Republic Services Inc (RSG) — Q3 2020 Earnings Call Transcript

Hello. I would like to welcome everyone to Republic Services' Third Quarter 2020 Conference Call. Don Slager, our CEO; Jon Vander Ark, our President; and Brian DelGhiaccio, our CFO, are joining me as we discuss our performance. I would like to take a moment to remind everyone that some of the information we discuss on today's call contains forward-looking statements, which involve risks and uncertainties and may be materially different from actual results. Our SEC filings discuss factors that could cause actual results to differ materially from expectations. The material that we discuss today is time-sensitive. If in the future, you listen to a rebroadcast or a recording of this conference call, you should be sensitive to the date of the original call, which is November 5, 2020. Please note that this call is the property of Republic Services, Inc. Any redistribution, retransmission or rebroadcast of this call in any form without the expressed written consent of Republic Services is strictly prohibited. I want to point out that our SEC filings, our earnings press release, which includes GAAP reconciliation tables and a discussion of business activities, along with the recording of this call, are all available on Republic's website at republicservices.com. I want to remind you that Republic's management team routinely participates in investor conferences. When events are scheduled, the dates, times and presentations are posted on our website. With that, I would like to turn the call over to Don.

Thanks, Stacey. Good afternoon, everyone, and thank you for joining us. We are extremely pleased with our third quarter results, which clearly demonstrate the strength and resiliency of our business. The Republic team is working hard every day, delivering quality service to our customers and communities. Our deep expertise and dedication, together with the strength of our market position and assets, made these results possible. During the quarter, we delivered adjusted earnings per share of $1, which is an 11% increase over the prior year, and expanded adjusted EBITDA margin 230 basis points to 30.3%. These strong operating results, together with effective cash management, helped us deliver $1.1 billion of adjusted free cash flow through Q3, which represents a 14% increase over the prior year. We believe investing our free cash flow in quality acquisitions is the best way to increase long-term shareholder value. We continue to prioritize acquisition opportunities to further strengthen our leading market positions and expand into new markets with attractive growth profiles. Year-to-date, we have invested $154 million in acquisitions. We recently received regulatory approval on a leading recycling and solid waste provider in the Twin Cities area. Combined with the previously discussed pending acquisition of Santek, we now expect to invest $850 million to $900 million in acquisitions in 2020. Our acquisition pipeline remains robust, and we expect 2021 will be another strong year of activity. Year-to-date, we've returned nearly $500 million to our shareholders through dividends and share repurchases. Our Board recently approved a $2 billion, 3-year share repurchase authorization, which will begin in January 2021. This is consistent with prior practice. As we look forward, we remain optimistic about our business and continued prospects for profitable growth. Pricing continues to exceed cost inflation, volumes continue to recover, and margins are expanding. Accordingly, we are raising our full year 2020 adjusted free cash flow guidance to a range of $1.15 billion to $1.2 billion. Additionally, with better visibility through the end of the year, we are reinstating adjusted EPS guidance. We now expect to achieve adjusted earnings per share in a range of $3.37 to $3.40 for the full year 2020. With respect to 2021, Jon will provide some color in just a few minutes. Before I turn the call over, I'd like to congratulate the Republic team for being certified as a Great Place to Work for the fourth consecutive year. We believe an engaged and diverse workforce is the greatest indicator of our success and the most important element in driving lasting results. This is yet another recognition of the inclusive culture we are building at Republic, one where the best people come to work.

