Earnings Call Transcript - CVLG Q1 2021

Operator, Operator

Please be aware that each of your lines is in a listen-only mode. At the conclusion of today's presentation, we will open the floor for questions. At this time, I would now like to turn the conference over to Joey Hogan. Please go ahead, sir.

Joey Hogan, CEO

Thank you. Welcome to the Covenant Logistics Group First Quarter Conference Call. As a reminder for everyone, this call will contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to risks and uncertainties, and actual results could differ materially from those contemplated in the forward-looking statements.

Operator, Operator

We'll take our first question. Caller, your line is live, please state your name.

Jason Seidl, Analyst

Hey guys. This is Jason Seidl from Cowen. How are you this morning?

Joey Hogan, CEO

Hey, Jason. Good morning.

David Parker, CFO

Hey Jason.

Jason Seidl, Analyst

I want to concentrate a little bit on the obvious here, the Dedicated segment that seems to be where you guys sort of have the most upside. You alluded to some changes that were made and then some improved numbers in March. You told us directionally where you think profitability is going in Q2; can you guys turn to profit? And then also if you could expand upon some of the, let's say, problem children that you might have among your customer base and what to be done about that?

Paul Bunn, Senior Vice President

Hey, Jason, this is Paul. How are you doing this morning?

Jason Seidl, Analyst

Good, sir. Yourself?

Paul Bunn, Senior Vice President

Doing well. Reflecting on the first quarter, it's important to consider the significant impact of the weather in February, which had a negative effect, but we saw a marked improvement in March. Some of the rate increases began to take effect, and as we've mentioned before, about half of our business operates at acceptable margins and represents strong long-term potential. The other half is more commoditized and given the rising driver market, we will need to adjust our pricing accordingly. Many contracts are set to have rate increases in June and July, which should lead to incremental improvements. I anticipate breakeven in the second quarter, although it won't reach our long-term expectations. The third quarter is expected to perform better than the second, and we will continue to build momentum as clients choose to partner with us and invest in the services we provide. Additionally, the dynamic nature of the driver market will support this growth. I hope that clarifies things for you.

Jason Seidl, Analyst

No, it does, Paul. And when we look at the half of the business that you would consider sort of good long-term dedicated contracts, what sort of OR would you put upon that half?

Paul Bunn, Senior Vice President

Yes, probably low 90s.

Jason Seidl, Analyst

Low 90s. Okay. And in terms of the driver market, what should we expect from pay? I mean, are there more pay increases coming down the road here?

Paul Bunn, Senior Vice President

We're adopting a wait-and-see strategy regarding the Expedited side, largely influenced by our competitors and the solo market. The expedited pay increase has been well-received, not just in terms of pay but also with the mileage we're assigning to the trucks, which is resulting in strong W-2 wages for those drivers. On the Dedicated side, adjustments are needed, with more accounts requiring upward adjustments than not. Our recent analysis indicates a connection between accounts that fall into the green category for driver pay, which is 75% or better, and their solid returns. Conversely, accounts in the red, indicating the lowest 30% of pay, are not generating significant profits. Therefore, while Dedicated will need tariff rate increases, the specific amount will vary based on location.

Jason Seidl, Analyst

Yes, that makes sense. On the last question on the Logistic segment, obviously, just an excellent quarter for you guys. Can you talk a little bit about how we should look at that growth throughout the year?

Paul Bunn, Senior Vice President

If the market stays as hot as it is today, I think you're going to see similar returns. I think what happens to Managed Freight will depend on how long you think we stay in this cycle. As we've said before, that segment, a large percentage of that is where we play in the spot market. You're seeing a lot of spot rates there and a lot of spot freight and pop-up type freight among a number of customers. There are customers that are expedited that we have Expedited and Dedicated business with. So how that business goes for the rest of the year is going to depend on how hot the overall freight market maintains. I mean, if Q4 is like Q1, you'll probably see a similar number. If things were to trail off, you're going to start seeing the volume in that division going down and the margin going up a little bit.

Jason Seidl, Analyst

That makes sense. I'll turn it over to somebody else. Gentlemen, I appreciate the time as always. Be safe out there.

