COVENANT LOGISTICS GROUP, INC. - Annual Report: 2016 (Form 10-K)

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

Commission file number 0-24960

COVENANT TRANSPORTATION GROUP, INC.

(Exact name of registrant as specified in its charter)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

[  ] Yes   [X] No

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.

[  ] Yes   [X] No

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

[X] Yes   [  ] No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

[X] Yes   [  ] No

 

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S‑K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10‑K or any amendments to this Form 10‑K.  [X]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See definitions of "accelerated filer, "large accelerated filer," and "smaller reporting company" in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

[  ] Yes  [X] No

The aggregate market value of the common equity held by non-affiliates of the registrant as of June 30, 2016, was approximately $220.0 million (based upon the $18.07 per share closing price on that date as reported by NASDAQ).  In making this calculation the registrant has assumed, without admitting for any purpose, that all executive officers, directors, and affiliated holders of more than 10% of a class of outstanding common stock, and no other persons, are affiliates.

As of March 10, 2017, the registrant had 15,902,290 shares of Class A common stock and 2,350,000 shares of Class B common stock outstanding.

Portions of the materials from the registrant's definitive proxy statement for the 2017 Annual Meeting of Stockholders to be held on May 16, 2017, have been incorporated by reference into Part III of this Form 10-K.

Table of Contents

 

PART I

ITEM 1.          BUSINESS

This Annual Report on Form 10-K contains certain statements that may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended and such statements are subject to the safe harbor created by those sections and the Private Securities Litigation Reform Act of 1995, as amended.  All statements, other than statements of historical or current fact, are statements that could be deemed forward-looking statements, including without limitation: any projections of earnings, revenues, or other financial items; any statement of plans, strategies, and objectives of management for future operations; any statements concerning proposed new services or developments; any statements regarding future economic conditions or performance; and any statements of belief and any statements of assumptions underlying any of the foregoing. In this Annual Report, statements relating to our ability to achieve our strategic plan, our ability to recruit and retain qualified independent contractors and qualified driver and non-driver employees, our ability to react to market conditions, our ability to gain market share, future demand for and supply of new and used tractors and trailers (including expected prices of such equipment), expected functioning and effectiveness of our information systems and other technology we implement, expected sources and adequacy of working capital and liquidity, future relationships, use, classification, compensation, and availability with respect to third-party service providers, future driver market conditions, future allocation of capital, expected settlement of operating lease obligations, future asset sales and acquisitions, future insurance, litigation, and claims levels and expenses, future tax expense and deductions, future fuel management, expense, and the future effectiveness of fuel surcharge programs and price hedges, future interest rates and effectiveness of interest rate swaps, expected capital expenditures (including the future mix of lease and purchase obligations), future asset utilization and efficiency, future trucking capacity, expected freight demand and volumes, future rates, future depreciation and amortization, future compliance with and impact of existing and proposed federal and state laws and regulations, future salaries, wages, and other employee benefit expenses, future earnings from and value of our investments, future customer relationships, future defaults under debt agreements, future  unforeseen events such as strikes, work stoppages, and weather catastrophes, future acquisitions, future credit availability, future performance of our subsidiaries, and future operating and maintenance expenses, among others, are forward-looking statements. Such statements may be identified by their use of terms or phrases such as "believe," "may," "could," "expects," "estimates," "projects," "anticipates," "plans," "intends," and similar terms and phrases.  Forward-looking statements are based on currently available operating, financial, and competitive information. Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified, which could cause future events and actual results to differ materially from those set forth in, contemplated by, or underlying the forward-looking statements.  Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled "Item 1A. Risk Factors," set forth below. Readers should review and consider the factors discussed in "Item 1A. Risk Factors," along with various disclosures in our press releases, stockholder reports, and other filings with the Securities and Exchange Commission.

All such forward-looking statements speak only as of the date of this Annual Report.  You are cautioned not to place undue reliance on such forward-looking statements.  We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in the events, conditions, or circumstances on which any such statement is based.

References in this Annual Report to "we," "us," "our," or the "Company" or similar terms refer to Covenant Transportation Group, Inc. and its subsidiaries.

GENERAL

Background and Strategy

We were founded in 1986 as a provider of expedited long haul freight transportation, primarily using two-person driver teams in transcontinental lanes.  Since that time, we have grown from 25 tractors to approximately 2,550 tractors and expanded our services from predominantly long haul dry van to include refrigerated, dedicated, cross-border, regional, and brokerage.  The expansion of our fleet and service offerings have placed us among the nation's twenty-five largest truckload transportation companies based on 2015 revenue.

 

 

Generally, we transport full trailer loads of freight from origin to destination without intermediate stops or handling.  We provide truckload transportation services throughout the continental United States, into and out of Mexico, and into and out of portions of Canada.  Our truckload freight services utilize equipment we own or lease or equipment owned by independent contractors for the pick-up and delivery of freight.  In most of our truckload business, we transport freight over nonroutine routes.  Our dedicated freight service offering provides similar transportation services, but does so pursuant to agreements whereby we make our equipment available to a specific customer for shipments over particular routes at specified times.  To complement our truckload operations, we provide freight brokerage/logistics services and accounts receivable factoring services.  Through our asset based and non-asset based capabilities, we transport many types of freight for a diverse customer base.

We concentrate on market sectors where we believe our capacity in relation to sector size and our operating proficiency can make a meaningful difference to customers.  The primary sectors in which we operate are as follows:

●          Expedited / Long haul: In our expedited / long haul business, we operate approximately 1,000 tractors, approximately 700 of which are driven by two-person driver teams.  Our expedited operations primarily involve high service freight with delivery standards, such as 1,000 miles in 22 hours, or 15-minute delivery windows that are difficult for competitors to satisfy with solo-driven tractors or rail-intermodal service.  Our expedited services often involve high value, high security, or time-definite loads for integrated global freight companies, less-than-truckload carriers, manufacturers, and retailers. We believe we are one of the five largest team expedited providers, and that growth in omni-channel, organic food, manufacturing, and e-commerce freight make this an attractive sector.

●          Temperature-Controlled: In our temperature-controlled business, operated through our SRT subsidiary, we operate approximately 850 tractors, approximately 200 of which are driven by two-person driver teams, and also offer intermodal service in longer haul lanes.  The temperature-controlled sector includes fresh and frozen foods, pharmaceuticals, cosmetics, and other freight where extreme heat or cold could cause damage.  We believe we are among the ten largest temperature-controlled providers, and that factors such as United States population growth, increasing consumer preference for fresh and organic produce, and demographic trends requiring more pharmaceuticals make this an attractive sector.  Improving results of operations at SRT is one of our primary goals for 2017.

●          Dedicated: In our dedicated contract business, we operate approximately 700 tractors, approximately 150 of which are driven by two-person driver teams, primarily for manufacturers located in the southeastern United States.  The dedicated sector typically involves longer-term contracts that allocate a specified number of tractors and trailers to a specific customer, with fixed and variable compensation.  Many of our dedicated contract customers are automotive companies or shippers of produce, where the nature of the product we ship requires high service standards. We believe these sectors are growing because of an improved manufacturing environment in the United States, particularly in the Southeast, growth in organic produce, customer concerns about trucking capacity, and a need for dependable service.

●          Capacity Provider Solutions and Logistics Services / Equipment Sales and Leasing: We primarily provide freight brokerage and logistics capacity to customers when the freight does not fit our network or profitability requirements. In addition, we participate in the market for used equipment sales and leasing through our 49% ownership of Transport Enterprise Leasing, LLC ("TEL"), and we assist current and potential capacity providers with improving their cash flows through secured invoice factoring services.  We believe this suite of services links our interests with those of our customers and current and potential third party capacity providers.  We intend to expand our presence in these sectors, which we believe offer attractive growth opportunities with lower capital investment than our truckload operations.

As our fleet has grown over three decades and our service platform matured, several important trends dramatically affected the truckload industry and our business.  First, supply chain patterns became more fluid in response to dynamic changes in labor and transportation costs, ocean freight and rail-intermodal service standards, retail distribution center networks, governmental regulations, and other industry-wide factors.  Second, the cost structure of the truckload business rose dramatically, particularly equipment, driver wages, and, at times, fuel prices, impacting us and our customers' freight decisions.  Third, customers used technology to constantly optimize their supply chains, which necessitated expanding our own technological capability to optimize our asset allocation, manage yields, and drive operational efficiency.  Fourth, a confluence of regulatory constraints, safety and security demands, and scarcity of qualified driver applicants, negatively impacted our asset productivity and reinforced what a precious resource professional truck drivers are (and we believe increasingly will be) in our industry.

 

While the results for 2016 were not as robust as those achieved in 2015, which provided the highest annual earnings in the Company’s 31-year history, we are proud of earning a profit for the fifth consecutive year after only producing a profit in one calendar year from 2006-2011.  We believe our return to profitability on a consistent basis is the result of redefining and retooling our business model, and as the result of our strategic planning process, whereby we annually focus on five initiatives that fall under the following key tenets:

●          Organizational Excellence and Entrepreneurial Spirit. We have re-aligned our management team, added talent, and implemented best practices in part through using Franklin Covey's Four Disciplines of Execution® to bring a new focus to metrics, accountability, and incentive compensation.  Through multiple programs recognizing individual initiative, we have also been instilling an ownership culture throughout our company.  We also implemented a single enterprise management system across all subsidiaries to improve visibility and coordination of customers, operations, and financial activities.

●          Focus on the Driver. Drivers are the lifeblood of our company and our industry.  We employ a broad range of safety, lifestyle, compensation, equipment technology, and personal recognition methods to convey our respect and appreciation for our drivers and to improve their careers.  A portion of these techniques involve sophisticated analytics to identify likely candidates, match teams, evaluate recruiting spending, deliver training content to drivers, and design tractor specifications. 

●          Focus on the Customer Experience. Our mission statement begins:  "CTG's mission is to be a problem solver for every customer…"  We offer premium service in sectors where we can make a difference, and we use our brokerage subsidiary, Covenant Transport Solutions, Inc. ("Solutions"), to cover loads that cannot be as efficiently serviced through our Truckload segment.  With each interaction, we seek to enhance the value we bring to the customer relationship.

●          Rigorous Capital Allocation Process and Reduce Leverage. Our senior management annually ranks capital investment opportunities against available capital and acceptable leverage levels, and material investments must pass return on investment and capital investment committee approval processes. In addition, reducing our total leverage has been a primary strategic goal.  Our leverage decreased in 2016 over 2015, as we remain focused on investing capital when we can obtain acceptable returns and reducing our leverage.  We believe our disciplined investment review has contributed to our improved results by allocating capital to more profitable business units and downsizing other units into greater profitability.

●          Risk Management—Assess and Mitigate. We consistently evaluate risk areas with significant volatility, as well as the costs and benefits associated with mitigating the volatility. Diesel fuel prices, insurance and claims cost, and used equipment prices are all areas where we identified significant risk and volatility for our business.  To manage these risks, we have employed fuel hedging contracts on a portion of our fuel usage not covered by customer fuel surcharges, lowered our self-insured accident liability retention, and expanded our ability to sell our used equipment to increase bargaining power with the tractor and trailer manufacturers.

●          Technology. We purchase and deploy technology that we believe will allow us to operate more safely, securely, and efficiently.  Our information systems are integrated into a single platform that represents a multi-year investment to upgrade the hardware and software of our information systems.  This technology was purchased off the shelf, which minimizes our fixed cost investment, and enables us to stay current with the latest developments.