Thanks, Don. During the third quarter, we successfully executed our pricing program, improved volume performance on a sequential basis, effectively managed costs, and continued to make investments to drive future growth. Total core price was 4.5%. This included open market pricing of 5.4% and restricted pricing of 3.2%. Core price represents price increases to our same-store customers, net of rollbacks. Average yield was 2.6%. Average yield measures the change in average price per unit and takes into account the impact of customer churn. As expected, volumes were down compared to the prior year, but our performance improved sequentially. In the third quarter, volume decreased 3.4%. This compares favorably to the 7.4% volume decrease we experienced in the second quarter with all lines of business showing improvements from Q2 levels. By September, volumes were down only 2.7% versus the prior year. Third quarter small-container volume decreased by 4.8% and was relatively consistent throughout the quarter. We continue to see most of the volume decline concentrated to customers in the education, hospitality, and restaurant businesses. However, we continue to see positive signs in our customer base, including small-container customers. Approximately 80% of customers that paused service have now returned, and approximately 45% of customers that decreased service levels at the onset of the pandemic have subsequently resumed. Said another way, only 1% of our small-container customer base is not receiving some level of service. Additionally, container weights were only 5% lighter during the third quarter compared to 13% lighter in the second quarter. This suggests continued improvement in economic activity. Third quarter large-container volume decreased 5.4%. The volume decline was relatively consistent between the permanent and temporary portions of this business. By September, large-container volume was down 3.7% versus the prior year. Total landfill volume decreased 3.1% versus the prior year. This included an increase of 3.3% in MSW volume, which is offset by a decrease of 2.5% in C&D volume and a decrease of 11.7% in special waste volume. The decrease in special waste volume was due to jobs being deferred, not canceled, and the pipeline remains strong. Our customers continue to value our quality service and commitment to supporting them throughout the pandemic. Our Net Promoter Score increased 8 points from the prior year, and we maintained our low customer churn of 7%. We continue to invest in capabilities to deliver our customer-centric digital experience, which we believe will further differentiate us from our competitors. For example, during the quarter, we began piloting automated proactive communications to our customers. This allows customers to set up customized preferences to receive tailored communications through the channel of their choice. Further advancements in customer-facing technology were made possible by the strong foundation we built as part of our digital transformation, including our RISE platform. We continue to partner with our municipal customers to address the impact of COVID on our business. Third quarter residential weights remained up 10% versus the prior year, which was consistent with Q2. We also made further progress on renegotiating contracts with favorable pricing terms. We now have $855 million of annual revenue or 34% of our CPI-based contracts tied to a waste-related index or a fixed rate increase of 3% or greater. From an operational perspective, we effectively managed cost to meet the change in underlying demand for service. Thanks to the team's unwavering efforts, we reduced costs to more than offset the decline in revenue. This resulted in a $41 million increase in adjusted EBITDA and margin expansion of 230 basis points. This was enabled in part by our RISE platform, which allows us to dynamically adjust our routes. We are now 97% complete with the implementation of the RISE platform across the organization. We also maintained our record-setting safety performance by reducing safety incidents by approximately 20% versus the prior year. This drove a 10% decrease in risk management costs. Next, turning to our environmental services business. Third quarter environmental services revenue decreased $34 million from the prior year. This resulted in a 130 basis point headwind to total revenue growth. This was primarily due to a decrease in drilling activity and delays of implant project work. Since mid-August, we have seen rig counts begin to increase, but expect revenue to remain compressed through the end of the year. Finally, turning to recycling. Recycled commodity prices increased 38% to $99 per ton in the third quarter. This compared to $72 per ton in the prior year. The benefit from higher recycled commodity prices was partially offset by a 7% decrease in inbound recycling volume. With that, I will now turn the call over to Brian.

