis point decrease in SG&A expense on lower incentive based compensation and a 25 basis point reduction in third-party disposal, transfer, taxes, and pass through expenses. Regarding fuel, which is almost 6.4% of revenue in the quarter, we average approximately $3.52 per gallon for diesel in Q2, or about $0.10 a gallon below the year-ago period.

As a reminder, adjusted results for the period exclude cost associated with the relocation of our corporate headquarters from California to Texas and acquisition related expenses. These costs, which are all reflected in SG&A totaled 3.4 million in the current year period. We now believe our total relocation costs excluding any charge for the write off of our prior office lease, could be closer to $10 million rather than the $15 million we had originally estimated. We have benefited from a combination of lower than expected losses on the sale of employee houses and moving expenses.

Depreciation and amortization expenses for the second quarter increased $3.5 million year-over-year. As expected, D&A increased 11.2% of revenue, or up 30 basis points year-over-year.

Net interest expense in the quarter was $12.7 million, or about $700,000 above the prior-year period. This increase was primarily due to increased borrowings spreads associated with the July 2011 refinancing of our credit facility, offset somewhat by lower outstanding debt balances.

Debt outstanding increased almost $100 million during Q2 to $982 million, net debt, or debt less cash decreased about $35 million as we ended the quarter with about $136 million of cash on the balance sheet. A portion of this cash was used to fund the SKB acquisition on July 1st. Our leverage ratio, as defined in our credit facility, was about 1.9x debt-to-EBITDA. We do not get credit in out leveraged ratio calculation for cash balances.

Our effective tax rate for the quarter was 39.2% consistent with our outlook. Our fully diluted outstanding share count for Q2 was 124 million shares, an increase of about 10 million shares from the year ago period due to the impact of the equity offering earlier this year, somewhat offset by share repurchases since the year ago period.

As Ron noted earlier, we resumed our share repurchase program buying back about 200,000 shares in late June and targeting the repurchase of about 4% and 5% of outstanding shares per atom [ph].

GAAP EPS in the second quarter was $0.34 and adjusted EPS was $0.36 down $0.03 compared to the year-ago period almost fully due to the increased share count. The increased share count will continue to impact year-over-year EPS comparisons until the excess capital is deployed.

Free cash flow through June $148.3 million or 18.8% of revenue. We remain on target for our original $250 million to $260 million outlook for the full year.

I will now review our out look for the third quarter of 2012. 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 and our various SEC filings. We encourage investors to review these factors carefully. Our outlook assumes no change in the current economic environment or commodity values and excludes the impact of any additional acquisitions that may close during the period and expensing of acquisition-related transaction costs, as well as costs incurred in connection with the relocation of the Company's corporate headquarters in California to Texas.

Looking first at revenue. Revenue in the second quarter is estimated to be between $422 million and $424 million, up almost 5% over Q3 2011. Organic growth is estimated to be between -0.2% and -2.5%, with the components as follows: Net price of about 3%; volume growth between -3% and -3.5%; and recycling intermodal and other around -2%. With estimated organic growth of -2%-2.5%, Q3 should posed our most difficult year-over-year comparisons for the reasons Ron noted earlier. Special waste, Chiquita Canyon, and epic high recycled commodity values last year.

We expect volume growth to improve sequentially to -2% in Q4 and recycling and other to improve to about -0.5% at commodity values. This would be a combined 50% improvement in those two line items from expected Q3 levels.

Operating income, before depreciation and amortization and accretion for Q3 is estimated to be between $136 million and $137 million, reflecting a margin of almost 32.3%. Some of the more typical sequential margin improvement from Q2 to Q3 is assumed to be offset by lower recycled commodity values in Q3 compared to Q2.

Depreciation and amortization for the third quarter is estimated to be about 11.4% of revenue. This increase from Q2 as a percentage of revenue was attributed to higher D&A associated with purchase accounting for the SKB transaction.

Operating income for the third quarter is estimated to be about 20.9% of revenue. Net interest expense in Q3 is estimated to be about $11.8 million. Our effective tax rate in Q3 is estimated to be about 38%, slightly lower than our typical 39.2% due to certain credits expected in conjunction with the tax return filings during this upcoming quarter.

