Waste Connections, Inc. Q1 FY2022 Earnings Call

Greetings, and welcome to the Waste Connections First Quarter 2022 Earnings Conference Call. As a reminder, this conference is being recorded today on Wednesday, May 4, 2022. Now I would like to turn the conference over to Worthing Jackman, President and CEO. Please go ahead.

Thank you, operator, and good morning. I'd like to welcome everyone to this conference call to discuss first quarter results and to provide a detailed outlook for the second quarter. Joining me this morning is Mary Whitney, our CFO. As noted in our earnings release, we are extremely pleased by our strong start to the year with record solid waste pricing growth, driving underlying margin expansion in spite of inflationary pressures. Our 50 basis points year-over-year decline in adjusted EBITDA margin in the quarter included 90 basis points combined margin impact, as expected, from $10 million of COVID-related frontline support in January and acquisitions completed since the prior year period. Looking ahead, further sequential improvement in solid waste pricing growth, increasing E&P waste activity, and strong operational execution should continue to differentiate our performance. We are on track to meet or exceed our full year adjusted free cash flow outlook of $1.15 billion and the elevated cadence of solid waste acquisition activity has continued with approximately $175 million in annualized revenue year-to-date, confirming our expectations for another outsized year of such activity. Before we get into much more detail, let me turn the call over to Mary for our forward-looking disclaimer and other housekeeping items.

Thank you, Worthing, and good morning. The discussion during today's call includes forward-looking statements made pursuant to the safe harbor provisions of the U.S. Private Securities Litigation Reform Act of 1995, including forward-looking information within the meaning of applicable Canadian securities laws. Actual results could differ materially from those made in such forward-looking statements due to various risks and uncertainties. Factors that could cause actual results to differ are discussed both in the cautionary statement included in our May 3 earnings release and in greater detail in Waste Connections filings with the U.S. Securities and Exchange Commission and the Securities Commissions or similar regulatory authorities in Canada. You should not place undue reliance on forward-looking statements as there may be additional risks of which we are not presently aware or that we currently believe are immaterial, which could have an adverse impact on our business. We make no commitment to revise or update any forward-looking statements in order to reflect events or circumstances that may change after today's date. On the call, we will discuss non-GAAP measures such as adjusted EBITDA, adjusted net income attributable to Waste Connections on both a dollar basis and per diluted share, and adjusted cash flow. Please refer to our earnings releases for a reconciliation of such non-GAAP measures to the most comparable GAAP measures. 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. I will now turn the call back over to Worthing.

Thank you, Mary. In the first quarter, we delivered solid waste price plus volume growth totaling 7.6%. The all-in price of 7.1%, including about 80 basis points in fuel and material surcharges, marks our highest reported price and ranges from about 4% in our mostly exclusive market Western region, to between 7.5% and 8.5% in our competitive markets, up 140 basis points sequentially from Q4. Our Q1 pricing was 60 basis points above our outlook and ramped during the quarter as we continued to address the accelerating inflationary headwinds during the period. Looking ahead to Q2, we expect another sequential increase in both core price and surcharges with all-in price growth exceeding 8%. Our pricing strength continues to reflect our purposeful approach to addressing the headwinds of inflation and the resilience of our market model, both of which are hallmarks of our strategy. Moreover, the differentiated level of price is a testament to the execution and accountability of local leadership in our decentralized operating structure and the visibility on cost, which informs our approach to pricing. Reported volume growth of positive 50 basis points also exceeded our outlook. As noted last quarter, reported volumes reflect about 80 basis points impact from the expiration of 2 poor quality municipal contracts, applying underlying volumes up about 1.3%. On a normalized basis, volumes were up in all regions and continue to be strongest in our Western region, which was up 2.6% in the period. Looking at year-over-year results in the first quarter on a same-store basis, commercial collection revenue was up 12% year-over-year. Roll-off pulls per day were up 5% on revenue per pull, up 7% and landfill tons were up 4%, led by a 12% increase in special waste with MSW tons up 2% and C&D tons up 1%. Special waste activity was broad-based in both Canada and in several U.S. markets, including Colorado, Illinois, and Minnesota, including some markets where favorable weather may have accelerated the timing of some jobs otherwise planned for Q2. Looking at Q1 revenues from resource recovery that is recycled commodities, landfill gas, and renewable energy credits, or RINs. Excluding acquisitions, collectively, they were up about 35% year-over-year due to higher values for both recycled commodities and RINs, resulting in a margin tailwind in the period of about 60 basis points. Prices for OCC, or old corrugated containers, averaged about $163 per ton in Q1 as expected, and RINs mostly stayed in the range of $3 to $3.25, slightly below the levels we were seeing earlier in the year. And finally, on E&P waste activity, we reported $40.8 million of E&P waste revenue in the first quarter, up 65% year-over-year and up 19% sequentially from Q4 on a pickup in activity during the quarter from increased drilling as well as remediation jobs primarily in the Permian Basin. Given the backdrop of higher rig counts and elevated crude pricing levels, we are encouraged by the improving trends we saw during Q1 and which continued into April, bringing the quarterly run rate to about $45 million. We are similarly encouraged by the cadence of acquisition activity. Year-to-date, we've closed approximately $175 million in annualized revenues, all in solid waste and in both the U.S. and Canada. Through 4 months, we've already completed what we would consider an above average year for us, and the pipeline remains robust. As always, we remain selective about the markets we enter and the multiples we pay as we maintain our focus on long-term value creation. To that end, we continue to take an opportunistic approach to share repurchases. We repurchased $425 million of outstanding shares in early Q1. We also accessed the capital markets early this year to lock in more long-term debt at an attractive rate and free up capacity on our bank facility. Given the strength of our balance sheet, with leverage about 2.6x on a net debt-to-EBITDA basis, we remain well positioned to capitalize on this period of outsized acquisition activity with optionality around our continued return of capital to shareholders. In addition to share repurchases, we would expect to maintain our established practice of increasing our annual per share dividend when we undertake our typical review in October. Now I'd like to pass the call to Mary to review more in depth the financial highlights of the first quarter and provide a detailed outlook for Q2. I will then wrap up before heading into Q&A.

