Covenant Logistics Group, Inc. Q3 FY2024 Earnings Call

Welcome to today's Covenant Logistics Group Third Quarter Earnings Release and Investor 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.

Good morning, everyone, and welcome to the Covenant Logistics Group third quarter 2024 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 our prepared comments and additional financial information is available on our website at www.covenantlogistics.com/investors. I am joined on the call today by David Parker and Paul Bunn. Our core business performed well in the third quarter, overcoming softer-than-anticipated volumes in our Expedited division as a result of lingering weakness in our overall freight environment. Compared to a year ago, consolidated freight revenue increased by approximately $5.2 million, or 2.1%, to $258.6 million and adjusted operating income increased by $1.5 million, or 8.3%, to $19.3 million. The year-over-year increase in freight revenue was primarily derived from new business growth within our Dedicated segment, partially offset by reductions from the Expedited segment and Managed Freight segment. The growth in adjusted operating income was principally derived from both Dedicated and Warehousing segments, offset by reductions from Expedited and Managed Freight. Adjusted net income of $15.2 million for the current quarter was essentially flat with the third quarter of 2023 primarily because higher adjusted operating income was offset by a $0.6 million increase in pre-tax interest expense and a $1.3 million reduction in pre-tax earnings from our equipment leasing company investment, TEL. Key highlights for the quarter include: Our asset-based truckload operations, consisting of Expedited and Dedicated, grew its average tractor count by 169 units, or 7.9%, grew freight revenue by $11.4 million, or 7.2%, and improved its adjusted operating income by $1.6 million, or 12.6%. Our asset-light operations, consisting of Managed Freight and Warehousing, experienced a $6.2 million reduction in freight revenue, or 6.5%, but was able to improve margin in a manner so that total adjusted operating income was only reduced by $0.2 million, or 3.0%. Our net capital investment for revenue producing equipment was approximately $18 million for the quarter, consisting of both specialized equipment CapEx for growth and maintenance CapEx. The average age of our fleet at September 30th improved to 20 months compared to 23 months a year ago. The sale of revenue equipment resulted in a $0.2 million loss in the quarter, compared to a $0.6 million gain in the prior year. TEL produced $0.22 per diluted share, compared to $0.29 per diluted share versus a year ago period. Our net indebtedness as of September 30th declined sequentially by $36.6 million to $236.7 million, yielding an adjusted leverage ratio of approximately 1.6 times and debt-to-capital ratio of 35.4%. On an adjusted basis, return on invested capital was 8.1% for the current quarter versus 10% in the prior year. The decline is primarily attributable to the increase in the average invested capital base associated with acquisitions, growth CapEx, and reducing the average age of our fleet. Now, I'd like to turn it over to Paul for some more color on the items affecting the individual business segments.

Thanks, Tripp. Our Expedited segment fell slightly short of our operating expectations this period, with freight revenue of $87.4 million and adjusted operating income of $7 million, resulting in an adjusted operating ratio of 92. The miss was primarily a result of declines in utilization that resulted from softer-than-anticipated volumes and an imbalanced network, particularly in the last month of the quarter. This softness has extended into the fourth quarter, and we are currently working hard to mitigate its impact through new business awards and repositioning equipment to optimize our network. Dedicated was successful in growing both freight revenue and operating income while yielding an adjusted operating ratio of 91. Compared to the prior year, freight revenue grew $15.7 million, or 23.5%, and adjusted operating income grew $3.2 million, or 73.9%, and margin improved 260 basis points compared to the prior year. Managed Freight experienced a 9.1% reduction in freight revenue and a 29.5% decrease in adjusted operating profit compared to the prior year, reporting an adjusted operating ratio of 95.7. The reductions in freight revenue and adjusted operating income are attributable to the combination of lower volumes of profitable freight and cargo related claim expenses incurred in the current period compared to the prior year. Our Warehouse segment saw a 0.5% increase in freight revenue and an 85.1% increase in adjusted operating profit compared to the prior year, reporting an adjusted operating ratio of 91.5. We are pleased with the improvement in profitability within this segment, which struggled to produce adequate returns during the prior two years when the business was rapidly growing, and labor inflation outpaced our ability to obtain rate increases from our customers. Our minority investment in TEL contributed pre-tax net income of $4 million for the quarter, compared to $5.3 million in the prior-year period. The decrease was largely due to the continued softness in the equipment market, suppressing gains on sale of used equipment, and increased interest expense. TEL's revenue in the quarter increased 6% and pre-tax net income decreased by approximately 24% versus the third quarter of '23. TEL increased its truck fleet in the quarter versus the year ago by 133 trucks to 2,328 and increased its trailer fleet by 477 to 7,490. Regarding our outlook for the future, for the remainder of the year, we believe the general freight market will remain challenging despite overall fundamentals slowly improving with excess carrier capacity exiting an environment that has had unsustainable conditions. Absent an outside catalyst to facilitate improved demand, we remain uncertain about the pace at which general freight conditions will meaningfully improve, allowing us to improve our margins with customers who are not providing an adequate return on capital. Despite these challenges, we remain optimistic about our business model as evidenced by the durability and growth of our core operations over the last 24 months. In the fourth quarter, we believe we have both the momentum and team to continue to improve the efficiency of our operations and execute on opportunities that present themselves regardless of the status of the freight market. Thank you for your time, and we will now open the call for any questions.