Thanks, Jon. Adjusted EBITDA margin expanded 230 basis points to 30.3% in the third quarter. The components of margin expansion included 70 basis points of improvement from favorable net fuel and higher recycled commodity prices and 160 basis points of improvement from the underlying business. Margin expansion in the underlying business was broad-based, and nearly all operating expenses improved compared to the prior year. Additionally, SG&A as a percent of revenue was 10%, an improvement of 40 basis points over the prior year. Our performance reflects cost controls put in place and reductions in nonessential spending while continuing to make investments for the future to ensure the long-term health of our business. Although we're not providing specific EBITDA margin guidance, I'd like to remind you that there's a 50 basis point headwind in the fourth quarter due to the timing of CNG tax credits. Even with this headwind, we expect EBITDA margin to be at or above fourth quarter 2019 performance. This would result in full year margin expansion and exceed our original full year EBITDA margin guidance that we provided back in February. Year-to-date, adjusted free cash flow was $1.1 billion, an increase of 14% over the prior year. Free cash flow growth was driven by an increase in earnings and improvements in working capital. The contribution from working capital includes a 1.5-day improvement in DSO, a 2-day improvement in DPO and $68 million of deferred payroll taxes under the CARES Act. It's important to note that even without the benefit of the payroll tax deferral, adjusted free cash flow would be up nearly 7% compared to the prior year. Cash collections remain strong. We believe our DSO performance reflects our customers' willingness to pay for the high-quality service we provide and the essential nature of our business. As Don mentioned, we are raising our adjusted free cash flow guidance to a range of $1.15 billion to $1.2 billion for the year. It's important to note that this level of performance assumes over $1.2 billion of capital expenditures, which is an increase from our prior guidance and relatively consistent with the level of spend we contemplated in our original guidance back in February. While we have already achieved over 90% of this full year guide, it should be noted that certain expenditures are backend loaded. During the fourth quarter, we expect to pay approximately 70% of our full year cash taxes, receive approximately 1/3 of our full year capital expenditures and anniversary the benefit from DSO and DPO improvements. Our full year adjusted free cash flow guidance assumes we will defer approximately $100 million under the CARES Act in 2020. However, if our performance is trending at or above the high end of our guidance range, it is highly likely we would repay the deferred taxes early. During the quarter, total debt was $8.8 billion, and total liquidity increased to $3.4 billion. This includes our new 364-day credit facility. Our leverage ratio was approximately 3.1x. We have plenty of capacity to fund outsized acquisition growth while maintaining leverage within an optimal range. Interest expense in the third quarter was $89 million and included $17 million of noncash amortization expense. During the quarter, we refinanced our 2021 bonds to capitalize on the low interest rate environment. This will reduce cash interest by approximately $22 million per year, which we'll begin to realize in the fourth quarter. Our adjusted income tax provision was $75 million, which resulted in an effective tax rate of 19%. Together with the $8 million charge from solar investments, we had a total tax-related impact of $83 million during the quarter or 21% of adjusted earnings before taxes. The charge related to solar investments is recorded as a loss from unconsolidated investments on our income statement. The 21% all-in rate was less than our statutory rate of 27%, which resulted in an EPS benefit of approximately $0.08 during the quarter. We expect an all-in tax-related impact of 27% of EBT in the fourth quarter, which will be made up of the income tax provision and charges from solar investments. Let me now turn the call over to Jon to provide some initial thoughts on 2021.

You've heard Don, Brian, and me talk about the positive momentum in the business, which we believe will carry over into 2021 to drive continued growth in revenue, earnings, and free cash flow. In particular, we believe we will improve free cash flow conversion and deliver high single-digit adjusted free cash flow growth in 2021. As usual, we will provide full year 2021 guidance on our fourth quarter earnings call. With that, operator, I'd like to open the call to questions.

My first question is about free cash conversion. Before the pandemic, Republic operated at around 41%. Your biggest competitor is in the high 40% range. Can you discuss whether reaching the high 40s is achievable? Is there anything structural that might hinder that? I'm not considering 2020 since it was a very different year, but based on your historic free cash flow conversion compared to your largest peer, what should we keep in mind regarding catching up?

Hamzah, this is Don. Yes is the short answer. Cash flow conversion is a conversation we have here all the time. Our cash flow conversion is moving north. There's nothing structural that prevents us from getting above the 40%, midpoint into the high 40s. When we provide a detailed guidance with you guys in February, we're going to be talking more about that. But yes, you can expect the cash flow conversion to move up from its historical levels.

And just to add to that, I think you'll see opportunities on both sides, right, the numerator and the denominator. We see opportunities to both increase the EBITDA margin as well as manage capital expenditures to drive that number.

Yes. And to Jon's point, Hamzah, that's the real leverage, right? So if you're expanding both, that's why we believe that we're going to be able to grow free cash flow by improving free cash flow margin at a greater rate than we're increasing earnings.

Got it. That's very helpful. And just my follow-up question, I'll turn it over. Very strong margin performance, 30%-plus EBITDA. Could you maybe talk about the sustainability of that margin profile going forward? I know time and weight is a big part of your cost structure, and this is a unique time. But how should we think about sort of cost coming back into the system as you see volume improve? And how much of the margin increase we've seen is kind of structural in nature?

Yes. Good question, Hamzah. So a couple of things to keep in mind. One is seasonality. Third quarter is typically our high point in terms of margin. So you're going to see some natural regression if you get seasonality in the business. And to your point, during the pandemic, there have been a few tailwinds just in terms of productivity with lack of traffic as well as lower container waste and small-container while maintaining that revenue profile. So those certainly help us, and we expect to dissipate some as we go forward. That being said, we've learned a lot of things in the pandemic and do believe we found a different level of performance in terms of productivity and safety, which is associated with our risk cost. And some of that is the pandemic, and some of that is just the return on the investment we've made over the years in digital operations and our operating discipline. And those things are all starting to accrue to the bottom line. And again, we expect to have line of sight to a 30% margin over the next few years on a sustainable basis.