We believe the ongoing execution of our strategic plan has contributed to the substantial improvement in operating results and profitability we have generated over the past several years. Some of the significant successes resulting from our strategic planning efforts include the completion of a follow-on stock offering in 2014 that helped significantly deleverage our balance sheet;  enhancements to recruiting, retention, and business intelligence; upgraded information technology; focus on service and on time delivery; and enhanced cross-marketing opportunities between our subsidiaries.  Each of these accomplishments positively impacted the success of the key initiatives identified above, our overarching financial goals, and ultimately, the Company.  However, some of our key metrics and our profitability were negatively impacted in 2016 compared to 2015, and, accordingly, we still have significant work ahead to achieve our goals, deliver a strong and stable product for our customers, provide a bright future for our employees and owner-operators, and create meaningful value for our stockholders.

 

 

The Company

We operate a relatively new tractor fleet and employ sophisticated tractor technology that enhances our operational efficiencies and our drivers' safety.  Our company-owned tractor fleet has an average age of approximately 1.8 years, which compares favorably to an average U.S. Class 8 tractor age of approximately 8 years in 2016. Some of the technologies we employ include the following: (1) freight optimization software that can perform sophisticated analyses of profitability and other measures on each customer, route, and load; (2) routing software that selects the best route, identifies fuel stops, and warns of deviations from routing instructions; (3) a tracking and communications system that permits direct communication between drivers and fleet managers, as well as constant location and delivery updates; (4) electronic logging devices in all of our tractors; (5) aerodynamics and other fuel efficiency systems that have significantly improved fuel mileage; and (6) safety technology, including rollover stability control, collision mitigation, and lane-change warning.  We believe our modern fleet lowers maintenance costs, improves fuel mileage, improves safety, contributes to better customer service, and assists with driver retention.

Business Units

We have one reportable segment, our truckload services ("Truckload").

The Truckload segment consists of three operating fleets that are aggregated because they have similar economic characteristics and meet the aggregation criteria.  The three operating fleets that comprise our Truckload segment are as follows: (i) Covenant Transport, Inc. ("Covenant Transport"), our historical flagship operation, which provides expedited long haul, dedicated, temperature-controlled, and regional solo-driver service; (ii) Southern Refrigerated Transport, Inc. ("SRT"), which provides primarily long haul, regional, dedicated, and intermodal temperature-controlled service; and (iii) Star Transportation, Inc. ("Star"), which provides regional solo-driver and dedicated services, primarily in the southeastern United States.

In addition, our Solutions subsidiary has service offerings ancillary to our Truckload operations, including: freight brokerage service directly and through freight brokerage agents, who are paid a commission for the freight they provide, and accounts receivable factoring. These operations consist of several operating segments, which neither individually nor in the aggregate meet the quantitative or qualitative reporting thresholds.

The following charts reflect the size of each of our operating subsidiaries measured by 2016 total revenue, net of fuel surcharge revenue, which we refer to as "freight revenue":

Our Truckload segment comprised approximately 89%, 89%, and 90% of our total freight revenue in 2016, 2015, and 2014, respectively.

 

 

In our Truckload segment, we primarily generate revenue by transporting freight for our customers.  Generally, we are paid a predetermined rate per mile for our truckload services.  We enhance our truckload revenue by charging for tractor and trailer detention, loading and unloading activities, and other specialized services, as well as through the collection of fuel surcharges to mitigate the impact of increases in the cost of fuel.  The main factors that could affect our Truckload revenue are the revenue per mile we receive from our customers, the percentage of miles for which we are compensated, and the number of shipments and miles we generate.  These factors relate, among other things, to the general level of economic activity in the United States, inventory levels, specific customer demand, the level of capacity in the trucking industry, and driver availability.

The main expenses that impact the profitability of our Truckload segment are the variable costs of transporting freight for our customers.  These costs include fuel expenses, driver-related expenses, such as wages, benefits, training, and recruitment, and purchased transportation expenses, which primarily include compensating independent contractors.  Expenses that have both fixed and variable components include maintenance and tire expense and our total cost of insurance and claims. These expenses generally vary with the miles we travel, but also have a controllable component based on safety, self-insured retention versus insurance premiums, fleet age, efficiency, and other factors.  Historically, our main fixed costs include rentals and depreciation of long-term assets, such as revenue equipment and terminal facilities, and the compensation of non-driver personnel.

We measure the productivity of our Truckload segment with three key performance metrics:  average freight revenue per total mile (excluding fuel surcharges), average miles per tractor, and average freight revenue per tractor per week (excluding fuel surcharges).  A description of each follows:

 

 

Our Solutions subsidiary comprised approximately 11%, 11%, and 10% of our total operating revenue in 2016, 2015, and 2014, respectively. Solutions derives revenue from providing brokerage and logistics services, particularly arranging transportation services for customers directly and through relationships with thousands of third-party carriers and integration with our Truckload segment.  Solutions provides freight brokerage services directly and through freight brokerage agents, who are paid a commission for the freight brokerage service they provide and accounts receivable factoring.  The main factors that impact profitability in terms of expenses are the variable costs of outsourcing the transportation freight for our customers and managing fixed costs, including salaries and selling, general, and administrative expenses.  Our brokerage loads increased to 62,614 in 2016, from 36,217 in 2015, while average revenue per load decreased approximately 41% to $1,068 in 2016, from $1,820 in 2015, primarily due to the full year impact of a new customer added in 2015 and reduced peak-season freight opportunities during the fourth quarter of 2016.  Additionally, revenue from Solutions' accounts receivable factoring improved by approximately 6% year-over-year to $2.6 million in 2016 from $2.4 million in 2015.

In May 2011, we acquired a 49.0% interest in TEL. TEL is a tractor and trailer equipment leasing company and used equipment reseller. We have accounted for our investment in TEL using the equity method of accounting and thus our financial results include our proportionate share of TEL's net income since May 2011, or $3.0 million in 2016, $4.6 million in 2015, and $3.7 million in 2014. As a result, TEL's results and growth are significant to our current year results and, in our estimation, to our longer-term vision.

Refer to Note 16, "Segment Information," of the accompanying consolidated financial statements for further information about our reporting segment's operating and financial results for 2016, 2015, and 2014.

Customers and Operations

We focus on targeted markets throughout the United States where we believe our service standards can provide a competitive advantage.  We are a major carrier for transportation companies such as parcel freight forwarders, less-than-truckload carriers, and third-party logistics providers that require a high level of service to support their businesses, as well as for traditional truckload customers such as manufacturers, retailers, and food and beverage shippers.  Our three operating fleets within the Truckload segment are truckload carriers and as such we generally dedicate an entire trailer to one customer from origin to destination.  We also generate revenue through providing ancillary services, including freight brokerage services and accounts receivable factoring.

In 2016 and 2015, one customer accounted for more than 10% of our consolidated revenue.  Wal-Mart accounted for $69.4 million of total revenue in 2016, while UPS accounted for $75.8 million and $82.6 million of revenue in 2015 and 2014, respectively. Both customers were serviced by both our Truckload segment and our Solutions subsidiary.  Our top five customers accounted for approximately 39%, 34%, and 29% of our total revenue in 2016, 2015, and 2014, respectively.

 

 

We operate tractors driven by a single driver and also tractors assigned to two-person driver teams.  Our single driver tractors generally operate in shorter lengths of haul, generate fewer miles per tractor, and experience more non-revenue miles, but the lower productive miles are expected to be offset by generally higher revenue per loaded mile and the reduced employee expense of compensating only one driver.  In contrast, our two-person driver tractors generally operate in longer lengths of haul, generate greater miles per tractor, and experience fewer non-revenue miles, but we typically receive lower revenue per loaded mile and incur higher employee expenses of compensating both drivers.  We expect operating statistics and expenses to shift with the mix of single and team operations.

We operate throughout the U.S. and in parts of Canada and Mexico, with substantially all of our revenue generated from within the U.S.  All of our tractors are domiciled in the U.S., and we have generated less than two percent of our revenue in Canada and Mexico in 2016, 2015 and 2014.  We do not separately track domestic and foreign revenue from customers, and providing such information would not be meaningful.  Excluding a de minimus number of trailers, all of our long-lived assets are, and have been for the last three fiscal years, located within the United States.

In 2009, we began a multi-year project to upgrade the hardware and software of our information systems.  The goal upon completion of the project was to have uniform operational and financial systems across the entire Company as we believe this provides improved customer service, utilization, and enhances our visibility into and across the organization.  All of our operating subsidiaries are now operating on the new system.  We implemented the new operating system at SRT in February 2014.  As expected with any large conversion project, SRT experienced inefficiencies that resulted in a year-over-year reduction in first quarter 2014 profitability; however, by the second quarter of 2014 those inefficiencies were largely resolved and in 2015, we began realizing the efficiencies of having all subsidiaries on one operating platform.  We expect to continue to evaluate where we can leverage the system to add further efficiencies across the Company.

Drivers and Other Personnel

Independent contractors provide a tractor and a driver and are responsible for all operating expenses in exchange for a fixed payment per mile. We do not have the capital outlay of purchasing the tractor.  The payments to independent contractors are recorded in revenue equipment rentals and purchased transportation.  When independent contractor tractors are utilized, we avoid expenses generally associated with company-owned equipment, such as driver compensation, fuel, interest, and depreciation. Obtaining equipment from independent contractors and under operating leases effectively shifts financing expenses from interest to "above the line" operating expenses.

 

 

We continue to educate our drivers and non-driver personnel regarding the Federal Motor Carrier Safety Administration ("FMCSA") Compliance Safety Accountability program ("CSA") to ensure we keep our top talent and challenge those drivers that need improvement.  We believe CSA, in conjunction with other U.S. Department of Transportation ("DOT") regulations, including those related to hours-of-service, has reduced and will likely continue to impact effective capacity in our industry as well as negatively impact equipment utilization.  Nevertheless, for carriers that are able to successfully manage this regulation-laden environment with driver-friendly equipment, compensation, and operations, we believe opportunities to increase market share may be available. Driver pay may increase as a result of regulation and economic expansion, which could provide more alternative employment opportunities. If economic growth is sustained, however, we expect the supply/demand environment to be favorable enough for us to offset expected compensation increases with better freight pricing.

We use driver teams in a substantial portion of our tractors.  Driver teams permit us to provide expedited service on selected long haul lanes because teams are able to handle longer routes and drive more miles while remaining within DOT hours-of-service rules.  The use of teams contributes to greater equipment utilization of the tractors they drive than obtained with single drivers.  The use of teams, however, increases the accumulation of miles on tractors and trailers as well as personnel costs as a percentage of revenue and the number of drivers we must recruit.

We are not a party to any collective bargaining agreement.  At December 31, 2016, we employed approximately 3,600 drivers and approximately 800 non-driver personnel.  At December 31, 2016, we had active contracts with approximately 219 independent contractor drivers.

Revenue Equipment

At December 31, 2016, we operated 2,535 tractors and 7,389 trailers. Of these tractors, 2,181 were owned, 135 were financed under operating leases, and 219 were provided by independent contractors, who own and drive their own tractors.  Of these trailers, 4,759 were owned, 1,695 were financed under operating leases, and 935 were financed under capital leases.  Furthermore, at December 31, 2016, approximately 61.4% of our trailers were dry vans and the remaining trailers were refrigerated vans.

