Covenant Logistics Group, Inc. Q2 FY2023 Earnings Call

Welcome to today's Covenant Logistics Group Second Quarter Earnings Release Conference Call. Our host for today's call is Tripp Grant. At this time, all participants will be in a listen-only mode. Later we will conduct a question-and-answer session. I would now like to turn the call over to your host, Mr. Grant, you may begin. Thank you, Jen. Good morning, everyone, and welcome to the Covenant Logistics Group second quarter 2023 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 and Paul Bunn. We are pleased with our results for the quarter, which showed comparative resilience in the midst of a very soft freight environment. Consolidated freight revenue was down 9% compared to a very tough prior year comparable when the freight environment peaked. The decline related primarily to operating approximately 11% fewer weighted average tractors in our truckload operations and less overflow freight handled by our Managed Freight segment due to lower overall demand. Adjusted operating income fell approximately $12 million or 43% compared to the prior year quarter, primarily as a result of our Expedited and Managed Freight segments, which declined by approximately $7.5 million and $6.5 million, respectively, offset by an increase of approximately $2 million in our Dedicated segment. Adjusted net income decreased 44% to $14.4 million, and adjusted earnings per share decreased 34% to $1.07 per share compared to the year-ago quarter. Weighted average diluted shares decreased as a result of our share repurchase program. Key highlights for the quarter include; all four of our business segments, including Expedited, Dedicated, Managed Freight and Warehousing, achieved sequential improvement in profitability in the second quarter; the acquisition of Lew Thompson & Son Trucking, Inc., a dedicated contract carrier comprised of approximately 200 tractors, specializing in poultry and live haul transportation. We have been pleased with the operational results to date and are excited about the growth opportunities that lie ahead. Within our combined truckload segments, operations and maintenance-related expenses declined on a cents per total mile basis by $0.06 or 21%. And fixed equipment costs, including lease revenue equipment, depreciation and gains on sale, remained flat compared to the prior year. The average age of our fleet at June 30 remained flat sequentially at 26 months compared to March 31, 2023, largely due to the equipment acquired from Lew Thompson & Son Trucking. For the remainder of 2023, based on our current equipment order, we anticipate sequential improvement to the average age of our equipment. Gain on sale of revenue equipment was $2 million in the quarter compared to $0.4 million in the prior year. Our TEL leasing company investment produced $0.29 per diluted share compared to $0.33 per share versus the year-ago period. Our net indebtedness at June 30 climbed to $187.2 million in the quarter, primarily as a result of the acquisition, yielding a leverage ratio of approximately 1.7x and debt-to-equity ratio of 33.1%. On an adjusted basis, return on invested capital was 13% for the current quarter versus 17.6% 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 our results for the quarter, starting with our Expedited segment, freight revenue declined 7% compared to the prior year, largely due to a 6% reduction in the average fleet. Rates declined by just over 10%, but were offset by almost a 10% improvement in average total miles per truck compared to a year ago. The improvement in utilization was principally attributable to newer equipment in the fleet and reduced downtime. While we are pleased with the segment's utilization improvement, we recognize that year-over-year freight revenue per total mile comparisons will continue to be challenging for the remainder of 2023. While cost headwinds from salaries and wages and fixed equipment costs compressed margins, they were somewhat offset with improvements to variable-based equipment costs for the quarter. Our Dedicated segment experienced an 8% reduction in freight revenue compared to the 2022 quarter as a result of a 217 or 15% reduction in the average number of total trucks, offset by an 8% increase in revenue per truck. Despite the addition of Lew Thompson & Son Trucking fleet, the overall fleet reduction in our Dedicated segment aligns with our strategy of exiting unprofitable or underperforming business and replacing it when opportunities arise that meet our profitability and return requirements. We were pleased with both the year-over-year and sequential improvement to the adjusted margin and expect to continue to improve upon this segment's profitability over the long term. Managed Freight experienced a 21% reduction of total freight revenue and a 76% reduction in adjusted operating profit. The significant reduction in revenue and operating profit was primarily attributable to little to no overflow freight from our asset-based truckload segments. The brokerage environment remains highly competitive with numerous brokers aggressively competing for volumes at the expense of margin. We anticipate continued margin pressure in this environment. Our Warehouse segment saw a 37% increase in freight revenue compared to the prior year, resulting from the startup of new customers during the previous 12 months. We are pleased with the top-line 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 significant top-line growth in the segment, we've only seen about a 10% improvement in adjusted operating profit compared to the prior year. Although we're pleased with the sequential profitability improvement within this segment, we will continue to focus on improving profitability at the mid single-digits through improved labor utilization and rate increases with existing customers. Our minority investment in TEL contributed pretax income of $5.4 million for the quarter compared to $7.1 million in the prior year period. The decline was largely due to reduced gains on the sale of used equipment compared to the year ago. TEL's revenue in the quarter grew 11%, and pretax net income decreased by 26% versus the second quarter of '22. TEL increased its truck fleet in the quarter versus a year ago by 210 trucks to 2,283 and grew its trailer fleet by 84 to 7,031. As a reminder, TEL focuses on managing lease purchase programs for clients, leasing trucks and trailers to small fleets and shippers, aiding clients in the procurement and disposition of their equipment through a robust equipment buy-and-sell program. Due to the business model, gains and losses on the sale of equipment are a normal part of TEL's business model and can cause earnings to fluctuate from quarter-to-quarter. Our investment in TEL is included in other assets on our consolidated balance sheet and has grown to $66 million as of June 30, 2023, from our original investment of $4.9 million in 2011. In 2022, we received $14.7 million in cash dividends from TEL, and we are anticipating approximately $19.8 million to be received during the second half of 2023. As we enter the third quarter, we are optimistic that the trough of the freight cycle is behind us, but are cautious about the rate at which we'll see improvements. Regardless of how the freight economy responds, our primary focus remains on the long-term by continuing to invest in areas that provide opportunities for us to make forward progress on our strategic plan. The acquisition of Lew Thompson & Son and our investments in new revenue-generating equipment, people, and technology are examples of this. Thank you for your time, and we'll now open up the call for questions.

