Covenant Logistics Group, Inc. Q4 FY2022 Earnings Call

Welcome to today's Covenant Logistics Group Fourth Quarter Earnings Release Conference Call. Our host for today's call is Tripp Grant. I would now like to turn the call over to your host. Tripp, you may begin. Thank you. Good morning, everyone, and welcome to the Covenant Logistics Group's fourth quarter 2022 conference call. As a reminder, this call will contain forward-looking statements under the Private Securities Litigation Reform Act, which are subject to risks and uncertainties that could cause actual results to differ materially. Please review our SEC filings and most recent risk factors. We undertake no obligation to publicly update or revise any forward-looking statements. A copy of the prepared comments and additional financial information is available on our website at www.covenantlogistics.com/investors. I'm joined on the call today by David Parker, Joey Hogan, and Paul Bunn. Before jumping into the quarter, I want to take a moment to reflect on 2022 as a whole. It was a remarkable year for us in many ways; it marked the second consecutive year of record earnings, record revenue, capital returns, and safety results. We repurchased approximately 20% of the outstanding stock of the company and acquired a small but highly profitable specialized truckload carrier, all while maintaining moderately low debt leverage. We also made progress on our operating model through improved contracts in our Dedicated segment and grew the core business in our asset-light segments comprised of managed freight and warehousing. Although the tailwinds of a strong freight cycle may well be behind us, we believe the combination of our improved operating model and strong balance sheet has us well-positioned for the future. Our company today is much improved, and we are grateful to all of our team members whose dedication and commitment made this possible. Focusing now on the fourth quarter, on an adjusted basis, we believe our team performed well during a market transition. Consolidated revenue was essentially flat compared with the fourth quarter of 2021, while improved revenue per tractor and brokerage margin more than overcame the significant inflationary cost to generate a better adjusted operating ratio and higher adjusted net income. Through acquiring and successfully growing AAT, working with long-term customers to improve the stability of contracted capacity in our expedited fleet, and selectively downsizing our least efficient dedicated operations, we did more with less. On an adjusted EPS basis, the impact of our capital allocation towards share repurchase was considerable, with adjusted EPS growing 28%. These results were earned in a difficult environment. Freight rates were up year-over-year but are under sequential pressure. Freight volumes turned negative prior to the fourth quarter and are continuing to feel soft. In addition, cost inflation and availability of equipment and parts continue to provide headwinds. Looking ahead, we expect difficult year-over-year revenue and income comparisons for the first time in many quarters. In this environment, our playbook remains consistent, and our urgency is high. The primary adjustments to our reported results resolve around our tractor fleet, particularly a group of underperforming leased units that needed to be removed from operations due to negative driver, customer, and cost considerations. Several factors transpired in the quarter, including receiving over half of our 2022 new tractor order in the period, delaying lease turn-ins due to parts availability for trade prep on used tractors whose lease terms have expired, and parking additional lease tractors with future lease maturity dates, which have been the source of significant operational cost headwinds throughout the year. The abandonment of these units in the period before the expiration of the lease has caused us to write down the right-of-use asset in the period and accrue any estimated future disposal costs on these units, resulting in a lease impairment charge. Although costly in the quarter, we believe this is our best opportunity to start the new year in the most cost-efficient manner possible. Key highlights for the quarter include adjusted net income increasing 8% to $19.5 million and adjusted earnings per share increasing 28% to $1.37 per share compared to the year-ago quarter. As a percentage, earnings per share growth outpaced net income growth due to the shares acquired throughout the year under our share repurchase program. During the quarter, we repurchased approximately 450,000 shares, bringing the total to $3.4 million for the year. Total freight revenue declined by 4.4% to $255 million compared to the 2021 quarter. Our asset-based truckload freight revenue grew 11% with 76 fewer trucks; our asset-light Managed Freight and warehousing segment's combined freight revenue declined by 22%, primarily because of the combination of a muted peak season and reduced volumes of overflow brokerage compared to the prior year. Truckload-related cost headwinds continue to play a major role in our results for the quarter, increasing $0.20 per total mile on an adjusted basis compared to the prior quarter. Salaries and wages, maintenance, and insurance all contributed to this increase. Gain on sale of equipment was $1 million in the quarter compared to $0.1 million in the prior year. On the safety side, we are proud to report that our DOT accident rate per million miles for the year was a new company record, beating last year's previous record by approximately 6%. Despite two consecutive years of favorable safety results, unfavorable development from a small number of prior period claims contributed to almost a $0.06 per total mile increase in insurance expense compared to the prior year quarter. The average age of our fleet at December 31 was 26 months, a 3-month reduction from September 30. For 2023, we have been able to increase our original tractor order, and we anticipate sequential improvement to the average age of our equipment throughout the year. Our Tel leasing company investment produced $0.21 per diluted share compared to $0.23 per diluted share versus a year-ago period. Our net indebtedness at December 31 was $46.4 million, yielding a leverage ratio of 0.34x and a debt-to-equity ratio of 10.9%. Return on invested capital for 2022 was 15.3% versus 12.8% in the prior year. Now, Paul will provide a little more color on the items affecting the individual business segments.