We believe that operating high quality, late-model equipment contributes to operating efficiency, helps us recruit and retain drivers, and is an important part of providing excellent service to customers.  We operate a modern fleet of tractors, with the majority of units under warranty, to minimize repair and maintenance costs and reduce service interruptions caused by breakdowns. We also order most of our equipment with uniform specifications to reduce our parts inventory and facilitate maintenance. At December 31, 2016, our tractor fleet had an average age of approximately 1.8 years, and our trailer fleet had an average age of approximately 4.3 years. As of December 31, 2016, 100% of our tractor fleet had engines compliant with stricter regulations regarding emissions that became effective in 2007 and 99.8% of our tractor fleet had engines compliant with stricter regulations regarding emissions that became effective in 2010.  We equip our tractors with a satellite-based tracking and communications system that permits direct communication between drivers and fleet managers.  We believe that this system enhances our operating efficiency and improves customer service and fleet management.  This system also updates the tractor's position approximately every fifteen minutes, which allows us and our customers to locate freight and accurately estimate pick-up and delivery times.  We also use the system to monitor engine idling time, speed, performance, and other factors that affect operating efficiency. At December 31, 2016, 100% of our fleet was equipped with electronic on board recorders ("EOBRs," now referred to as electronic logging devices, or "ELDs"), which electronically monitor tractor miles and facilitate enforcement of hours-of-service regulations.

Over the past decade, the price of new tractors has risen dramatically and there has been significant volatility in the used equipment market.  This has substantially increased our costs of operation.

Industry and Competition

Truckload is the largest segment of the for-hire ground freight transportation market based on revenue, surpassing the combined market size of less-than-truckload, railroad, intermodal, and parcel delivery combined.  The truckload market is further segmented into sectors such as regional dry van, temperature-controlled van, flatbed, dedicated contract, expedited, and irregular route.

The U.S. trucking industry is highly competitive and includes thousands of "for-hire" motor carriers, none of which dominate the market. Service and price are the principal means of competition in the trucking industry. We compete to some extent with railroads and rail-truck intermodal service but attempt to differentiate ourselves from our competition on the basis of service. Rail and rail-truck intermodal movements are more often subject to delays and disruptions arising from rail yard congestion, which reduce the effectiveness of such service to customers with time-definite pick-up and delivery schedules.  Historically, in times of high fuel prices or decreased consumer demand, however, rail-intermodal competition has been more significant.

 

 

Our industry is subject to dynamic factors that significantly affect our operating results.  These factors include the availability of qualified truck drivers, the volume of freight in the sectors we serve, the price of diesel fuel, and government regulations that impact productivity and costs.  Recently, our industry has experienced softened freight demand, scarcity of qualified truck drivers, decreased fuel costs, a depressed used tractor market, and regulations that limit productivity.  In 2016, these factors contributed to an environment of challenging freight volumes, rate pressure, and increased costs, particularly around tractor depreciation expense and gains and losses on used tractors, for many trucking companies, including us.  Based on our assessment of future regulatory changes, driver demographics, and expected growth rates of our major customers and sectors, we expect the pricing environment to improve in the latter half of 2017 and into 2018 and 2019, offset in part by higher driver pay and other inflationary costs.  We believe large and diversified companies, like ourselves, are best positioned to capitalize on the current industry environment, because we can offer significant capacity commitments to major customers, safe and comfortable new equipment to drivers, and optimized routing and other business analytics to make the most of our drivers' federally limited operating hours.

We believe that the cost and complexity of operating trucking fleets are increasing and that economic and competitive pressures are likely to force many smaller competitors and private fleets to consolidate or exit the industry.  As a result, we believe that larger, better-capitalized companies, like us, will have opportunities to increase profit margins and gain market share.  In the market for dedicated services, we believe that truckload carriers, like us, have a competitive advantage over truck lessors, which are the other major participants in the market, because we expect to be able to offer lower prices by utilizing back-haul freight within our network that traditional lessors may not have.

Regulation

Our operations are regulated and licensed by various U.S. agencies.  Our limited Canadian business activities are subject to similar requirements imposed by the laws and regulations of Canada, as well as its provincial laws and regulations.  We operate within Mexico by utilizing third-party carriers within that country.  Our company drivers and independent contractors also must comply with the safety and fitness regulations of the DOT, including those relating to drug and alcohol testing and hours-of-service.  Such matters as weight and equipment dimensions are also subject to U.S. regulations.  We also may become subject to new or more restrictive regulations relating to fuel emissions, drivers' hours-of-service, ergonomics, or other matters affecting safety or operating methods.  Other agencies, such as the Environmental Protection Agency ("EPA") and the Department of Homeland Security ("DHS") also regulate our equipment, operations, and drivers.

The DOT, through the FMCSA, imposes safety and fitness regulations on us and our drivers, including rules that restrict driver hours-of-service.  In December 2011, the FMCSA published its 2011 Hours-of-Service Final Rule (the "2011 Rule"). The 2011 Rule requires drivers to take 30-minute breaks after eight hours of consecutive driving and reduces the total number of hours a driver is permitted to work during each week from 82 hours to 70 hours.  The 2011 Rule also provides that the 34-hour restart may only be used once per week and must include two rest periods between one a.m. and five a.m. (together, the "2011 Restart Restrictions").  These rule changes became effective in July 2013.  We believe the 2011 Rule led to decreased productivity and caused some loss of efficiency, as drivers and shippers have needed supplemental training, computer programming has required modifications, additional drivers have been employed or engaged, additional equipment has been acquired, and shipping lanes have been reconfigured.

In December 2014, the 2015 Omnibus Appropriations bill was signed into law. Among other things, the legislation provided temporary relief from the 2011 Restart Restrictions while the FMCSA conducted a study to determine whether such restrictions had a positive result on driver safety (the "Study"), and essentially reverted to the more straightforward 34-hour restart rule that was in effect before the 2011 Rule became effective.  In December 2016, a short-term funding bill was signed into law that directly tied the reinstatement of the 2011 Restart Restrictions to the outcome of the Study and requires the Study to demonstrate that the 2011 Restart Restrictions offer a "statistically significant improvement" in safety related matters in order for the 2011 Restart Restrictions to be reinstated.  In March 2017, the results of the Study were released, and they did not show the necessary improvement needed to reinstate the 2011 Restart Restrictions.  Based on these results, the FMCSA is expected to issue a formal notice permanently removing the 2011 Restart Restrictions from the hours-of-service regulations.

 

 

The DOT uses two methods of evaluating the safety and fitness of carriers. The first method is the application of a safety rating that is based on an onsite investigation and affects a carrier’s ability to operate in interstate commerce. We currently have a satisfactory DOT safety rating under this method, which is the highest available rating under the current safety rating scale. If we received a conditional or unsatisfactory DOT safety rating, it could adversely affect our business, as some of our existing customer contracts require a satisfactory DOT safety rating. In January 2016, the FMCSA published a Notice of Proposed Rulemaking outlining a revised safety rating measurement system which would replace the current methodology. Under the proposed rule, the current three safety ratings of "satisfactory," "conditional," and "unsatisfactory" would be replaced with a single safety rating of "unfit."  Thus, a carrier with no rating would be deemed fit.  Moreover, data from roadside inspections and the results of all investigations would be used to determine a carrier’s fitness on a monthly basis.  This would replace the current methodology of determining a carrier’s fitness based solely on infrequent comprehensive onsite reviews. The proposed rule underwent a public comment period that ended in June 2016 and several industry groups and lawmakers expressed their disagreement with the proposed rule, arguing that it violates the requirements of the FAST Act and that the FMCSA must first finalize its review of the CSA scoring system, described in further detail below.  Based on this feedback, in January 2017, the FMCSA announced that a Supplemental Notice of Proposed Rulemaking outlining certain changes to the proposed rule would be released in the future. Therefore, it is uncertain if, when, or under what form this proposed rule could take effect. However, if this rule or a similar rule was enacted, and we received a rating of "unfit," it could materially adversely affect our operations.

In addition to the safety rating system, the FMCSA has adopted the CSA program as an additional safety enforcement and compliance model that evaluates and ranks fleets on certain safety-related standards. The CSA program analyzes data from roadside inspections, moving violations, crash reports from the last two years, and investigation results. The data is organized into seven categories. Carriers are grouped by category with other carriers that have a similar number of safety events (e.g., crashes, inspections, or violations) and carriers are ranked and assigned a rating percentile to prioritize them for interventions if they are above a certain threshold. Currently, these scores do not have a direct impact on a carrier’s safety rating. However, the occurrence of unfavorable scores in one or more categories may (i) affect driver recruiting and retention by causing high-quality drivers to seek employment with other carriers, (ii) cause our customers to direct their business away from us and to carriers with higher fleet safety rankings, (iii) subject us to an increase in compliance reviews and roadside inspections, or (iv) cause us to incur greater than expected expenses in our attempts to improve unfavorable scores, any of which could adversely affect our results of operations and profitability.

Under CSA, these scores were initially made available to the public in five of the seven categories. However, pursuant to the FAST Act, which was signed into law in December 2015, the FMCSA is required to remove from public view the previously available CSA scores while it reviews the reliability of the scoring system. During this period of review by the FMCSA, we will continue to have access to our own scores and will still be subject to intervention by the FMCSA when such scores are above the intervention thresholds.  Currently, certain of our subsidiaries are exceeding the established intervention thresholds in one or more of the seven categories of CSA, in comparison to their peer groups; however, they all continue to maintain a satisfactory rating with the DOT.  We will continue to promote improvement of these scores in all seven categories with ongoing reviews of all safety-related policies, programs, and procedures for their effectiveness.

In 2011, the FMCSA issued new rules that would require nearly all carriers, including us, to install and use ELDs in their tractors to electronically monitor truck miles and facilitate enforcement of hours-of-service regulations. These rules, however, were vacated by the Seventh Circuit Court of Appeals in August 2011.  In response, Congress passed legislation in July 2012 renewing the mandate, subject to new regulations to be promulgated by the DOT. Pursuant to its rulemaking authority, the FMCSA published a new final rule in December 2015 which requires the use of ELDs by nearly all carriers by December 2017 (the "2015 ELD Rule"). We have proactively installed ELDs on 100% of our tractor fleet, so we don’t believe the 2015 ELD Rule will impact our operations or profitability or our use of ELDs. Furthermore, we believe that more effective hours-of-service enforcement after the 2015 ELD Rule takes effect may improve our competitive position by causing all carriers to adhere more closely to hours-of-service requirements.

In the aftermath of the September 11, 2001 terrorist attacks, the DHS and other federal, state, and municipal authorities implemented and continue to implement various security measures, including checkpoints and travel restrictions on large trucks. The U.S. Transportation Security Administration ("TSA") adopted regulations that require a determination by the TSA that each driver who applies for or renews his or her license for carrying hazardous materials is not a security threat.  This could reduce the pool of qualified drivers who are permitted to transport hazardous waste, which could require us to increase driver compensation, limit our fleet growth, or allow trucks to sit idle.  These regulations also could complicate the matching of available equipment with hazardous material shipments, thereby increasing our response time on customer orders and our non-revenue miles.  As a result, it is possible we could fail to meet the needs of our customers or could incur increased expenses to do so.

In November 2015, the FMCSA published its final rule related to driver coercion, which took effect in January 2016.  Under this rule, carriers, shippers, receivers, or transportation intermediaries that are found to have coerced drivers to violate certain FMCSA regulations (including hours-of-service rules) may be fined up to $16,000 for each offense.  In addition, other rules have been recently proposed or made final by the FMCSA, including (i) a rule requiring the use of speed limiting devices on heavy duty trucks to restrict maximum speeds, which was proposed in 2016 but not yet made final, (ii) a rule mandating the creation of a national clearinghouse that employers and prospective employers must query to determine if current or prospective drivers have had any drug/alcohol positives or refusals, which was made final in December 2016, with a compliance date in January 2020, and (iii) a rule setting forth minimum driver-training standards for new drivers applying for commercial driver licenses for the first time and to experienced drivers upgrading their licenses or seeking a hazmat endorsement, which was made final in December 2016, with a compliance date in February 2020. The effect of these recently proposed or finalized rules could result in a decrease in fleet production and driver availability, either of which could adversely affect our business or operations.