Thank you, Worthing. In the first quarter, revenue was $1.646 billion, about $36 million above our outlook and up $250 million or 17.9% year-over-year. Organic growth was 10% in the quarter, and acquisitions completed since the year-ago period contributed about $112 million of revenue or about $110 million net of divestitures. Adjusted EBITDA for Q1, as reconciled in our earnings release, was $502.1 million and 30.5% of revenue. As a reminder, this reflects 60 basis points impact from the $10 million in COVID-related support that we provided in January, plus 30 basis points drag from acquisitions. Normalizing for this unique supplemental expense and the margin dilutive impact of acquisitions, adjusted EBITDA margin would be 31.4%, up 40 basis points year-over-year. Reported margins also reflect the impact of higher diesel costs during the quarter. Fuel expense in Q1 was about 4.0% of revenue, up about 70 basis points year-over-year, including the benefit from hedges on about half of our fuel purchases, mitigating the impact of higher prices. We averaged approximately $3.30 per gallon for diesel in the quarter, up about 30% from the year-ago period and up about 12% sequentially from Q4. Margin impacts reflect the quick run-up in fuel prices during late February and into March, which drove incremental costs of about $4 million for a drag of about 30 basis points beyond our expectations in February. Looking on a reported basis at Q1 year-over-year margin drivers. This 60 basis point benefit from higher commodity-driven revenues described earlier was more than offset by the 70 basis point fuel headwinds also noted, resulting in a net drag of about 10 basis points. Higher E&P waste revenues accounted for about 40 basis points margin expansion. As expected and noted, acquisitions resulted in a drag of about 30 basis points and the $10 million in COVID support from January accounted for a 60 basis point drag. And underlying solid waste margins expanded by 10 basis points, demonstrating the power of price and the importance of a proactive approach. To reiterate, in the face of record levels of inflation, which not only persisted but accelerated during the quarter, we achieved underlying margin expansion in solid waste hauling, transfer, and disposal. Finally, we delivered adjusted free cash flow of approximately $320 million or 19.5% of revenue in Q1, up 10.6% year-over-year in spite of capital expenditures being up over 55%. As such, we are well positioned to meet or exceed our full year adjusted free cash flow outlook of $1.15 billion provided in February. I will now review our outlook for the second quarter of 2022. 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 filings we've made with the SEC and the Securities Commissions or similar regulatory authorities in Canada. We encourage investors to review these factors carefully. Our outlook assumes no significant change in underlying economic trends. It also excludes any impact from additional acquisitions that may close during the remainder of the year and expensing of transaction-related items during the period. Revenue in Q2 is estimated to be approximately $1.785 billion. This includes solid waste price plus volume growth of 7.5% to 8.5%. As Worthing noted, we expect pricing growth to increase sequentially to a range of 8% to 8.5% and reported volumes of flat to down 0.5 point. Similar to Q1, our reported volumes will reflect about 80 basis points drag from expired contracts, thus implying continued positive underlying volume trends. E&P waste revenue is estimated at approximately $45 million and recovered commodity values are expected to remain largely in line with current levels. Adjusted EBITDA in Q2 is estimated at 31.2% of revenue or approximately $557 million. This reflects an expected 40 basis point margin dilutive impact from acquisitions completed since the prior year period, implying margins to be flat year-over-year, excluding such impact. Depreciation and amortization expense for the second quarter is estimated at about 12.8% of revenue, including amortization of intangibles of about $37.5 million or $0.11 per diluted share net of taxes. Interest expense, net of interest income, is estimated at approximately $45 million. And finally, our effective tax rate in Q2 is estimated at about 22.5%, subject to some variability. And now let me turn the call back over to Worthing for some final remarks before Q&A.