Our first question comes from Scott Group from Wolfe Research. Please go ahead, Scott.

Thank you. Good morning, everyone. Can you share your insights on the demand environment and how it developed throughout the quarter? What have you observed so far in Q4 following the storms? Is there a regional tightness, or is it likely to have a broader impact? Any high-level comments would be appreciated.

Yeah. Hi, Scott. This is Paul. I'll give you a little bit of color. July felt pretty good, the first 15, 20 days and then softened up a little. August is a month that doesn't have any holidays in it. So, we felt pretty good about revenue in the month of August. And then, we started sensing a little bit of softness in the month of September. And I would say, in general, that's carried over to the month of October, and that's primarily within the Expedited network. And as you know, there are a lot of PT-type accounts in there, and you guys have seen what the LTL industry has done, so that's some of it. But, yeah, there was a slight uptick in tightness we saw right around the hurricanes. I would say both hurricanes, and it faded pretty fast. It didn't last that long, especially with just the nature of our customer base. David, do you want to add anything to that?

I agree. Scott, I think the situation we've experienced over the last two years is still present. I’ve read all your writings and I genuinely believe we are at the bottom, and we're just kind of staying at that level, waiting for something to trigger a change. That's my perspective on the current state of the freight market.

Can you just remind us like what percentage of the Expedited business now is the LTL line haul? Like, is that ultimately what feels like it's gotten worse in the last, I don't know, couple of months?

Our LTL air freight and freight forwarding are all part of our transportation business, which accounts for about 55% to 60% of the total Expedited segment. So, it's a significant portion. When Apple released their product, it really boosted activity for a couple of weeks, but that has since subsided. The situation isn't dire; our utilization last month was over 15,000 miles per truck, which indicates that it's not in bad shape, but it isn't performing as well as it did six months ago. It's acceptable, but there is some softness. I notice a similar trend with the LTLs, which have also experienced a slowdown, primarily affecting the industrial base.

Makes sense. And lastly, David, I know last quarter you mentioned starting to gain a couple of customers with some pricing increases. As we approach bidding season and engage with more customers, how are you considering pricing for this upcoming cycle in terms of whether rates can increase? Can they rise a little or a lot? Any thoughts?

I remember last quarter I mentioned we had two, and now it's increased to five or six. Since our last call, we've completed three or four projects, all of which have been successful. I believe we will secure rate increases because we've been actively engaging our customers. I don't think our customers expect the industry to go three years without any rate hikes. I anticipate we can achieve rate increases of around 2% to 3%. In the latter half of the year, I expect similar numbers. While it might be challenging to present a 5% increase to customers at this point, we have managed to secure a few. Overall, I believe we can achieve 2% to 3% now and reassess in the summer. That's what we are communicating to our sales team as we move forward, and I am confident that our established relationships with customers will help us succeed in this endeavor.

