WASTE MANAGEMENT INC - 10-Q Quarterly Report

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2002

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM TO

COMMISSION FILE NUMBER 1-12154

WASTE MANAGEMENT, INC.
(Exact name of registrant as specified in its charter)

DELAWARE 73-1309529
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)

1001 FANNIN
SUITE 4000
HOUSTON, TEXAS 77002
(Address of principal executive offices)

(713) 512-6200
(Registrant's telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]

The number of shares of Common Stock, $.01 par value, of the registrant
outstanding at October 28, 2002 was 608,679,670 (excluding treasury shares of
21,628,363).

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PART I

ITEM 1. FINANCIAL STATEMENTS.

WASTE MANAGEMENT, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN MILLIONS, EXCEPT SHARE AND PAR VALUE AMOUNTS)

See notes to condensed consolidated financial statements.
1

WASTE MANAGEMENT, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN MILLIONS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)

See notes to condensed consolidated financial statements.
2

WASTE MANAGEMENT, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN MILLIONS)
(UNAUDITED)

See notes to condensed consolidated financial statements.
3

WASTE MANAGEMENT, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(IN MILLIONS, EXCEPT SHARES IN THOUSANDS)
(UNAUDITED)

See notes to condensed consolidated financial statements.
4

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

The consolidated financial statements of Waste Management, Inc., a Delaware
corporation, and subsidiaries ("Waste Management" or the "Company") presented
herein are unaudited. In the opinion of management, these financial statements
include all adjustments, which, except as described elsewhere herein, are of a
normal recurring nature, necessary for a fair presentation of the financial
position, results of operations, and cash flows for the periods presented. The
results for interim periods are not necessarily indicative of results for the
entire year. The financial statements presented herein should be read in
connection with the financial statements included in the Company's Annual Report
on Form 10-K for the year ended December 31, 2001.

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
certain estimates and assumptions. These estimates and assumptions affect the
reported amounts of assets and liabilities and disclosure of the contingent
assets and liabilities at the date of the financial statements. These estimates
and assumptions will also affect the reported amounts of certain revenues and
expenses during the reporting period. Actual results could differ materially
based on any changes in estimates and assumptions that the Company uses in the
preparation of its financial statements. Additionally, the estimates and
assumptions used in landfill airspace amortization and final closure and
post-closure rates per ton and environmental remediation liabilities require
significant engineering and accounting input. The Company reviews these
estimates and assumptions no less than annually. In many circumstances, the
ultimate outcome of these estimates and assumptions may not be known for decades
into the future. Actual results could differ materially from these estimates and
assumptions due to changes in environmental-related regulations or future
operational plans, and the inherent imprecision associated with estimating
matters so far into the future. See "Management's Discussion and Analysis"
elsewhere herein.

In the Company's Annual Report on Form 10-K for the year ended December 31,
2001, the Company reported accrued interest of $137 million as a component of
accounts payable. In its Quarterly Report on Form 10-Q for the quarter ended
March 31, 2002, the Company started reporting accrued interest as a component of
accrued liabilities instead of accounts payable. In order to conform the prior
period presentation of accrued interest to the current period presentation, the
Company has reclassified the $137 million of accrued interest at December 31,
2001 to accrued liabilities in the condensed consolidated balance sheet
presented elsewhere herein.

During the second quarter of 2002, the Company reviewed the accounting and
reporting for certain contractual arrangements entered into in the mid-1980s
relating to a waste-to-energy plant owned by a subsidiary of Wheelabrator
Technologies Inc. ("WTI") and determined to change its previous accounting by
recording the assets and liabilities associated with these arrangements on the
Company's balance sheet. As a result, the Company recorded an increase in
property, plant and equipment in the second quarter of 2002 of approximately $72
million; an increase in other long-term assets of approximately $52 million; an
increase in debt of approximately $114 million (which included the then current
portion of approximately $20 million that was paid in the third quarter of
2002); and an increase in other liabilities of $5 million. The Company also
recognized income of $5 million for the quarter ended June 30, 2002 for the
adjustments to the accounting for the contractual arrangements. As of September
30, 2002, approximately $94 million of debt, of which $6 million is current,
associated with this agreement has been included in the condensed consolidated
balance sheet.

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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

1. LONG-TERM DEBT

Long-term debt consisted of the following (in millions):

On June 27, 2002, the Company replaced its $750 million syndicated 364 day
line of credit with a $620 million syndicated revolving credit facility (the
"Three Year Revolver"). During the third quarter of 2002 the credit capacity of
the Three Year Revolver was increased to $650 million. The Company maintained
its $1.75 billion syndicated revolving credit facility (the "Five Year
Revolver"). No balances were outstanding from the Company's revolving credit
facilities as of December 31, 2001 or September 30, 2002. The Three Year
Revolver matures in June 2005 and the Five Year Revolver matures in June 2006.
As of September 30, 2002, the Company had letters of credit in the aggregate
amount of approximately $1,600 million (of which approximately $1,490 million
were issued under the revolving credit facilities) that generally have terms
allowing automatic renewal after a year. At September 30, 2002, the Company had
unused and available credit capacity under these facilities of approximately
$910 million.

In May 2002, the Company privately placed $500 million of 7 3/4% senior
unsecured notes due May 15, 2032. Interest on the notes is due on November 15
and May 15 of each year. The net proceeds of the offering were approximately
$498 million, after deducting underwriters' discounts and expenses. The Company
used a portion of these proceeds to pay the $300 million of 6.625% senior notes
that matured on July 15, 2002 and utilized the remaining proceeds along with
cash on hand to pay the $285.7 million of 7.7% senior notes that matured on
October 1, 2002.