Thanks, Tripp. Taking a moment to dive deeper into what drove the consolidated results for the quarter, our expedited segment's freight revenue grew 26% compared to the prior year quarter as a result of the combination of a 16% rate improvement and operating 67 additional tractors. The increases are related to the AAT acquisition we had in the first quarter and the loosening driver market, allowing us to seek more tractors. We are pleased with expedited rate and utilization in the quarter, which was improved by FEMA freight in October that resulted from Hurricane Ian. Cost headwinds from increased salaries and wages, maintenance, and insurance continue to play a major impact in the quarter and condensed our margins. We believe the combination of our work to resolve a significant number of prior period claims and the impact of the equipment replacement plan will help improve costs in this segment going forward. Driver pay remains stable at the present time. Our Dedicated segment had a 5% reduction in freight revenue compared to the '21 quarter as a result of 143 or 10% reduction in the average number of total trucks in the period, offset by a 5% increase in revenue per truck. Although we are pleased with both the year-over-year and sequential improvement to the margin, we fell short of our profitability target, primarily because of the same cost increases, which were affecting our expedited segment. The fleet reduction we've experienced in this segment is a product of two factors: intentionally exiting unprofitable business and reducing fleet counts with existing customers based on reduced volumes. We continue to work diligently to improve margins in this segment by enhancing our customer mix, contractual terms, and operating a younger, more efficient fleet. Managed Freight experienced a 30% reduction of total freight revenue and a 20% reduction in operating profit. The significant reduction in revenue was the product of less overflow freight from our asset-based truckload segments, a reduction in peak revenue, offset by FEMA freight in the quarter compared to the prior year. We are pleased with the fact that Managed Freight was able to hold margins for the quarter, but we are now experiencing a much more aggressive environment with competitors competing for volumes at the expense of margin. We anticipate significant margin compression in this softening environment. Our warehouse segment, although the smallest of all of our business segments, saw a 31% increase in revenue compared to the prior year, resulting from the start-up of four new customers in the year, the largest of which became operational in December. We are pleased with the top-line revenue growth we've achieved in this segment, and the team has done a phenomenal job in executing these start-ups, which are both intense and time-consuming. However, despite the top-line growth in this segment, we've seen sequential deterioration in margins throughout the year. Our focus in 2023 will be to continue to grow this segment and restore profitability to the mid- to high single digits through improved labor utilization and rate increases with existing customers. Our minority investment in TEL produced pretax net income of $3.9 million for the quarter compared to $5.2 million in the prior year period. Although the fourth quarter is typically soft for TEL, it was especially soft due to an adjustment to accelerate depreciation on a specific group of equipment that is expected to be sold in the near term. The adjustment negatively impacted the quarter's results by approximately $1.5 million. TEL has a strong track record of producing gains on the sale of equipment throughout good and bad cycles, and we believe this adjustment is isolated to a specific quantity of similar make and model equipment. TEL's revenue in the quarter grew 47% while pretax operating profit decreased by 22% versus the fourth quarter of '21. TEL increased its truck fleet in the quarter versus a year ago by 243 trucks to 2,237 and grew its trailer fleet by 654 to 7,149. After receiving more than a $7 million distribution during the quarter, our investment in TEL, which is included in other assets in our consolidated balance sheet, was approximately $55 million. As a reminder, TEL focuses on managing lease purchase programs for clients, leasing trucks and trailers to small fleets and shippers, and assisting clients in the procurement and disposition of their equipment through a robust equipment buy-sell program. Due to this business model, gains and losses on the sale of equipment are a normal part of the business and can cause earnings to fluctuate from quarter to quarter. Regarding our outlook for the future; there is no doubt that 2023 will be a challenging year, but it's also a year our team has been anticipating and working hard to prepare for. We view it as a test of the resiliency of our operating model and an opportunity to identify areas where we can continue to improve. As such, our primary focus remains on continued progress on our long-term strategic plan. We are also focused on aggressively improving our operating cost profile. With our equipment replacement plan and strong safety results, we see opportunities to improve costs in the short term to improve fuel economy, reduce operations, maintenance, and insurance costs in an environment that will be pressured from both a rate and margin perspective. We expect market headwinds from a softer market during the contract renewals as well as continued inflationary pressures. However, based on company-specific factors, including investments we have made in our sales team, the AAT acquisition, share repurchase program, and the equipment upgrade plan, along with reduced insurance casualty costs resulting from our improved safety results, we expect less earnings volatility than in prior periods of economic weakness. Over the past five years, our customer base has been strategically shifted to less cyclical industries through our full-service logistics focus. Even with a heavy equipment investment year, we expect our cash generation, low leverage, and available liquidity to provide a full range of capital allocation opportunities to benefit our shareholders. Thank you for your time. I want to open up the call for any questions.