Thank you. Our first question today will come from Jason Seidl with TD Cowen.

Thank you, operator. Gentlemen, good morning. I wanted to cue in on that last comment that you talked about in terms of the broader trucking industry. I'm with you guys that we're sort of off the bottom here, but how should we think about pricing on a sequential basis? Because I'm still getting some feedback from some private truckers just receiving really lowball pricing out there like paid in North Carolina at less than $1 a mile being offered. So how should we think about that at least in the near term?

Jason, here's what I would say: we're still seeing that too. But as a reminder, most of our stuff's tied up under contract rates. So when we talk about continuing to see margin pressure in the brokerage, that's really where we've got exposure to that. On the Dedicated and Expedited side, I don't think we're going to see any pricing pressure in the near term. I think we'll see what contract rates do next year, which will probably have the larger effect on us. And I think it's probably too early to tell exactly what those are going to do next year. But yes, a lot of the stuff that's out there in the spot market will negatively affect the brokerage a little bit, but it shouldn't affect Expedited and Dedicated for the balance of the year.

That makes a lot of sense. Also, you called out a little bit of gains on sale. How should we look at gain on sale going forward? And what does the equipment market look like?

Let me talk about the market, and I'll let Tripp talk about gains on sale. The used equipment market has just continued to drop precipitously. It dropped a little bit from January to March, but since March, it's been kind of in a free fall. It seems like July may have hit a bit of a floor in the used equipment market, but March to July was a pretty big drop.