During the first quarter of 2002, the Company refinanced approximately $49
million of fixed-rate tax-exempt bonds maturing in 2011 with variable-rate
tax-exempt bonds maturing in 2022. As a result, the Company incurred prepayment
penalties and other fees for a total extraordinary item charge, net of tax
benefit, of approximately $1 million. Also in the first quarter of 2002, the
Company retired its 4% convertible subordinated notes due February 2002 by
payment of $427 million to the holders of the outstanding notes.

The Company has $350 million of 6.5% senior notes due December 15, 2002.
The Company also has $450 million of 7.1% senior notes due August 1, 2026 that
are subject to early redemption on August 1, 2003 at the option of the holder.
The Company has classified these borrowings as long-term at September 30, 2002
based upon its ability to use its revolving credit facilities, which are both
long-term, to refinance these borrowings at their respective maturity or
repayment dates. The Company intends to pursue other sources of

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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

long-term financing to refinance the borrowings; however, in the event other
sources of long-term financing are not available, the Company intends to use its
revolving credit facilities.

The Company manages its debt portfolio by using interest rate derivatives
to achieve a desired position of fixed and floating rate debt, which is
approximately 65% fixed and 35% floating at September 30, 2002. Interest rate
swap agreements that were outstanding as of December 31, 2001 and September 30,
2002 are set forth in the table below (dollars in millions):

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(a) The fair value for interest rate derivatives is included in the Company's
balance sheet as components of other long-term assets and other long-term
liabilities.

(b) The interest rate contract's terms do not qualify for hedge accounting.
Therefore, the contract is accounted for using mark-to-market accounting and
changes in fair value are immediately recognized in interest expense.

(c) The terms of the interest rate contracts and the underlying debt instruments
are identical. Accordingly, these interest rate contracts are recorded at
fair value and changes in fair value of these interest rate contracts are
deferred as an adjustment to the carrying value of the underlying debt
instruments and recognized in interest expense over the life of the
underlying debt instruments.

(d) The fair value for these interest rate derivatives at December 31, 2001, is
comprised of $20 million long-term risk management assets and $20 million
long-term risk management liabilities.

In July 2002, the Company elected to terminate several interest rate swap
agreements with a notional amount of $600 million prior to the scheduled
maturities and received cash of $55 million (which is comprised of $43 million
for the fair value of the swaps that were terminated and $12 million of accrued
but unpaid interest receivable) from the counterparties to the interest rate
swaps. Under the hedge method of accounting for these types of derivatives, the
unamortized adjustment to long-term debt for the terminated swaps remains
classified as long-term debt. The proceeds received from the termination of the
interest rate swap agreements have been classified as a change in other assets
or other liabilities within operating activities in the accompanying condensed
consolidated statement of cash flows.

The carrying value of debt instruments have been increased by approximately
$255 million and $62 million as of September 30, 2002 and December 31, 2001,
respectively, related to the accounting for interest rate swap contracts. The
following table summarizes the accumulated fair value adjustments from interest
rate swap agreements by underlying debt instrument category (in millions):

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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

Interest rate swap agreements reduced interest expense by $21 million and
$64 million for the three and nine months ended September 30, 2002,
respectively, and $16 million and $21 million for the three and nine months
ended September 30, 2001, respectively.

The Company also entered into hedging agreements in February 2001 and
during the second quarter of 2002 to secure the then current market interest
rate in anticipation of senior unsecured note issuances. At September 30, 2002,
these cash flow hedges resulted in a deferred loss, net of taxes, of $50
million, which is included in accumulated other comprehensive income. The $50
million deferred loss includes $8 million for hedges that have terminated
concurrently with a senior unsecured note issuance. Of this $8 million, $1
million (on a pre-tax basis) is scheduled to be reclassified into interest
expense over the next 12 months.

During June 2002, the Company entered into forward contracts, which expire
in December 2002 and 2003, and cross-currency swaps, which expire in May 2004,
with net notional amounts of $165 million Canadian dollars to mitigate the risk
of foreign currency exchange rate fluctuations associated with the conversion of
Canadian dollars into US dollars. At September 30, 2002, these derivatives have
a net fair value of approximately $3 million and are included in other long-term
assets. The Company had no foreign currency derivatives outstanding at December
31, 2001.

2. INCOME TAXES

The current and deferred tax obligations associated with the provision for
income taxes recorded in the statement of operations are reflected in the
accompanying condensed consolidated balance sheets as a component of accrued
liabilities and deferred income taxes, respectively. The difference in federal
income taxes computed at the federal statutory rate and reported income taxes
for the three and nine months ended September 30, 2002 is primarily due to state
and local income taxes, offset in part by non-conventional fuel tax credits. In
addition, the Company recognized a tax benefit of approximately $12 million in
the third quarter of 2002 due to the anticipated capital gain from a fourth
quarter 2002 sale which enables the Company to utilize a previously fully
reserved capital loss that arose from a divestiture that occurred earlier in
2002. The remaining benefit will be recognized in the fourth quarter. For the
three and nine months ended September 30, 2001, the difference is primarily due
to state and local income taxes, non-deductible costs related to acquired
intangibles and non-deductible costs associated with the impairment and
divestiture of certain businesses. Additionally, in the second quarter of 2001,
scheduled Canadian federal and provincial tax rate reductions resulted in a tax
benefit of $42 million, which was offset in part by a tax expense of $30 million
related to the Company's plan to repatriate certain Canadian capital and
earnings previously deemed permanently invested in Canada.