Non-controlling interest is expected to reduce that income by about $275,000. And, finally, our diluted share count at Q3 is assumed to be 123.8 million shares, excluding the impact of any share repurchases that may occur during the quarter.

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

Ronald Mittelstaedt

Okay. Thank you, Worthing. Again, we are pleased with our results in the first half of 2012, but are now more cautious about the remainder of the year given the increasingly challenged economic environment.

The good news is we have strong visibility on core pricing growth and free cash flow for the year and recently completed acquisitions more than offset any potential softening in volumes. As such, we expect full year revenue to be between $1.62 billion and $1.625 billion, a $5 million to $10 million increase over our original outlook for the year.

Adjusted operating income before depreciation, amortization and accretion is estimated to be about 31.8% of revenue for the full year reflecting current commodity values. And as noted earlier, free cash flow remains on target to be between $250 million and $260 million. Additional acquisitions or any improvement in the economy or recycle commodity values would provide upside to these estimates and/or platforms for growth in the upcoming years.

We appreciate your time today and will now turn this call over to the operator to open up the lines for your questions. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And the first question comes from the line of Scott Levine, JP Morgan.

Scott Levine - JP Morgan Chase

Hi, good morning, guys.

Worthing F. Jackman

Hi, good morning.

Ronald Mittelstaedt

Good morning.

Scott Levine - JP Morgan Chase

So, it sounds like incrementally caught more cautious tone with regard to the cyclical and the volume outlook in general, however, it sounds like most of the incremental weaknesses in the special waste area, which we also thought... you know, used to thinking of as project-driven and lumpy. If you could characterize or maybe separate the general macro environment you're seeing and how much incremental weakness you might be seeing there versus the special waste activity.

And then follow-up, is this special waste driven more by commercial real estate pulling back or pull back on government-sponsored projects? Additional color there.

Ronald Mittelstaedt

Yeah. Okay, Scott. Let's see. First off there's two components to the special waste that are causing a year-over-year decline. One is just purely very good comps in last year's Q3 and a record amount of special waste. As you saw, we gave Q4 preliminary volume guidance and it was almost twice as good, if you will, as the third quarter guidance we just gave and special waste in Q4 is really at one of the worst times.

So, part of it is just a comp issues, but the second part of it is that we're seeing more hold up on the government projects that we were seeing really flow in 2011, that latter part of '10 and even the beginning of '12, both federal, state and local. We're just seeing those sort of come... kind of a slowdown. In many cases they're being deferred for some period of time due to predominately budgetary constraints. So, that's where we are in the special waste.

We would tell you that our view was is that we were seeing a pretty nominal but steady improvement sort of each quarter of 2011 as we marched along and the first quarter of 2012 and beginning in about June things seemed to slow down and not uptick seasonally the way we've traditionally seen and that has continued into July. Now that is geographic. That is not across the board. What we're seeing is that the mid west down into the panhandle and into Texas remains very strong and that is driven really by oil and gas and MP activity driving the economies there. We're seeing low unemployment there. But when we get either east or west of that, west of the Rockies or really sort of east of Nebraska, what we see is that things are slowing in those areas, nominally, but they're slowing and we just didn't see our normal seasonal uptick.

So, again, if you take, as we said in our commentary, if you take special waste out we're seeing roughly a flat environment. We categorized that as sort of negative -.5 to -1, but the reality is between -1 and positive 1. That's only an $8 million swing in a quarter or $30 million in the year. So we would call that on $1.62 billion, we would call that flat, $30 million either direction. So that's what we're seeing right now.

Scott Levine - JP Morgan Chase

Got it. One follow-up on cash deployment. So, another good quarter here. Like you say you're keeping full year guidance despite running at 60% of that target in the first half and your leverage. You're obviously following the secondary. It seems like your conditioning us to expect a typical bye-back cadence. Why not accelerate maybe the deployment and/or you're expecting an abnormally high level of M&A activity given what you see in the deal pipeline there.

Ronald Mittelstaedt

Well, I think there's three answers to that, Scott. I mean, number one, we are still cautiously optimistic that we are going to see accelerated deal pace over the next 18 months based on what we're seeing in our pipeline right now. We've always said that our first and best use of cash and leverage is on appropriately priced strategic acquisitions.

