Covenant Logistics Group, Inc. Q4 FY2024 Earnings Call

Welcome to today's Covenant Logistics Group Fourth 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 fourth 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. Our prepared comments and additional financial information are available on our website at www.covenantlogistics.com/investors. Joining me on the call today are CEO, David Parker; President, Paul Bunn; and COO, Dustin Koehl. Before addressing the quarter's results, I would like to take a moment to comment on the year as a whole. For the second consecutive year, our business model demonstrated durability in a weak general freight environment, which would not have been possible without the commitment of our talented team executing on a common strategic goal. In 2025, we will continue to focus on factors within our control that make Covenant a more profitable and consistent company over the long term. We made great strides in 2024 and will continue to work on improving our model and financial results in the year ahead. Focusing now on the quarter. The positives and negatives for the quarter roughly offset to deliver consolidated operating results consistent with our expectations. On a segment basis, in general, dedicated performed below expectations and expedited was on target, while managed freight and warehousing exceeded our profitability expectations. Year-over-year highlights for the quarter include consolidated freight revenue grew by 4.6% as a result of the execution of new multiyear customer agreements within our dedicated segment. Consolidated adjusted operating income grew 4.7% primarily as a result of margin improvements in our asset-light segments, which includes managed freight and warehousing. Our net indebtedness as of December 31st declined by $28.7 million to $219.6 million yielding an adjusted leverage ratio of approximately 1.5 times and debt to capital ratio of 33.4%. The average age of our tractors at December 31st slightly increased to 20 months compared to 19 months a year ago. On an adjusted basis, return on an average invested capital was 8.1% versus 8.9% 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 providing a little more color on the performance of the individual business segments. Expedited finished the quarter strong and yielded a 92 adjusted operating ratio. The impact of network disruptions early in the quarter from Hurricane Helene were largely offset by higher freight rates and volumes within our specialized government services fleet. Compared to the prior year, expedited's average fleet size shrunk by 40 units or 4.4% to 875 average tractors in the period. We expect the size of this fleet to flex up and down modestly based on various market factors. While we are pleased with the durability of our operating margin in the segment over the past two years, as general market conditions improve in 2025, our focus will be on improving margins through rate increases, exiting less profitable businesses, and adding more profitable business. Dedicated experienced average fleet growth in the fourth quarter of 198 units or approximately 16.2% and grew freight revenue by $14.8 million or 22.4% compared with the 2023 quarter, an accomplishment that aligns with our strategic plan of allocating capital to operations with high service requirements, resulting in more consistent above-market returns over the long term. While we are pleased with the growth in this segment, profitability for the quarter fell short of our expectations. In the quarter, we experienced both year-over-year and sequential margin erosion as a result of prolonged customer shutdowns and volume reductions due to internal operating issues, Hurricane Helene in the Southeast, and the impact of midweek holidays. Costs were also headwinds for the quarter with higher-than-normal driver wages and salaries, claims expense, and operations and maintenance expense. Going forward, we remain focused on our strategy of growing our dedicated fleet, specifically in areas that provide value-added services for customers. We believe that if we are successful in providing best-in-class service and controlling our costs, growth and improved profitability will result. Managed Freight exceeded profitability expectations for the quarter by capitalizing on overflow freight from our asset-based segments as well as seizing on peak opportunities available. We believe the margin achieved in the fourth quarter is not likely to carry into 2025. Going forward, we seek to grow managed freight with profitable revenue from new customers, work closely with our asset-based segment to capitalize on overflow opportunities when available, and optimize cost to yield longer-term margin goals in the mid-single digits, which will generate an acceptable return on capital given the asset-light nature of this business. Warehousing improved its adjusted operating profit compared to the prior year by 56% reporting an adjusted operating ratio of 90.7%. We are pleased with the improvement in profitability within this segment, which struggled to produce adequate returns over the prior two years when the business was rapidly growing and labor inflation outpaced our ability to obtain rate increases from customers. In the future, we plan to continue to grow revenue and operating income in this segment through a robust organic growth pipeline and cost management. Longer-term profitability goals are in the high single digits. Our minority investment in TEL contributed pretax net income of $3 million for the quarter compared to $4.7 million in the prior year period. The decrease was largely due to the cost of operating a larger fleet of newer, more costly equipment, bad debt expense with a small number of customers, and higher interest expense associated with more debt at a higher weighted average rate. Revenue in the quarter increased by 13% and pretax net income decreased by approximately 36% versus the fourth quarter of 2023. TEL increased its truck fleet in the quarter versus a year ago by 342 trucks to 2,473 and increased its trailer fleet by 1,042 trailers to 7,852. Regarding our outlook for the future, we expect consolidated earnings to improve for 2025 compared with 2024 based on the following assumptions. The fundamentals of the general freight industry have improved to a level that is now allowing us to negotiate pricing from a better posture than the last two years. Assuming the trend continues, we expect to achieve improved pricing year-over-year under certain expedited, non-specialized dedicated, and managed freight contracts. The level of increase is expected to build throughout the year as contracts renew. The specialized dedicated business is expected to yield new contracts and revenue growth as we are evaluating several expansion opportunities. However, start-up costs associated with new contracts and a lackluster poultry production forecast for 2025 may weigh on margins in this segment during the near term. We will continue to make incremental progress on safety and claims management. There are no major fluctuations in the market for new and used equipment. Based on these assumptions, we believe 2025 will be a year of recovery for the industry and Covenant. Our goal is to steadily improve our customer and freight mix and our margins while continuing to review growth opportunities in niche businesses. Our primary objective remains to improve long-term returns to our investors by filling network needs, developing our team, and aligning with customers who truly need value-added services. Additionally, with modest leverage and significant liquidity, we have the full range of capital allocation alternatives available to us. Thank you for your time. And we will now open the call for any questions.