Thank you, Mary. We're extremely pleased with our start to the year, particularly given the challenges of record levels of inflation magnified by geopolitical events, ongoing supply chain disruptions and labor constraints as well as the overhang from COVID-related variant impacts. It has been our focus throughout the pandemic, we have continued to provide outsized levels of support for the health and welfare of our employees and their families. To that end, we're also getting back to a regular cadence of in-person training and other opportunities to be together for shared celebrations, recognition, and collaboration. We believe we are well positioned for the remainder of 2022 with record solid waste pricing, underlying volume growth, further growth in E&P waste, and easing cost comparisons. In addition, acquisitions completed year-to-date, coupled with a robust pipeline suggest we are solidly on track to meet or exceed our full year 2022 outlook. That said, we'll stick to our typical approach and wait until our Q2 earnings release to update our outlook for the full year. Q1 is a fitting start to our 25th anniversary year, a year in which we remind ourselves that our intentional culture, intentional strategy, and intentional value creation have driven our success through the years. We appreciate your time today. I'll now turn the call back over to the operator to open up the lines for your questions.

Operator Instructions. And we'll get to our first question on the line from Toni Kaplan with Morgan Stanley.

I wanted to ask if you could talk about attrition trends versus history. Obviously, you're in really exclusive secondary markets and attractive strategy for attrition. So just wanted to understand if pricing has had any impact on it or not really because of basically the strategy that you have?

Toni, with respect to attrition or pricing retention, said another way, as we've observed really for the past several quarters throughout last year and into this year, the retention rates have really been at historic highs. I think the fact that we keep continuing to deliver price in excess of the way we guide reflects that as well as the fact that we did incremental price increases and some people have asked if we see a difference across geographies in terms of the receptivity to price increases. And the short answer is no. We've seen a very broad-based, highly receptive environment for price increases.

That's super. And separately, on recycling, I want to hear just long term, what do you see recycling sort of growing to as a percent of revenue? What would be the main objective there that you have?

It won't change much as a percentage of revenue compared to what you see currently. The values of commodities do influence this to an extent, but we have two additional facilities currently under construction that should be operational by the end of next year. This will make a small contribution to total recycling revenue. However, the rate of acquisition activity will continue to regulate its proportion of the total.

That's great. One last 1 for me. Just sort of a broad question around volume. I know you've had more of a price-focused strategy. I know volumes have been impacted by the expiring contracts this year. But just long term, should we think about your volume growth in line with the market? Or is there something about the selectivity of your markets that should lead to a lower volume level than the market?

Well, through the years, we've always said that we think of this industry as being a 1% to 2% volume growth industry. Obviously, there are periods where it exceeds 2% and some periods where it might be below 1%. But the thing you got to remember here is, especially in our model, given the geographies we cover, so much of our business is a fixed pay system. And so the actual calculation of volume growth is likely closer to being impacted by 15% to 20% of our revenue. But for new contracts, it might be 1 episodically. And so to be reporting between 1% and 2% volume growth, you're reporting between a 10% and 15% growth on that 15% to 20% of revenue that's really impacting reported volumes. And that's really meaning roll-off activity and third-party tons across our scales.

We go to our next question on the line is from Walter Spracklin with RBC Capital Markets.

I wanted to discuss acquisitions again, as we touched on it previously. I'm curious if your competitors are exploring adjacent markets, emphasizing the lower capital intensity and strong returns, which makes a compelling case. This broadens the scope for potential acquisitions at a time when deals may be becoming less attractive in terms of valuation or availability. Worthing, what is your perspective on the likelihood of entering adjacent markets based on the argument that they still offer high returns and align somewhat with the markets you are currently involved in?