Thank you, guys. Appreciate the time.

Thanks, Scott.

Our next question comes from Jason Seidl from TD Cowen. Please go ahead, Jason.

Hey, thanks, operator. Good morning, gentlemen. Piggybacking on that question a little bit, David, would you define success as 2% to 3% in this market, given where costs have gone?

Yes. Yeah. If somebody said, here's January 1, here's 2.5%, we'll just use that number. Here's 2.5%, I would say that's successful, seeing if the market gets better and then say we got to come again.

Okay. Well, then let's take that and extrapolate it out for '25. As I look this year, you guys are going to earn probably about $4, give or take, right? So, what type of earnings growth can we expect, knowing that you guys have a little bit of a different business mix than your stereotypical truckload player in a 2% to 3% up-pricing scenario?

Jason, we've received comments about operating leverage and rate increases. In 2024 year-to-date, we've taken on many costs that began in 2023 and have continued to rise. We're doing everything we can to manage these costs, but there’s not much more we can do at this point. The costs are reflected in the P&L, and as you mentioned, we could end up around $4. While I’m not claiming that's the final outcome, it’s worth noting. If you consider the miles we run each year, it’s just under $300 million. Even a 1% or 2% change significantly impacts operating leverage. Most of that would flow directly to the bottom line regarding rates, resulting in a notable increase in operating income and EPS, especially with a lower share count. We plan to engage the market to capitalize on opportunities, which might require a phased approach, as David indicated. I believe we can grow operating income, and we have positive momentum in Dedicated with our growth. Our fleet is the youngest we've had in a while, positioning us well for the upcoming upswing when it occurs. We are prepared to seize opportunities as they come, regardless of what the market presents.

That's great color. And you sort of are leading me into my next question. You talked about the youngest fleet. How should we think about CapEx as we look at '25?

I anticipate a decrease in capital expenditures. To provide some approximate figures, we are expecting to finish this year with about $90 million in CapEx. A significant portion of that, around $40 million, is attributed to growth-related expenses. For next year, you can expect continued investment in CapEx, primarily for maintenance. We have already set aside extra equipment for growth CapEx early in the year, so that's already been purchased. Therefore, I expect a much lighter CapEx, likely in the range of $50 million to $60 million. While our CapEx plans are not yet finalized, we are committed to continuing our investments.

And so, if it's $50 million to $60 million, so what would maintenance CapEx be for you guys? About $40 million-ish?

That sounds about right. I would estimate our maintenance CapEx next year to be between $50 million and $60 million. We have some growth-related CapEx planned for this year. If business starts to pick up, we have the capacity to handle that for a short time. So, if we experience more growth than expected or achieve significant wins, which we have done this year unexpectedly, we can adapt quickly and that number might increase a bit.

Okay. That's fair enough. And just to follow up a little bit on the LTL line haul stuff, has there been a recent drop in the LTL line haul, or was that more consistent through the quarter?

I would say, Jason, it's probably more in the second and third month of the quarter. We start sensing it a little bit post 4th of July, and then it kind of materialized over the balance of the quarter.

Got you. Gentlemen, I appreciate it, as always.

Thank you, Jason.

Our next question comes from Daniel Imbro from Stephens. Please go ahead, Daniel.

Hey, good morning, guys. Maybe to follow up on that Expedited piece, so maybe the LTL demand stays softer in the near term, and it sounds like that's your expectation. Just curious, with the network being out of whack, I guess, what can you do to drive up utilization as you look to improve that in the fourth quarter and kind of start levering those costs? And then related, maybe to follow up on the last one, just how are you thinking about Expedited tractor counts? Should we see that fleet go down if demand stays challenged for a while, or how are you thinking about investing there?

I believe the fleet counts will remain relatively stable as we are making progress in addressing the imbalances. We are actively working to fill gaps in our network. Although we have seen some progress in the past few weeks, there is still more work to be done. The peak period is approaching, a term we don't frequently use anymore. However, there is certainly some peak business beginning to emerge now, and we anticipate a bit more in November and early December. Our team is diligently searching for freight to fill these gaps and increase truck efficiency compared to the past ten weeks. We have reverted to holding three or four meetings a week to ensure accountability in filling these gaps, as our network is quite tight. It doesn't take many loads—just a few hundred in the right locations on the right days—to optimize our performance. Therefore, it’s primarily about the basics of execution combined with our peak preparation efforts.