And our first question will come from Daniel Imbro with Stephens.

David, maybe I want to start on a little bit of a higher level. Another quarter here of sequential rate per mile increases. It feels like we're seeing some positive indicators in the cycle. I guess, can you talk about how early bid season is going, how you feel about rate momentum through the year? Tripp, you just mentioned you expect it to improve. And then on the 1Q weather comment, can you help us size up how you're thinking about either revenue or profit impact? And how does that compare to last January when we also saw some winter weather?

Daniel, I want to emphasize that the weather in the first two weeks of January has been challenging, particularly in the South, from Houston to Florida, and even here in Chattanooga where we experienced significant snowfall that disrupted operations for a couple of days. However, despite these weather issues, I feel more optimistic than I have in the last two and a half years. There are positive developments in the market that we've been anticipating for a long time. I'm sharing with our team that I truly believe by March, we will see favorable freight conditions, and by mid-summer, around June or July, we will observe a substantial increase in freight volumes. If I set aside the weather and focus on the current freight environment and customer interactions, particularly in terms of bidding activity and rate improvements, I am very pleased with our progress. I genuinely believe that 2025 will be a strong year for transportation. Three months ago, our goal was to engage with customers in September and October to negotiate rate increases for January, aiming for an increase of between 2% and 3%. Back in October, we were uncertain but decided to proceed with these discussions, and I am happy with the results. We've achieved approximately a 2.5% rate increase on about 55% of our business.

Yes, 50%, 55%.

50%, 55% of the business, about 2.5% because our goal is this. And of which we told all of our customers that have been gracious enough to give us the increases in January then here's what our goal is. Our goal is to get 2% to 3% in the month of January and then expect us in June to come back, and I believe that there's no doubt. If the market goes into depression, you're not going to be able to go back in June but I don't think that's going to happen because of what I'm seeing in the month of January. So that and then as I look at bids. I'm going to tell you, I was looking to this just in the last couple of days getting caught up on exactly where all the bids, we have won more bid numbers this year, in the first three weeks this year than we won in six months last year, I'm very pleased with that. And then I would tell you that 70% of it is with brand new customers, stuff that's happening, it's all I know. Something is happening that we're being successful. And the bids are at higher rates than what I was hauling three weeks ago and two months ago, excluding peak. So Daniel, I hope I answered your questions but I'm very pleased with what's happening.

I would like to focus on the dedicated business, which has remained stable. There may be some temporary customer shutdowns, which are continuing into the first quarter. Can you provide any insights on whether there's increased competition in that area or if it's just related to current external issues? Additionally, how should we anticipate this evolving throughout the year? Will there be a recovery once these temporary challenges pass, or is that revenue permanently lost? How does that situation look for the rest of the year?