Paul, I wanted to kick things off and talk a little bit about managed freight first and then jump in the truckload. On the managed freight side, you said that basically prepare for significant margin compression. Can you give us a range of what you consider significant? And then maybe walk us through some of the puts and takes to just how bad it is out there? Because it seems like all of this is coming from competitive pressures in the marketplace.

Yes, Jason. Here's what I'd say on the managed freight side. The market is crazy competitive out there right now. I would say it's going to return to historical truckload brokerage margins. I think not just us, but a number of our competitors have been running margins in these brokerage businesses that are multiple times more than the historic margins that truckload brokerages operate. Everybody is returning back to pre-pandemic, pre-supply chain issue brokerage margin levels. Those are mid-single-digit kind of numbers. We're seeing just like our peers return to those numbers. There's no doubt there are folks out there trying to buy volume in this space right now, and a lot of logistics departments are trying to recoup costs from the last few years. That said, a lot of these rates we're seeing are just unsustainable where they're 10%, 20%, 30% below what a small carrier can run at. It's just kind of a purge I think the whole industry on the brokerage and the truckload side is going to have to go through. Some small carriers stacked up some money running the spot market the last couple of years, but you can't run 10% or 20% below your costs forever.

No, that's clear. And what's your percent of business between contract and transactional right now?

Probably 65%, 70% contract, about 30% spot in that business right now.

Is that just more from the spot market drying up in terms of loads?

Yes. The contract rates to the brokerage involve repeated bids from those who continually participate in the process.

Okay, that's good color. I want to jump over to the asset-based side now and maybe talk a little bit about some of the deterioration you're seeing. We held a call with a bunch of private companies earlier this month, and they basically said that the market has deteriorated a lot in the last 60 days. What are your expectations for sort of the pricing gains that you're going to get out of the contracts that you signed here during this bid season?