I think, secondly, we don't know what the ongoing weakness in the economy between now and the election is going to bring and whether or not there's going to be just an overall weak market as people sort of hunker down. And, thirdly, it seems like there's number of larger announcements in the sector going on that could affect this sector.

So, as we look at those three things, we think its prudent to be paced rather than really and paced and opportunistic in a buy-back rather than necessarily aggressive immediately without knowing sort of the lay of the land over the next two to four months.

Scott Levine - JP Morgan Chase

Got it. Makes sense. Thanks.

Operator

Your next question comes from the line of Hamzah Mazari, Credit Suisse.

Hamzah Mazari - Credit Suisse

Good morning. Thank you. On the commercial side of your business, maybe if you could just talk about what your seeing in new versus lost business, service increases versus decreases. Did that business get incrementally worse for you as the quarter went on and into July or is that still just very flat?

Ronald Mittelstaedt

Yeah, Hamzah, I would say that it did not necessarily get incrementally worse in the quarter, but it's flat and the spread of decreases to increases is really not closing. It was closing and then as we've looked at the last two quarters that gap has sort of flattened out at about what it was last year. And the same thing with new business activity compared to closed businesses and lost business activity. That gap is just not incrementally improving in Q2 or the latter half of Q1 and the beginning of Q3 the way it had been. So it didn't get worse, but we didn't see the gap continue to close the way it had been.

Hamzah Mazari - Credit Suisse

Okay. That's fair enough. And then maybe if you could comment on, you know, you spoke about the acquisition pipeline, the Veolia asset deal is pretty much off the table. You spoke of being more aggressive on buy-backs. Maybe if you could just talk about in your pipeline what is the ratio of large assets like Harold LeMay versus small assets.

Ronald Mittelstaedt

Well, I would tell you that we have two or three, again, by our model, fairly large acquisitions and I would characterize those a couple hundred million in annual revenue or better. So, that was the approximate size of the LeMay group and we have two or three of those that we are pretty active discussions with right now. And, then, the balances are typical transactions, which have tuck-ins ranging from $1 million to $5 million and sort of standalone and new market entries of $10 million to $30 million much like we just announced today with SKB and a tuck-in in Louisiana that was $5 million. So we've got a smattering of those as well as a few larger fish.

Hamzah Mazari - Credit Suisse

Great. Just last question and I'll turn it over. On franchise versus competitive pricing, if you could just tell us what that's running and what to expect to be your guidance.

Ronald Mittelstaedt

Yeah, we're still running about the same, Hamzah. We're running between really about 2% and 2.2%. We have had a few larger recent franchise increases, where in some smaller markets there was a higher CPI, but if you use 2% to 2.2% that's a very good number of what we're running and then we're running about almost 4%, if you will, in our competitive and that's with a 52/48 blend between franchise and competitive. That's how you get to that mix of right at 3%.

Hamzah Mazari - Credit Suisse

Great. Thanks a lot.

Operator

Your next question comes from the line of Joe Ritchie, Goldman Sachs.

Joe Ritchie - Goldman Sachs

Good morning, everyone.

Worthing F. Jackman

Thank you. Good morning.

Ronald Mittelstaedt

Good morning, Joe.

Joe Ritchie - Goldman Sachs

Just following up on that pricing question, you're getting 4% in your competitive markets. Can you talk a little bit more, provide some anecdotal evidence on what your stating in your really urban competitive markets? You mentioned both Houston and Denver in your prepared comments. Like to hear how those markets are progressing.

Ronald Mittelstaedt

Well, again, as you know in our business model we have a fairly nominal amount of what we would categorize as urban exposure just based on model design. I mean Houston and Denver were both parts of larger divested acquisitions that came along when we did those divestitures and we've made a run at those markets.

I would tell you the pricing is quite different. I mean you think see that when waste and republic both report every quarter. In those markets we attempt to go out after a 4% type price, but the churn in those markets is dramatically higher. Churn in those markets is probably four times what the churn is in our typical secondary market.