Paul Bunn, Senior Vice President

Thanks, Jason.

Joey Hogan, CEO

Thanks, Jason.

Operator, Operator

Thank you. And we'll take our next question. Caller, your line is live, please state your name.

Jack Atkins, Analyst

Hey, great. Good morning, everybody. It's Jack Atkins from Stephens. Thank you for taking my questions.

Joey Hogan, CEO

Hey, Jack.

David Parker, CFO

Hi, Jack.

Jack Atkins, Analyst

So, let me start by addressing one of your last points regarding how you anticipate the next several quarters will unfold from a cycle perspective. With the challenges we're hearing about in finding drivers, it certainly appears that we are in for a prolonged cycle this time. I'm not sure who should respond, but David, I'd appreciate your insights considering your experience in the industry. Where do you think we will go from here, in terms of rates and our ability to recruit enough drivers to expand the fleet?

David Parker, CFO

Hey Jack. First of all, how do we get enough drivers? I don't know. It's definitely a challenging environment. Part of this challenging environment does limit capacity, which can be a blessing at times. Regarding the freight environment, I had a significant management meeting last week and discussed this with some of our teammates. When I think about the future, I always keep in mind that I don't know how my five-year-old grandchild will afford it. But if I focus on the next couple of years, I believe we are going to see a norm of around 5% GDP growth, if not more, based on the current actions from Washington. As it pertains to the next few years, I think the freight environment will be strong. While we are experiencing some declines now, I anticipate it will slow down. We are currently seeing GDP growth of about 7% to 8%, which could decrease to 5% or stay steady at 7% or 8%. Even if there are slight fluctuations, we will still experience numbers that are unprecedented from a freight perspective. I don't see this trend changing; I expect a solid couple of years in this kind of environment.

Paul Bunn, Senior Vice President

You mentioned expanding the fleet and how challenging it is to invest in growth right now. The primary issue is the difficulty in attracting drivers; the situation is so challenging that simply maintaining our current operations is a struggle.

Jack Atkins, Analyst

Yes. No, absolutely. And that's what we're hearing from others. I guess when you kind of put all those comments in context, with the efforts that you guys have been undertaking over the last year to structurally improve the profitability of your business, and you put this type of super-cycle on top of it, you've got to be pretty excited about certainly your Expedited, managed freight business as you look out over the next couple of years. But this really has to be a very strong backdrop to be able to get the changes you need implemented at Dedicated?

David Parker, CFO

Yeah, you're exactly correct. The thing that we've told entirely through our people, and it's true, and that is we are producing some numbers now that we have never produced from a standpoint of turning our company around. In fact, if I think about 12 months ago, this time 12 months ago, none of us knew where this virus was going. Now, none of us know if it’s a week or five years, but we made decisions to shut down the assets and the solo operation and those kind of things during the second quarter last year. To see the improvement we've made, because that was part of our plan. Our plan, as you all know, was to be up where we're at today, and the background has helped us tremendously. That's why we're using the words internally that the runway is very long. We have runway, and it’s everything you've talked about: getting our Dedicated straightened out; we could not ask for a better market to get our Dedicated straightened out, and we will get it straightened out. We just have to work with the customers. Again, the pipeline is good on the ones that we can't work with or who decide not to work with us. But yes, we are very, most excited we've been in 35 years in this business.

Paul Bunn, Senior Vice President

One thing I'd like to add regarding the driver situation that David mentioned is that we might receive some assistance when the government subsidies come through, which could provide a slight boost. However, with the focus on an infrastructure bill and increased spending, we realize that construction is a significant competitor in our industry. If any measures do get approved, they could draw resources away because those jobs will need to offer competitive pay. I believe the current labor situation, impacting various industries, will create a capacity constraint, raising questions about inflation and its effects. Overall, capacity will be limited, as original equipment manufacturers are not significantly increasing their production due to labor issues and rising commodity prices. I fully agree with David that for at least the next couple of years, capacity will remain reasonable and will not see aggressive growth in fleet sizes.

