COVENANT LOGISTICS GROUP, INC. quarterly report, Q2 FY2016

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Covenant Transportation Group, Inc. — Q2 2016 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2016. Amounts below are in millions of dollars unless otherwise noted. The filing identifies the registrant as Covenant Transportation Group, Inc.

Business context and results

The company provides asset-based truckload transportation, with additional freight brokerage, factoring, and related services. Management described Q2 as challenging due to weak freight demand, plentiful industry capacity, and rate pressure. The company reported one segment, Truckload; other operations include Solutions.

  • Q2 revenue: $158.8, down 9.5% year over year. Freight revenue, excluding fuel surcharges, was $144.4, down 5.1%; fuel-surcharge revenue fell $8.9 to $14.4.
  • Q2 earnings: Operating income was $7.3 versus $18.8; net income was $3.6 versus $11.0. Diluted EPS was $0.20 versus $0.60.
  • Six-month revenue and earnings: Revenue was $315.2, down 8.0%; freight revenue was $289.1, down 2.2%. Operating income was $14.7 versus $28.8; net income was $8.0 versus $21.2. Diluted EPS was $0.44 versus $1.16.
  • Margins: Q2 operating ratio was 94.9% versus 87.7% (higher is worse); net margin was approximately 2.3% versus 6.3%. The six-month operating ratio was approximately 94.9% versus 91.0%.
  • Segment performance: Q2 Truckload operating income declined to $8.7 from $16.7. Other operations’ revenue rose to $14.1 from $12.7 and operating income to $1.5 from $0.6, reflecting customers added in late 2015.

Cash flow, balance sheet, and liquidity

  • Six-month cash flow: Operating cash flow was $64.4 versus $56.9. Investing activities used $11.2, including $60.7 of equipment purchases and $49.4 of disposition proceeds. Financing activities used $49.2. Cash increased $3.9 to $8.4.
  • Liquidity: Working capital was $15.5, down from $46.4 at year-end 2015. At June 30, the $95.0 revolving facility had $10.9 drawn, $26.8 of undrawn letters of credit, and $54.9 of available borrowing capacity. Management said liquidity was adequate for at least the next 12 months and it did not expect to test the fixed-charge covenant in the foreseeable future.
  • Debt and leases: Balance-sheet debt was $192.5, with $13.7 of capital lease obligations; debt and capital leases together totaled $206.2, down from $249.0 at December 31, 2015. The company separately reported net indebtedness, including the present value of off-balance-sheet lease obligations, of $197.8, down $47.7 since year-end. Operating lease payments remaining were approximately $19.2; discounted lease payments and residual guarantees were approximately $19.9.
  • Equity: Stockholders’ equity was $219.8 at June 30, 2016.

Material changes and management commentary

  • Truckload freight revenue weakness reflected lower average freight revenue per tractor per week and a smaller average tractor fleet; Q2 average miles per tractor fell 3.3% year over year. Management cited elevated costs per mile, including net fuel and capital costs.
  • Net fuel expense rose 21.4% in Q2 and 27.6% for the six months, despite lower fuel prices, due to reduced surcharge recovery, increased hedging losses, more brokered freight, and higher empty miles. Fuel hedge losses reclassified to expense were $4.1 in Q2 and $9.1 for the six months.
  • Depreciation and amortization increased 12.1% in Q2 and 14.7% for the six months, driven by equipment residual-value assumptions, newer and more expensive tractors, and the headquarters purchase. Management expected depreciation to rise further as equipment financing shifts toward purchases and capital leases.
  • Solutions improved, while refrigerated subsidiary SRT had two consecutive quarters of operating losses. Management identified improving SRT performance, securing peak-season customer commitments, adding drivers to trucks, increasing freight revenue per tractor, and managing fleet size, costs, and capital as priorities.
  • Safety performance improved: DOT-reportable accidents were down more than 10% year over year in Q2. Team trucks reached 39.0% of the fleet, up from 37.3% in Q1.

Outlook, risks, and unusual items

  • Outlook: Management remained cautious for the rest of 2016. If weak demand persists, it expected rates and utilization to resemble Q2 levels, apart from seasonal fourth-quarter improvement related to e-commerce. It noted that stronger economic growth or electronic logging device mandates could affect industry capacity and pricing.
  • Capital spending: 2016 net capital expenditures were forecast at approximately $55–$65.
  • Insurance litigation: A 2008 cargo-claim case had a prior judgment of approximately $5.9 plus prejudgment interest and costs. The Sixth Circuit reversed part of the decision and remanded the remaining issue; trial was scheduled for November 2016. Management believed existing reserves were adequate, but an unfavorable outcome could increase expense.
  • Fuel and interest-rate exposure: Fuel hedges covered approximately 25.2% of projected remaining 2016 fuel needs, 25.2% of 2017 needs, and 15.8% of 2018 needs. The company expected about $6.1 of fuel-hedge losses, net of tax, to be reclassified to earnings over the next 12 months. A $28.0 interest-rate swap fixed the related headquarters borrowing at 4.2% through 2035.
  • Prior-period comparison: Q2 2015 included a $3.6 pretax credit from commuting prior auto-liability insurance policies, which boosted the comparison-period result. The company adopted ASU 2016-09 early, recording a $2.2 increase to opening retained earnings and a $0.6 tax benefit in Q1 2016.
  • Seasonality and risk: The filing cautioned that interim results may not indicate full-year results. It also highlighted driver recruitment and retention, claims severity, freight demand and rates, fuel surcharge recovery and hedging, equipment residual values, and credit-facility covenant compliance as areas of risk.

Important facts for investors to verify

  • Whether freight demand, utilization, and freight revenue per tractor improve or remain near Q2 levels.
  • Whether management’s SRT turnaround and driver-recruitment plans improve operating performance.
  • Actual 2016 net capital expenditures and the effect of shifting equipment financing from operating leases to debt and capital leases.
  • The outcome and financial exposure of the November 2016 cargo-claim trial, including any change in reserves.
  • Future net fuel expense, hedge-loss reclassifications, and the company’s ability to improve fuel-surcharge recovery.
  • Whether the reported $54.9 of revolver availability and liquidity remain adequate as results and working capital fluctuate.