That's helpful. And then maybe shift over to the Dedicated side of the business. I think if I remember right, live bird should be strengthening here in the fourth quarter, that should be OR accretive just from a mixed standpoint. So, how do you think about maybe Dedicated OR here in the near term in the fourth quarter? Are there any offsets we should be aware of that would offset that benefit from the strength in live bird?

I believe the poultry business will perform well in the fourth quarter. We're starting to see positive trends this week, and I expect it to continue improving until Christmas. We did make some adjustments in rates with certain customers to maintain business in the third quarter, which will have a full quarter impact. In terms of Dedicated, I think it will remain about the same in the third versus the fourth quarter. I don’t see any significant improvements, but I also don’t anticipate any major declines.

Great. Appreciate it. And last one for me, just on the cash flow side, you mentioned CapEx being down next year. Maybe margins are getting better if we get the rate. I guess I should spit out more free cash. How are you thinking about M&A opportunities out there? You've seen anything else getting shaken loose given the prolonged downturn?

I would tell you, I think everybody knows what we're looking for. And it's niche, stable, good margin business that's not competing with the OTR environment, not competing with all the general freight environment. And we continue to have a number of things come across our desk. And so, I think we will continue to look at those, but we're not going to let any cash burn a hole in our pocket. If we do something, it's going to have to be the right deal at the right time with the right business model. And so, we're just going to continue to evaluate and see what happens over the next year or so.

I would echo Paul's comment on that. You likely noticed the reduction in net debt during the sequential reduction, which is essentially an accumulation of cash. While we don't have any imminent acquisitions targeted, I prefer having a bit of cash as a cushion. It was a strong quarter, but our strategy remains unchanged. The key for us is to be patient and find the right acquisition that fits us well in terms of culture and leadership. We've been successful in our last few acquisitions and will continue to follow that approach. We are committed to our strategy, and you will see us keep pursuing it.

Makes sense. Thanks so much.

And our next question comes from Jeff Kauffman from Vertical Research Partners. Please go ahead, Jeff.

Thank you very much, and congratulations in a very difficult environment. I want to look beyond the fourth quarter and kind of pick your brain on kind of the longer term that you're seeing in the market. We all know the market is dislocated. I think people are talking about how long this downturn has been, although arguably we're coming off a sugar high when we started. But kind of what changes do you think you've seen in the market structurally versus what kind of weakness we're seeing as more just the short-term normal ebb and flow of the market?

I have a few points to share that relate to what Daniel mentioned. Specialized businesses are performing very well, even those we might not have direct interest in. The increase in brokers is negatively impacting the market's ability to recover, along with smaller carriers that profited significantly during the latter half of 2021 and 2022, building up cash reserves, and now taking on a lot of freight at rates below their cost structure. The rise of small brokerages during COVID and the decisions made by some small transportation companies in the past two years, which seem inconsistent with economic principles, have had a lasting impact. However, businesses that operate outside that competitive landscape and avoid bidding on commoditized contracts still follow sound business practices, prioritizing returns on capital, and are maintaining solid economic fundamentals.

I agree 100%, yeah.

So, I want to go back then to your comment on, we feel like we're almost out of bullets here. I mean, I love the niche strategy, if you will, to your point on the specialized businesses. But at this point, is it really just we batten down the hatches and we're waiting patiently for the turn, or are there niches that you aren't as heavily exposed in today that make sense more than they used to in this kind of market?