Jack Atkins, Analyst

Okay, that's very helpful. Last question, I would like to discuss cash flow since this year's capital needs are not significant. I understand that the net CapEx is around $20 million according to the press release for your plan this year. How should we consider free cash flow in 2021? Can you assist us in thinking that through?

Joey Hogan, CEO

Yes. So, we took a little bit of a step backward from a debt perspective in Q1, because of the indemnification call, but our plan is to pay down debt and to continue to buy back stock as we get it. So, I think from a free cash flow perspective the rest of the year, probably in the neighborhood of $80 million.

Jack Atkins, Analyst

Okay, that's great. That's great to hear. Thanks again for the time, guys. Appreciate it.

Joey Hogan, CEO

Yes.

Operator, Operator

Thank you. We'll take our next question. Caller, your line is live, please state your name.

Scott Group, Analyst

Yes, Scott Group from Wolfe Research. Thank you. Good morning, guys.

Joey Hogan, CEO

Hey, Scott.

David Parker, CFO

Hey, Scott.

Scott Group, Analyst

So, just on the Expedited side, can you talk about the underlying pricing trends there? And if we're doing 9% margins in the first quarter, how should we think about those margins for the rest of the year?

Joey Hogan, CEO

Yes, Scott, the pricing for Expedited was strong in the first quarter, especially in January and for the last two and a half months. We anticipate this trend will continue and expect more opportunities to raise prices in the Expedited segment. We have three or four top accounts that we negotiate with annually, and we've already started those discussions for a few in the first quarter. This puts us in a good position by early May-April to benefit from those adjustments. We won't return to those customers for another increase until the year is complete. For all our other accounts, any new business is coming in at higher prices. We genuinely believe our Expedited model, while sometimes volatile, is now 35% of the total instead of the previous 75%. We project that the range will shift to 83% to 93%, operating at 93% in tough times and around 83% during more favorable conditions. Additionally, we are managing long-term contracts with customers in our top five accounts, where we are working on the second contract that prevents them from downsizing their fleets over certain periods. Ultimately, we expect prices to keep rising, and it's crucial to note that we believe we are currently operating at an 83% to 93% operating ratio in that model compared to where we used to be.

David Parker, CFO

I think, Scott, one thing I'd add is that we talked about it at the last quarter call that there is a difference versus history. When Expedited was a much bigger piece of the pie, in good times, we were always trying to grow it, which added to the volatility factor of the model. Now we're not. Now, whether or not we could if we wanted to, isn't that the question because of the drivers, but it's strategically we have made the decision, we're very happy with the fleet size; we're not planning to grow the fleet size; the division is performing very well. Take that pressure off to continue to grow the capital base and to feed that thing, but to improve it inside of itself. Only time will tell if that’s successful or not. But it helps the volatility question significantly in my mind, who has lived through a lot of different cycles in the past that says, oh my goodness, I wish we hadn't done that; 200 trucks in or that 400 trucks in or whatever. So, now we're living with it. Only time will answer that, but that's a significant move for us versus the past that's contributed to a lot more volatility as much of the growth, frankly, at the wrong time. We’ll see how that plays out.

Scott Group, Analyst

As far as margins, Paul, how would you comment on the margins?

Paul Bunn, Senior Vice President

I think incrementally better as the year goes on; again, back to the same comment. If driver stays high, the market stays hot. I think it'll get incrementally better each quarter, not materially, but incrementally better without dealing with weather and some of those.

Scott Group, Analyst

Can I just follow up? I'm just putting those comments together. If the right range is an 83% to a 93% OR for that Expedited business, I would think this is the kind of environment where we'd be closer to that 83%. Why wouldn't we start trending closer to that level?

Paul Bunn, Senior Vice President

Good question, Scott. I think we haven't reached our desired position yet. We did disclose some temporary costs that returned to the model at the beginning of 2021. We managed to work through that, and it turned out to be slightly less than expected. Nevertheless, we discussed it. We are transitioning, and we believe that will continue. That being said, 91% is the best first quarter in Expedited's history. The first quarter is typically the weakest for Expedited, so I think it started the year off strong. Yes, the market is good, but it began the year very well.