So that's estimating that the churn in those markets is probably between 25% and 30%, whereas in our markets we see more of a 6% to 10% churn. So, your net pricing doesn't end up being close to 4%. Your net pricing probably ends up closer to that 1% to 2%., which is, I think, what you've been seeing out of a larger urban-centered company. So we're certainly not doing better than that in our urban-centered markets.

Joe Ritchie - Goldman Sachs

That's helpful color and I know that you don't come up against Waste Management and RSG in most of your markets, but today in the markets that you do compete against them, are you seeing them getting more competitive? What's the trend been over the last three months?

Ronald Mittelstaedt

No, I'd say that's been pretty stable. I mean, again, we're not a great barometer for either Waste Management or Republic. I'll remind you that we have about 20% revenue overlap with Waste Management and less than 10% overlap with Republic and those 10% and 20% are in the same geographies for the most part. So, again, an 85% plus of our revenue we don't compete with them, so we're not a great barometer.

But where we do, again, we find that predominately the smaller private independents are the ones who are pursuing market share more aggressively and I would say that the larger public companies tend to be a lot more price disciplined overall than the privates.

Joe Ritchie - Goldman Sachs

Okay. Great. And I've got one more question on M&A. Can you provide some color on what you pay for the STP acquisition. The EBITDA margins for that business. And, then, also, I think you mentioned in the last call that there was potential for two privatization opportunities by the end of 2012. Any update there would be great.

Ronald Mittelstaedt

Sure. Well, we're not, right now, just due to the confidentiality of it, we're not providing any of the details, but on SKB or specifics. But here's what I can tell you, if you assume we paid roughly 6.5 to 7 times EBITDA for this transaction and that it's margins are at our corporate average or slightly better and we gave your the $30 million revenue, you'll get to a number that's very close to the purchase price.

Secondly, with regard to the two privatization opportunities, both are proceeding. We are in the midst of both. They are moving as privatizations often do, fairly glacially, but they are proceeding and we are in the midst of both of them.

Joe Ritchie - Goldman Sachs

Okay. Thanks for taking my questions.

Ronald Mittelstaedt

Yes.

Operator

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

Michael Hoffman - Wunderlich Securities

Hi, good morning and thank you for taking my question. Can you share with us, given the current business environment you’re looking at, how would you frame your outlook in 2013?

Ronald Mittelstaedt

You know, Michael, I would tell you that we're cautious. We feel that right now you would see roughly flat volumes. You would see commodity pricing that, if it stayed at current, fairly nominally down. You should see pricing that is approximately at what pricing this year was, maybe down a little bit due to weaker CPI if the economy remains in this condition. And I think you would see surcharges roughly flat.

So I would say that you get some benefit from comps next year, Michael, and so it looks a little better, but I would describe it as roughly flat volume with reasonable pricing. Not to mention this, but it has a lot to do with what happens in November. I really do. I just think that will affect sentiment in either direction. Right now you just have, in the business community, I don't think it's the waste industry. You're seeing it through all consumer manufacturers. You're seeing it through retailers. You're just seeing sort of a weak to floating along business sentiment that's going on due to really uncertainty at the federal and many state levels.

Michael Hoffman - Wunderlich Securities

Okay. And, then, with regards to the deal pipeline, are the pace of the conversion, has it been impacted by just the capital gains delay, potential delay, or are people on the sidelines waiting to see what the pricing came out on DOE as well?

Ronald Mittelstaedt

In the larger ones I think that they were certainly waiting to see what happened with a fairly visible and public Veolia. The smaller ones I don't think they really have the leverage to do that, but larger ones do. I would say the following; I think people are looking at that. I think in some cases some of the things we're looking, people were looking at the public markets and wondering whether they could possibly access capital through that. And that's been extremely volatile and there really hasn't been a "IPO" market of late, maybe for some technology companies only.

And, then, I think people are wondering whether the tax cuts are going to be extended past January 1 perhaps to January 1 of '14 and do they have a longer window. So, I think it's just, again, uncertainty breeds conservatism and you're hearing that from us and I think we're hearing that from potential sellers.

Michael Hoffman - Wunderlich Securities

And have you thought the combination of those, does the tax cut one weigh more heavily on lots of your small ones and so, theoretically, in '13 the pace should pick up since everybody agrees it's going up, it's just when?