Sure. This will be the third call where we receive this question, and it will also be the third time we'll provide the same answer. We have significant opportunities within the solid waste sector. Many of the deals we are finalizing are ones we've pursued for many years. As you know, in our business model, the sellers decide when the right time to sell is, and our relationship facilitates a negotiated deal. We cannot dictate timing; it is determined by the seller, so we must be prepared to act accordingly. The pipeline you see that is actionable greatly exceeds the $175 million that has been closed so far this year. We have a long runway ahead of us. Notably, many of the transactions available to us in new markets are of a size that presents fewer issues regarding potential DOJ concerns, which larger national companies might face. Regarding returns, the profile remains highly attractive. We focus on cash-on-cash analysis, acquiring businesses with strong and resilient cash flow. A lot of related businesses have lower margins and fewer barriers to entry. We've observed the volatility in those sectors during various economic cycles. Therefore, we see no reason to change our strategy as we work towards our goal of reaching $10 billion.

It's great to hear that. I understand the repeated concern about changes. Regarding acquisitions, when an opportunity arises, it can be fleeting, and you must act quickly. In this current environment, where deals can vanish, are you considering being more aggressive? I know some peers are willing to take more risks to secure deals. You've navigated challenges like the pandemic and recessions, showcasing your resilience. Would you contemplate exceeding a 3x leverage, for instance, to seize these unique and temporary opportunities to accelerate growth through mergers and acquisitions?

Well, to start, we have over $900 million of free cash flow after the dividend, and the first $900 million we allocate goes towards reducing our debt, which helps enhance our EBITDA. It requires significant acquisition activity to reach a leverage ratio of 3x or higher. In terms of transactions, a revenue increase of $20 million to $40 million is still considered substantial within our framework. While we have a few deals that exceed this, transactions generating over $100 million in revenue are quite rare in our model. To make a meaningful impact on our leverage, we would need to invest close to $2 billion and still strive to reach 3x. It's essential for us to be cautious with our transactions. I can't comment on others' strategies, but I recognize the importance of being diligent. We've seen labor costs rise significantly over the past two years, along with spikes in fuel and third-party logistics expenses. Therefore, any acquisition we pursue must have a solid plan in place to address current inflation challenges or should be ready to implement actionable strategies soon. We need to avoid basing valuations on 2021 results while facing an underlying cost increase of 8% to 10%. We must ensure that the companies we engage with meet these criteria, as we prefer not to see multiples increase.

Great. I have one final question for Mary Anne. The margin expansion seems to be less pronounced than in the past. I understand you mentioned the impact of employee compensation by 60 basis points and acquisitions by 30. Is that everything? Will we see a return to the usual improvement of 50 to 75 or even 80 basis points, especially now that some of the pressure from employee compensation is easing? Or could there be continued pressure on margins that might lead to lower reports compared to what we typically expect?

Certainly, I appreciate you recognizing the 90 basis points. To clarify, our reported margins would have reached 31.4% without those discretionary cost additions and the opportunities for deals. Additionally, the impact of fuel presented a 70 basis point challenge, yet we still achieved underlying margin expansion in solid waste despite this headwind. If these pressures hadn't been present, margin expansion could have been greater, but we wouldn't have required as much price. Looking ahead to Q2, we anticipate that underlying margin expansion should be greater than in Q1 based on current observations.

You need to consider that in an 8% inflationary environment, if the company only recovers the dollar impact, it would result in a 140 basis points reduction in margins. As we guide for Q2, with acquisition activities taken into account, we're flat year-over-year. This indicates an increase of 140 basis points to get back to that point. Therefore, I believe that in this current environment, we will perform significantly better than the 30 to 50 basis points margin expansion just to maintain flat year-over-year. As inflationary pressures decrease, the starting point of down 140 reduces, revealing reported margin expansion in the future.

We'll get to our next question on the line from Jerry Revich from Goldman Sachs.

I'm wondering if you could talk about the leading edge inflation indicators that you look for in your business? And how are they trending? We're going to be coming up on comps where we started to see pretty high inflation in the back half of last year. And I'm just wondering, are those comps at a point where we might see percent inflation slowing in the business potentially in the back half of the year? Can you just talk about what you're seeing since you folks were among the first to see inflation accelerating to the upside?