Yes, I agree. Honestly, I don't expect the used equipment market to improve in the next six to eight months. The rates have dropped significantly over the last few months. This is a critical capital expenditure year for us. Over the past year and a half, we have invested in upgrading our fleet, and we plan to continue doing that because we believe it is beneficial. This approach optimizes our fleet operations in terms of ongoing variable costs, and it provides some fixed cost advantages with uptime. Moving forward, while we will have more newer equipment, we are not anticipating significant fleet count growth in the latter half of the year, which means we will be selling a considerable amount of equipment as well. The concern is how much prices will keep declining. I don't foresee substantial gains from sales in the third and fourth quarters; there may be minor gains, but I also don't expect significant losses. Overall, it seems marginal. We are monitoring our equipment depreciation closely to ensure proper accounting, and I believe we will manage well in that aspect.

Okay, that's great color. Last one, and I'll turn it over to somebody else here. Lew Thompson, you got about two-thirds of a quarter; looks like a good acquisition for you guys, getting you in a niche end market that you really weren't in. When I was hosting some calls with industry people before earlier this quarter, a lot of them were talking about how there's a lot fewer financial buyers in the marketplace for sort of smaller niche acquisitions. Do you foresee other opportunities for yourself down the road because multiples have come in a little bit?

Jason, here's what I would say. A, I agree, there's less financial buyers in the market; B, we're always looking for those really niche, value-added, contractual-type businesses. We've got to digest. Remember, we did AAT in February 2022, and then we just did Thompson in April. We've got to digest. But any of that niche, good margin, contractual-type businesses out there, yes, we continue to field calls and will keep looking at stuff like that as it comes about.

Yes, and I just want to add a bit to that, ensuring that our balance sheet can absolutely support another acquisition, and it’s something we may look at in the future. However, our main focus, whether it’s AAT or Lew Thompson, is really on learning that business and starting off on the right foot, which we have in the first two months since we acquired them. But there’s a lot of executional risk at play whenever you do something a bit different, which Paul mentioned. But we’re really focused on execution and want to ensure we do those transactions the right way. I believe we’ll reap benefits from those that we’ve already done in the future if we can continue to refine our processes and ensure we're executing at a high level.

Well, thank you gentlemen. I appreciate the time as always.

Thanks, Jason.

Thanks, Jason.

And our next question will come from Scott Group with Wolfe Research.

Hey, thanks. Good morning, guys. Can you just talk us through how you're thinking about the back half of the year from an earnings standpoint? Do you think we see further sequential earnings growth from Q2 into the back half of the year? What are the puts and takes?

Yes, I mean, I don't want to get into giving any sort of defined guidance, but we feel optimistic about the back half of the year. We said that there’s a feeling that we're at the trough of the freight recession, and part of that may be due to our model. We've got a lot of LTL customers in Expedited. If you look at Q2, we have just two months of Lew Thompson. We've talked earlier about the optimism regarding how well Lew Thompson is running out of the gate as well as some potential growth opportunities that may come to fruition later in the year and early next year. So I think I'm optimistic about being able to increase earnings sequentially in Q3. I think there’s a big question mark for Q4; there’s some downtime with the holidays, and I’m just not sure how much that’s going to contribute this year in 2023. But yes, I think we’re bullish on the next half of the year for us.

Yes, Scott, let me add one thing to that. I agree with everything Tripp said. I think the one thing to watch is with our reduced share count; a few things going in the right direction could really be accretive in the back half of the year. But one bad accident could pull it in the other direction. I think that’s one of the things everybody has to remember with this reduced share count: the earnings have a lot of leverage on the upside, but you also have a bad accident or something that could pose a downside risk. Overall, I agree with what Tripp said. I think we’re optimistic about the back half of the year and expect to continue improving earnings quarter-over-quarter.

Okay, that's helpful. You mentioned having many LTL customers. What are you observing in the market lately as shippers try to shift away from Yellow? How is this affecting your operations?

Yes. We're fielding a number of calls in the Expedited division. As you know, we do business with practically every major LTL and freight forwarder in that division. We continue to field a lot of calls as people need some incremental capacity. It’s probably maybe 5% growth on Expedited revenue during the quarter. I mean, it’s definitely going to be a positive for Expedited in the third quarter. There was really none of that in the second quarter. So it should be a positive for Expedited in the third quarter and likely into the fourth.