Ronald Mittelstaedt

Yeah, I think, certainly without question, the largest impact on the smaller deals is capital gains tax rates and state capital gains rates. I mean if you look at a state like California, remember their state income tax at 10% is applicable to capital, as well, and it's going to a vote of 13.3. So it's not just the federal rates.

Michael Hoffman - Wunderlich Securities

Okay. Thank you very much.

Ronald Mittelstaedt

Yep.

Operator

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

Albert Kaschalk - Wedbush Securities

Good morning.

Worthing Jackman

Good morning, Al.

Ronald Mittelstaedt

Good morning, Al.

Albert Kaschalk - Wedbush Securities

Just a couple of broader questions if I may to the team here. First, and I realize it's a small percentage, but on Houston and Denver, are there strategic reasons you may need to stay there in terms of the urban market benefit? In other words, shifting or sharing volume. Maybe if you could just talk a little bit about that.

Ronald Mittelstaedt

No. I mean, number one, there are not strategic reasons that we need to stay there or we need to stay anywhere necessarily. We look at every asset and mark it individually. I think it's important to understand how that saying that a market like a Denver or a Houston does not perform as well or has more competitiveness than our more traditional market does not mean our performance in that market is not acceptable, whether is be on a return on capital basis or a margin basis or anything. I think that's a critical differentiation.

Yes, they may not be at our corporate integrated margins, but they're still better than most.

Worthing Jackman

Yeah, what you find is the most competitive fees in those market, the residential, and we're primarily a commercial and (inaudible) company.

Ronald Mittelstaedt

In those two markets.

Worthing Jackman

So you can define a strategy within that kind of environment and make an attractive asset positioning and attractive returns.

Ronald Mittelstaedt

But it is, without question, more volatile.

Albert Kaschalk - Wedbush Securities

Okay. Does that imply or maybe you kind of said it, I'm a little slow here this morning, but that the ROIC and those markets may be lower than corporate average or lower than some of the other areas?

Ronald Mittelstaedt

No, I don't think it does implies that. Remember, I mean, you can have lower margins and it depends what your input cost on the capital side is and in many cases, to give you an idea such as Denver, our input value was substantially lower than our corporate average. So you can have adequate or equal ROICs in those markets depending on what your input value was going in.

Albert Kaschalk - Wedbush Securities

Okay. And, then, just a follow-up I think to how much you made in the past in trying to triangulate here with the volumes and the recycling and the other on the new guidance, so to speak. You had talked about the competitor ripping out some volumes as related to the Oak Leaf acquisition they did. Is that now fully incorporated in these numbers and is there any way to try to maybe isolate how much of the decline on your forecasting is in large part that?

Ronald Mittelstaedt

Very good question, Al. Number one, the forecast does not include any of the potential Oak Leaf volumes that Waste Management may internalize to themselves at some point. It does not include any of that. Now, having said that, approximately 40% to 45% of those volumes that we thought we could lose we have negotiated contract extensions and swaps and other types of arrangements to retain in many of the markets the Oak Leaf volumes on a go-forward basis.

So the potential number has been virtually cut in half from what we started at. Not quite. And there are still some ongoing negotiations about some potential other markets. So, maybe that number gets to (inaudible) maybe a little north. But that is not incorporated because we do not yet know when, specifically, they will choose to internalize those volumes.

Albert Kaschalk - Wedbush Securities

So, in other words, if they decide to internalize it, you could be at a spot where that down 2% is down a little bit further?

Ronald Mittelstaedt

Yes is the answer to that, but that number would not be a full percent, but it could be a half a percent in a quarter. If the remainder of what they had maybe decide tomorrow to, "Hey, we're going to internalize this volume."

Albert Kaschalk - Wedbush Securities

Okay. And do you expect to hear or do you have a window of time you expect an update or are you just kind of... every day is a different day and you never know until that day?

Ronald Mittelstaedt

No, we've had some ongoing scheduled discussions and we should know at some point in August what is the schedule that they plan to take over those customers or which of those they plan to take over and I would expect that to occur either in September or October if it's going to happen. So, the impact in the third would be de minimis because we'd be talking about less than a million or so dollars in the quarter, but then we would have it so that we could talk about what it is in the fourth quarter.