3. 2002 RESTRUCTURING

In March 2002, the Company adopted a new organizational structure designed
to better align collection, transport, recycling and disposal resources within
market areas. The Company believes the new structure will yield a number of
benefits, including clearer accountability and responsibility for business
performance and profitability in specific markets; simplification of structure;
cost savings through consolidation of duplicate administrative and other support
functions; improved utilization of operating assets; and better customer
responsiveness.

In March of 2002, all of the Company's operations other than WTI and
Canadian Waste Services ("CWS") were restructured to reduce the number of field
layers of management from four to three and the number of field layers that have
administrative and functional staff from four to two. Under the new structure,
the Company's approximately 1,200 operating sites, including waste collection
depots, transfer stations, landfills and recycling facilities, were restructured
into approximately 82 newly established Market Areas. These Market Areas are
responsible for the sales and marketing of the Company's services and for
directing the delivery of service by the districts. The Market Area is also the
profit center, and the districts, all of which
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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

used to be profit centers, became cost centers. The largest Market Areas are
headed by a Vice President and the others are headed by a General Manager. The
Market Areas consolidate financial reporting and provide a range of assistance
in the areas of finance and accounting, procurement, people, market planning and
development, fleet services, recycling, legal services, engineering, regulatory
compliance, safety and public affairs to support the districts. These Market
Areas all report to one of four Groups that divide the United States
geographically, and which were formerly known as the Company's "Areas." CWS,
which was restructured into ten newly established Market Areas in July 2002, and
WTI were the fifth and sixth Groups under the previous structure and continue as
the fifth and sixth Groups under the new structure.

The Company recorded $1 million and $38 million of pre-tax charges for
costs associated with the implementation of the new structure for the three and
nine months ended September 30, 2002, respectively. These charges include $36
million for employee severance and benefit costs and $2 million related to
abandoned operating lease agreements. The Company expects to incur an additional
$3 million of restructuring expenses in the last quarter of 2002 primarily
related to the relocation of employees and the consolidation of facilities to
support the new organizational structure.

Under the new structure approximately 1,900 field-level administrative and
operational positions have been eliminated. The Company's obligation for
severance payments will continue during the last quarter of 2002 and, in some
cases, into 2003. As of September 30, 2002, payments of $29 million for employee
severance and benefits and for abandoned leases had been recorded against the
restructuring liability that was previously established.

4. EARNINGS PER SHARE

The following reconciles income before extraordinary item and cumulative
effect of changes in accounting principle as presented on the condensed
consolidated statements of operations with diluted net income for the purposes
of calculating diluted earnings per common share (in millions):

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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following reconciles the number of common shares outstanding at
September 30 of each year to the weighted average number of common shares
outstanding and the weighted average number of common and dilutive potential
common shares outstanding for the purposes of calculating basic and diluted
earnings per common share (shares in millions):

For the three months ended September 30, 2002 and the three and nine months
ended September 30, 2001, the effect of the Company's convertible subordinated
notes is excluded from the diluted earnings per share calculation because its
inclusion would be antidilutive.

At September 30, 2002, there were approximately 47 million shares of common
stock potentially issuable with respect to stock options, warrants and
convertible debt, of which approximately 25 million shares were not included in
the diluted earnings per share computation because their exercise price was
greater than the average per share market price of the Company's stock for the
three and nine months ended September 30, 2002. Including the impact of these
potentially issuable shares in the current period calculations would have been
antidilutive for the periods presented, but could further dilute earnings per
share in the future.

In the third quarter of 2002, the Company declared an annual cash dividend
of $0.01 per share, or approximately $6 million, to stockholders of record on
September 30, 2002, which was paid on October 15, 2002.

5. DERIVATIVE INSTRUMENT POTENTIALLY SETTLED IN COMMON STOCK

In the first quarter of 2002, the Company entered into a transaction to
purchase stock under an accelerated stock repurchase master agreement,
purchasing approximately 10.9 million shares at $27.46 per share for a total of
approximately $300 million. Under the agreement, if the weighted average daily
market price at the end of the valuation period times the number of shares
initially purchased exceeded the approximately $300 million paid by the Company,
the difference would have been paid by the Company to the counterparty. However,
if at the end of the valuation period the weighted average daily market price
times the number of shares initially purchased was less than the amount paid by
the Company, this deficiency would be paid by the counterparty to the Company.
The Company accounted for the initial payment as a purchase of treasury stock
and classified the future settlement with the counterparty as an equity
instrument because the Company had the option under the agreement to settle its
obligations, if it had any obligations, in shares of its common stock.

The weighted average daily market price of the stock during the valuation
period times the number of shares initially purchased by the Company was
approximately $18 million less than the approximately $300 million the Company
paid for the repurchase. Therefore, during the third quarter of 2002 the
counterparty paid the Company approximately $18 million in cash to settle the
agreement. The Company accounted for the cash receipt as an adjustment to the
carrying value of treasury stock and has therefore

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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

included it in common stock repurchases within financing activities in the
accompanying condensed consolidated statement of cash flows.