A lot of our reductions are primarily due to decreased volume as many of our customers simply do not have the same freight levels they once did. Our declining margins are a result of needing to take on more broker freight to fill the trucks rather than direct price reductions from customers. On the expedited side, we are seeing modest changes, with customer loads being either slightly lower or stable. There isn't significant margin pressure in expedited services. However, if a customer reduces their loads by around 10% compared to five months ago, we are faced with the challenge of either finding replacements or resorting to broker freight, which tends to be less profitable than what we previously handled. This situation is impacting truckload margins.

Okay. Fair enough on that. I wanted to talk a little bit about the changes in the fleet, obviously, a far newer fleet than you had before. Talk a little bit about the savings that can maybe help offset some of the market pressures we're seeing.

Yes, I may be able to help with that. There's no doubt about it that new equipment is more costly than from a price perspective than some of the older equipment that we're taking out of the fleet. We've been pretty vocal on the last couple of calls on really looking at our ops and maintenance spend, the cost of running that older equipment. Just to frame this up for you, if you look just on a cents per mile basis, our ops and maintenance costs in our Truckload division ran $0.21 a mile in 2021. When we look at 2022, it ran up to $0.29 a mile. Sequentially, it got worse and worse. It was pretty early in the year where we decided we've got to get in front of this. We got in front of it by being more aggressive on new acquisition or acquiring incremental tractors beyond our 2022 trade plan. Those incremental tractors, about 250 units landed in the quarter in the fourth quarter on top of what we were scheduled to receive. We've also bumped up our trade plan for 2023. I think our original order was somewhere in the neighborhood of 600 tractors, and that's been revised to closer to 900 now. What this did in the short term, compounded with the fact we identified the most expensive tractors in the fleet, which were these leased units that we discussed in the earnings release, we went ahead and proactively parked those units. All that being said, it created a little bit of a logjam of excess equipment. We had newer equipment we received and deployed, and then we had leased assets that were generating costs, and we weren't able to turn them in. So I don't want to get into specific numbers, but I do think that you're going to see meaningful improvement in both ops and maintenance costs. I think you'll also see, even though the cost of equipment is going up, if you think about the little gain on sale we had this year, which was just over $2.2 million or about $3 million adjusted when you exclude out the terminal sale, you're going to see meaningful improvement because what we're going to be selling next year, we're not going to be trading in leased vehicles; we're going to be selling used vehicles that we own. There will be meaningful improvement in gain on sale next year. We think the fixed cost of equipment could be flattish even though the price for that equipment is going up, but we believe there will be meaningful improvement in ops and maintenance and also significant savings in fuel economy with that newer equipment.

Tripp, just two clarifications. One, when you say next year, are you referring to 2024 or 2023?

I'm stuck in the past; I'm a balsa. I got to live in the past. I'm talking about 2023.

Sure.

So the other thing I wanted to say; you went from $0.21 a mile to $0.29 a mile worsening as you went throughout the year. What is the maintenance cost on these new trucks that you're bringing in, so you can put it into perspective for us per mile? Exponentially better. I think that there have been costs, and I don't know if it's realistic to get back to what we consider all-in ops and maintenance costs of 2021 number of $0.21 per mile; the parts of the cost of tires, labor, and parts all have seen significant cost inflation. But I think you could see that number land somewhere between the $0.21 and $0.29 per mile. It's hard to say because the other key component to this is uptime and utilization. Throughout 2022, we had a considerable number of excess units, particularly in our dedicated fleet because we would have a customer that would require 15 trucks, and we'd be putting in 20 trucks because five were down. This change will help us with uptime and utilization, so it gets a little muddy when trying to do cost reconciliation just by looking at ops and maintenance. But overall, we expect improvement and efficiency in the truckload segment, which includes expedited and dedicated.