Albert Kaschalk - Wedbush Securities

Okay. Thanks a lot, Al. I'll get back in queue.

Operator

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

Adam Thalhimer - BB&T Capital Markets

Hi. Good morning, guys.

Worthing Jackman

Hey. Good morning.

Adam Thalhimer - BB&T Capital Markets

Have you seen any change in the competitive environment for new franchise contracts?

Ronald Mittelstaedt

Well, I mean, that's a... there really are not new franchise contracts. What the franchises are very long term by description and we really don't see them turn over. They're predominately acquired through private companies and so we see very minimal amount of turn in them.

Now, municipal contracts, which are component of our exclusive revenue and are what many companies call franchises. That's not what we call franchises. I mean, municipal contracts tend to be sort of five to seven years in nature. They go out for bid about 70% to 80% of the time at the expiration. They tend to be highly competitive. Now that is about a third of what we call exclusive revenue. It's a large part of what the other companies define as exclusive revenue, such as Republic, as an example.

The competitive nature of those has been very high of late. We are seeing that, for the most part on those, whether, almost irrespective of whether it's a public or a private provider that they are rebidding those down in price between 1% and 25% to retain them. So, yes, the environment for the renewal or the bid of municipal contracts I categorize as highly competitive in what is sort of a volume less recovery.

Adam Thalhimer - BB&T Capital Markets

And you think about those municipals contracts as about a third of your franchise revenue.

Ronald Mittelstaedt

Yeah, what we call our exclusive revenue. So if that's 52%, call it at roughly a third of 52.

Adam Thalhimer - BB&T Capital Markets

Got it. Okay. And, then, on the construction environment more broadly, you described as spotty. Where are you seeing strength? Where are you seeing weakness in construction?

Ronald Mittelstaedt

Well, the west coast continues to be extremely weak. In fact, California went backwards in Q2 year-over-year and it just continues to be woefully weak across the board in construction in California. The Pacific Northwest has been very spotty at best. I'd categorize it as stable, but also still fairly weak. And we saw some weakness in the parts of the northeast that we are in, which is sort of upstate New York and then we saw strength really throughout the mid west. I mean everywhere that there is exploration and production activity going on, which is the Dakotas through Montana down through Colorado, Oklahoma, Nebraska, Iowa, Oklahoma, Kansas, Texas, we saw strength, and Louisiana and Mississippi. Very strong for us in roll-off activity and other.

And, then, our new market entry into Alaska is also very strong. Again, a large exploration of production market area. So, that's what we've seen.

Questioner

Okay, that's good color. Thanks, Ron.

Operator

The next question comes from the line of Corey Greendale, First Analysis.

Corey Greendale - First Analysis Securities

Hi, good morning.

Ronald Mittelstaedt

Hi, Corey, how are you doing?

Worthing Jackman

Hi, Corey.

Corey Greendale - First Analysis Securities

Good, how are you?

Ronald Mittelstaedt

Good.

Corey Greendale - First Analysis Securities

Just a couple quick questions, I appreciate you giving some thoughts on 2013. Is it fair to say that given the dynamics around Chiquita and Puente Hills, that the year is probably more back half loaded that you see, and given kind of the moving pieces that comps with special waste that you see [ph] volumes improving? Maybe still down in the first half of the year, and doing positive in the back half?

Ronald Mittelstaedt

First off, I would say this. Certainly, Chiquita Canyon and the closing of Puente Hills, as you've seen this year, plays a large part. But remember, next year in the first half of the year, those comps are going to be flat. Right? In fact, as it sat today, they would be up next year in Q1 on Chiquita Canyon, because our volumes have improved throughout this year, and we chased the volume out at the end of Q4 last year. So, by Q1 of '13, our comps at Chiquita are going to just mathematically be better, and then improve throughout the year.

So, I wouldn't necessarily say that it's reliant on the second half. I would say the second half should be better than the first, but mathematically we should just be better across the board on a comp basis, particularly with regard to Chiquita. Now, other sites, I mean again, Corey, I don't want to put too much into it, but you hear about this fiscal eclipse [ph] and stuff. I think it depends what happens in the election, what happens with Congress at the end of the year with regard to federal budgets and other things.