Hey, Brian, so lots of info in the prepared remarks, but I just want to be clear. So in the 2020 guide of free cash flow, you're assuming $120 million payroll deferral benefit this year?

$100 million, Tyler.

Okay. So then, Jon, whenever we think about your comments about free cash flow for next year being, I think, up in the high single-digit range, so is that number assuming something like $150 million payroll deferral negative comp?

Well...

Right. But your high single digit is a comp, right, versus prior year?

Yes. Yes, correct.

Yes. No, you're right, it's $150 million.

Correct.

Starting point to end point headwind we're overcoming and still achieving the high single-digit free cash flow growth.

Yes, yes, yes, that's my point. Okay. That's good. And then so in the table in the release, I think, Jon, you noted that resi yields were north of 3% this quarter. I think that maybe the first time, at least in a limited history, I'm looking at it. But I'm just curious, do you think that we have enough of that alternative index that separate the increased mix to kind of drive sustainability in that?

We won't have enough until we have the entire book. Therefore, we continue to engage with City Hall to establish a pricing index that accurately reflects our cost structure while providing our frontline workforce with a sustainable wage increase each year, which we achieve. Recycling plays a significant role in this. We've discussed improving our pricing mechanism for recycling. Additionally, we have been very active at the curb during the pandemic as people have stayed at home, shifting the waste flow from small businesses to residences. We already have over 100 customers who have agreed to price increases to align with the heightened cost structure, and we are determined to keep pursuing these price adjustments.

So listen, there's some puts and takes any given quarter on when pricing hits sort of the resets of given markets. But our aspiration to get a yield that better reflects our overall business mix in residential is unrelenting, and we'll continue to work with our municipal customers on that front. Did resi margins go up?

They did. Yes.

So my first question here is on technology. Obviously, you've made some significant and meaningful investments on the technological front. If we were to put it into 3 buckets as being kind of revenue-generative as you provide a better service as a result of that technology, cost saving because you're becoming more efficient or safety-related, if you look at the $1 spent last year in technology, how would you bucket into those categories? And what evidence, say, for revenue-generative have you seen the success of that technological spend?

We do not disclose the specific details of our spending. However, we have made consistent investments in all three categories, including safety, which has been a focus for several years. We have increased our spending on operational and customer initiatives. While there are distinctions between these two areas, they are also interconnected. For example, the implementation of our RISE dispatch platform and the use of tablets in our trucks enhances both productivity and efficiency. This improvement also elevates the customer experience, contributing to our already high 99.9% on-time delivery rate. Additionally, it enables us to engage with customers in new ways through proactive service notifications and ongoing verification, ultimately enhancing our product and fostering greater customer loyalty.

Yes. And I think you saw, Walter, in my remarks, I talked about spending a similar level of CapEx this year as we originally guided. Even though we've got lower volumes, a lot of that is because we're investing more in this digital transformation. And we think that based on the benefits we've seen so far, that there's much more to come, and that's why we're trying to accelerate that spend.

Okay. That's great color. And my second follow-up question here is on the M&A environment. Can you speak a little bit about your pipeline, I guess, specifically whether there had been a degree of pull forward of M&A activity in advance of the election and whether you think a lull might be created here post election as a result of that pull forward?

Yes. There was certainly some accelerated activity in wanting deals to close in a certain time period. I think there's far much less people who wanted to sell because they thought there was going to be a certain political risk and then, therefore, don't want to sell because they see the election coming out in a different way than they expected. But people typically sell for structural events, right? They have a change in their life circumstances. There's a generational transition where the next generation doesn't want to run the business. There's some life-changing events, something happens that triggers people to sell. And again, the political risk and what they think would be implications around taxes might accelerate timing a month or 2, but that isn't really driving activity in our experience.

So the pipeline, as you see it, really hasn't changed from October to December?

The pipeline has not changed, and it remains strong.

I just want to focus on volumes. They're a bit better than I expected and better than your peers, even your sequential improvement was better. You're also one of the few calling for kind of gradual improvement here for the remainder of this year, whereas others seem to be more flattish. Is there anything notable that is driving this relative to the others? And just any high-level thoughts on the economy from your vantage point and views on different subsectors here going into 4Q?