I think it's both of those. I think that you need to be prepared to do both, and that is batten down the hatches, and when is this thing going to turn. Now, I will also say that I can paint a picture that, with the Fed, what they did, 50 basis points, and are they going to do another 25 basis points in '25? I personally don't know that they've got inflation straightened out yet or not, but that's a side note. But if they reduced interest rates, we're going to feel that. It's going to be felt, and there's a lot of freight in housing, there's a lot of freight in automotive that will start coming forth in the next few months if the Fed continues to lower interest rates. And I think the election is going to be a very important election. I think if it goes one way, I think it's going to be some more freight out there. If it goes the other way, I think that we may have kind of where we're at today, but aside, whichever President wins the election, I think what the Fed is doing on interest rates is going to help transportation in the next few months. The other side of that, so you batten your hatches down, at the same time, I think you're going to get some help, and then, as Paul said, we continue to look at acquisitions that make sense, and the niche ones make sense. And so, it's just a matter if you find the one that has the interest or find the one that you can agree upon, because that's the way in which we're building our company in the future.

Does that help, Jeff?

No, that was tremendously helpful. Thank you. Just kind of following along that path, I think we all agree capacity isn't going to be our savior here, because it's just coming out too slowly, but outside of housing, is there anything out there that would make a material difference, positive or negative, to your '25 outlook in terms of parts of the economy?

Great question.

I think domestic industrial production going up would definitely help. And I'll be honest with you, I've talked to a few folks just from my prior life in public accounting and some stuff, I think a piece of this industrial production slowdown, it's the old election year thing. And I think you might see a pickup in industrial production post-election, no matter who wins. There's a lot of people just sitting on the sidelines right now between interest rates in the election. And so, CapEx spending, fueled by industrial production, I think that, I think housing, I think auto, I think all those things would be really beneficial to us.

No, I agree, decision paralysis. Break that up would be very helpful. Well, all things considered, congratulations and thank you.

Thanks, Jeff.

Thanks, Jeff.

And our next question comes from Michael Vermut from Newland Capital. Please go ahead, Michael.

Hey, gentlemen, how are you doing? Fantastic operating through all this.

Thank you.

Regarding our cash flow situation, since we have the youngest fleet, I expect capital expenditures to decrease. If you look at the free cash flow projections for the next two to three years, assuming we don’t make any large acquisitions, we should be close to being debt-free in that timeframe. Currently, we are trading at 12 times earnings, while the group trades between 20 to 40 times, indicating a significant discount. If we don't find suitable acquisitions, should we consider buying back stock? Is there an ideal level of leverage we should aim for before making that decision? The free cash flow we anticipate generating over the next few years will be substantial, so I'm interested in your perspective on this.

I would say that nothing has changed since we began this journey two years ago. Internally, I've mentioned that someone is going to appreciate us, whether it's Wall Street or ourselves, and we've chosen to invest in ourselves by repurchasing significant amounts of stock and pursuing acquisitions. Therefore, we will pursue whichever opportunity presents itself.

The math's going to be what the math's going to be.

The math will be what it will be, and I'm fine with either outcome. We can continue to pursue acquisitions, and if a great opportunity arises, we will take it. However, if it doesn't, you can expect us to do something with our cash, and we have a track record of that. So, whichever direction opens up is the path I want us to take.

Yeah, Mike, I would echo David's thoughts. I mean, I'm pretty happy with our capital allocation, the playbook, again, like I told Jeff, is working. We've had three acquisitions. We significantly restructured our business in 2020. A lot of significant changes. And I still don't think investors maybe have gotten that message yet. The longer part of our history would suggest that we're a very, very volatile company, and I get frustrated when people try to look at 10-year, 15-year averages of how we've performed. I'm like, don't pay attention to that, because it's a very, very different structural company, much more efficient, much more resilient, much more insulated, poised for growth. And I think that we're going to just keep focusing on the things that we can control and try to be the best that we can be at those things, execute at a high level, continue with our capital allocation playbook. And I think you're going to see more of the same of what you've seen over the last three or four years. We're in a great position. I mean, we mentioned some headwinds in the release, but I would say that we've had headwinds throughout the last two-and-a-half years that we've overcome, and this one just kind of came at the tail end of what we thought was going to be a fantastic quarter. And it is a good quarter, but they come and go, and I think there's more blue sky ahead of us than there are clouds.