Because again, on the special waste side, we've said that we're seeing the Government side sort of come to a halt. If things aren't freed up, that part will get worst in the first half of next year, relative to the first half of this year. So, it depends on what happens there as well. I think that the MSW side is going to get a little better just mathematically. The Special Waste side could get worst, depending on what goes on at state and federal level on the Budgetary side.

Corey Greendale - First Analysis Securities

Okay. That's helpful. The other question is, without going into kind of excruciating detail, could you just give us a little bit on kind of your view of the Minnesota market you just entered, in your positioning? How many more markets are there like this that we would view as kind of cities that maybe would still fit your model?

Ronald Mittelstaedt

Yeah. Well, first off, I would tell you that this is a unique set of assets because it's fairly rare to find a $30 million disposal-based asset as your anchor to go into the market. This has three landfills, industrial and C&D landfills, as well as two MSW transfer stations. This covers really four market areas throughout the state of Minnesota, which is anchored in the Twin Cities, but also has operations to the north and the south of the Twin Cities.

That's a market we know very well, and is a market that is highly dominated for the most part by large independence, and has been for a number of years. I think that's fairly rare for more a large suburban or more urban market area. To answer your question of how many are there, again, I think markets like that are fairly rare.

But as far as our ability to continue to open new market areas in the competitive footprint, again, there's substantial opportunity for that. I would tend to tell you there are not markets that look like the Twin Cities.

Corey Greendale - First Analysis Securities

Okay. I appreciate it, thank you.

Operator

The next question comes from the line of Justin Maurer, Lord Abbett.

Justin Maurer - Lord Abbett

Good morning, guys.

Ronald Mittelstaedt

Good morning, Justin.

Worthing Jackman

Good morning.

Justin Maurer - Lord Abbett

Hey, Ron, I think in the ten years I've listened to your conference calls, you guys have talked more about the "big competitors", this call more than the prior combined. You mentioned in your prepared comments and just said, the markets haven't really changed, pricing hasn't really changed. So, I'm just kind of wondering, it just seems like there's a lot of discussion about that in recent months and on the call relative to history.

It seems like you guys have done a nice job over the years telling people how you're differentiated than that model. Again, it doesn't seem like things have changed. It's not as though you're competing with them more than you have, correct? Other than the Denver and Houston example that you sited, albeit small. So, I'm just curious why this thing is kind of - the ball is starting to roll a little bit here.

Ronald Mittelstaedt

Well, I think you and the investors and analysts, I'd say about eight of every ten questions relates to Waste Management or Republic that we get asked. So, most of that, what we get asked and the commentary that inbound chatter that we get, really doesn't relate to us. It's really asking us our opinion of what's going on with them. So, I think it's driven more by that than anything else, Justin.

Again, we've been in Denver for 12 years. Denver is nothing new to us. We've been in Houston for four and a half years now. As I said in my commentary earlier when somebody asked a question that our overlap with Republic is 10%, our overlap with Waste is 20%, and they're in the same market areas, and combined our revenue overlap is 15%.

So, nothing has really changed on our end of that with regard to our market strata or our strategic focus. I just think that there is a lot of inbound questions due to the variety of company-specific issues going on at those two companies, and we get asked.

Justin Maurer - Lord Abbett

Yeah. All right, it just seems like... I'm not pointing fingers at you or vice versa. It's just that it seems to have been kind of deflected in the past to say, "Hey, this is not a - Ask away, but it really doesn't affect what we do." Like you articulated in your comments, pricing is the same, market overlap is the same. It really hasn't changed your business model yet, it just seems to be more of a focus, but that's fine.

Ronald Mittelstaedt

Yeah. I think what we say is, we just point to results.

Justin Maurer - Lord Abbett

Yep. The Chiquita direction, just so I understand, should it take another step down as we get closer to closure of the competitive landfill? Or is this kind of a run right now that you anticipate both in volume and price?

Ronald Mittelstaedt

Yes. I do not believe it will take a step downward. If anything, it has taken an upward trajectory of late on both volume and price on both. We expect that trajectory to continue. I do not expect any downward step.