Yes, we are seeing steady improvement. There are fluctuations in different areas, so focusing on a specific geography might reveal some stagnation, or temporary shelter-in-place orders may lead to minor pullbacks. However, the overall strength of our portfolio, both geographically and across different business lines, remains robust. We also have a strong special waste pipeline for the fourth quarter, which gives me confidence. We're observing steady improvements throughout the business. While we remain cautious due to the ongoing uncertainty of the pandemic, we are seeing positive momentum based on current trends. We have maintained strong engagement with our customers, with a sales team dedicated to addressing their needs. If they require reduced service, we accommodate that, and when they are ready to ramp up services, we stay in close contact to assist them. We successfully transitioned our call centers to 98% remote work within 72 hours without compromising service quality, and our performance metrics have remained strong in this environment, allowing us to effectively serve our customers.

Yes. The top line has performed better than expected, and our operations have been notably strong. We have consistently highlighted the strength of our company and team, as well as the resilience of our business model, and that remains true. What we are experiencing now is agility; we have quickly adapted to new working methods and embraced tools like the RISE platform. The momentum generated by our investments and efforts over the past decade is culminating in a significant breakthrough, especially against the backdrop of COVID. This all contributes to our positive momentum throughout the year and positions us well for 2021.

Got you. And just a follow-up. I think you mentioned that you continue to see the biggest volume declines in education, hospitality, and I missed the third category. But is there any way to quantify your exposure to these kind of subsectors? And how have they performed in October relative to September?

Well, let me take education, for example, right? I mean, normally, we have a pretty big seasonal upswing here in September as all those schools come back online. And we've just seen what you've seen, which is people are moving all over the place. Some schools are fully in person, some are fully remote, and then others have hybrid options that have every kind of variation in between. So we've been flexible with our customers to adjust our service level to better meet their needs.

It's clearly temporary, right? It's going to, at some point, get back to in-class learning, right? And then that business just comes back when it comes back. And it builds right into our route base, so it usually comes in at a pretty decent margin to boot.

Yes. And one of the things we had mentioned last quarter what the impact was from education. And if you take a look in the third quarter, it was about 20% of our small-container decline was due to education alone.

I just wanted to ask Hamzah's question just in a bit of a different way. I mean just considering all these moving parts, considerably better margins than expected this year, is sort of a normal 30 basis points-ish kind of margin expansion outcome achievable in 2021?

You're talking about for the full year, 30%?

I'm just talking about, can RSG expand margins sort of at a normalized, say, 30 basis point level year-over-year in 2021 in light of some of these nonrecurring cost savings in 2020?

Yes. Look, I think you do have to take into consideration, Jon mentioned it, right, there are certainly some things that are happening in the macro environment, right, things that are helping productivity, some of the lighter container weights. So there are some puts and takes. But we do feel that 30% margin, an improvement towards 30% margin is something that's in the near term, right? And it's going to be something that we're going to continue to move toward. '21 might have a little bit of noise in it just because you have some of those macro benefits modulating. But after that, certainly, 30-plus basis points a year is something that's certainly achievable.

We're on the cost.

Got you. All right. Great. And is there any reason to think price won't trend up next year? I mean it was called out, the resi yield number was really a standout in the quarter. Does that give us some juice into next year? I mean what are the puts and takes there?

Yes. Our pricing philosophy has remained consistent throughout the pandemic, focusing on obtaining a fair price for the excellent work we deliver. You can expect to see strong pricing in the open markets. Regarding landfill pricing, there may be a slight headwind on the Consumer Price Index, as there is typically a 10 to 18-month lag before CPI changes are reflected in our contracts and escalators. This may pose some challenges, but our fundamental pricing philosophy remains unchanged. We anticipate achieving a strong yield in the mid-2s at the very least.

Yes. We have made significant progress in converting the residential municipal business that Jon mentioned. About 100 contracts have already engaged with us and approved price increases due to higher volumes, which is a positive trend. We will continue to navigate similar situations moving forward. Landfill pricing has remained strong, and we believe there is still potential for further increases in that area due to the cost structure and challenges with permitting and expanding landfills. That pricing is expected to stay robust. Overall, despite the current market fluctuations, the market has been quite rational, and that serves as the context for our outlook.

Yes. Excellent. Super helpful summary there. And again, nice work.

Okay. Thank you.