Yes. And then just lastly, you mentioned the increased sort of leveraged earnings because of the buyback. What is the plan with the buyback going forward? Are you going to continue to be aggressive with it? Do you pause it? How do you think about that?

I mean, I can't really give specifics. All I can say is we do have an open buyback plan right now that has some parameters around it that the bank will repurchase based on those parameters. But here's what I would say: I really like how we've deployed capital over the last couple of years, and buybacks have been a big portion of that. I think that they are always going to be part of our playbook; it's not saying that we're going to buy back a specific number of shares in Q3 or Q4, but I think as circumstances warrant, buybacks will always be a potential option within our capital deployment plan. We like them, and we’ve seen benefits from them. The question is, as circumstances change, how do you prioritize those types of decisions? But they’re always going to be there, and I think you guys will likely see us think about or talk about moving forward with another buyback in the future when the circumstances warrant.

Make sense. Thank you, guys.

Thanks, Scott.

And our next question will come from Jack Atkins with Stephens.

Okay, great. Good morning and thanks for taking my questions, guys. Congrats on a great quarter. So I guess, just kind of going back to the LTL and sort of the Expedited comments there for a moment. How are you guys thinking about approaching deploying additional capacity into that market? I mean, you have some longer-term partnerships there. Is it really a function of looking to secure longer-term commitments for additional trucks that you’d be willing to deploy into that LTL line haul part of the market?

Yes, Jack, you’re right. There are a few trucks available, but to add a significant number of trucks, we will focus on our long-term partners. As we allocate these trucks, we will prioritize those who are willing to commit for the long term and have been with us through the cycles of 2021, 2022, and now 2023. That’s how we plan to grow our resources for them.

But as you think about this from an investor perspective, I guess the point I'm trying to make there or the question I’m asking is, as you bring on new business there, this isn't just a short-term stopgap for some of these guys; this is potentially a longer-term step-up in business activity with this particular part of your customer base?

Yes. I think we'll keep a high percentage of whatever we add with these customers on a longer-term basis. Because to your point, they're digesting this growth, and their model is changing. So, yes, we're strategically trying to ensure that the areas where we grow the most are with people that are going to be sticky.

Because, Jack, keep in mind, about 55% to 60% of that Expedited revenue is on guaranteed contracts.

Right. Absolutely. That makes sense.

As Paul was saying, when we add these trucks, whatever we do is going on to those customers that have been partners with us, and we're partners, and part of that partnership includes long-term agreements between us.

Absolutely. And that’s paid dividends over the last couple of years, for sure. So I guess, David, good to hear your voice. I guess maybe would love to get your perspective as well in terms of just how you're thinking about the cycle. I know you bring a lot of perspective to this. I guess, could you maybe kind of help us think about where we are in terms of coming off the bottom here? And as you think about capacity and all the puts and takes, are you more or less optimistic about sort of where we're headed from a cycle perspective over the next six months?

I recently attended a conference with insurers and participated in a carrier panel. During this event, the final question posed to the panel was about the timing of improvement in the industry. The feedback from other carriers ranged from expecting changes as early as spring to as late as December of next year. I was the last to respond, and I believe we will start noticing changes by September. In the coming months, I anticipate that trucking companies, particularly those focused on truckloads, will experience capacity constraints. While I don't expect a repeat of 2022, I do think conditions will improve compared to the last year. This is largely due to the decrease in available capacity in our industry, alongside the drop in used truck prices mentioned by Paul recently. Although this situation is challenging now, the long-term outlook is positive as reduced capacity should lead to improved pricing power, which may compensate for the disappointment of not selling used trucks. I truly believe that trucking will begin to perceive these changes within the next few months, assuming the economy remains stable. These are my insights.