David Parker, CFO

Yes, Scott, is it going to get to an 83%? I don't know. But is it going to improve? Should each quarterly be better than the first quarter sequentially? Yes.

Scott Group, Analyst

Yeah. And so I guess big picture, though, your point is, we've made a lot of mixed changes in the business here to improve profitability and reduce cyclicality here. And yes, we're seeing tremendous benefits of cyclicality on the upside. But we're not chasing the market. So we don't think we'll see as much of the pressure on the downside of cyclicality when that environment emerges.

Joey Hogan, CEO

Absolutely, that's been the plan. We've been working on this for the last five years, I would say. In the last year, all the difficulties we've encountered have actually accelerated the transition; there's no doubt about that. However, our current position has given us a lot of confidence. As we mentioned in the prepared comments, we are starting to see less cyclicality compared to the prior year. We didn’t experience a significant decline. The fourth quarter was relatively strong from a freight perspective, and we are not expecting a substantial increase in the fourth quarter either. In previous years, we saw more volatility, but we hope that year-to-year, the cycles will be less pronounced than in the past.

Paul Bunn, Senior Vice President

You know, Scott, a couple of things. Joey talked about expediting being less volatile, long-term, because of the kind of constriction on the size and really dialing in, what we're doing and who we're doing it for. Maybe not being as exposed; getting dedicated, getting that 50% of those dedicated trucks where we need them is probably the biggest key to that. And then the other factors, don't forget, is the cost structure changes we made last year. Those are also aiding and helping make returns, and the margins more consistent.

Joey Hogan, CEO

I want to highlight that despite facing significant challenges from the weather in February, which primarily affected our Expedited group, we still achieved 91% in the first quarter. The weather impact likely accounted for a minimum of two or three percentage points of that quarter. If the weather conditions had occurred in a month like April, we probably would have seen a figure closer to 88%.

Scott Group, Analyst

Okay. Very helpful. Thank you, guys. Appreciate it.

Paul Bunn, Senior Vice President

Thanks, Scott.

Joey Hogan, CEO

Thank you.

Operator, Operator

Thank you. And we'll take our next question. Caller, your line is live, please state your name.

Dan Moore, Analyst

Hey, guys. How are we doing?

David Parker, CFO

Good. Who is this?

Dan Moore, Analyst

I'm sorry. This is Dan Moore with Scopus.

David Parker, CFO

Hey, Dan. We didn't hear. Good to hear you.

Dan Moore, Analyst

No worries, no worries. Congratulations on a great quarter, and obviously challenging operating environment. One thing I wanted to focus on a little bit more was Dedicated. I think most people view that as an extremely important segment to the long-term success of the organization and the turnaround you guys are progressing through. Paul, you kind of said as much with Scott on the line a second ago. What I'd like to ask is your peers tend to focus on double-digit returns in dedicated, not 8%, not 6%. Someone would argue that something, in fact, north of 10 is necessary to generate the kind of returns on assets that you want to deliver long-term. Could you talk to us a little bit about what your return profile is in that business long-term? What you're targeting? And I guess, it sounds like the driver environment is the biggest impediment. Beyond that, if there's anything else we need to be aware of? Thanks.

Paul Bunn, Senior Vice President

I would say we are aiming for around that double-digit target. We would be happy to see that segment get down to the very low 90s. We have some legacy accounts that are good to operate in this space. Throughout this journey, we've been working to consolidate our dedicated operations under one system and leadership team, with one group handling recruitment. It has become clear that there are two types of customers in this group. The first includes customers who fit the profile we've discussed, and we want to deepen our relationships with them. We will approach those customers to see if we can earn more of their business. The second group consists of customers with commoditized dedicated services, which are currently the most challenging to serve and expand. They either need to add value or we will reallocate those resources to better customers. We have remained committed to our culture and history. Unlike other companies that may quickly remove trucks, we will honor our commitments. However, we also cannot operate dedicated with an operating ratio of 98, 99, or even 100.