 

 

In March 2014, the Ninth Circuit Court of Appeals held that California state wage and hour laws are not preempted by federal law. The case was appealed to the Supreme Court of the United States, which in May 2015 refused to review the case, and accordingly, the Ninth Circuit Court of Appeals decision stands. Current and future state and local wage and hour laws, including laws related to employee meal breaks and rest periods, may vary significantly from federal law. As a result, we, along with other companies in the industry, could become subject to an uneven patchwork of wage and hour laws throughout the United States. There is proposed federal legislation to preempt state and local wage and hour laws; however, passage of such legislation is uncertain. If federal legislation is not passed, we will either need to comply with the most restrictive state and local laws across our entire network, or overhaul our management systems to comply with varying state and local laws. Either solution could result in increased compliance and labor costs, driver turnover, and decreased efficiency.

Tax and other regulatory authorities, as well as independent contractors themselves, have increasingly asserted that independent contractor drivers in the trucking industry are employees rather than independent contractors, for a variety of purposes, including income tax withholding, workers' compensation, wage and hour compensation, unemployment, and other issues. Federal legislators have introduced legislation in the past to make it easier for tax and other authorities to reclassify independent contractor drivers as employees, including legislation to increase the recordkeeping requirements for those that engage independent contractor drivers and to heighten the penalties of companies who misclassify their employees and are found to have violated employees' overtime and/or wage requirements.  Additionally, federal legislators have sought to abolish the current safe harbor allowing taxpayers meeting certain criteria to treat individuals as independent contractors if they are following a long-standing, recognized practice, extend the Fair Labor Standards Act to independent contractors, and impose notice requirements based upon employment or independent contractor status and fines for failure to comply.  Some states have put initiatives in place to increase their revenues from items such as unemployment, workers' compensation, and income taxes, and a reclassification of independent contractor drivers as employees would help states with this initiative.  Further, class actions and other lawsuits have been filed against certain members of our industry seeking to reclassify independent contractors as employees for a variety of purposes, including workers' compensation and health care coverage.  Taxing and other regulatory authorities and courts apply a variety of standards in their determination of independent contractor status.  Our classification of independent contractors has been the subject of audits by such authorities from time to time.  While we have been successful in continuing to classify our independent contractor drivers as independent contractors and not employees, we may be unsuccessful in defending that position in the future.  If our independent contractor drivers are determined to be our employees, we would incur additional exposure under federal and state tax, workers' compensation, unemployment benefits, labor, employment, and tort laws, including for prior periods, as well as potential liability for employee benefits and tax withholdings.

We are subject to various environmental laws and regulations dealing with the hauling and handling of hazardous materials, fuel storage tanks, air emissions from our vehicles and facilities, engine idling, and discharge and retention of storm water. Our truck terminals often are located in industrial areas where groundwater or other forms of environmental contamination could occur. Our operations involve the risks of fuel spillage or seepage, environmental damage, and hazardous waste disposal, among others. Certain of our facilities have waste oil or fuel storage tanks, and fueling islands.  A small percentage of our freight consists of low-grade hazardous substances, which subjects us to a wide array of regulations.  Additionally, increasing efforts to control emissions of greenhouse gases may have an adverse effect on us.  Although we have instituted programs to monitor and control environmental risks and promote compliance with applicable environmental laws and regulations, if we are involved in a spill or other accident involving hazardous substances, if there are releases of hazardous substances we transport, if soil or groundwater contamination is found at our facilities or results from our operations, or if we are found to be in violation of applicable laws or regulations, we could be subject to cleanup costs and liabilities, including substantial fines or penalties or civil and criminal liability, any of which could have a materially adverse effect on our business and operating results.

EPA regulations limiting exhaust emissions became more restrictive in 2010.  In 2010, an executive memorandum was signed directing the National Highway Traffic Safety Administration ("NHTSA") and the EPA to develop new, stricter fuel efficiency standards for heavy trucks.  In August 2011, the NHTSA and the EPA adopted final rules that established the first-ever fuel economy and greenhouse gas standards for medium-and heavy-duty vehicles (the "Phase 1 Standards").  The Phase 1 Standards apply to tractor model years 2014 to 2018 and require the achievement of an approximate 20 percent reduction in fuel consumption by the 2018 model year, which equates to approximately four gallons of fuel for every 100 miles traveled.  In addition, in February 2014, President Obama announced that his administration would begin developing the next phase of tighter fuel efficiency and greenhouse gas standards for medium-and heavy-duty trucks and trailers (the "Phase 2 Standards").  In October 2016, the EPA and NHTSA published the final rule mandating that the Phase 2 Standards will apply to trailers beginning with model year 2018 and tractors beginning with model year 2021.  The Phase 2 Standards require nine percent and 25 percent reductions in emissions and fuel consumption for trailers and tractors, respectively, by 2027.  We believe these requirements will result in additional increases in new tractor and trailer prices and additional parts and maintenance costs incurred to retrofit our tractors and trailers with technology to achieve compliance with such standards, which could adversely affect our operating results and profitability, particularly if such costs are not offset by potential fuel savings. We cannot predict, however, the extent to which our operations and productivity will be impacted.

 

 

The California Air Resources Board ("CARB") also adopted emission control regulations that will be applicable to all heavy-duty tractors that pull 53-foot or longer box-type trailers within the state of California.  The tractors and trailers subject to these CARB regulations must be either EPA SmartWay certified or equipped with low-rolling, resistance tires and retrofitted with SmartWay-approved aerodynamic technologies.  Enforcement of these CARB regulations for model year 2011 equipment began in January 2010 and will be phased in over several years for older equipment.  We currently purchase Smart Way certified equipment in our new tractor and trailer acquisitions. In addition, in February 2017 CARB proposed California Phase 2 standards that generally align with the federal Phase 2 Standards, with some minor additional requirements, and as proposed would stay in place even if the federal Phase 2 Standards are affected by action from the Trump administration.  Federal and state lawmakers also have proposed a variety of other regulatory limits on carbon emissions and fuel consumption. Compliance with these regulations could increase the cost of new tractors and trailers, impair equipment productivity, and increase operating expenses.  These effects, combined with the uncertainty as to the operating results that will be produced by the newly designed diesel engines and the residual values of these vehicles, could increase our costs or otherwise adversely affect our business or operations.

The regulatory environment has recently changed under the administration of President Trump.  In January 2017, the President’s office issued a temporary moratorium on proposed and recently published regulations, which will delay the effectiveness of such regulations for at least 60 days.  Additionally, in January 2017, the President signed an executive order requiring federal agencies to repeal two regulations for each new one they propose and imposing a regulatory budget, which would limit the amount of new regulatory costs federal agencies can impose on individuals and businesses each year.  The impact of these actions by the Trump administration may inhibit future new regulations and/or lead to the repeal or delayed effectiveness of existing regulations. Therefore, it is uncertain how we may be impacted in the future by existing or proposed regulations.

Fuel Availability and Cost

The cost of fuel trended lower in 2016, compared to 2015 and 2014, as demonstrated by a decrease in the Department of Energy ("DOE") national average for diesel to approximately $2.30 per gallon for 2016 compared to $2.71 per gallon for 2015. Our fuel cost was further decreased in 2016 due to an increase in our average fuel miles per gallon during 2016 as a result of purchasing equipment with more fuel-efficient engines.

 

 

We actively manage our fuel costs by routing our drivers through fuel centers with which we have negotiated volume discounts and through jurisdictions with lower fuel taxes, where possible.  We have also reduced the maximum speed of many of our trucks, implemented strict idling guidelines for our drivers, purchased technology to enhance our management and monitoring of out-of-route miles, encouraged the use of shore power units in truck stops, and imposed standards for accepting broker freight that includes minimum rates and fuel surcharges. These initiatives have contributed to significant improvements in fleet wide average fuel mileage. Moreover, we have a fuel surcharge program in place with the majority of our customers, which has historically enabled us to recover some of the higher fuel costs.  However, even with the fuel surcharges, the price of fuel can affect our profitability.  Our fuel surcharges are billed on a lagging basis, meaning we typically bill customers in the current week based on a previous week's applicable index.  Therefore, in times of increasing fuel prices, we do not recover as much as we are currently paying for fuel.  In periods of declining prices, the opposite is true.  In addition, we incur additional costs when fuel prices rise that cannot be fully recovered due to our engines being idled during cold or warm weather, empty or out-of-route miles, and for fuel used by refrigerated trailer units that generally is not billed to customers.  In addition, from time-to-time customers attempt to modify their surcharge programs, some successfully, which can result in recovery of a smaller portion of fuel price increases.  Rapid increases in fuel costs or shortages of fuel could have a materially adverse effect on our operations or future profitability.

To reduce the variability of the ultimate cash flows associated with fluctuations in diesel fuel prices, we periodically enter into various derivative instruments, including forward futures swap contracts.  Historically diesel fuel has not been a traded commodity on the futures market so heating oil has been used as a substitute, as prices for both generally move in similar directions.  Recently, however, we have been able to enter into hedging contracts with respect to both heating oil and ultra-low sulfur diesel ("ULSD"). Under these contracts, we pay a fixed rate per gallon of heating oil or ULSD and receive the monthly average price of New York heating oil per the New York Mercantile Exchange ("NYMEX") and Gulf Coast ULSD, respectively.  Because the fixed price is determined based on market prices at the time we enter into the hedge, in times of increasing fuel prices the hedge contracts become more valuable, whereas in times of decreasing fuel prices the opposite is true.  At December 31, 2016, we had forward futures swap contracts on approximately 12.1 million and 7.6 million gallons of diesel to be purchased in 2017 and 2018, respectively, or approximately 27% and 17% of our projected annual 2017 and 2018 fuel requirements, respectively.  Due to the relative stability of petroleum prices in 2016, and the completion of multiple contracts that were entered into during periods of higher heating oil and ULSD prices, the fair value of our fuel hedging contracts at December 31, 2016, represented a $3.6 million liability compared to a $27.3 million liability at December 31, 2015.

Seasonality

In the trucking industry, revenue has historically decreased as customers reduce shipments following the winter holiday season and as inclement weather impedes operations.  At the same time, operating expenses have generally increased, with fuel efficiency declining because of engine idling and weather, causing more equipment repairs resulting from physical damage. For the reasons stated, first quarter results historically have been lower than results in each of the other three quarters of the year, excluding charges. Over the past several years, we have seen increases in demand at varying times, primarily related to restocking required to replenish inventories that have been held significantly lower than historical averages.  Additionally, we have seen surges between Thanksgiving and Christmas resulting from holiday shopping trends toward delivery of gifts purchased over the internet.  In recent years, we have seen the duration of this holiday "peak" season become compressed as consumers have come to expect shorter and shorter shipping times and our customers’ networks have adjusted accordingly.

Additional Information

At December 31, 2016, our corporate structure included Covenant Transportation Group, Inc., a Nevada holding company organized in May 1994, and its wholly owned subsidiaries: Covenant Transport, Inc., a Tennessee corporation; Southern Refrigerated Transport, Inc., an Arkansas corporation; Star Transportation, Inc., a Tennessee corporation; Covenant Transport Solutions, Inc., a Nevada corporation; Covenant Logistics, Inc., a Nevada corporation; Covenant Asset Management, LLC, a Nevada limited liability company; CTG Leasing Company, a Nevada corporation; Driven Analytic Solutions, LLC, a Nevada limited liability company, Heritage Insurance, Inc., a Tennessee corporation, and IQS Insurance Retention Group, Inc., a Vermont corporation.