Justin Maurer - Lord Abbett

Okay. You said October of '13?

Ronald Mittelstaedt

Yes, that's correct. Halloween of '13.

Justin Maurer - Lord Abbett

Okay. Once we get through this calendar year, though, the negative year-over-year impact should be pretty de minimus, because we've already felt that impact. Is that a fair statement?

Ronald Mittelstaedt

Yeah. Well, that's what I was saying to Corey is that you don't have to wait until the second half of the year. In the first half of the year, the comps will be better next year because we took that in January of this year.

Justin Maurer - Lord Abbett

Got it, thanks. Then, lastly, just, Worthing, real quick, on the expenses and maybe just because you gave more line item detail than you normally do, it seemed like the different line items kind of bounced around a bit more than usual. Is that a fair description or no?

Ronald Mittelstaedt

Yeah. This is Ron, Justin. I know you said to Worthing, but this is really just math when you peel a large part of it. If you peel off the 3 million in recycled commodities that just come off as just price, there's no cost differential. When you peel off the Chiquita volumes that we drove away, there's really no cost differential other than some DD&A with some of the competitive activity that we did site in both Houston and Denver, albeit a small part of our business, that's on the price side.

So, your costs are the same. So, what you have is you have a degradation in the quality of revenue, and therefore your line items climb as a percentage of revenue.

Worthing Jackman

Yeah, many of the line items were the similar ones we called down in Q1, and frankly, were anticipated. They've been anticipated for the past couple of quarters as we threw the budget together for this year because we're tracking what's going on in the Maintenance side. We know what's happening on the Landfill and Leachate side and some of the wet weather we've had.

So anyway, these are things that are anticipated, and as you saw, we hit the midpoint of our EBITDA guidance because we're forecasting them.

Justin Maurer - Lord Abbett

Yeah. Okay. Thanks gentlemen.

Ronald Mittelstaedt

Thanks, Justin.

Operator

Your next question comes from the line of Tony Bancroft, Gabelli & Company

Tony Bancroft – Gabelli & Company

Good morning, gents. How are you?

Worthing Jackman

Hey, good morning.

Ronald Mittelstaedt

Good.

Tony Bancroft – Gabelli & Company

This is a question on the SKB deal. Why now? Why did it happen now? Was it priced right? I mean, it sounds like after you talked about the deal a little more, it sounds like a pretty salacious business there. Do you think this could be a potential for - you said there's not many of them out there - but some more good deals or some of these pretty sexy assets out there?

Worthing Jackman

Hold on. I've got to look up salacious. Hold on a minute.

Tony Bancroft – Gabelli & Company

Actually, I just looked it up myself. It means a killing.

Ronald Mittelstaedt

Well, thank God.

Tony Bancroft – Gabelli & Company

Yes.

Ronald Mittelstaedt

The answer of why now; this was a private company that was looking over the last year or so at the potential sale of the company, tax planning and estate planning was a very large driver for this family. The primary shareholder just turned 60 and was looking at retirement options over the next three to five years. So, this was driven by tax, the potential rise in capital gains tax, and estate planning as far as the timing.

We can't really control - we don't force these things, if you will. The only way you force things is by price and when you do that, you overpay. So it needs to be when the seller has some motivation in addition to a fair value. So, that's really your answer to why now. I mean are there others that are attractive like this? Yes, absolutely. We think we've made a track record of delivering those year-in and year-out and building a network of those types of assets overtime. We're continuing to - there are still several of those that we're looking at.

Tony Bancroft – Gabelli & Company

Got it, thank you so much.

Operator

This concludes the question and answer portion for today's conference. I would now like to turn the call back to Ron Mittelstaedt for closing remarks.

Ronald Mittelstaedt

Okay, thank you operator. Well, if there are no further questions, on behalf of our entire management team, we appreciate your listening to and interest in our call today. Worthing and Mary Anne Whitney will be here to take your questions. Any questions that are direct that we did not cover that we are allowed to answer under Regulation FD or Regulation G they will both be around and available today to answer. Thank you again. We look forward to speaking with you at our upcoming investor conferences or on our next earnings call.

Operator

Thank you very much. This concludes today's conference. Thank you again for your participation. You may now disconnect and have a great day.

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