Sure. That's a good question because, look, just like the use of the word transitory last year, that wasn't our view as inflation. You got to be prepared for inflation to be sticking around at these levels for a couple more quarters and run the business, assuming that now if we're wrong because we started anniversarying higher levels in the prior year, and it does ease a little bit. As we've always said, that's upside for us. Our expectation that it could be running at more elevated levels for longer, meaning through this year or most of this year is that some people relate to the realizing inflationary pressures last year, believe it or not. I mean look at vendors even this year that are trying to play catch-up or what they didn't do last year. They're just waking up to the realities of higher labor and wages that they're paying wasn't transitory, right? And so we're still seeing price increases, especially at certain vendors that even today are ranging upwards of low teens. And so we're going to run our business assuming that, that is the environment until it's not. With regards to wages, our wages were up about 8% year-over-year in Q1. Q1 was our toughest comp because we really started pushing wages in Q2 of last year. And so our kind of wage pressures will start easing with regards to inflationary pressures on from third-party vendors and stuff we're still seeing that in the macro. Look, fuel should be unknown right now. So when you say labor is mostly known and fuel is known, then it should start to ease, but we're going to again run our business assuming it's not until it does.

Super. And then can we just talk about in your recycling business, we're seeing strong interest from chemicals companies on procuring recycled plastics. I'm wondering if you can comment on what the pricing point is for recycled plastic for you versus virgin plastic? And what's the potential that we might see a meaningful premium development in that market over time?

Sure. So I would say, let's start with sort of framing where the value of recycled commodities is, and it's really been primarily in the fiber. So when we talk about that basket, it's really been 50% to 70% of the value sits in fiber. It's moving up toward the higher end of that range as OCC has come back. And you're at this 160, 165 type of level for OCC. I mentioned that because, yes, plastics are part of the equation, but they're a small piece of the equation. And the reality is that it's not as though there's a price point at which our interest changes expect this is the basket of commodities and to the extent there's greater value in a piece of it will do better. Now have we seen some differentiation among different grades of plastic? Yes, there is greater demand for some than others. And so that's a good thing. It just increases the value of the basket. And frankly, if it increases the interest in doing more recycling, whether it's from a consumer standpoint or a manufacturing standpoint, that's all additive and good timing since we're adding recycling capacity.

And also, as you know, I mean, look at the refiners, one, again, the plastic business, we applaud them. Just to be clear, we're not going to get in the refinery business.

And are you seeing an improvement in what you're selling the plastic at versus what virgin plastic would look like? Has that started that happen yet? Because obviously, in the past, it used to be a discount. I'm just wondering if you're starting to see that discount narrow at all? Is that something that...

Certainly. Yes, certainly narrowing. And as I said, certain grades have outperformed and there's a general lift in plastic values overall.

We'll get our next question on the line from Michael Hoffman with Stifel.

I'd like to come back to the volume to ask it from a different perspective because the data that you're looking at support a thesis that new business formation, so that small container service interval trends are being positive, neither of those have peaked. That's one of the factors that you alluded to that market growth 1 to 2, but things that contribute to what can be higher. What's your data telling you about the underlying business activity?

Let's see. Q1 net new business for us doubled year-over-year. And that's measuring what's happening through our sales force, which obviously sits in competitive markets.

Okay. So that's a good positive statement. And then we hear equipment is on allocation. All right, we know labor is tight. So are you seeing potentially less competition for that piece of growth, somebody puts a store in a new business and needs a garbage service because the competitors sitting there are going, where do I get the equipment? Where do I get the labor?

I don't think it's primarily related to that type of business. I believe some municipalities are trying to rebid their contracts as they reach the end of their terms. In the past, they might have had lead times of six to eight months for bidding. For larger bids, they're discovering it’s challenging for companies to compete because it's difficult to gather 40 trucks within a six-month timeframe. As a result, we often see municipalities looking to extend existing contracts by a year to allow more time for the RFP process.

So if you have the business, renewal rates are up a little bit, and that's good for you.

Renewal pricing is up dramatically as well.

We go to our next question on the line is from Walter Spracklin with RBC Capital Markets.

I wanted to discuss acquisitions again. I know we have mentioned this previously, but I wanted to confirm that your competitors are beginning to explore adjacent markets, which present lower capital intensity and strong returns. This creates a compelling situation that broadens the scope for potential acquisitions, especially at a time when deals may be becoming less attractive in terms of valuation or availability. I'd like to hear your thoughts, Worthing, on the likelihood of entering adjacent markets based on the idea that these opportunities still yield high returns and align somewhat with your current markets.