Our headquarters is located at 400 Birmingham Highway, Chattanooga, Tennessee 37419, and our website address is www.ctgcompanies.com.  Our Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all other reports we file or furnish with the SEC pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") are available free of charge through our website.  Information contained in or available through our website is not incorporated by reference into, and you should not consider such information to be part of, this Annual Report on Form 10-K.

 

 

Additionally, you may read all of the materials that we file with the SEC by visiting the SEC's Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549.  If you would like information about the operation of the Public Reference Room, you may call the SEC at 1-800-SEC-0330.  You may also visit the SEC's website at www.sec.gov.  This site contains reports, proxy and information statements and other information regarding the Company and other companies that file electronically with the SEC.

ITEM 1A.          RISK FACTORS

Our future results may be affected by a number of factors over which we have little or no control.  The following discussion of risk factors contains forward-looking statements as discussed in Item 1 above.  The following issues, uncertainties, and risks, among others, should be considered in evaluating our business and growth outlook.

Our business is subject to general economic, credit, business, and regulatory factors affecting the truckload industry that are largely beyond our control, any of which could have a materially adverse effect on our operating results.

The truckload industry is highly cyclical, and our business is dependent on a number of factors that may have a materially adverse effect on our results of operations, many of which are beyond our control.  We believe that some of the most significant of these factors include (i) excess tractor and trailer capacity in the trucking industry in comparison with shipping demand; (ii) declines in the resale value of used equipment; (iii) strikes, work stoppages, or work slowdowns at our facilities or at customer, port, border crossing, or other shipping-related facilities; (iv) increases in interest rates, fuel taxes, tolls, and license and registration fees; (v) rising costs of healthcare; and (vi) fluctuations in foreign exchange rates.

We are also affected by (i) recessionary economic cycles, such as the period from 2007 through 2009 freight environment, which was characterized by weak demand and downward pressure on rates; (ii) changes in customers’ inventory levels and in the availability of funding for their working capital; (iii) changes in the way our customers choose to utilize our services; and (iv) downturns in our customers’ business cycles, particularly in market segments and industries, such as retail and manufacturing, where we have significant customer concentration. Economic conditions may adversely affect our customers and their demand for and ability to pay for our services.

Economic conditions that decrease shipping demand and increase the supply of available tractors and trailers can exert downward pressure on rates and equipment utilization, thereby decreasing asset productivity. The risks associated with these factors are heightened when the United States economy is weakened. Some of the principal risks during such times, which risks we have experienced during prior recessionary periods, are as follows:

We are subject to cost increases that are outside our control that could materially reduce our profitability if we are unable to increase our rates sufficiently.  Such cost increases include, but are not limited to, increases in fuel and energy prices, driver and office employee wages, purchased transportation costs, taxes, interest rates, tolls, license and registration fees, insurance premiums and claims, revenue equipment and related maintenance, tires and other components, and healthcare and other benefits for our employees.  We could be affected by strikes or other work stoppages at our service centers or at customer, port, border, or other shipping locations.  Further, we may not be able to appropriately adjust our costs and staffing levels to changing market demands. In periods of rapid change, it is more difficult to match our staffing level to our business needs.

 

 

Healthcare legislation and inflationary cost increases also could negatively impact financial results by increasing annual employee healthcare costs going forward.  We cannot presently determine the extent of the impact healthcare costs will have on our financial performance.  In addition, rising healthcare costs could force us to make changes to existing benefits program, which could negatively impact our ability to attract and retain employees.

Fluctuations in the price or availability of fuel, the volume and terms of diesel fuel purchase commitments, surcharge collection, and hedging activities may increase our costs of operation, which could have a materially adverse effect on our profitability.

We have a prior history of net losses and may be unsuccessful in maintaining or increasing profitability.

We have generated a profit in each of the last five years.  Maintaining and improving profitability depends upon numerous factors, including the ability to increase average revenue per tractor, increase velocity, improve driver retention, and control operating expenses.  We may not be able to improve profitability in the future, which could negatively impact our liquidity, financial position, and results of operations.

We operate in the United States pursuant to operating authority granted by the DOT and in various Canadian provinces pursuant to operating authority granted by the Ministries of Transportation and Communications in such provinces.  We operate within Mexico by utilizing third-party carriers within that country.  Our company drivers and independent contractors also must comply with the safety and fitness regulations of the DOT, including those relating to drug and alcohol testing, driver safety performance, and hours-of-service.  Matters such as weight, equipment dimensions, exhaust emissions, and fuel efficiency are also subject to government regulations. We also may become subject to new or more restrictive regulations relating to fuel efficiency, exhaust emissions, hours-of-service, ergonomics, on-board reporting of operations, collective bargaining, security at ports, speed limiters, driver training, and other matters affecting safety or operating methods.  Future laws and regulations may be more stringent, require changes in our operating practices, influence the demand for transportation services, or require us to incur significant additional costs.  Higher costs we incur, or higher costs incurred by suppliers who pass the costs on to us, could adversely affect our results of operations. In addition, the Trump administration has indicated a desire to reduce regulatory burdens that constrain growth and productivity, and also to introduce legislation such as infrastructure spending, that could improve growth and productivity. Changes in regulations, such as those related to trailer size limits, hours-of-service, and mandating ELDs, could increase capacity in the industry or improve the position of certain competitors, either of which could negatively impact pricing and volumes, or require additional investments by us.  The short and long term impacts of changes in legislation or regulations are difficult to predict and could materially adversely affect our operations.  The Regulation section in Item 1 of Part I of this Annual Report on Form 10-K discusses several proposed, pending, suspended, and final regulations that could materially impact our business and operations.

Receipt of an unfavorable DOT safety rating could have a materially adverse effect on our operations and profitability.

We currently have a satisfactory DOT rating, which is the highest available rating under the current safety rating scale.  If we were to receive a conditional or unsatisfactory DOT safety rating, it could materially adversely affect our business, financial condition, and results of operations as customer contracts may require a satisfactory DOT safety rating, and a conditional or unsatisfactory rating could materially adversely affect or restrict our operations.

The FMCSA has proposed regulations that would modify the existing rating system and the safety labels assigned to motor carriers evaluated by the DOT.  Under the proposed regulations, the methodology for determining a carrier’s DOT safety rating would be expanded to include the on-road safety performance of the carrier’s drivers and equipment, as well as results obtained from investigations. Exceeding certain thresholds based on such performance or results would cause a carrier to receive an unfit safety rating.  If these proposed regulations are enacted and we were to receive an unfit safety rating, our business would be materially adversely affected in the same manner as if we received a conditional or unsatisfactory safety rating under the current regulations.

Properties with environmental problems may create liabilities for us.

Under various federal, state, and local environmental laws, statutes, ordinances, rules, and regulations, as an owner of real property, we may be liable for the costs of removal or remediation of certain hazardous or toxic substances at, on, in, or under our properties, as well as certain other potential costs relating to hazardous or toxic substances (including government fines and penalties and damages for injuries to persons and adjacent property).  These laws may impose liability without regard to whether we knew of, or were responsible for, the presence or disposal of those substances.  This liability may be imposed on us in connection with the activities of an operator of, or tenant at, the property.  The cost of any required remediation, removal, fines, or personal or property damages and our liability therefore could exceed the value of the property and/or our aggregate assets.  In addition, the presence of those substances, or the failure to properly dispose of or remove those substances, may adversely affect our ability to sell or rent that property or to borrow using that property as collateral, which, in turn, would reduce our liquidity and adversely affect our operations.

We are not aware of any environmental condition with respect to any of our property interests that we believe would be reasonably likely to have a material adverse effect on us.  However, in connection with the eleventh amendment to our Credit Facility and pledging of certain properties as collateral, we commissioned Phase I environmental inspections on certain real properties we own. A number of these inspections revealed conditions that warranted a Phase II inspection.  If we receive unfavorable results from such inspections, we may incur significant unanticipated expenditures, which could adversely affect our financial condition and results of operations.

Volatility in the used equipment market could have a materially adverse effect on our business, financial condition, results of operations, and profitability.

A decreased demand for used revenue equipment could adversely affect us and our operating results.  As we continually replace our equipment, we rely on the used equipment market to extract remaining value out of our used equipment. The market for used equipment is impacted by several factors, including the demand for freight, the supply of used equipment, the availability of financing, the presence of buyers for export to foreign countries, and commodity prices for scrap metal.  A depressed market for used equipment could require us to trade our revenue equipment at depressed values or to record losses on disposal or impairments of the carrying values of our revenue equipment that is not protected by residual value arrangements.  If there is a deterioration of resale prices, it could have a materially adverse effect on our business, financial condition, and results of operations.  Trades at depressed values, decreases in proceeds for equipment disposals, and impairments of the carrying values of our revenue equipment could have a materially adverse effect on our business, financial condition, and results of operations. A deterioration of demand for used equipment could make it more difficult to dispose of and replace older equipment and may reduce our ability to refresh our fleet and dispose of less fuel efficient equipment, both of which could negatively impact our profitability.

If we cannot effectively manage the challenges associated with doing business internationally, our operating revenue and profitability may suffer.

A component of our operations is the business we conduct in Mexico, and to a lesser extent Canada, and we are subject to risks of doing business internationally, including fluctuations in foreign currencies, changes in the economic strength of Mexico and Canada, difficulties in enforcing contractual obligations and intellectual property rights, burdens of complying with a wide variety of international and United States export and import laws, and social, political, and economic instability.  Additional risks associated with our foreign operations, including restrictive trade policies and imposition of duties, taxes, or government royalties by foreign governments, are present but largely mitigated by the terms of NAFTA.

Litigation may adversely affect our business, financial condition, and results of operations.

Our business is subject to the risk of litigation by employees, independent contractors, customers, vendors, government agencies, stockholders, and other parties through private actions, class actions, administrative proceedings, regulatory actions, and other processes. Recently, trucking companies, including us, have been subject to lawsuits, including class action lawsuits, alleging violations of various federal and state wage and hour laws regarding, among other things, employee meal breaks, rest periods, overtime eligibility, and failure to pay for all hours worked. A number of these lawsuits have resulted in the payment of substantial settlements or damages by the defendants.

The outcome of litigation, particularly class action lawsuits and regulatory actions, is difficult to assess or quantify, and the magnitude of the potential loss relating to such lawsuits may remain unknown for substantial periods of time. The cost to defend litigation may also be significant. Not all claims are covered by our insurance, and there can be no assurance that our coverage limits will be adequate to cover all amounts in dispute. To the extent we experience claims that are uninsured, exceed our coverage limits, involve significant aggregate use of our self-insured retention amounts, or cause increases in future premiums, the resulting expenses could have a materially adverse effect on our business, results of operations, financial condition, or cash flows.