Excellent. One of the last things, in a lot of your releases you discuss, the model now is much more consistent, and you may not have as much upside leverage as others. You'll have still dramatic upside leverage. That's on an operating income level, I assume, because when you look at the capital structure, I think you took down 2 million, 3 million shares over the last four years, something like that. So, the bottom line, there will be dramatic leverage, right? Now, you've changed that capital structure forever, so it's really the leverage on the top income line, not the bottom line.

That's right. And so, I'm absolutely excited about it. I think that, one of the things we have to remind investors, again, going back, it's a different company. We were so volatile in the past, and I've read some releases before where they're still being mentioned. And there's still not a full conviction that we are, in fact, a different company, and we are more contractual, we are more profitable, we're more stable, but we've pulled the share count down, our OR has materially improved in a trough market. I mean, the fundamentals of our business, the team is solid, all pulling the rope in the same directions, we're going to continue down the path that we've been on. There's no reason for us to deviate. And so, I think that there's, like I said, every indicator gives me the confidence that makes me believe that we're going to continue to be successful over the longer term.

Excellent. All right. Congrats, guys. Eventually, it'll be recognized. So, congrats.

Thanks, Mike.

Thanks, Mike.

Our next question comes from Dan Moore from Scopus. Please go ahead, Dan.

Hey, guys. Congratulations again on a great quarter to echo everybody else's comments.

Thank you, Dan.

I appreciate the opportunity. I have a couple of questions that tie into the ongoing discussion about a long-term perspective. This downturn has been particularly challenging, and I've witnessed quite a few in my time. I believe we have a solid understanding of where the lowest earnings are likely to be. I'd like to spend a minute discussing what the next growth cycle might look like for your company. To provide some context, Tripp mentioned that even a small increase in rates can significantly impact earnings growth and leverage. It seems reasonable to assume that during the next cycle, we could see margins improve by 500 basis points, but we likely won't experience the same level of volatility that would lead to a 300% increase in profits as we did a decade or more ago. With this opportunity, improved free cash flow will allow for substantial capital redeployment, both in the business and for share buybacks. Could you elaborate on the potential path for increasing rates in a rising market, improving margins, and how you view the current earnings potential of the business compared to the past? Thank you.

Sure, I'm happy to discuss that. If you examine our adjusted earnings from the previous period or last year, we reported $4.16. Looking at our performance this year, if we estimate around $4—just referring to what someone else mentioned—we have maintained a strong position from an earnings standpoint. In terms of costs, David and I reviewed this, and considering a 2% increase in our earnings from 280 million miles, it translates to $6 million in operating income. We've absorbed many costs, and a significant portion will flow to the bottom line. That $6 million equates to over $0.30 in EPS. Furthermore, in a rising freight market, we expect TEL to strengthen. Though they've faced challenges with high debt and equipment deployment, they have done exceptionally well in growing their business over time. Despite a downturn, I fully expect them to make continued progress in the long run. I prefer not to divulge specific earnings numbers, but our main focus will be on our Managed Freight business, which remains the unpredictable factor among our segments. Looking back at 2021 and 2022, achieving a sub-90 OR in Managed Freight doesn't seem feasible long-term. We will prioritize growth in areas we control, emphasizing profitable business and customers who allow us to add value, which should lead to improved profitability in our Dedicated and Expedited segments. We currently have a strong customer mix that we are pleased with, and as we expand, we intend to partner with those who provide us adequate returns. There are numerous factors at play, but I believe there is considerable potential for growth. While we may not return to the earnings levels of 2021 or 2022, I do see a promising upside in earnings. Does this address your inquiry, Dan?

It seems to me that the entire industry is experiencing significantly lower rates, and we might see rates increase by 5% to 10% over the next couple of years. Such an increase could nearly double earnings with a 10% improvement. I would like to discuss this further with you and gain a clearer understanding of how to approach some of these businesses. Congratulations again on a fantastic quarter. The hard work over the past couple of years has clearly paid off, and I look forward to checking in again after the December quarter. Thank you.

Thank, Dan.

And at this time, there are no further questions. I'd like to turn the call back over to Tripp for closing remarks.

All right, everyone. Thank you for joining us today, and thank you for your interest in Covenant Logistics. We look forward to speaking with you in the fourth quarter or in January for our fourth quarter results. Have a good day.

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