I want to share some insights from our internal discussions. In my view, the dedicated market remains crucial. Customers who previously operated 50 trucks have scaled down to 30, largely due to a lack of available freight. Though these customers prefer to maintain their dedicated service, they are faced with the reality of needing to reduce their fleet size further. This trend has been evident over the past two years and has likely influenced the market dynamics, which appear to have stabilized. The customers currently in dedicated services are committed to it, while those who wanted to exit due to market shifts have already done so. As a result, we anticipate a flat performance going into this year. Regarding the impact of AI that we're experiencing in the poultry sector, it's significant, and we expect the effects to linger for another couple of months. From what I've observed, AI has affected specific farms rather than spreading uniformly across the country. In places like Modesto or Arkansas, some farms are hit while others remain unaffected. When a farm is quarantined, it can take about two to three weeks for officials to assess the conditions and dispose of infected chickens. Following that, it takes additional time for new birds to grow enough to be productive again, with timelines varying based on whether they are chickens or turkeys. After about 10 to 11 weeks of this process, particularly for turkeys, there is a surge in work as farms strive to catch up on supply to avoid losing customers. This situation is parallel to what we see in trucking when unexpected events occur; the goal is always to protect client relationships. So far, only a portion of our poultry fleet has been affected by these challenges. As we move towards March, I believe we will see a return to normalcy, with the expectation of increased operations from six-day work weeks instead of five as we recover. Overall, I feel we are past the most challenging phase and are now focused on rebuilding our poultry supply.

Our next question will come from Jason Seidl with TD Cowen.

Sticking on bird flu for a second, the last time this hit, how did the recovery look for Lew Thompson?

Bird flu tends to occur every year, and we experienced some cases last year. We weren't with the business the year before, but we’ve had discussions with them. I would say it’s a recurring issue, particularly during flu season and the winter months. Some years are definitely worse than others. Last year was relatively mild, but we saw some cases. This year, there have been slightly more instances. As David mentioned, it is seasonal and not typically an all-year concern. Additionally, the impact is usually short-term, and we generally see a recovery depending on supply and demand across the various sectors. Does that clarify things?

Tripp, I wanted to go back to something I think you said you mentioned your expectations for I think the used equipment market to remain flat. Is that what you're seeing in the marketplace right now or did I mishear you?

I believe we've seen some stabilization in the used equipment market. Although sales volumes were slightly down in Q4, we are starting to move equipment. There is interest in drive-ins and used tractors. Earlier this year, we struggled to move equipment and had to take some losses. However, the recent stabilization in the used equipment market is encouraging, especially since Q4 presented some challenges with high costs on both the fixed and variable sides of equipment. A quarter with low volumes, low revenue, and high costs does not contribute to a favorable operating ratio or solid earnings. We are optimistic that this trend will improve with the market, and we expect to see improvements in the first quarter, possibly as spring weather arrives.

It's not going to get any worse, I can tell you that.

That's right. And the stuff that we're pulling out on the maintenance side is going to be in really good shape. We got behind with COVID for quite a bit and some of the stuff we were selling last year and even the previous year was pretty beat up stuff. So we've got some quality stuff coming out and expect to maintain our fleet and we're looking forward to what we're seeing in 2025.

Let me switch over to dedicated a little bit. When you're looking in sort of the regular dedicated marketplace, how is the level of competition out there and what are sort of customer accounts existing fleets look like? Are they maintaining them, are they trying to grow them this year with some enthusiasm, or are they shrinking?

Jason, it's Paul. I want to echo what David said. I don’t think we are seeing many companies shrinking, as that largely occurred in the past two years. There is still a lot of competition, and many are relying on their established positions. Securing new contracts, particularly in the more commoditized dedicated segment, such as 53-foot dry vans and heavy trailer ratios, remains quite competitive. We are focusing more on specialized dedicated services, involving specialized drivers, trucks, and trailers. We are committing more resources to this area, which can be harder to succeed in, but there is potential for higher margins and long-term stability.

I want to revisit the weather for a moment. It seems that this year’s weather is considerably worse than last year, even though we did experience some issues last year. We're seeing storms in regions that haven't encountered them before. You mentioned that the CFO remarked for the first time about snow removal costs in New Orleans. How should we estimate the financial impact of this in the first quarter, knowing that there may be further costs ahead? What are your thoughts on what you're observing?

As I mentioned earlier, we are nearing the end of January, and February often brings severe weather. However, I want to commend our safety department for their exceptional work in guiding us through these weather challenges, more effectively than we have seen in the last 15 to 20 years. This situation has created a headwind for us due to the increased volume and number of road closures, as we have also been shutting down operations for safety reasons even before roads close. It’s challenging to quantify the impact, but I want to emphasize that this isn’t unique to us; it’s an industry-wide issue due to widespread weather conditions. While it may affect our earnings by a few cents, it’s essential not to let this overshadow our successful management and focus on safety. As David mentioned, we have significant momentum, and I don’t want temporary weather conditions to detract from the positive developments we have planned for 2025.