6. COMPREHENSIVE INCOME (LOSS)

Comprehensive income (loss) is as follows (in millions):

The components of accumulated other comprehensive loss were as follows (in
millions):

7. ENVIRONMENTAL LIABILITIES

The Company has material financial commitments for final closure and
post-closure obligations with respect to the landfills it owns or operates.
Estimates of final closure and post-closure costs are developed using input from
the Company's engineers and accountants and are reviewed by management,
typically at least once per year. Adjustments for final closure and post-closure
estimates are accounted for prospectively over the remaining capacity of the
landfill. The estimates are based on the Company's interpretation of current
requirements and proposed regulatory changes. For landfills, the present value
of final closure and post-closure liabilities is accrued using a calculated rate
per ton and charged to expense as airspace is consumed. Each year the Company
revises its calculated rate per ton to reflect accretion on the present value of
the liability. The revised rate per ton is calculated by dividing the revised
present value of the liability, less the accumulated liability recognized to
date, by the estimated remaining capacity of the landfill. The present value of
total estimated final closure and post-closure costs will be fully accrued for
each landfill at the time the site discontinues accepting waste and is closed.
Final closure and post-closure accruals consider estimates for the final cap and
cover for the site, methane gas control, leachate management and groundwater
monitoring, and other operational and maintenance costs to be incurred after the
site discontinues accepting waste, which is

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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

generally expected to be for a period of up to thirty years after final site
closure. For purchased disposal sites, the Company assesses and records a
present value-based final closure and post-closure liability at the time the
Company assumes closure responsibility. This liability is based on the estimated
final closure and post-closure costs and the percentage of airspace used as of
the date the Company has assumed the closure responsibility. Thereafter, the
difference between the final closure and post-closure liability recorded at the
time of acquisition and the present value of total estimated final closure and
post-closure costs to be incurred is accrued using the calculated rate and
charged to operating costs as airspace is consumed.

In the United States, the final closure and post-closure requirements are
established by the EPA's Subtitles C and D regulations, as implemented and
applied on a state-by-state basis. The costs to comply with these requirements
could increase in the future as a result of legislation or regulation.

The Company routinely reviews and evaluates sites that require remediation,
including sites listed on the EPA's National Priorities List ("NPL sites"). The
Company considers whether the Company was an owner, operator, transporter, or
generator at the site, the amount and type of waste hauled to the site and the
number of years the Company was connected with the site. The Company also
reviews the same information with respect to other named and unnamed potentially
responsible parties ("PRPs"). The Company then reviews the estimated cost for
the likely remedy, which is based on management's judgment and experience in
remediating such sites for the Company as well as for unrelated parties,
information available from regulatory agencies as to costs of remediation, and
the number, financial resources and relative degree of responsibility of other
PRPs who may be liable for remediation of a specific site, as well as the
typical allocation of costs among PRPs. These estimates are sometimes a range of
possible outcomes. In those cases, the Company uses the amount within the range
that constitutes its best estimate. If no amount within the range appears to be
a better estimate than any other, the Company uses the amounts that are the low
ends of the ranges in accordance with Statement of Financial Accounting
Standards No. 5, Accounting for Contingencies, and its interpretations. Were the
Company to use the high ends of such ranges, it is reasonably possible that the
Company's potential liability would be approximately $220 million higher on a
discounted basis in the aggregate than the estimate recorded in the consolidated
financial statements as of September 30, 2002. As used in this context,
"reasonably possible" means the Company believes it is more than remote but less
than likely.

As of September 30, 2002, the Company or its subsidiaries had been notified
that they are potentially responsible parties in connection with 75 locations
listed on the NPL at which the Company's liability has not been rendered remote
as a result of a settlement, judgment or other facts. Of the 75 NPL sites at
which claims remain unliquidated, 17 are sites that the Company currently owns.
All of the NPL sites owned by the Company were initially developed by others as
landfill disposal facilities. At each of the 17 owned facilities, the Company is
working with the appropriate government agency to characterize or remediate
identified site problems. In addition, at these 17 owned facilities, the Company
has either agreed with other liable parties on an arrangement for sharing the
costs of remediation or is pursuing resolution of an allocation formula. The
Company believes that the remediation costs associated with the 17 NPL sites it
currently owns are accrued for adequately. The 58 NPL sites at which claims
against the Company remain unliquidated and that are not owned by the Company
are at different procedural stages under Superfund. At some of these sites, the
Company's liability is well defined as a consequence of governmental decisions
as to the appropriate remedy and agreements among liable parties as to the share
each will pay for implementing that remedy. At others where no remedy has been
selected or the liable parties have been unable to agree on an appropriate
allocation, the Company's future costs are uncertain, and as they become
estimable, could have a material adverse effect on the Company's financial
statements.

Estimates of the Company's degree of responsibility for remediation of a
particular site and the method and ultimate cost of remediation require a number
of assumptions and are inherently difficult, and the ultimate outcome may differ
materially from current estimates. It is possible that technological, regulatory
or enforcement developments, the results of environmental studies, the inability
to identify other PRPs, the

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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

inability of other PRPs to contribute to the settlements of such liabilities, or
other factors could necessitate the recording of additional liabilities that
could be material. Additionally, the Company's ongoing review of its remediation
liabilities could result in revisions that could cause upward or downward
adjustments to income from operations. These adjustments could be material in
any given period.

Where the Company believes that both the amount of a particular
environmental liability and the timing of the payments are reliably
determinable, the cost in current dollars is increased for inflation until
expected time of payment and then discounted to present value. The inflation
rate and discount rate, which are based on the rates for United States Treasury
bonds, are reviewed on an annual basis. At both September 30, 2002 and December
31, 2001, the inflation rate and discount rate were 2.0% and 5.5%, respectively.
The accretion of the interest related to the discounted environmental
liabilities for operating landfills is included in the annual calculation of the
landfill's final closure and post-closure cost per ton and is charged to
operating costs as landfill airspace is consumed. This practice, as it relates
to operating landfills, will change upon the Company's adoption of Statement of
Financial Accounting Standards No. 143, Accounting for Asset Retirement
Obligations ("SFAS No. 143"). See Note 12 for additional comments on this
pronouncement.