Sure, this will be the third call in a row where we receive this question, and we will provide the same answer as before. We have a long runway in the solid waste sector. Many of the deals we're completing have been pursued for several decades. In our model, most agreements are made by sellers who decide when it’s the right time to sell. The relationship leads to a negotiated transaction, and we can’t control the timing; it’s up to the sellers. We must be prepared to act when the opportunity arises. The actionable pipeline you see is many times greater than the $175 million we have closed year-to-date. Our runway is extensive, and many of the transactions occurring are in new markets and of significant size. This reduces concerns regarding DOJ issues that larger national firms might encounter. Regarding returns, the return profile remains very attractive. We conduct cash-on-cash analysis, acquiring businesses with strong and resilient cash flow. Many related industries have lower margins and barriers to entry, resulting in volatility through various economic cycles. Therefore, we see no reason to alter our strategy as we move toward our goal of $10 billion.

It's encouraging to hear this. There’s always a recurring question about ensuring nothing has changed, and it’s good to receive this affirmation. Regarding acquisitions, when an opportunity arises, it tends to be fleeting unless acted upon immediately. Given this environment, do you ever feel tempted to adopt a more aggressive stance? I've noticed some competitors are willing to push the limits to secure deals. Having navigated through a pandemic and various recessions, you've demonstrated resilience. Would you consider increasing leverage beyond 3x to seize these unique and short-lived opportunities for quicker growth in M&A?

First of all, with over $900 million in free cash flow after the dividend, the first $900 million will go toward reducing our debt, since that will also increase EBITDA. It takes significant acquisition activity to reach a leverage ratio of 3x or higher. In our model, transactions generating between $20 million and $40 million in revenue are considered substantial. Although we have a few larger deals, it's uncommon to see transactions exceeding $100 million in revenue in our model. To make a meaningful impact on our leverage and approach 3x, we need to invest close to $2 billion. It's crucial from a transaction perspective to be cautious. While I can’t comment on how others operate, I'm certain they are also being careful. With labor and fuel costs spiking over the past two years, any acquisition must have a clear, actionable plan to address the current inflationary pressures. We don’t want to base our valuations on 2021 performance while facing 8% to 10% cost increases. Therefore, for the companies we are considering acquiring, we must ensure we can affirm that their plans are ready to tackle these challenges, as we want to avoid an increase in multiples.

Great. I have one final question for Mary Anne. The margin expansion is slightly less than we have observed previously. You mentioned the employee compensation impact of 60 basis points and acquisitions contributing 30 basis points. Is that essentially the whole picture? Will we return to the usual improvement of 50 to possibly 75 or 80 basis points now that you're addressing at least part of the employee compensation issue? Or could there be a continuation of pressure on margins throughout the year that would prevent reporting in line with what is typically expected?

Sure. I appreciate you acknowledging the 90 basis points. To clarify, our reported margins would have been 31.4% without those discretionary costs and the opportunities for deals. Additionally, the impact of fuel has created a 70 basis point headwind, yet we still managed to achieve underlying margin expansion in solid waste despite this headwind. If these pressures hadn't existed, margin expansion would have been even greater, but we also wouldn't have needed as much price. Looking ahead to Q2, we expect underlying margin expansion to be greater than it was in Q1 based on current observations.

We'll get to our next question on the line from Jerry Revich from Goldman Sachs.

I'm wondering if you could talk about the leading edge inflation indicators that you look for in your business? And how are they trending? We're going to be coming up on comps where we started to see pretty high inflation in the back half of last year. And I'm just wondering, are those comps at a point where we might see percent inflation slowing in the business potentially in the back half of the year? Can you just talk about what you're seeing since you folks were among the first to see inflation accelerating to the upside?

Sure. That's a good question because, look, just like the use of the word transitory last year, that wasn't our view as inflation. You got to be prepared for inflation to be sticking around at these levels for a couple more quarters and run the business, assuming that now if we're wrong because we started anniversarying higher levels in the prior year, and it does ease a little bit. As we've always said, that's upside for us. Our expectation that it could be running at more elevated levels for longer, meaning through this year or most of this year is that some people relate to the realizing inflationary pressures last year, believe it or not. I mean look at vendors even this year that are trying to play catch-up or what they didn't do last year. They're just waking up to the realities of higher labor and wages that they're paying wasn't transitory, right? And so we're still seeing price increases, especially at certain vendors that even today are ranging upwards of low teens. And so we're going to run our business assuming that, that is the environment until it's not. With regards to wages, our wages were up about 8% year-over-year in Q1. Q1 was our toughest comp because we really started pushing wages in Q2 of last year. And so our kind of wage pressures will start easing with regards to inflationary pressures on from third-party vendors and stuff we're still seeing that in the macro. Look, fuel should be unknown right now. So when you say labor and is mostly known and fuel is known, then it should start to ease, but we're going to again run our business assuming it's not until it does.