Jason, David and I were talking yesterday and maybe this will help you to Tripp's point, weather is incrementally worse this year versus last year. But if you look at this like the weather forecast, we see a lot of sunny skies ahead because when we're not dealing with the weather, things feel pretty good right now. So you kind of look at the forecast of the picture and say, all right, maybe it's cloudy, it's going to be partly sunny tomorrow but there's some good beach weather coming for the truckers.

And last but certainly not least, a great job on the warehousing side of things. How much can you tell is from customers getting worried about tariffs and possibly trying to push some items into the warehouse ahead of time? Is there any of that, or is it just a different type of growth?

I would say, Jason, we don't do a lot. Our warehouses really aren't heavily affected by port volumes. And so I think there are some folks that are probably set out with their warehousing business. Ours is just a function of a lot of production from the customer's domestic production and a lot of volume. And I think what I would say is when you go back and look at the third quarter too, you're starting to kind of see warehouse settle into a spot that where we hope it can run, as Tripp said in his prepared remarks, that hopefully warehouse is kind of in a different run rate than it was 12 to 18 months ago.

Just to add on to that, and I always want to frame this up in the context of the larger picture. You go back to 2021, our warehouse division was about $60 million of top line revenue. So we've grown at 70% over the course of a couple of years when labor inflation was going up every month. And growing it with new badges, new businesses trying to optimize it and make efficient is one thing but growing in an environment with rapid inflation and trying to adjust customer contracts for rate increases. My point is between '21 and '23, there was a lot of noise going on in terms of growth and cost that we finally got kind of straightened out through 2024. And so what you've seen is some pretty consistent margins. Q4 was probably the best margin for the warehousing division in the year but they've all been high single digits and we've been really, really proud about that group. And they've also got a really good organic pipeline for 2025, too, to continue growing it. And so doing this organically and spinning off the cash that they've done has been fabulous and they've done a great job.

Our next question will come from Scott Group with Wolfe Research.

I just want to clarify my understanding. You began the call discussing weather, poultry, and start-up costs, and then David expressed his excitement about what's happening. So, ultimately, how should we approach the model here? Is there a distinction in how we should consider Q1 versus the full year? How should we think about margins and earnings in the near term for the year? Any guidance you could provide would be helpful.

So Scott, I'll start and I'll flip it to David. I think what you're hearing us say is that we believe we're going to grow earnings of '25 over '24 because we think the fundamentals are setting up for some acceleration within the truckload industry. I do think, to your point, there could be some near-term headwinds because of weather. Just if you think about the cadence of earnings, Q2 and Q3 are always going to be our best quarters. Q4 will be the next best. And just like every transportation company, Q1 is probably going to be the worst. And so I think what you're hearing us say is a little bit of short-term headwinds but a lot of long-term opportunity.

And then, David, your comments about, hey, March we're going to feel it and by June, we're going to really, really feel it. What's the actual visibility to that? Is that a feel or is there something based on customer discussions that we can really…

In the last two years, I've appreciated everyone's support, including analysts and CEOs. It has been a period of uncertainty, and we've all been waiting for improvement. Recently, there has been a shift, particularly with the bid awards we've won in the past two to three weeks, which is significant as we haven't experienced this volume in a while. I'm noticing a more promising freight flow. Given that this is happening in January—typically the slowest month of the year—I believe things are set to improve. Unless there are unexpected economic downturns, I anticipate positive trends ahead. I'm observing current conditions and have confidence in future economic performance. Capacity in our industry is bound to improve, albeit more slowly than we would prefer, leading to more freight availability, which will benefit the entire sector. That's my perspective, Scott.

And maybe just lastly, I mean you guys have found a couple of really nice niche acquisitions the last few years that have helped keep up the earnings in this downturn. Are we any closer to finding another smaller but nicely profitable deal?

I'd say we're going to operate under the same playbook that we've operated under the last few years, and which includes a number of things, dividend, share repurchases, and acquisitions. And I think we've said this before, we're always looking but we're always going to be disciplined in what we look for and what we sign up for and there are a lot of boxes that need to be checked. And so we're on the lookout but I can't really comment or say that we got one ready to go or not but it is part of the playbook.

And we'll move next to Jeff Kauffman with Vertical Research Partners.

David, I want to follow up on the comments you're making about visible change and kind of what the feel is versus what you're actually seeing. Do you believe that it's more the business decisions and the business confidence that's changing out there, or do you believe it's more the market for truck capacity that's changing out there?