Liabilities for final closure, post-closure and environmental remediation
costs consisted of the following (in millions):

The changes to environmental liabilities are as follows (in millions):

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(a) The Company has recorded a reclassification entry since December 31, 2001
of approximately $56 million to increase its environmental liabilities,
with the offset primarily being an increase to other long-term assets.

8. COMMITMENTS AND CONTINGENCIES

Financial instruments -- The Company has provided letters of credit,
performance bonds, trust agreements, financial guarantees and insurance policies
to support tax-exempt bonds, contracts, performance of landfill final closure
and post-closure requirements, and other obligations. The Company also uses
captive insurance, or insurance policies issued by a wholly-owned insurance
company, the sole business of which is to issue such policies to the Company, in
order to secure such obligations. In those instances where the use of captive
insurance is not acceptable, the Company generally has available alternative
bonding mechanisms. Because virtually no claims have been made against these
financial instruments in the past, and considering

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WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

the Company's current financial position, management does not expect that these
instruments will have a material adverse effect on the Company's consolidated
financial statements. The Company has not experienced any unmanageable
difficulty in obtaining performance bonds or letters of credit for its current
operations. However, the tragic events of September 11, 2001, as well as
recently publicized financial difficulties of several large public companies,
have had an impact on the financial status of a number of insurance, surety and
reinsurance providers, which could cause an increase in the cost and a decrease
in the availability of surety and insurance coverages available to the Company
in the future. The Company has arranged for new sources of bonding capacity and
continues to evaluate a number of options for further capacity increases.

For the 14 months ended January 1, 2000, the Company insured certain risks,
including auto, general and workers' compensation, with Reliance National
Insurance Company ("Reliance"). On June 11, 2001, the ultimate parent of
Reliance, Reliance Group Holdings, Inc., filed for bankruptcy under Chapter 11
of the Bankruptcy Code of 1978, as amended (the "Bankruptcy Code"). On October
3, 2001, Reliance was placed in liquidation by a Pennsylvania Court. The Company
has determined that it will have various levels of coverage through various
state insurance guarantee funds in some, but not all, of the jurisdictions where
it is subject to claims that would have been covered by the Reliance insurance
program. While it is not possible to predict the outcome of proceedings
involving Reliance, the Company believes that because of the various insurance
guarantee funds and potential recoveries from the liquidation, it is unlikely
that events relating to Reliance will have a material adverse impact on the
Company's financial statements.

Environmental matters -- The Company's business is intrinsically connected
with the protection of the environment. As such, a significant portion of the
Company's operating costs and capital expenditures could be characterized as
costs of environmental protection. Such costs may increase in the future as a
result of legislation or regulation. However, the Company believes that it
generally tends to benefit when environmental regulation increases, which may
increase the demand for its services, and that it has the resources and
experience to manage environmental risk.

For more information regarding commitments and contingencies with respect
to environmental matters, see Note 7.

Litigation -- A group of companies that sold assets in exchange for common
stock in March 1996 to Waste Management Holdings, Inc. ("WM Holdings"), which
was acquired by the Company in July 1998 (the "WM Holdings Merger"), brought an
action against the Company in March 2000 for breach of contract and fraud, among
other things. The parties have agreed to resolve this dispute through
arbitration, which is currently scheduled for November 2002. The extent of
damages in the dispute has not yet been determined.

In December 1999, an individual brought an action against the Company, five
former officers of WM Holdings, and WM Holdings' former auditor, Arthur Andersen
LLP ("Andersen"), in Illinois state court on behalf of a proposed class of
individuals who purchased WM Holdings common stock before November 3, 1994, and
who held that stock through February 24, 1998, for alleged acts of common law
fraud, negligence, and breach of fiduciary duty. In May 2001, the court granted
in part and denied in part the defendants' motion to dismiss. This action is
currently in the discovery stage and the extent of possible damages, if any, has
not yet been determined.

To the extent that the Company is liable for any damages in the lawsuits
described above, it may be able to seek reimbursement of some of these damages
from a third party. However, it is reasonably possible that if any such
reimbursement is ultimately sought, the Company would not be successful in
collecting such amounts, and the Company would be required to recognize an
additional loss.

The Company is one of the defendants in a class action lawsuit arising from
events related to its earnings announcements in July and August of 1999. On
November 7, 2001, the Company announced that it had reached a settlement
agreement with the plaintiff in this case, resolving all claims against it as
well as claims
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

against its current and former officers and directors. The agreement provides
for a payment of $457 million to members of the class and for the Company to
consent to the certification of a class for the settlement of purchasers or
acquirers of the Company's securities from June 11, 1998 through November 9,
1999. The payment provided for by the settlement agreement is included in the
accompanying condensed consolidated balance sheets as a component of accrued
liabilities. A hearing was held April 29, 2002 at which the settlement was
approved. There is currently pending before the court a motion to vacate the
final approval order brought by a non-class member whose motion to intervene was
disallowed by the court. The same would-be intervener, along with one other
person (both former participants in WM Holdings' ERISA plans), has also filed a
separate case in Washington, D.C. against the Company and others attempting to
increase the recovery of a class of ERISA plan participants based on allegations
related to both the events alleged in and the settlements relating to the class
action against WM Holdings that was settled in 1998 and the complaint in this
action.