Can you just compare how you're thinking about the volume recoveries between both small-container and large-container at this point? I know large-container had a larger initial drop, and now they're booked down about a similar rate in this quarter. So just going forward, would you expect a large-container recovery to pick up faster, especially given some tailwinds we're seeing, especially around housing? Or would you expect those to move relatively in lockstep going forward?

Yes. When we analyze single-family housing starts and the strength we've observed in those figures, we know from our investor presentations that this positively affects our volumes approximately 12 months later, indicating a lag. It's important to note that a significant portion of our large-container business is permanent. Therefore, the discussion primarily revolves around the temporary aspect, which relates to construction and certain event projects. This is where we might anticipate some acceleration on the event side. However, the permanent large-container and small-container segments typically progress at a similar pace.

Yes. It really just depends what happens with schools. It depends what happens with the restaurants. And a lot of restaurants have gotten very innovative in the North in terms of outdoor dining, and that will be more of a challenge as we move into the late fall/winter season here. So there'll be a few puts and takes that could impact us the next quarter or 2 in small-container in terms of that trend, maybe a little bit less than the large-container firm. But I don't think there'll be any fundamental differences for that.

Yes. And the sequential gap continues to close, I guess.

Okay. That was all very helpful. And then on the recent pledge to purchase 2,500 electric trucks, and I know you're a few years away from actual integration of those vehicles, but can you just talk about how you view those trucks relative to diesel and CNG in operations today? And maybe any rule of thumb we can think of in terms of financial benefit, if any, you'd be expecting? Or is it mostly just an environmental benefit from your point of view? Just any thoughts there would be helpful.

Yes. No, we're very bullish on electrification long term. We think that's the winning technology in the space because that's the only truly 0 emissions option out there. But we've said all along, it's going to be a challenge, and it'll take time, right? We're going to have to work making commitments in the space because we need to innovate and help innovate. We've got relationships across the value chain, right, that we're showing a leadership position in that over time. We also have fundamental belief that if something is going to be environmentally sustainable over time, it's got to be economically sustainable. So we don't expect to do this by reducing returns. We expect over time to amp returns. Now there might be some puts and takes between higher upfront CapEx and then lower operating costs through reduced fuel cost or reduced maintenance costs over time. But again, we're very proactive in that space.

Now look, we're the seventh largest vocational fleet in the nation. And to Jon's point, we are the right kind of company to be innovating and to be pushing innovation onto the market. And again, when you get there, those benefits accrue in large ways because we've got 16,000 trucks on the street every day.

I have two specific questions, but first, I want to ensure that everyone hears the answer clearly. My first question is about the 160 basis points improvement in solid waste. Considering traffic and productivity, what impact does that have on the 160 basis points when everyone is working full time and you have increased labor for that?

Yes, Michael, it's difficult to pinpoint exactly because we have a combination of two factors. First, there are lower traffic patterns due to people sheltering in place, and second, our digital tools are enhancing productivity. While we don't expect to maintain all aspects of this, we hope to keep a significant part of the productivity gains. Notably, we've observed that there isn't a major difference in productivity between rural and urban markets, indicating benefits in both areas. If the improvements were solely pandemic-related, I would have anticipated a much larger increase in urban markets. Instead, we're seeing advantages across the board. Therefore, as we focus on our plan to expand margins, a significant part of that will involve capturing some of these productivity benefits moving forward.

Yes. So look, there's definitely some impact, to your point, Michael, with traffic. But look, the initial rollout of the RISE platform is the foundational element surprise. The stuff the team is working on now, the next things that they'll layer in now once the platform is rolled out and established is additive, right? So there's going to be layer after layer of additional feature benefit and capability on that digital platform that's going to drive new margin expansion and better operations, better customer-facing stuff, more information in our pricing tools and just better, safer operations.

Yes. We've implemented tablets in our trucks, providing our people with visibility both at the branch and for the drivers, allowing them to see where the trucks are located. For instance, a large-container route can have seven movements in a day. Our goal is to achieve eight movements in the same timeframe while enhancing safety and delivering improved customer service. This is a clear example of how these tools are positively impacting our bottom line.

Hey, Michael, one thing I just wanted to kind of clarify that, too, is that when we talk about the 160 basis points, call it, at the underlying business, that's not just solid waste, that also includes the impact from environmental services. So the only thing that doesn't include of the 230 basis points of total margin expansion is the impact of both net fuel and higher commodity prices had on margin expansion.