We'll proceed with the next question on the line from Sean Eastman with KeyBanc Capital Markets.

Could we discuss the topic of inflation in relation to capital spending? I'm curious about how we are performing against our budget for capital expenditures, particularly with inflation possibly being balanced out by delays in deliveries. Could you clarify that for us?

Sure. I think you've highlighted the main points. This year, some pricing for construction or certain units that weren’t previously locked in has exceeded original expectations. Additionally, we’re likely facing delays in the number of units as we look back later this year. These delays create a gap that we need to fill due to inflation. We’re investing more capital now because it’s crucial to acquire as much fleet as possible in the current environment and to have surplus fleet available for upcoming contracts. We are addressing some of the delays by trying to access fleet earlier this year. It’s important to note that capital expenditures also face inflation, and we don’t recover that inflation directly through the P&L. As we’ve always emphasized, we need to focus on margins to meet our capital requirements. We plan to meet or exceed our cash flow guidance for the year, and when we update our guidance in July, we expect to see increased revenue and EBITDA to support that.

We'll get to our next question on the line from Noah Kaye from Oppenheimer.

So last year in 2Q, you started adding back discretionary and medical costs that were stripped out during 2020. Are those discretionary costs, would you say fully back? Are there any incremental headwinds this year?

Well, taking a step back, there certainly were different buckets of both discretionary costs. And as you said, there are things like medical costs, which I'd say we're at a more normalized run rate, generally speaking, with respect to things like travel, meetings, that has stepped up. And as we said, we're as Worthing said in his prepared remarks, we're happy to be back together and we are spending money on those things. We didn't call them out in Q1, but they're part of what we've already reported and what we will report the way we're guiding Q2.

Yes, this is a year where we're fully committed to discretionary costs. We're pleased to be back together. There are numerous celebrations happening across our company for our 25th anniversary. As Mary mentioned, there are several training sessions held every week. It’s wonderful to reunite, and this could potentially benefit us in the following year.

We'll see. But that's good to hear. And then just on the labor situation, where is turnover retention currently? Are you still, would you describe it kind of short-staffed on any of your key regions or routes? Give us an update, if you can, on the retention rates.

Sure. I think every company, regardless of the industry, wishes they had more labor. Typically, we operate at about 4% to 5% less than what I would consider full employment. In the current environment, we're likely running about 5% to 6%, which is 100 basis points higher than usual. Distributing that extra percentage of employees across many locations dilutes the impact; if it were concentrated in one place, it would be more significant. We've focused heavily on our hiring and onboarding processes and on retaining employees. We've been monitoring the progression of our new hires during their first few months. I'm happy to report we're seeing improvements in turnover among new employees. Overall, though, our turnover is slightly above pre-pandemic levels. Given the challenges of the current job market and the so-called great resignation, it's noteworthy that we've managed the situation as effectively as we have over the past three to four years.

We'll get our next question on the line from Chris Murray from ATB Capital Markets.

Just maybe going back to free cash flow and your conversion in the quarter looked pretty strong. Just trying to think about all the moving parts as we kind of go through the year when we're talking about kind of hitting guidance. I guess a few pieces of this, anything to think about in terms of working capital? And then the other piece is CapEx looks like it was a little bit lower than at least what you're running at in Q4? Should we be expecting that you'll probably have some catch up? I mean, I think you alluded to the fact that you're having some trouble maybe getting equipment. But if you can just give us an idea of some of the moving parts into your free cash flow thoughts right now, that would be great.

Yes, to start, our capital expenditures have increased by over 55% year-over-year. We are certainly not having an issue with spending. We intentionally advanced many of our chassis purchases in the fourth quarter and the first quarter to ensure we stay ahead with fleet deliveries. The primary reason for the year-over-year increase is the timing of those chassis deliveries. We're currently meeting our expectations for capital expenditure spending. Additionally, there are shifts in working capital that need to be considered. We had to settle an item related to an acquisition, which is reflected in our working capital usage, but it's simply a timing matter associated with that acquisition. As you may know, the first quarter typically has the lowest tax payments of the year, which can also affect cash flow from quarter to quarter.