Also on November 7, 2001, the Company announced that it would receive $20
million (less fees of approximately $5 million awarded to counsel for the
derivative plaintiffs) as a result of a settlement reached between the
derivative plaintiffs and Andersen in a stockholder derivative suit filed on
July 3, 2001 in Texas state court against Andersen, as the Company's independent
auditor. The derivative plaintiffs alleged, among other things, that Andersen
engaged in professional malpractice in connection with certain services that it
performed for the Company. Andersen informed the Company that neither the
complaint nor the settlement affected its independence in 2001 or prior years,
when Andersen served as the Company's independent auditor. The settlement was
approved in May 2002. Andersen's payment will become due at the same time the
Company's payment to the plaintiffs in settlement of the class action lawsuit
described above becomes due, which is the date that all time periods for appeal
have lapsed or the judgment becomes final after all appeals have been exhausted.
Because of current motions before the Court and the possible appeals process,
the Company cannot predict when the class action payment will be due, and thus
cannot predict when the Andersen receivable will become due. Although Andersen
has experienced highly publicized negative events and has recently announced
significant curtailments in its business, the Company presently has no reason to
believe that the settlement amount will not be paid and the receivable that the
Company has recorded will not be collected. Any prolonged delay in the payment
ultimately becoming due could make such payment more uncertain, depending on
Andersen's financial status at such time. If such uncertainties develop in the
future, it is reasonably possible that the Company will be required to write
down the receivable up to the full amount due from Andersen.

On June 29, 2000, a putative class action was filed against the Company in
Delaware state court by a class of former Eastern stockholders falling within
the scope of the Eastern Merger Subclass described above. The plaintiffs allege
that the Company stock they received in exchange for their Eastern shares was
overvalued for the same reasons alleged in the consolidated class actions in
Texas. The named plaintiffs in the Delaware case have excluded themselves from
the Texas class action settlement and are pursuing their claim as individuals
and not as a class action. The case is still at a relatively early stage, and
the amount of damages, if any, cannot yet be determined.

Two groups of stockholders have filed separate lawsuits in state courts in
Texas against the Company and certain of its former officers. The petitions
allege that the plaintiffs are substantial stockholders of the Company's common
stock who intended to sell their stock in 1999, or to otherwise protect
themselves against loss, but that the individual defendants made false and
misleading statements regarding the Company's prospects that, along with public
statements, induced the plaintiffs to retain their stock or not to take other
measures. Plaintiffs assert that the value of their retained stock declined
dramatically. Plaintiffs assert claims for fraud, negligent misrepresentation,
and conspiracy. The Texas state court granted the Company's motion for summary
judgment in the first of these cases in March 2002, which the plaintiffs have
appealed. The second of these cases is in an early stage, and the extent of
damages, if any, cannot yet be determined.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Company's business is intrinsically connected with the protection of
the environment, and there is the potential for the unintended or unpermitted
discharge of materials into the environment. From time to time, the Company pays
fines or penalties in environmental proceedings relating primarily to waste
treatment, storage or disposal facilities. As of September 30, 2002, there were
nine proceedings involving Company subsidiaries where the sanctions involved in
each could potentially exceed one hundred thousand dollars. The matters involve
allegations that subsidiaries (i) operated a hazardous waste incinerator in such
a way that its air emissions exceeded permit limits, (ii) engaged in the
importation and disposal of hazardous waste in contravention of applicable
federal regulations, (iii) are responsible for remediation of landfill gas and
chemical compounds required pursuant to a Unilateral Administrative Order
associated with an NPL site, (iv) are responsible for late performance of work
required under a Unilateral Administrative Order, (v) improperly operated a
solid waste landfill and caused excess odors, (vi) improperly operated a solid
waste landfill by failing to maintain required records, properly place and cover
waste and adhere to proper leachate levels, (vii) violated the state's clean
water act, (viii) under-reported solid waste volumes that were received at a
municipal solid waste landfill, and (ix) did not comply with air regulations
requiring control of emissions at a closed landfill. The Company does not
believe that the fines or other penalties in these matters will, individually or
in the aggregate, have a material adverse effect on the Company's financial
condition or results of operations.

It is not possible at this time to predict the impact that the above
lawsuits, proceedings, investigations and inquiries may have on the Company, nor
is it possible to predict whether any other suits or claims may arise out of
these matters in the future. The Company and each of its subsidiaries intend to
defend themselves vigorously in all the above matters. However, it is reasonably
possible that the outcome of any of these matters may have a material adverse
impact on the Company's financial conditions or results of operations in one or
more future periods.

The Company and certain of its subsidiaries are also currently involved in
other routine civil litigation and governmental proceedings relating to the
conduct of their business. The Company does not believe that any of these
matters will have a material adverse impact on the Company's financial
statements.

Other -- The Company is a party to an agreement pursuant to which it is
obligated to purchase certain operating assets in Canada no later than December
2005. However, there is an option in the agreement that allows either party to
cause an earlier purchase. The purchase price is based on certain calculations
of the financial performance of the assets to be acquired, which will be
determined at the time of purchase. In addition, the Company subcontracted
certain business to the owner of the assets to be purchased. The owner has
informed the Company that it believes the Company is required to repurchase the
subcontracted business. The Company strongly disagrees with this position. The
Company does not currently believe that the purchase or other liabilities
associated with its relationship with this third party will have a material
effect on its financial statements.

The Company is currently under audit by the Internal Revenue Service and
from time to time is audited by other taxing authorities. The Company is fully
cooperating with all audits, but plans to defend its positions vigorously. These
audits are in various stages of completion. Results of the audit assessments by
the taxing authorities could have a material effect on the Company's financial
statements.

9. SEGMENT AND RELATED INFORMATION

The Company's one reportable segment consists of its North America solid
waste ("NASW") operations. The NASW operations provide integrated waste
management services consisting of collection, transfer, disposal (solid waste
landfill, hazardous waste landfill and waste-to-energy facilities), recycling,
independent power production plants ("IPPs"), and other miscellaneous services
to commercial, industrial, municipal and residential customers throughout the
United States, Puerto Rico and Canada.