Our tractor productivity decreases during the winter season because inclement weather impedes operations, and some shippers reduce their shipments after the winter holiday season.  Our expedited operations, which is a growing part of our business, historically have experienced a greater reduction in first quarter demand than our other operations.  Revenue also can be affected by bad weather and holidays, since revenue is directly related to available working days of shippers.  At the same time, operating expenses increase and fuel efficiency declines because of engine idling and harsh weather creating higher accident frequency, increased claims, and more equipment repairs. In addition, many of our customers, particularly those in the retail industry where we have a large presence, demand additional capacity during the fourth quarter, which limits our ability to take advantage of more attractive spot market rates that generally exist during such periods.  Further, despite our efforts to meet such demands, we may fail to do so, which may result in lost future business opportunities with such customers, which could have a materially adverse effect on our operations.  Recently, the duration of this increased period of demand in the fourth quarter has shortened, with certain customers requiring the same volume of shipments over a more condensed timeframe, resulting in increased stress and demand on our network, people, and systems.  If this trend continues, it could make satisfying our customers and maintaining the quality of our service during the fourth quarter increasingly difficult.  We may also suffer from weather-related or other unforeseen events such as tornadoes, hurricanes, blizzards, ice storms, floods, fires, earthquakes, and explosions.  These events may disrupt fuel supplies, increase fuel costs, disrupt freight shipments or routes, affect regional economies, destroy our assets, or adversely affect the business or financial condition of our customers, any of which could have a materially adverse effect on our results of operations or make our results of operations more volatile.  Weather and other seasonal events could adversely affect our operating results.

 

 

ITEM 1B.       UNRESOLVED STAFF COMMENTS

None.

ITEM 2.          PROPERTIES

Our corporate headquarters and main terminal are located on approximately 180 acres of property in Chattanooga, Tennessee.  This facility includes an office building of approximately 182,000 square feet, a maintenance facility of approximately 65,000 square feet, a body shop of approximately 60,000 square feet, and a tractor wash.  Our Solutions subsidiary is also operated and managed out of the Chattanooga facility.  We maintain seven terminals, which are utilized by our Truckload segment located on our major traffic lanes in or near the cities listed below.  These terminals provide a base for drivers in proximity to their homes, a transfer location for trailer relays on transcontinental routes, parking space for equipment dispatch, and the other uses indicated below.  All of the properties noted below are subject to mortgages or deeds of trust under our Credit Facility, with the exception of our Chattanooga headquarters, which is subject to a deed of trust under a separate financing.

ITEM 3.          LEGAL PROCEEDINGS

From time-to-time, we are a party to ordinary, routine litigation arising in the ordinary course of business, most of which involves claims for personal injury and property damage incurred in connection with the transportation of freight.

We maintain insurance to cover liabilities arising from the transportation of freight for amounts in excess of certain self-insured retentions. In management's opinion, our potential exposure under pending legal proceedings is adequately provided for in the accompanying consolidated financial statements.

In August 2014, the U.S. District Court for the Southern District of Ohio issued a pre-trial decision in a lawsuit against SRT relating to a cargo claim incurred in 2008. The court awarded the plaintiff approximately $5.9 million plus prejudgment interest and costs and denied a cross-motion for summary judgment by SRT. Previously, the court had ruled in favor of SRT on all but one count before overturning its earlier decision and ruling in favor of the plaintiff. SRT filed a Notice of Appeal with the U.S. Sixth Circuit Court of Appeals on September 24, 2014. On November 5, 2015, the Sixth Circuit reversed the district court in part, finding that the plaintiff could not recover under two of its causes of action. The Sixth Circuit remanded the proceedings to the district court for further factual determinations relating to whether the plaintiff could recover under a third cause of action. The case is currently pending resolution of motions for summary judgment.

Our Covenant Transport subsidiary is a defendant in a lawsuit that was filed on August 17, 2015 in the Superior Court of the State of California, Los Angeles County.  This lawsuit arises out of the work performed by the plaintiff as a company driver for Covenant Transport during the period of August, 2013 through October, 2014.  The plaintiff is seeking class action certification under the complaint.  The case was removed from state court in September, 2015 to the U.S. District Court in the Central District of California, and subsequently, the case was transferred to the U.S. District Court in the Eastern District of Tennessee on October 5, 2015 where the case is now pending.  The complaint asserts that the time period covered by the lawsuit is "the four (4) years prior to the filing of this action through the trial date" and alleges claims for failure to properly pay for rest breaks, inspection time, waiting time, fueling and paperwork time, meal periods  and other related wage and hour claims under the California Labor Code.  The parties engaged in mediation of the dispute, which resulted in a comprehensive settlement of all class member claims upon payment of $500,000 by Covenant Transport.  The settlement received preliminary approval of the court in December, 2016 and is now pending final approval.

 

 

Our SRT subsidiary is a defendant in a lawsuit filed on December 16, 2016 in the Superior Court of San Bernardino County, California.  The lawsuit was filed on behalf of David Bass (a California resident and former driver), who is seeking to have the lawsuit certified as a class action case, wherein he alleges violation of multiple California wage and hour statutes over a four year period of time, including failure to pay wages for all hours worked, failure to provide meal periods and paid rest breaks, failure to pay for rest and recovery periods, failure to reimburse certain business expenses, failure to pay vested vacation, unlawful deduction of wages, failure to timely pay final wages, failure to provide accurate itemized wage statements, and unfair and unlawful competition.

Based on our present knowledge of the facts and, in certain cases, advice of outside counsel, management believes the resolution of open claims and pending litigation, taking into account existing reserves, is not likely to have a materially adverse effect on our consolidated financial statements.

ITEM 4.          MINE SAFETY DISCLOSURES

None.

PART II

ITEM 5.          MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Price Range of Common Stock

Our Class A common stock is traded on the NASDAQ Global Select Market, under the symbol "CVTI." The following table sets forth, for the calendar periods indicated, the range of high and low sales price for our Class A common stock as reported by NASDAQ from January 1, 2015, to December 31, 2016.

On March 10, 2017, the last reported sale price of our Class A common stock on the NASDAQ Global Select Market was $18.86.

As of March 10, 2017, we had approximately 117 stockholders of record of our Class A common stock; however, we estimate our actual number of stockholders is much higher because a substantial number of our shares are held of record by brokers or dealers for their customers in street names.  As of March 10, 2017, Mr. Parker, together with certain of his family members, owned all of the outstanding Class B common stock.

Dividend Policy

We have never declared and paid a cash dividend on our Class A or Class B common stock.  It is the current intention of our Board of Directors to continue to retain earnings to finance our business and reduce our indebtedness rather than to pay dividends.  The payment of cash dividends is currently limited by our financing arrangements.  Future payments of cash dividends will depend upon our financial condition, results of operations, capital commitments, restrictions under then-existing agreements, and other factors deemed relevant by our Board of Directors.

See "Equity Compensation Plan Information" under Item 12 in Part III of this Annual Report on Form 10-K for certain information concerning shares of our Class A common stock authorized for issuance under our equity compensation plans.

Issuer Purchases of Equity Securities

The table below sets forth the information with respect to purchases of our Class A common stock made by or on behalf of us during the quarter ended December 31, 2016:

ITEM 6.          SELECTED FINANCIAL DATA

The information set forth above should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's consolidated financial statements and notes thereto included in Items 7 and 8, respectively, of this Form 10-K.

ITEM 7.          MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Cautionary Note Regarding Forward-Looking Statements

Item 7, as well as other items of this Annual Report on Form 10-K, contains certain statements that may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and such statements are subject to the safe harbor created by those sections and the Private Securities Litigation Reform Act of 1995, as amended.  All statements, other than statements of historical or current fact, are statements that could be deemed forward-looking statements, including without limitation: any projections of earnings, revenues, or other financial items; any statement of plans, strategies, and objectives of management for future operations; any statements concerning proposed new services or developments; any statements regarding future economic conditions or performance; and any statements of belief and any statements of assumptions underlying any of the foregoing. In this Item 7, statements relating to future demand for and supply of new and used tractors and trailers (including expected prices of such equipment), expected sources and adequacy of working capital and liquidity, future relationships, use, compensation, and availability with respect to third-party service providers, future driver market conditions, future allocation of capital, expected settlement of operating lease obligations, future asset sales and acquisitions, future insurance, litigation, and claims levels and expenses, future tax expense and deductions, future fuel management, expense, and the future effectiveness of fuel surcharge programs and price hedges, future interest rates and effectiveness of interest rate swaps, expected capital expenditures (including the future mix of lease and purchase obligations), future trucking capacity, expected freight demand and volumes, future rates, future depreciation and amortization, future compliance with and impact of existing and proposed federal and state laws and regulations, future salaries, wages, and other employee benefit expenses, future earnings from and value of our investments, future customer relationships, future defaults under debt agreements, future performance of our subsidiaries, and future operating and maintenance expenses,  among others, are forward-looking statements.  Such statements may be identified by their use of terms or phrases such as "believe," "may," "could," "expects," "estimates," "projects," "anticipates," "plans," "intends," and similar terms and phrases. Forward-looking statements are based on currently available operating, financial, and competitive information.  Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified, which could cause future events and actual results to differ materially from those set forth in, contemplated by, or underlying the forward-looking statements.  Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled "Item 1A. Risk Factors," set forth above.  Readers should review and consider the factors discussed in "Item 1A. Risk Factors," along with various disclosures in our press releases, stockholder reports, and other filings with the Securities and Exchange Commission.

All such forward-looking statements speak only as of the date of this Annual Report.  You are cautioned not to place undue reliance on such forward-looking statements.  We expressly disclaim any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in our expectations with regard thereto or any change in the events, conditions, or circumstances on which any such statement is based.

Results for 2016 were not as robust as the record earnings achieved in 2015, where 2015 was the best annual results experienced in the Company’s 31 year history. Our operating ratio declined 460 basis points to 95.2%.  Our adjusted operating ratio (as defined below), a key measure of profitability in our industry, contracted 530 basis points to a 94.7%.  These declines were the result of overall softness in freight within the Truckload segment, resulting in a slight decline in miles per tractor per week and a 3.9% decrease in the average tractor count, even considering a 5.3% increase in the number of team tractors, and average rates per total mile declining 2.2 cents per mile. Cost in the Truckload segment increased 8.3 cents per mile, primarily as a result of increased capital cost, resulting from the significant decline in used equipment values and related increase in depreciation. On the contrary, our non-Truckload operations experienced growth in both revenue and profitability as we were able to take advantage of the market dynamics and realize the full year effect of several business model changes and new customers added in 2015. Our consolidated financial results are summarized as follows:

 

 

Although 2016 was not what we had hoped, we are still encouraged by the trend line over the last several years.  Our turnaround efforts at SRT were fully engaged in 2016, including a new management team, and we have established a roadmap that we believe will be successful in returning SRT’s results to levels where they produce an acceptable return.  We continue to focus on deleveraging the balance sheet resulting in total indebtedness, net of cash and including the present value of off-balance sheet lease obligations decreasing by approximately $37.5 million to $226.7 million, since December 31, 2015. Additionally, earnings and the reduced impact of fuel hedges have increased tangible book value per basic share 16.1% to $12.95 from $11.15 at December 31, 2015.

In addition to operating ratio, we use "adjusted operating ratio" as a key measure of profitability.  Adjusted operating ratio is not a substitute for operating ratio measured in accordance with GAAP. There are limitations to using non-GAAP financial measures.  Adjusted operating ratio means operating expenses, net of fuel surcharge revenue, expressed as a percentage of revenue, excluding fuel surcharge revenue. We believe the use of adjusted operating ratio allows us to more effectively compare periods, while excluding the potentially volatile effect of changes in fuel prices. Our Board and management focus on our adjusted operating ratio as an indicator of our performance from period to period. We believe our presentation of adjusted operating ratio is useful because it provides investors and securities analysts the same information that we use internally to assess our core operating performance. Although we believe that adjusted operating ratio improves comparability in analyzing our period-to-period performance, it could limit comparability to other companies in our industry, if those companies define adjusted operating ratio differently. Because of these limitations, adjusted operating ratio should not be considered a measure of income generated by our business or discretionary cash available to us to invest in the growth of our business. Management compensates for these limitations by primarily relying on GAAP results and using non-GAAP financial measures on a supplemental basis.