Yes. And I would just echo that and add that the conversion rate that you referred to in Q1, it's always a little outsized in Q1. That's pretty typical. And the other observation I'd make just with respect to working capital is a reminder that we'd like to come in with a cushion. We did this year as we had in the prior year, the outside cushion. So we like the optionality that gives us, but we certainly intend to end the year with some cushion as well. So I'd say the comments Worthing made about having more revenue to drive more EBITDA dollars to then drive the free cash flow, certainly, when we update or consider updating in July, we'll address that.

We'll get to our next question on the line from Kevin Chiang with CIBC.

Maybe following up on an earlier question you got just on M&A strategy and maybe what some of your peers are looking to do. Just wondering if you're seeing any impact on valuation multiples if some of your larger competitors are looking outside of solid waste? And you mentioned DOJ concerns as well and maybe smaller players are also facing a more challenging operating environment. Is that going to any deflation in the valuation multiples you're seeing out there?

Yes. From an underlying standpoint, they are down 21% from last year. Geography can also play a role since some of our larger acquisitions are in the West Coast, East Coast, and Canada. What's unique about some of these transactions is the underlying real estate value, which can often exceed 25% of the total consideration. This is not common. In some instances, sellers may prefer to retain ownership of the real estate, which means it's not included in the deal and results in a rent payment. Additionally, we believe that owning the real estate is crucial for our market presence in certain areas. Thus, while the underlying multiples may have decreased slightly, looking at the overall multiples, they haven't changed significantly because the real estate in those regions holds substantial value.

No, that's interesting color. And maybe just last 1 for me. Obviously, good pricing in the first quarter sequentially, you're going to continue to grind that higher here. You have this decentralized model. I suspect a lot of us haven't seen inflation at these levels for a decade. I'm just wondering, has that changed the feedback loop between I guess, corporate in the regions to make sure they stay ahead of inflation. So because I suspect the things they were tracking 5 years ago to figure out where costs were going, is probably a little bit different today. Has that changed at all in terms of how you interact with the region to make sure you're seeing the full inflationary picture? Or does the decentralized model, they're staying on top of this pretty good here.

I believe that the core of our strategy has been a decentralized model combined with a consistent feedback loop that we established early last year. We proactively raised wages and adjusted prices throughout this period due to this decentralized structure. We continuously assess our current position while also looking ahead one, two, or three months and further, making ongoing annual updates to fully understand the impact of inflation beyond just short-term views. This approach is integral to our identity and how we manage the business. Pricing and financial decisions are commitments that our local teams are accountable for, addressing wage and cost pressures as part of our operations. Running a business is never easy, yet our teams excel at pricing, managing costs, and creating value. We emphasize this because it has been a crucial aspect of our strategy since the beginning, proving effective even in challenging times like the pandemic, high inflation, or the Great Recession. Our understanding of pricing remains consistent, and we still provide quarterly guidance, a practice we've maintained since our initial public offering with $30 million in revenue, now scaling to over $7 billion. Therefore, pricing is something we are always prepared for, enabling us to predict what's coming and how our business is performing.

We'll proceed with the next question on the line from Stephanie Yee with JPMorgan.

I just wanted to ask about pricing as we kind of beyond this year. I know this year, we're expecting inflation to probably stay elevated. Who knows what next year is going to bring, but let's assume some of the pressures ease a little. Should we see some of the pricing kind of roll back either from there is the comp issue, the year-over-year comp is, but also just the prices that you've been pushing forward to customers, would you kind of, I guess, roll some of that back just to give the customers a break as well as we're seeing some of these pressures ease across the board?

Certainly, we consider the two different types of markets. In the exclusive markets where we're linked to CPI, you can expect the 4% we are experiencing this year to increase next year, as it typically reflects the midpoint of the previous year. Whether that figure will reach 5% or higher next year is uncertain, but it suggests a general upward trend and contributes positively to our overall pricing reports. Additionally, we need to consider our position at the end of the year, as the price increases implemented this year will influence next year. We will also evaluate the market conditions as we plan for the remainder of 2023. If there is less urgency to implement aggressive increases, we will take that into account in our planning.

And Mr. Jackman, we have no further questions on the line. I'll turn the call back to you.

Perfect. 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. Mary is available today to answer any direct questions that we do not cover. There were a lap answer on the Reg FD, Reg G and applicable securities laws in Canada. Thank you again. We look forward to seeing you at upcoming investor conferences or on our next earnings call.

Thank you very much, and thank you, everyone. Thank you. And that does conclude the conference call for today. We thank you for your participation. Please disconnect your lines. Have a great day.