Okay, that's helpful. I have a clarification question. Someone asked about margin and margin expansion, and I was taking notes quickly. You mentioned expecting margins to expand next year, and while 30 is a great goal, you’re not setting a specific target, but you do anticipate margin expansion. It seemed like, from my notes, it sounded like you might be expecting margins to remain flat.

No. We expect margins to expand. We're not giving a guide on that topic, but we are expecting margins to expand.

Michael, that's the point of momentum. When you heard me mention it, Jon used it too. There’s underlying strength in our business, development in our people, and resilience in our mid-business model. We have a rational backdrop and have shown agility through this downturn. You can see how quickly the company turned, reacted, adapted, and demonstrated proven agility and momentum. That is the key takeaway here. There is really strong momentum in the business, within the team, and in all the work that's been done over the past years that will carry us into 2021.

Okay. And then my second one is on free cash flow, and it's got both a clarification and a question in it. Maybe your conversion rate has been less than peers, but your fundamental year-over-year growth rate has been better than your major peer for a decade, one; and two, you do have headwinds. Your leverage ratio has been consistently higher and you pay out more in closure and post closure in absolute dollars. So the question is, do you expect to be able to raise this number by high single digit and still have all of that in front of you?

Yes. Look, we're not going to change the structural issue with legacy landfills, right, overall, right? I mean they're going to have that cost, maybe somebody else doesn't have. And our formula of returning cash to shareholders, the way we do is a very time-tested formula, right? We're going to continue to invest in capital even through this tough time. I mean, look, when we went through the Great Recession, we didn't stop investing in the business. We had strong enough cash flow to carry us. We continue to invest in fleet, all the other things. Through this year, we didn't shut it down. We actually, in some cases, accelerated some of the spending in some of the digital tools. And yes, I mean we're very strongly focused on cash flow conversion. And as I said earlier, we're going to get ahead of that 45% and going to carry us into northern 40% territory.

Right. And that's why I was saying, Michael, as I made those comments about both the combination of EBITDA margin expansion and being able to reduce expenditures, that combination is why we feel that there's going to be an accelerating event here on free cash flow conversion to drive that free cash flow growth.

Look at the progress that Jon, Tim, and the team have made. We have already discussed changing the pricing mechanism for municipal services to ensure a fair and equitable arrangement, which is currently in progress. We are making significant strides in recycling as well. It's not just the recycling markets that will benefit us; we are actively retooling that business to ensure it is genuinely sustainable. This is happening now. Additionally, we are addressing pricing on the residential side for elevated weights, along with various underlying operational benefits. Safety, employee turnover, and engagement are all positive stories contributing to our overall success, and these will manifest regardless of COVID. In fact, COVID provided us with new agility and required us to implement operational changes that will benefit us going forward.

Last quarter, you mentioned that about 15% of your labor cost was overtime, and it was down 25%. Can you tell us by how much overtime was down year-over-year in the third quarter and October, if you care to share that data?

Yes. In the third quarter, overtime hours decreased by about 10% compared to the previous year.

Well, if you think about seasonality, typically, what you see is an uptick in the second and primarily the third. So from a seasonal perspective, then you start to see it kind of come down in the fourth quarter. So your toughest bogey is generally the third quarter hit from a year-over-year perspective when you talk about seasonal volumes. So there typically isn't something that increases significantly in the fourth quarter from a volume perspective when you look at Q3 to Q4.

Yes. Except you might have some other just recovery because certain sectors open up, that book maybe shut down, right?

Yes.

Yes. Some of it is purely seasonal, which is in the North, there's construction activity that just doesn't happen because of the weather. Now there could be some special waste jobs that are teed up for us that we would have in the second or third quarter that have just gotten delayed. And now that people have more clarity going forward, that they'll hit, and we, again, feel really good about that pipeline. So there should be some modest opportunities there.

Look, normally, seasonally, Q3 is our strongest quarter, Q2 is our second strongest then Q4 and then Q1.

And Q1, right. So we don't see certainly any headwinds as we look in the fourth quarter from a seasonal perspective year-over-year versus what we just went through in the third quarter.

Don, for many years, we were hearing about you guys intentionally shedding business. Every call, there would be a lot of questions on why your volumes were underperforming some peers. I guess my question is, one, are you guys kind of through that intentional shedding? And two, how do you think that has positioned you guys going into this downturn and really coming out of the downturn?