That's a great explanation. And last, and I'll turn it over to somebody else. Expectations for share repurchases. Obviously, you guys were very aggressive last year in repurchasing your own shares. This year is going to be a down year by anybody's estimates in terms of just your overall financials. Are we going to see you still be as aggressive as you were in 2021?

I don't want to comment on what we're going to do in the future, but it is public information on what we have out there and what we've repurchased today. We still have about $20 million of availability on what has been approved and is in the market today. We'll evaluate that. Obviously, we have the strength in our balance sheet to do that if we choose, but there are several different options that we may choose not to take. It's certainly in the arsenal of things we could act on, but there's been no decision or public disclosure of us committing to something additional beyond what's out there today.

Okay. Sounds good. Gentlemen, I really appreciate the time as always.

Thanks, Jason.

Okay, great. So, I guess maybe I'd like to ask you about the trends into the first quarter here, but maybe we could take a step back and kind of think about, Paul, going back to the last couple of quarters, you guys have sort of commented on the cyclicality in the business and how you think you've been able to mute that a bit, given all the work you've done in the last few years. But you do sound a bit more bearish about the trends in the business that you're seeing over the last few months. As you think about the run rate for the business today based on your outlook for the managed transportation managed freight business in mid-single-digit margins. Do you think down 25% to 30% peak to trough earnings is still how to think about it? Or has that changed any over the last few months?

Jack, I would say that's still our goal. We're aiming for a reduction in the range of 25% to 30%. We have not abandoned that objective for 2023. We had an important meeting about it yesterday, and we discuss it regularly. Historically, we have experienced declines of 50% to 70% at times. Looking back at the years when we made 2.86 and then the following year saw a drop of about 61 or 75%, it's uncertain whether we will see a 25%, 30%, or even 35% decline this time. Much of this will depend on market conditions, but we expect the situation to be less severe than what we experienced over the last decade. We remain confident in the adjustments we've made to our model to decrease volatility compared to the previous 10 to 15 years. Each day, we strive for that 25% to 30% reduction. How feasible this goal is will depend on how much further the market declines and whether it rebounds or remains stagnant. However, we are committed to becoming less volatile.

Yes. No doubt about it. And I think that's helpful, and I appreciate the way you've framed that up. I guess as you think about the first quarter, I know that a lot of people are looking at the 4Q to 1Q trend and considering whether we should see better or worse than normal seasonality given all the factors external. You guys sounded strong in October, but you didn't have much peak season in November and December. So as you think about the way the business is trending into the first quarter, consensus is about $0.90 or so. Do you feel like that's in the right ballpark based on the trends that you're seeing in the business today? I know January is tough too.

Yes, it's tough to peg it off January, but that's in the range of reasonableness. October was strong, and November and December definitely pulled back. Our cost structure for the first quarter is going to look better than our cost structure in the fourth quarter. So revenue won't be as good, but our cost structure will be better.

Okay, that's helpful. And I'd be curious about what your customers are telling you regarding the trends within their business and their inventory levels. Do you think that we can get back to normal levels of replenishment, normal ordering levels in the second quarter? Or do you think that's something that we will need to see in the second half of the year?

Jack, this is David. There are four key points I would say: I really believe that the first and second quarters from an economic standpoint are going to be negative GDP; that's what I believe. As it relates to transportation, I think we hit the bottom around Thanksgiving, and I think we've just been there. We haven't seen a second downward trough past Thanksgiving. We have seen this all in January as well. I'm optimistic that the industry and we are at the bottom level. I believe the first and second quarters will be negative GDP. When they start buying more Coca-Colas and it gets warm in May and late April, freight is going to pick up even if it's negative GDP growth. I believe that's going to be a second-quarter event when the inventory levels are corrected. As soon as that happens, that will be a tailwind for the industry. That's what a lot of our customers are doing right now; they're correcting their inventory levels. We're just having to muddle through it. But I'm optimistic that the pipeline is good. I believe in January, the market is weak, but just floating on that downward shift. I'm optimistic about the pricing levels I'm seeing thus far.