Okay. All right. No, I appreciate that. Maybe last question, long-term strategically. I mean, as you think about the way you'd like to have your mix of assets deployed within the truckload market, you've been investing more outside of the traditional long-haul, over-the-road, highly cyclical parts of the truckload market into things like AAT, Lew Thompson & Son, and longer-term commitments within your Expedited team business for LTL. How do you think about the long-term mix of assets between traditional OTR truckload and more niche parts of the market that really reduce cyclicality and where you can see compounded growth?

I would say that we've been on this journey since 2015 when we decided to change our company around. We’re moving away from being dependent on the market and hoping for immediate improvement. We started this transformation in 2015 and saw it take off with the acquisition of Landair in 2018 and further progressed in 2020 when we exited the over-the-road solo side of the Covenant business. We're now primarily focused on Expedited, Dedicated, Warehousing, and Managed Freight. Managed Freight involves brokerage and TMS. We're looking at these four avenues and ensuring that we create value for our customers, as they must reciprocate with value to us. That’s the essence of a successful relationship. We’ve grown tired of traditional cycles where we increase rates when the market is up and give it all back when it’s down. Our current model is moving away from that dynamic, focusing instead on creating sustainable, value-driven partnerships. Our Expedited business is one of the largest team providers out there, and if you genuinely need teams, it’s essential to pay for what it costs to operate them.

Absolutely. David, it looks like it’s clearly working. I’ll hand it over.

And our next question comes from Barry Haimes with Sage Asset Management.

Hi guys. Thanks very much. Good quarter. I had two questions. One is, David, I wanted to circle back on your comment about capacity leaving the industry. So when you look at your brokerage segment, you might be able to get a read on that in terms of all the carriers that you work with. Is there anything either numerical or anecdotal that you could share to flesh that out a little more? And I had one other question, but go ahead.

Yes. On the broker side, I'd say yes, you can. The main thing that's happened is that small carriers have reached a point where they're not going lower on rates. This is showing that capacity is starting to tighten a little bit because the rates are not falling like they were before.

Got it. Okay. Thank you. And then the other question is about the asset-based businesses that, as you've pointed out, are more contract-oriented. Are most of those renewals taking place in the spring? And any feel for where contract rates are in the market now versus where they might have been six months or a year ago? Thanks.

Yes, most of our stuff is in the spring. I would say January to April is when most of the asset-based contracts reset. Pricing is probably down mid-single digits when you combine Dedicated and Expedited. If you weight those, I would say our pricing is probably down mid-single digits; those with more OTR exposure have seen pricing decreases that are more substantial.

No, I agree. It’ll bring a bit next year when rate evaluations occur. I agree with Paul on this.

Great. And just one last quick follow-up on that. So looking at the cost side for next year, as we start thinking about next year, are there any big attributes we should consider regarding cost structure in '24 versus '23? Thanks.

So on the cost side, we've been pleased with what we've seen. We’ve been laser-focused, as an enterprise, starting in the fourth quarter of last year. I think we felt it significant in November 2022. As a response, we've focused on cost savings throughout the enterprise, both in business units and back office. This can only go so far, but a significant part of our success is our investment in new tractors. We experienced some fleet disruptions and an impairment charge last year; however, we’re now seeing improved fuel economy, maintenance costs, and retention rates due to newer, more efficient equipment. Thus, our utilization has improved as well. I believe we’ll continue to see cost improvements as we upgrade and reduce the average age of our fleet. Fuel is somewhat unpredictable, and it fluctuates, but I think it's directionally headed down. However, I don't foresee much reduction in wages. So it's mixed. I feel good about our cost journey to date, but for 2024, with leverage potential and whether we can offset some costs remains uncertain. We’re pleased with how we’re managing what we can control and our progress to date.

Great. Thanks very much. Good luck.

Thank you.

It seems there are no further questions at this time. Mr. Grant, I'll turn the call back to you for any additional or closing remarks.

Yes, Jen, thanks so much. I just wanted to thank everyone for your time and participation today. We're excited about the quarter, pleased with our results and are optimistic about the future. We look forward to speaking with everyone next quarter. Thanks very much, and have a good afternoon.

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