16

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The Company has broken out its one reportable segment in the table shown
below into "NASW (excluding WTI)" and "WTI," to provide more detailed
information. NASW (excluding WTI) includes the Company's Eastern, Midwest,
Western, Southern and CWS Groups plus its national recycling operations. WTI is
the Company's sixth Group and consists of the Company's waste-to-energy
facilities and its IPPs. The Company's previously reported segment that
consisted of waste management services in international markets outside of North
America and non-solid waste services, all of which were divested by March 31,
2002, is shown in the table below as "Other."

Summarized financial information concerning the Company's reportable
segments is shown in the following table (in millions). Prior period information
has been restated to conform to the current year presentation.

- ---------------

(a) Corporate functions include the treasury, legal, information technology,
tax, insurance, management of closed landfills and related insurance
recoveries, centralized service center and other typical administrative
functions. Corporate functions' loss from operations for the three and nine
months ended September 30, 2001 includes a $374 million charge to asset
impairments and unusual items which is attributable to agreements that were
reached to settle shareholder class action and shareholder derivative
litigation. For discussion related to the settlement see Note 8.

(b) Other operations are net of intersegment revenue with NASW of $1 million
for the nine months ended September 30, 2002 and $15 million and $34
million for the three and nine months ended September 30, 2001,
respectively. There are no other significant sales between reportable
segments. However, WTI operations are net of intrasegment revenue with NASW
(excluding WTI) of $14 million and $43 million for the three and nine
months ended September 30, 2002, respectively, and $13 million and $41
million for the corresponding periods of 2001. Additionally, NASW
(excluding WTI) operations are net of intrasegment revenue with WTI of $6
million and $16 million for the three and nine months ended September 30,
2002, respectively, and $6 million and $18 million for the corresponding
periods of 2001.

(c) The Company's operating revenues tend to be somewhat lower in the winter
months, primarily due to the lower volume of construction and demolition
waste. The volumes of industrial and residential waste in certain regions
where the Company operates also tends to decrease during the winter months.
The Company's first and fourth quarter results of operations typically
reflect this seasonality. In addition, particularly harsh weather
conditions may result in the temporary suspension of certain of our
operations.

(d) For those items included in the determination of income from operations,
the accounting policies of the segments are generally the same as those
described in the summary of significant accounting policies in the
Company's Form 10-K for the year ended December 31, 2001, except as it
relates to goodwill. Income from operations in 2001 included goodwill
amortization of $39 million and $117 million for the three and nine months
ended September 30, 2001, respectively, of which $29 million and $87
million for the three and nine months ended September 30, 2001 was in the
NASW (excluding WTI) operations, $8 million and $23 million

17

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

for the three and nine months ended September 30, 2001 was in the WTI
operations, and $2 million and $7 million for the three and nine months
ended September 30, 2001 was in the corporate function. As discussed in
Note 12, the Company ceased the amortization of its goodwill in conjunction
with the adoption of SFAS No. 142 on January 1, 2002. In 2002, the
Company's corporate functions began charging its NASW operations an expense
similar to what those NASW operations' goodwill amortization would have
been had the Company not been required to adopt SFAS No. 142. For the three
and nine months ended September 30, 2002, this charge increased income from
operations for the corporate functions by $38 million and $111 million,
respectively, and decreased income from operations for the WTI operations
by $8 million and $23 million, respectively, and the NASW (excluding WTI)
operations by $30 million and $88 million, respectively.

The mix of NASW operating revenues for the three and nine months ended
September 30, 2002 and 2001 is reflected in the table below. The presentation of
prior period operating revenues has been conformed to the current period
presentation (in millions).

- ---------------

(a) Intercompany revenues between operations have been eliminated in the
consolidated financial statements.

10. PAPER DERIVATIVES AND HEDGING ACTIVITIES

All derivative transactions are subject to the Company's risk management
policy. Swap agreements expose the Company to credit risk to the extent the
counterparty is unable to meet its monthly settlement commitment. The Company
carefully monitors the creditworthiness of each counterparty.

The Company enters into paper swap agreements to secure margins on certain
paper products to be sold from its material recovery facilities. The Company
expects to achieve the margins by entering into transactions to mitigate the
variability in cash flows from sales of waste paper products at floating prices,
resulting in a fixed price being received from sales of such products. The
Company's paper swap agreements have an average term of approximately two years
with the maximum term being five years. The terms of the agreements represent
the span of time over which the Company is hedging its exposure to variability
in future cash flows from the sale of waste paper products. The Company accounts
for these derivatives as cash flow hedges. In addition, the Company has entered
into paper swap agreements with the objective of generating profits from
exposure to changes in market prices of waste paper and other paper products.

As of September 30, 2002, the net fair value of the Company's paper
derivatives was approximately a $1 million net asset. As of September 30, 2002,
the Company has included in accumulated other comprehensive income a net
deferred loss of $1 million, which is net of taxes, on derivative commodity
financial instruments designated as cash flow hedges. The Company's long-term
position is a gain, however, its current position is a loss and will require
approximately $4 million (on a pre-tax basis) of deferred loss to be
reclassified as offsets to revenues over the next 12 months.

For the Company's waste paper swap agreements not designated as hedges, the
Company experienced almost no earnings impact for the three months ended
September 30, 2002. However, for the nine months

18

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

ended September 30, 2002, the Company increased revenues by approximately $3
million for waste paper swap agreements not designated as hedges.