You heard Jon mention the phrase, the power of the portfolio, which we often discuss. After spending many years building and consolidating our business with five public companies, we've encountered some challenges that needed addressing. We're mostly past that now. We've made adjustments in various markets, entering and exiting as needed. Previously, we spoke about national accounts that we had to let go, but that's not a focus for us anymore. Our strong acquisition pipeline, which Jon referenced last quarter, ensures we may acquire some business that doesn't quite align with our model and could be discarded. However, we believe we've implemented effective filtering and testing processes for our new business, supported by our recently launched sales tools, which enhances our organic sales efforts. While some business may still be shed due to robust mergers and acquisitions, we feel confident in our position. The power of our portfolio relies on a balanced mix of geographies and various business sizes. We have also made significant improvements in our municipal sector, which has faced challenges with difficult recycling contracts and escalators, but we're starting to see positive changes there. This demonstrates the dedication of our team. All this effort contributes to the strength of our portfolio. A strong portfolio helps mitigate seasonal impacts from winter and weather events, similar to how an investment portfolio works. We have worked hard to build and continuously improve our portfolio, and it will keep getting better over time.

That makes sense. And Don, just piggybacking off that, this is kind of a big-picture question. I mean you've seen a lot of consolidation in your day, big and small. Some of your peers right now are integrating some large-scale acquisitions in Q4 in the middle of COVID. You guys have elevated M&A, but you passed on some of these bigger deals. I'm curious how you and the management team think that positions the company kind of into 2021.

We have evaluated every reasonable deal that has come our way. There have been instances where we've taken the lead on some deals, but on a return on investment basis, we couldn't feel as confident as we wished, so we decided to pass. In a few cases, others moved forward with those deals, and some paid more than we might have considered. We face strong competition from many high-quality companies and have a clear understanding of who they are and how they operate. We are in discussions with those top-quality organizations. However, we recognize that we won't secure every deal. Typically, there's a natural buyer involved, which may relate to cultural or geographical compatibility, or even the purchasing company’s current stage in its lifecycle and commitments made to the market. We aren’t pursuing deals under pressure to meet unrealistic growth expectations. We focus on what we do best. We have an excellent M&A team who are knowledgeable about their markets. Each of our regions has strategic plans for growth, whether through landfill expansions, acquisitions, or new business lines, and all these initiatives are in progress. I recall when we paused M&A after a significant merger over ten years ago, and over the years, I’ve communicated our plans for future acquisitions, sometimes not hitting the mark because we turned down opportunities that later seemed valuable after due diligence revealed concerns. Our priority has been to make decisions that serve the company’s best interests rather than just meeting numbers. This year, however, we anticipate significant successes due to new opportunities. The companies we are acquiring now are high-quality and align well with our objectives. We continue to expand our core capabilities, particularly in the environmental space, which we are excited about. We have not provided specific guidance on this yet but will discuss it in February based on our pipeline. When we say we are well positioned, you can trust that statement.

What do you expect to close in 2020? Can you provide a number on how much rollover we anticipate on the top line? Is there a way you can frame that for us?

Yes. With that $850 million to $900 million investment that we guided to, again, it's going to be very heavily back-end loaded. We would expect, call it, 150 basis points plus of acquisition rollover on the top line.

Okay, that's perfect. And just lastly, I know I might have missed this regarding October. Did you mention if October volumes were up compared to September, or if they were fairly flat sequentially? I might not have caught that.

Yes. They were somewhat flattish from September levels, but about a 100 basis point improvement from the Q3 average.

Thank you, Chad. In closing, we are very pleased with our third quarter performance and continue to have a positive outlook on our business. We delivered double-digit adjusted EPS and free cash flow growth, expanded EBITDA margin and achieved EBITDA margin performance above 30%. We raised our full year 2020 adjusted free cash flow guidance, and we see strong free cash flow growth in 2021. Once again, we have proved the resiliency of our business and the strength of our model. I'd like to take a moment to recognize the hard work, commitment, and dedication exhibited by our 36,000 team members this year. At the onset of COVID, we launched our Committed to Serve program to recognize our frontline employees who deliver an essential service to our communities across the country each and every day. And since then, their dedication has continued. Even through record-setting weather events, including fires and hurricanes and, frankly, you name it, they've never let up. And it's their consistency and willingness to take care of our customers, communities, and each other that makes them truly relentless and makes me proud to work for Republic Services. I hope you all have a good evening. Stay safe out there.