I believe it's a combination of both factors. The environment seems to be improving, and there is growing optimism. When people feel optimistic, their purchasing behavior tends to increase. This shift appears to be underway. Additionally, there’s anticipation around the implications of tax changes, both personal and corporate, which might stimulate more activity in the U.S. economy. I'm encouraged by what we're seeing from the automotive sector and Jeep, as I view it as the start of economic activity that can benefit us in terms of freight. Therefore, optimism plays a role, but so does capacity. Looking at recent bids we've participated in over the last couple of years, I’m pleased to report that we've recently won some of them at higher rates than in previous years. This indicates a positive development regarding capacity. I believe if we experience a good stretch of weather in January, we will see favorable conditions for freight. However, there’s a possibility that we may need to wait until March to see certain improvements. The weather can severely impact areas in the south, causing delays that can linger longer than in other regions. Despite these challenges, I genuinely think the freight situation is solid for January and will continue to improve, driven by optimism and increased spending and reinvestment from companies.

You're on a roll, this is awesome. Question for Tripp, if I can. Tripp, what are you seeing going on with cost inflation in the business? What areas are you seeing cost inflation moderating and what areas are you seeing cost inflation still being stubborn right now?

I think we are observing some moderation in operations and maintenance costs. Defining moderation is challenging because 2022 and 2023 were unprecedented. Given the capital expenditures, fleet refreshment, and equipment costs, we've faced pressures on profitability in 2024 due to equipment challenges. However, I feel we're beginning to stabilize on the maintenance front by managing a younger fleet. One surprising factor in 2024 was the rising cost of insurance throughout the year, which became a significant challenge in the fourth quarter. Nonetheless, I have a more positive outlook for 2025. There are a couple of uncertainties for 2025, including fuel costs, which are somewhat beyond our control and can fluctuate, and driver pay. If the market turns and begins to improve over a longer timeframe, we may see increases in driver pay. However, I believe we can also achieve some cost improvements in specific areas in 2025 that could mitigate these increases. Therefore, I’d be cautious about claiming we will be cost neutral; I anticipate some inflation next year. Yet, if we can secure rate increases throughout the year, not just the ones we've already seen, we could achieve significant operational leverage as those rates contribute positively to our bottom line.

Our next question will come from Michael Vermut with Newland Capital.

I have a question for you. It seems like we're entering a much better environment, right? It can't get much worse than it has been. No one has really touched on the balance sheet, but it’s improving. I’d like to discuss the targets from a leverage perspective. Currently, we're trading at 11 or 12 times earnings, while others are closer to 30 times. There’s a significant disconnect. We've performed much better through this downturn. At what point do we consider starting a buyback, given that we have a solid balance sheet and the future looks promising, as it has for the past three to four years? How are you approaching this compared to the other opportunities available? The spread we have versus the group is the largest we’ve seen.

Without a doubt, I believe we are making progress over the long term and establishing our model. Time will help us bridge the current gap. Despite this, we find ourselves at a significant discount for various reasons. Focusing on what we can control, we feel confident with our current leverage of approximately 1.5 times EBITDA. While we don’t have a specific target, we are comfortable operating between 1 and 2 times leveraged, and we plan to be opportunistic. We've experienced the benefits of past acquisitions, which could lead us to reduce leverage to 1 times if we don't identify suitable opportunities, or possibly increase it to 2 times or slightly above if we find the right match that supports growth and margin. Additionally, capital allocation and M&A considerations cannot ignore share repurchases, which we have executed successfully in the past. In 2022 and 2023, we repurchased around $110 million of stock at an average price of $13 after the split. We see opportunities to continue this approach and remain optimistic about the potential for our stock as we look ahead.

Mike, one thing I want to emphasize is that we frequently discuss our playbook. We plan to operate from a position of offense rather than defense, exploring whatever capital allocation options are best for long-term value creation for Covenant shareholders. It's not about passively waiting for opportunities to arise; we are actively seeking ways to create the most value over the long term, and while there’s nothing to announce right now, we will keep pushing forward.

No, it just seems that with how we've performed through this downturn and the outlook we've got, it's probably a decent idea here. But yes, maybe there's better acquisitions out there as well. So it's all good choices.

And it appears there are no further questions at this time. So I'd like to turn the conference back to our moderator for any additional or closing remarks.

Yes. Thank you, everyone, for joining us today and your interest in Covenant. And we look forward to speaking with you next quarter. Stay safe. Thank you.

And this concludes today's conference call. Thank you for attending.