I'm going to add one thing; you asked about changes and volatility and peak to trough. Here’s what I would say. I used the word 'niche' on last quarter's call. Everywhere we're niche and people need our teams, hazmat, heavy haul dedicated, or they really need us, our value-add is holding well in this market. We have a little bit of commoditized business here and there. But we’ll keep finding ways to be more value-added. The commoditized sectors will follow their own path, but I feel we are working on that path every day. Good market or bad market, that niche stuff where we add value for our customers and their value to us is something we're targeting.

I really appreciate all the commentary. So David, I guess I'd love your take on capacity attrition in the market. You discussed rates being at 1990 levels in certain markets. It doesn't seem like we've really seen a lot of capacity come out yet, at least from what we can tell. How do you see the capacity situation playing out over the next six months? What do you think needs to happen to trigger that attrition typically seen with rates at these levels?

I think going forward, we'll see a reduction in capacity because if you look at new DOT numbers, it's negative. There are not new trucking entries coming into the marketplace. I think what's happened is that those who came into the market in the spot and worked for $450 a mile are gone. Those were really small operators with just a few trucks. Those trucks have left, and you and I haven't felt that yet because they're driving for other companies now. You can't haul at those rates with costs in 2022, 2023 and think you're going to make it. I think in the next couple of months, we will see a rush of capacity leave because all of us truckload guys have our trucks virtually full. You'll start seeing capacity leaving in the next couple of quarters.

Yes, Jack. The ones that made a lot of money had some capital to hold on for a while. But again, you can't run at such rates forever, and I have talked to a few vendors in the last few weeks that deal with big and small truckers, and they're worried about small trucker delinquency rates. So, we won’t awake someday and realize all capacity is gone, but over a 6- to 9-month period, we will see it trend down.

Thank you for the time. David, maybe just a follow-up on your earlier comments. A few quarters back, you communicated a more bearish position toward future freight market fundamentals. Does that make you want to be more aggressive during the downturn? How do you try to gauge when the market is starting to turn?

Yes. I am more bullish than earlier given what I see in freight management and TEL. Things aren't great overall, but I'm becoming more optimistic. We're seeing more opportunities presenting themselves because of what Paul discussed; we’ve been deep in the supply chain since 2018. We've been focused on customer value, and we have those conversations with our customers. I don’t care if it’s 2020 or 2023 if we are not bringing value to a customer, one of us will leave, either day. We’ll adjust our fleet size, pursue acquisitions, or repurchase stock depending on what the market demands. There are opportunities out there that can withstand industrial production and housing declines.

We're a different company that has worked hard for the last four to five years to provide value. That’s why our rates have not dropped like the market has; our customers recognize that. They’re expressing that to us. Our business may be down, but you do such a great job; you give us the teams when we need them. We're not asking for rate reductions.

We didn’t capitalize on some previous situations, and now our customers are fair to us. For the 30% that aren’t, well, as David mentioned, we’ll work that out.

I appreciate your insights. Given the reduction of volatility, I think a lot of this has been due to your expedited side and improvement in dedicated. To maintain that 92% or better on expedited will likely determine whether you end up down by 25% or more like 35% in 2023. What are your thoughts on those segments remaining robust?

Managed freight margins will compress, but we still have a solid revenue base. We have long-term agreements in expedited that will hold up. Dedicated will continue to improve in incremental terms, and we expect our managed freight margins will go way down, but they currently are significantly high. We also see our warehousing margins starting to rightsize as that business continues to grow. Yes, I think managed freight will step down in the first quarter, and that will establish a new base moving forward versus Q4 margins.

All right, everyone. Thank you for joining us, and we look forward to talking to you next quarter.

Thank you. This concludes today's conference call. Thank you for attending.