Joey Hogan, CEO

It’s important to highlight the complementary nature of our services, particularly in the trucking sector, where Expedited and Dedicated operations work well together. We're just beginning to explore the opportunities that lie ahead, especially with Paul's new leadership role in operations. There are several exciting projects that will bring attention to these areas. While we've discussed them before, I believe integrating our efforts will move us forward. The services are distinct, yet there are mutual benefits, particularly from a driver’s perspective. I see potential in this that can also benefit us internally.

Paul Bunn, Senior Vice President

Yeah. To Joe's point, Dan, we're just looking at how we strategically manage the lifecycle of a driver and give them career options; you know, come to Covenant, never leave. We've probably got the best collaboration that we've had in my 12 years here, and we're starting to move down that path. There's still a lot of work to do, but we're excited about where it might take it.

Dan Moore, Analyst

And just as a follow-up to all of that. Could you touch on when you'll have had an opportunity to touch 100% of those contracts within Dedicated? Because I don't know what percentage of those contracts; we don't know if they're one year, or multi-year?

Paul Bunn, Senior Vice President

We will have pledged two-thirds of them by September 30. I think we'll know closer to where we are in Q4. So earlier, I said there are a number of them that are June and July; there are some that have some notice requirements that we're working through right now. Those might take four months, five months.

Joey Hogan, CEO

I believe that by the second quarter, we will have a clearer understanding of our position in the field. We will be able to identify which projects are likely to succeed and which are not. Taking a look at our pipeline, there are certain projects that will be rolled out in the third quarter. However, we should have a good sense of how things stand by the second quarter.

Paul Bunn, Senior Vice President

And Dan, regarding the pipeline, it probably goes without saying, but the pipeline are accounts that would fit in that first bucket of partnership, value, engineering, problem-solving, not commoditized, smaller fleets compared to maybe more commoditized fleets.

Dan Moore, Analyst

Got it. Congrats again on a great quarter and best of luck through the balance of the year.

Paul Bunn, Senior Vice President

Thanks, Dan.

Joey Hogan, CEO

Thanks, Dan.

Operator, Operator

Thank you. We'll take our next question. Caller, your line is live, please state your name.

Nick Farwell, Analyst

I think I've been released. This is Nick Farwell. Can you hear me, David? Joey?

David Parker, CFO

I can. Hi, Nick.

Nick Farwell, Analyst

Good morning. I'm curious; I missed the comment about free cash flow. I apologize. What was the number over the next six months, or annualized?

Joey Hogan, CEO

So we think it's kind of going to be in the neighborhood of about $80 million of free cash flow for the next nine months, if you will, for quarters Q3 through Q4.

Nick Farwell, Analyst

Got you. Okay. Thank you very much. And the other question is, David, what do you believe is a reasonable OR and dedicated once it's stabilized in a more normalized, whatever the hell that means environment? Do you think something below 90 is reasonable given that, as an example, Swift has achieved their old, sort of low to mid-80 OR?

David Parker, CFO

Yes. Yes. What you just said there is the internal discussions that we're also having, Nick. As you heard earlier, about half of that fleet, half of our dedicated businesses are in the low 90s. Let's say, it's 91, 92. There are a few of those that are 88 and 87; although as I'm sitting here looking at it, there are quite a few of those. Our first goal is to get the ones in the low 102s down to the low 92s. Then we'll see where the market is going to allow us to go. I feel confident we can take 10 points out of those underperforming assets and get it down to the first sale. That's why, Joey earlier mentioned, at some point or another, either released from one of these questions, that he said that fourth quarter, the first quarter, second quarter, next year, we are working toward that.

Nick Farwell, Analyst

And what would you say? I know you've commented a bit about that within the same sort of parameters, where do you think you can get long haul over-the-road business? What OR do you think might be sustainable, again, in a whatever the hell normalized environment?