 

Outlook

We are forecasting sequential improvement for 2017. In the first half of 2017 we do not expect to match the earnings per share levels we generated for the first and second quarters of 2016. However, we believe the combination of an improving economy, growth of time-sensitive e-commerce freight, industry regulatory changes, retail inventory declines, year-over-year net fuel expense savings from our improved fuel hedge positions, and operational progress at SRT should deliver earnings improvement that result in higher earnings for the second half and potentially the full year of 2017. The largest variable we foresee is the pace and magnitude of improvement at SRT, which we believe could contribute up to $10.0 million of pre-tax income in improved results as compared with 2016. The pace and amount of change will depend, in large part, on our ability to enhance the freight network, which depends on internally re-engineering lanes and a stronger refrigerated freight market. With net capital expenditures scheduled to be below normal due to the timing of our expected replacement cycle, along with anticipated positive operating cash flows, we expect to further reduce balance sheet and off-balance sheet debt over the course of fiscal 2017.  Our 2017 plans also include growing our dedicated service line and investing in personnel and trailer tracking equipment that will allow more cross-border freight opportunities.

The following table sets forth total revenue and freight revenue (total revenue less fuel surcharge revenue) for the periods indicated:

For 2016, total revenue decreased $53.6 million, or 7.4%, to $670.7 million from $724.2 million in 2015.  Freight revenue decreased $29.3 million, or 4.6%, to $610.8 million for 2016, from $640.1 million in 2015, while fuel surcharge revenue decreased $24.3 million year-over-year.  The decrease in freight revenue resulted from a $30.4 million decrease in freight revenue from our Truckload segment and a $1.1 million increase in revenues from Solutions.

The decrease in 2016 Truckload revenue relates to a decrease in average freight revenue per tractor per week of 2.2% compared to 2015 and a decrease in our average tractor fleet of 3.9% from 2015, partially offset by a $1.7 million increase in freight revenue contributed by our temperature-controlled intermodal service offering. The decrease in average freight revenue per tractor per week is the result of a 1.3% decrease, or 2.2 cents per mile, in average rate per total mile and a 0.6% decrease in average miles per unit when compared to 2015.  Team driven units increased approximately 5.3% to an average of approximately 1,000 teams in 2016 from approximately 950 teams in 2015.

The increase in Solutions' revenue is primarily the result of improved coordination with our Truckload segment, additional business from new customers added during the year, and the full year effect of a large customer added in 2015.

For 2015, total revenue increased $5.3 million, or 0.7%, to $724.2 million from $719.0 million in 2014.  Freight revenue increased $61.9 million, or 10.7%, to $640.1 million for 2015, from $578.2 million in 2014, while fuel surcharge revenue decreased $56.7 million year-over-year.  The increase in freight revenue resulted from a $49.6 million increase in freight revenue from our Truckload segment and a $12.3 million increase in revenues from Solutions.

The increase in 2015 Truckload revenue relates to an increase in average freight revenue per tractor per week of 5.0% compared to 2014 and a $4.6 million increase in freight revenue contributed by our temperature-controlled intermodal service offering, as well as an increase in our average tractor fleet of 3.5% from 2014. The increase in average freight revenue per tractor per week is the result of a 5.7% increase, or 9.1 cents per mile, in average rate per total mile partially offset by a 0.6% decrease in average miles per unit when compared to 2014.  Team driven units increased approximately 13.6% to an average of approximately 950 teams in 2015 from approximately 840 teams in 2014.

 

 

The increase in Solutions' revenue is primarily the result of additional peak-season freight opportunities during the fourth quarter of 2015, improved coordination with our Truckload segment, and additional business from new customers added during the year.

If capacity tightens as a result of regulations impacting the industry or economic growth, we expect the pricing environment to improve in the latter half of 2017 and into 2018 and 2019, offset in part by higher driver pay and other inflationary costs.

For comparison purposes in the discussion below, we use total revenue and freight revenue (total revenue less fuel surcharge revenue) when discussing changes as a percentage of revenue.  As it relates to the comparison of expenses to freight revenue, we believe removing fuel surcharge revenue, which is sometimes a volatile source of revenue, affords a more consistent basis for comparing the results of operations from period-to-period.  Nonetheless, freight revenue is a non-GAAP financial measure and is not a substitute for revenue measured in accordance with GAAP. There are limitations to using non-GAAP financial measures.  Our Board and management focus on our freight revenue as an indicator of our performance from period to period. We believe our presentation of freight revenue is useful because it provides investors and securities analysts the same information that we use internally to assess our core operating performance. Although we believe that freight revenue improves comparability in analyzing our period-to-period performance, it could limit comparability to other companies in our industry, if those companies define freight revenue differently. Because of these limitations, freight revenue should not be considered a measure of total revenue generated by or available to our business. Management compensates for these limitations by primarily relying on GAAP results and using non-GAAP financial measures on a supplemental basis.

Salaries, wages, and related expenses decreased approximately $10.3 million, or 4.2%, for the year ended December 31, 2016, compared with 2015.  As a percentage of total revenue, salaries, wages, and related expenses increased to 35.0% of total revenue for the year ended December 31, 2016, as compared to 33.8% in 2015.  As a percentage of freight revenue, salaries, wages, and related expenses increased slightly to 38.4% of freight revenue for the year ended December 31, 2016, from 38.2% in 2015. Salaries, wages, and related expenses decreased significantly on an overall dollar basis as a result of a 3.9% decrease in average tractors, but were relatively flat as a percentage of freight revenue, primarily due to pay adjustments for both driver and non-drivers since 2015, partially offset by a decrease in non-driver incentive compensation as a result of reduced profitability in 2016 versus 2015. Additionally, group insurance costs decreased approximately $2.3 million from 2015 as a result of better claims experience.

Salaries, wages, and related expenses increased approximately $13.0 million, or 5.6%, for the year ended December 31, 2015, compared with 2014.  As a percentage of total revenue, salaries, wages, and related expenses increased to 33.8% of total revenue for the year ended December 31, 2015, as compared to 32.2% in 2014.  As a percentage of freight revenue, salaries, wages, and related expenses declined to 38.2% of freight revenue for the year ended December 31, 2015, from 40.1% in 2014. Salaries, wages, and related expenses increased approximately 2.1 cents per mile primarily due to pay adjustments for both driver and non-drivers since 2014, as well as increased non-driver incentive compensation tied to our results of operations.  Additionally, group insurance costs increased approximately $0.9 million from 2014 as a result of more participants and fees directly related to the Affordable Care Act and we had additional costs of approximately $1.0 million due to an increase in non-driver headcount as a result of the increased average number of units.  These increases were partially offset by lower workers' compensation expense in 2015 at 1.7 cents per company mile compared to 3.4 cents in 2014 due to fewer claims with less severity.  Additionally, we had an increase in the percentage of our fleet comprised of independent contractors, whose costs are included in the purchased transportation line item.

Going forward, we believe salaries, wages, and related expenses will increase as a result of a tight driver market, wage inflation, higher healthcare costs, and, in certain periods, increased incentive compensation due to better performance. In particular, we expect driver pay to increase as we look to reduce the number of unseated tractors in our fleet in a tight market for drivers. Additionally, when the freight market allows for an increase in rates we would expect to, as we have historically, pass a portion of those rate increases on to our professional drivers.  Salaries, wages, and related expenses will fluctuate to some extent based on the percentage of revenue generated by independent contractors and our Solutions business, for which payments are reflected in the purchased transportation line item.

 

 

We receive a fuel surcharge on our loaded miles from most shippers; however, this does not cover the entire increase in fuel prices for several reasons, including the following: surcharges cover only loaded miles we operate; surcharges do not cover miles driven out-of-route by our drivers; and surcharges typically do not cover refrigeration unit fuel usage or fuel burned by tractors while idling.  Moreover, most of our business relating to shipments obtained from freight brokers does not carry a fuel surcharge.  Finally, fuel surcharges vary in the percentage of reimbursement offered, and not all surcharges fully compensate for fuel price increases even on loaded miles.

The rate of fuel price changes also can have an impact on results.  Most fuel surcharges are based on the average fuel price as published by the DOE for the week prior to the shipment, meaning we typically bill customers in the current week based on the previous week's applicable index.  Therefore, in times of increasing fuel prices, we do not recover as much as we are currently paying for fuel.  In periods of declining prices, the opposite is true.  Fuel prices as measured by the DOE averaged approximately $0.40 cents per gallon lower in 2016 compared with 2015 and $1.12 per gallon lower in 2015 compared to 2014.

Additionally, $16.7 million, $15.3 million, and $3.1 million were reclassified from accumulated other comprehensive (loss) income to our results from operations for the years ended December 31, 2016, 2015, and 2014, respectively, as additional fuel expense for 2016, 2015 and 2014, related to losses on fuel hedge contracts that expired.  We evaluate these contracts for "hedge effectiveness," which is the extent to which the hedge contract effectively offsets changes in cash flows that the contract was intended to offset.  In addition to the amounts reclassified as a result of expired contracts, we recognized a reduction of fuel expense of $1.4 million relating to previously recognized fuel expense as a result of the expiration of the fuel hedge contracts for which the fuel hedging relationship was deemed to be ineffective on a prospective basis in 2014.  As a result, the changes in fair value for those contracts were recorded as expense rather than as a component of other comprehensive loss. At December 31, 2016, all fuel hedge contracts were deemed to be effective and thus continue to qualify as cash flow hedges. There was no material ineffectiveness recorded on the contracts that existed at December 31, 2016.  The ineffectiveness was calculated using the cumulative dollar offset method as an estimate of the difference in the expected cash flows of the respective fuel hedge contracts compared to the changes in the all-in cash outflows required for the diesel fuel purchases.

To measure the effectiveness of our fuel surcharge program, we subtract fuel surcharge revenue (other than the fuel surcharge revenue we reimburse to independent contractors and other third parties, which is included in purchased transportation) from our fuel expense.  The result is referred to as net fuel expense.  Our net fuel expense as a percentage of freight revenue is affected by the cost of diesel fuel net of fuel surcharge collection, the percentage of miles driven by company tractors, our fuel economy, and our percentage of deadhead miles, for which we do not receive material fuel surcharge revenues.  Net fuel expense is shown below:

Total fuel expense decreased approximately $19.1 million, or 15.6%, for the year ended December 31, 2016, compared with 2015.  As a percentage of total revenue, total fuel expense decreased to 15.4% of total revenue for the year ended December 31, 2016, from 16.9% in 2015. As a percentage of freight revenue, total fuel expense decreased to 16.9% of freight revenue for the year ended December 31, 2016, from 19.1% in 2015.  These decreases primarily related to lower fuel prices and an increase in our average fuel miles per gallon during 2016 as a result of purchasing equipment with more fuel-efficient engines.  The decreases were partially offset by increased net losses from fuel hedging transactions of $16.7 million in 2016 compared to $13.9 million in 2015.

 

 

Net fuel expense increased $3.7 million, or 8.1%, for the year ended December 31, 2016 compared to 2015.  As a percentage of freight revenue, net fuel expense increased 0.9% for the year ended December 31, 2016 compared to 2015.  These increases primarily resulted from lower fuel surcharge recovery as a result of increased broker freight and the tiered reimbursement structure of certain fuel surcharge agreements. The increases were partially offset by improved miles per gallon due to new engine technology, internal fuel efficiency initiatives, and a greater percentage of miles driven by independent contractors.