For the three and nine months ended September 30, 2001 the Company recorded
a loss of approximately $1 million and a gain of $5 million, respectively,
related to derivative agreements with Enron North America Corp. ("Enron") as an
offset to operating expenses. In the fourth quarter of 2001, the Company
reclassified its year-to-date net paper swap mark-to-market adjustments to be an
adjustment to revenue instead of operating expenses. On December 2, 2001, Enron
declared bankruptcy under Chapter 11 of the Bankruptcy Code. Due to the
uncertainty of Enron's ability to satisfy all of its financial commitments, the
Company determined that all of its paper derivatives with Enron had zero fair
value at December 31, 2001. In February 2002, the Company terminated its
derivative instruments with Enron. The Company carries a deferred gain, net of
tax, as of September 30, 2002, which is included in accumulated other
comprehensive income, of approximately $3 million related to the paper
derivatives with Enron that had qualified through November 2001 as cash flow
hedges. This deferred gain is being amortized into earnings as the forecasted
transactions that were previously hedged actually occur and approximately $2
million (on a pre-tax basis) is expected to be reclassified into earnings over
the next twelve months.

11. CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

WM Holdings ("Guarantor"), which is 100% owned by the Company ("Parent"),
has fully and unconditionally guaranteed all of the senior indebtedness of the
Parent, as well as the Parent's 4% convertible subordinated notes that matured
and were repaid in February 2002. The Parent has fully and unconditionally
guaranteed all of the senior indebtedness of WM Holdings, as well as WM
Holdings' 5.75% convertible subordinated debentures due 2005. However, none of
the Company's nor WM Holdings' debt is guaranteed by any of the Parent's
indirect subsidiaries or WM Holdings' subsidiaries ("Non-Guarantors").
Accordingly, the following unaudited condensed consolidating balance sheet as of
September 30, 2002 and the condensed consolidating balance sheet as of December
31, 2001, the unaudited condensed consolidating statements of operations for the
three and nine months ended September 30, 2002 and 2001, along with the related
unaudited condensed consolidating statements of cash flows for the nine months
ending September 30, 2002 and 2001, have been provided below (in millions).

19

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CONDENSED CONSOLIDATING BALANCE SHEETS
SEPTEMBER 30, 2002
(UNAUDITED)

DECEMBER 31, 2001

20

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2002
(UNAUDITED)

THREE MONTHS ENDED SEPTEMBER 30, 2001
(UNAUDITED)

21

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CONDENSED CONSOLIDATING STATEMENTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 2002
(UNAUDITED)

NINE MONTHS ENDED SEPTEMBER 30, 2001
(UNAUDITED)

22

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2002
(UNAUDITED)

CONDENSED CONSOLIDATING STATEMENT OF CASH FLOWS
NINE MONTHS ENDED SEPTEMBER 30, 2001
(UNAUDITED)

23

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

12. NEW ACCOUNTING PRONOUNCEMENTS

SFAS NO. 141 AND SFAS NO. 142

In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 141, Accounting for Business Combinations
("SFAS No. 141"), and Statement of Financial Accounting Standards No. 142,
Accounting for Goodwill and Other Intangible Assets ("SFAS No. 142"). SFAS No.
141 requires that all business combinations be accounted for using the purchase
method of accounting and prohibits the pooling-of-interests method for business
combinations initiated after June 30, 2001. According to SFAS No. 142, goodwill
that arose from business combinations after June 30, 2001 cannot be amortized.
In addition, SFAS No. 142 required the continuation of the amortization of
goodwill and all intangible assets through December 31, 2001. The amortization
of existing goodwill ceased on January 1, 2002. SFAS No. 142 requires a two-step
impairment approach for goodwill. Companies must first determine whether
goodwill is impaired and if so, they must value that impairment based on the
amount by which the book value exceeds the estimated fair value. Companies have
six months from the date they initially apply SFAS No. 142 to test goodwill for
impairment and any impairment charge resulting from the initial application of
the new accounting pronouncement must be classified as the cumulative effect of
a change in accounting principle. Thereafter, goodwill must be tested for
impairment annually and impairment losses must be presented in the operating
section of the income statement unless they are associated with a discontinued
operation. In those cases, any impairment losses will be included, net of tax,
within the results of discontinued operations.

In accordance with the Company's adoption of SFAS No. 141, the Company
utilizes the purchase method of accounting for its business combinations. In
accordance with the Company's adoption of SFAS No. 142, the Company has not
amortized goodwill from any acquisitions that occurred after June 30, 2001. The
Company has no intangible assets, other than goodwill, that have ceased being
amortized upon adoption of SFAS No. 142.

Adopting SFAS No. 141 required the Company to write-off net negative
goodwill of approximately $2 million, which was recorded as a credit to
cumulative effect of change in accounting principle in the first quarter of
2002. In accordance with SFAS No. 142, goodwill is required to be tested for
impairment at the reporting unit, which is generally defined as an operating
segment or a component of an operating segment in certain circumstances. For the
purposes of applying SFAS No. 142, the Company has identified seven reporting
units, which are the six components in NASW (excluding WTI) and WTI, as
described in Note 9, Segment and Related Information. The Company incurred no
impairment of goodwill upon its initial adoption of SFAS No. 142. However, there
can be no assurance that goodwill will not be impaired at any time in the
future.

24

WASTE MANAGEMENT, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)

The following schedule reflects the three and nine months ended September
30, 2001 adjusted net income (excluding goodwill and negative goodwill
amortization) as compared to the results of operations for the three and nine
months ended September 30, 2002 (in millions, except per share amounts).