David Parker, CFO

We believe that we used to operate in the 87 to 97 range for our operational metrics. During the fourth quarter, we would sometimes drop to the low 80s. That was our long-standing model. In the first quarter, we aimed for breakeven and modest profits, particularly because our Expedited segment was at 75% efficiency, achieving a 97 operational ratio. We’ve adjusted our expectations to a range of 83 to 93. I think 93 might be a stretch. As mentioned in discussions about February, we just finished the first quarter with a 91 operational ratio, but we lost a couple of points in that period due to increased Expedited costs, including two-person truck operations and delays caused by winter weather in Wyoming. Previously, Expedited made up 75% of our business but has now fallen to 35%, and we aim to reduce that even further. The new operational range is now 83 to 93. Despite a difficult February where our operational ratio was in the high 90s, I believe that in a typical capacity, we can expect around 85 or 86. Current conditions are abnormal, and we are seeing an unprecedented freight environment. Nonetheless, we are doing our utmost to improve. As Paul mentioned, we've made significant cuts to our costs, which has enhanced our financial performance—assuming we can manage issues like the 40% increase in insurance rates that took effect on April 1st. We do face some challenges, but I hope that addresses your inquiry.

Nick Farwell, Analyst

Yes.

Joey Hogan, CEO

Hey, Nick, I want to clarify something real quick. Just your question on cash flow. If you're thinking about net debt right now, we're about $123 million. We've got net CapEx for the rest of the year of $10 million. We've got some cash tax payments. If you think about it, we're going to try to get down to about $80 million to $85 million of net debt by 12/31. So, that changes the numbers a little bit.

Nick Farwell, Analyst

Got you. Okay. That's still a hell of an accomplishment: $40 million to $45 million.

Joey Hogan, CEO

Yes. Yes. The model and the cash generation; there's another place that you can see week-to-week, month-to-month, quarter-to-quarter that the growth of the non-truck in the consistency of that growth is really contributing to the cash flow.

Nick Farwell, Analyst

Joey, while you and David have been around a while in this business, as an observation, I'm just curious. We've talked, you have and other trucking companies have talked about the constraints on the supply side, drivers for example, obviously, is a critical factor. You guys contracted your business; other long-haul truckers are contracting their business, and yet in theory, the demand for long-haul carriage hasn't changed in a significant dramatic sense. In fact, if anything, clearly, with this current pandemic, it's probably increased dramatically, hence the rate increases. I'm just curious; with the long-haul business being restructured by a number of companies, and yet demand is still, if not exceeding what it might have been earlier, it would seem to me the pricing would be better than stable for some period of time, maybe two, three years. I know that sounds rather bizarre, but with this significant imbalance in supply and demand, I could see over-the-road long-haul business perhaps sustaining something in the low 80s.

Joey Hogan, CEO

Yes, I believe there are several factors at play here. It seems that whenever expedited pricing increases significantly, competition tends to rise as well. I expect that competition will differ through various cycles moving forward, particularly among other freight providers, especially in the LTL space. Many LTL services are outsourced, and we see different scenarios depending on whether they are union or non-union. There are private companies we serve in the expedited product line, and major shippers on both the produce and LTL sides. There's a certain price point they are willing to pay, and another they are not. We strive to respect that limit to prevent customers from deciding to handle logistics on their own. It's a constant challenge to find that balance while still delivering excellent service, as both segments demand it and won't settle for less. Another factor is how pricing is influenced by fuel costs, and where some may opt for rail service instead, which requires considering container availability, spot rates, and equipment. I agree with you that the trajectory appears positive, and as David mentioned in earlier discussions, expedited services seem to be in a favorable position for at least a few years. That's just our perspective.

Nick Farwell, Analyst

Thank you very much. I appreciate it, Joey. It's a very intriguing environment for you guys with capacity. I don't mean just you, but anyone in the trucking business that has legitimate capacity.

Joey Hogan, CEO

Yes, I agree.

David Parker, CFO

Thanks, Nick. Casey, do we have any other questions?

Operator, Operator

We have no further questions in the queue.

David Parker, CFO

Okay. Thanks, Casey. Thanks everybody for joining us on the call. I look forward to visiting with you all next quarter. Thanks a lot.

Operator, Operator

Thank you, ladies and gentlemen. This concludes today's teleconference. You may now disconnect.