For the year ended December 31, 2015, total fuel expense decreased approximately $46.7 million, or 27.7%, compared with 2014.  As a percentage of total revenue, total fuel expense decreased to 16.9% of total revenue for the year ended December 31, 2015, from 23.5% in 2014. As a percentage of freight revenue, total fuel expense decreased to 19.1% of freight revenue for the year ended December 31, 2015, from 29.2% in 2014.  These decreases primarily related to an increase in our average fuel miles per gallon during 2015 as a result of purchasing equipment with more fuel-efficient engines.  The decreases were partially offset by net losses from fuel hedging transactions of $13.9 million in 2015 compared to $3.1 million in 2014.  Additionally, during the second quarter of 2014 we recognized an approximately $0.9 million fuel tax credit related to amended fuel tax returns for the years 2010 – 2013.

Net fuel expense increased $6.9 million, or 17.8%, for the year ended December 31, 2015 compared to 2014.  As a percentage of freight revenue, net fuel expense increased 0.5% for the year ended December 31, 2015 compared to 2014.  These increases primarily resulted from lower fuel surcharge recovery. The increases were partially offset by improved miles per gallon due to new engine technology, internal fuel efficiency initiatives, a greater percentage of miles driven by independent contractors, and an approximately $0.9 million fuel tax credit taken during the second quarter of 2014 related to amended fuel tax returns for the years 2010 – 2013.

We expect to continue managing our idle time and tractor speeds, investing in more fuel-efficient tractors to improve our miles per gallon, locking in fuel hedges when deemed appropriate, and partnering with customers to adjust fuel surcharge programs that are inadequate to recover a fair portion of fuel costs.  Going forward, our net fuel expense is expected to fluctuate as a percentage of revenue based on factors such as diesel fuel prices, percentage recovered from fuel surcharge programs, percentage of uncompensated miles, percentage of revenue generated by team-driven tractors (which tend to generate higher miles and lower revenue per mile, thus proportionately more fuel cost as a percentage of revenue), percentage of revenue generated by refrigerated operation (which uses diesel fuel for refrigeration, but usually does not recover fuel surcharges on refrigeration fuel), percentage of revenue generated from independent contractors, the success of fuel efficiency initiatives, and gains and losses on fuel hedging contracts.

Given recent historical lows, we would expect diesel fuel prices to remain flat or increase over the next few years.  However, due to hedging contracts being locked in at a lower rate on a portion of our expected gallons compared to 2016 and 2015, we expect net fuel cost to significantly decline in 2017 and 2018.

Operations and maintenance decreased $0.6 million, or 1.3%, for the year ended December 31, 2016, compared with 2015.  As a percentage of total revenue, operations and maintenance remained relatively even at 6.8% of total revenue in 2016, compared with 6.4% in 2015.  As a percentage of freight revenue, operations and maintenance increased to 7.5% of freight revenue for 2016, from 7.3% in 2015 due to an increase in unloading and other operational costs associated with our increase in dedicated freight, partially offset by lower maintenance cost on our revenue equipment.

For the year ended December 31, 2015, operations and maintenance decreased $0.8 million, or 1.7%, compared with 2014.  As a percentage of total revenue, operations and maintenance remained relatively even at 6.4% of total revenue in 2015, compared with 6.6% in 2014.  As a percentage of freight revenue, operations and maintenance decreased to 7.3% of freight revenue for 2015, from 8.2% in 2014 due to a decrease in our average age of equipment partially offset by increased driver recruiting costs.

 

 

Going forward, we believe this category will fluctuate based on several factors, including our continued ability to maintain a relatively young fleet, accident severity and frequency, weather, and the reliability of new and untested revenue equipment models.

Revenue equipment rentals and purchased transportation decreased approximately $1.1 million, or 0.9%, for the year ended December 31, 2016, compared with 2015.  As a percentage of total revenue, revenue equipment rentals and purchased transportation increased to 17.5% of total revenue for the year ended December 31, 2016, from 16.4% in 2015.  As a percentage of freight revenue, revenue equipment rentals and purchased transportation increased to 19.2% of freight revenue for the year ended December 31, 2016, from 18.5% in 2015. These changes were primarily the result of a $0.7 million increase in payments to third-party transportation providers related to increased revenues at our Solutions subsidiary and growth of our temperature-controlled intermodal service offering.  These increases were partially offset by a decrease in leased equipment rental payments due to a reduction in our trailers under operating leases from 2,239 at December 31, 2105 to 1,695 at December 31, 2016.

For the year ended December 31, 2015, revenue equipment rentals and purchased transportation increased approximately $6.8 million, or 6.1%, for the year ended December 31, 2015, compared with 2014.  As a percentage of total revenue, revenue equipment rentals and purchased transportation increased to 16.4% of total revenue for the year ended December 31, 2015, from 15.5% in 2014.  As a percentage of freight revenue, revenue equipment rentals and purchased transportation decreased to 18.5% of freight revenue for the year ended December 31, 2015, from 19.3% in 2014. These changes were primarily the result of a $14.4 million increase in payments to third-party transportation providers related to increased revenues at our Solutions subsidiary, growth of our temperature-controlled intermodal service offering and an increase in payments to independent contractors, which comprised a larger percentage of our total fleet.  These increases were partially offset by a decrease in leased equipment rental payments and by lower fuel surcharge pass-through payments to independent contractors and third party carriers.  For the year ended December 31, 2015, miles run by independent contractors increased to 9.0% of our total miles from 8.2% for 2014, and tractors under operating leases decreased to 115 units from 150 units in 2014.  We expect revenue equipment rentals to decrease going forward as a result of our increase in acquisition of revenue equipment through financed purchases or capital leases rather than operating leases.  As discussed below, this decrease may be partially or fully offset by an increase in purchased transportation as we expect to continue to grow our Solutions and intermodal service offerings.

We expect purchased transportation to increase as we seek to grow our Solutions subsidiary and if fuel prices continue to increase, which would result in an increase in what we pay third party carriers and independent contractors.  However, this expense category will fluctuate with the number and percentage of loads hauled by independent contractors, loads handled by Solutions, and tractors, trailers, and other assets financed with operating leases.  In addition, factors such as the cost to obtain third party transportation services, and growth of our intermodal service offerings, and the amount of fuel surcharge revenue passed through to the third party carriers and independent contractors will affect this expense category.  If industry-wide trucking capacity were to tighten in relation to freight demand, we may need to increase the amounts we pay to third-party transportation providers, independent contractors, and intermodal transportation providers, which could increase this expense category on an absolute basis and as a percentage of freight revenue absent an offsetting increase in revenue. We continue to actively recruit independent contractors and, if we are successful, we would expect this line item to increase as a percentage of revenue.

For the periods presented, the change in operating taxes and licenses was not significant as either a percentage of total revenue or freight revenue.

 

 

Insurance and claims, consisting primarily of premiums and deductible amounts for liability, physical damage, and cargo damage insurance and claims, increased approximately $0.7 million, or 2.2%, for year ended December 31, 2016, compared to 2015.  As a percentage of total revenue, insurance and claims increased to 4.9% of total revenue for the year ended December 31, 2016, from 4.4% in 2015.  As a percentage of freight revenue, insurance and claims increased to 5.3% of freight revenue for the year ended December 31, 2016, from 5.0% in 2015. These increases are primarily related to the non-recurring $3.6 million benefit in the second quarter of 2015 from commutation of our auto liability policy for the period from April 1, 2013, through September 30, 2014.  These increases also resulted from increased accident severity, resulting in total insurance cost increasing to 10.3 cents per mile for 2016 from 9.6 cents per mile in 2015. These increases were partially offset by decreased accident rates in 2016, as measured by a 6.8% improvement in DOT reportable accidents per million miles driven at 0.82% – the second lowest in the last ten years.

Insurance and claims decreased approximately $7.7 million, or 19.4%, for year ended December 31, 2015, compared to 2014.  As a percentage of total revenue, insurance and claims decreased to 4.4% of total revenue for the year ended December 31, 2015, from 5.5% in 2014.  As a percentage of freight revenue, insurance and claims decreased to 5.0% of freight revenue for the year ended December 31, 2015, from 6.8% in 2014. These decreases are primarily related to the difference between the approximately $7.5 million of additional reserves related to the adverse judgment in 2014 regarding a 2008 cargo claim compared with the $3.6 million benefit in the second quarter of 2015 from commutation of our auto liability policy for the period from April 1, 2013, through September 30, 2014. Excluding the 2008 cargo claim, insurance and claims cost per mile decreased to 9.6 cents per mile in 2015 from 9.9 cents per mile in 2014.

Our auto liability (personal injury and property damage), cargo, and general liability insurance programs include significant self-insured retention amounts.  The auto liability policy contains a feature whereby we are able to retroactively obtain a partial refund of the premium in exchange for taking on the liability for incidents that occurred during the period and releasing the insurers.  This is referred to as "commuting" the policy or "policy commutation."  In several past periods, including the policy period from April 1, 2013, through September 30, 2014, we have commuted the policy, which has lowered our insurance and claims expense. We are also self-insured for physical damage to our equipment.  Because of these significant self-insured exposures, insurance and claims expense may fluctuate significantly from period-to-period. Any increase in frequency or severity of claims, or any increases to then-existing reserves, could adversely affect our financial condition and results of operations.  In relation to the 2008 cargo claim reserve, the judgment was partially reversed and the proceedings were remanded to the district court for further factual determinations. If these further proceedings are resolved favorably to us, any reduction of the accrual could reduce insurance and claims expense in the period in which the claim is resolved.  On the other hand, if we are not successful in such a finding or mediation, insurance and claims expense may increase as a result of continuing litigation expenses, including pre and post judgment interest.  We periodically evaluate strategies to efficiently reduce our insurance and claims expense, which in the past has included the commutation of our auto liability insurance policy.  We intend to evaluate our ability to commute the current policy and any such commutation could significantly impact insurance and claims expense.

For the periods presented, the changes in communications and utilities were not significant as either a percentage of total revenue or freight revenue.

 

 

For the year ended December 31, 2016, general supplies and expenses increased approximately $0.4 million, or 2.9%, compared with 2015. As a percentage of total revenue, general supplies and expenses increased to 2.1% of total revenue for the year ended December 31, 2016, from 1.9% in 2015. As a percentage of freight revenue, general supplies and expenses increased to 2.4% of freight revenue for the year ended December 31, 2016, from 2.2% in 2015. These increases are primarily the result of increases in legal costs related to several large cases and an increase in travel due to the turnaround efforts at SRT.

For the year ended December 31, 2015, general supplies and expenses decreased approximately $2.9 million, or 17.4%, compared with 2014. As a percentage of total revenue, general supplies and expenses decreased to 1.9% of total revenue for the year ended December 31, 2015, from 2.4% in 2014. As a percentage of freight revenue, general supplies and expenses decreased to 2.2% of freight revenue for the year ended December 31, 2015, from 2.9% in 2014. These decreases are primarily the result of the approximately $1.2 million reversal of deferred rent expense and reduced building rent expense related to the purchase of our previously leased Chattanooga headquarters property.

Depreciation and amortization consists primarily of depreciation of tractors, trailers and other capital assets offset or increased, as applicable, by gains or losses on dispositions of capital assets.  Depreciation and amortization in 2016 increased $11.1 million, or 18.0%, compared with 2015.  As a percentage of total revenue, depreciation and amortization increased to 10.8% of total revenue for the year ended December 31, 2016 compared to 8.5% for 2015.  As a percentage of freight revenue, depreciation and amortization increased to 11.9% of freight revenue for the year ended December 31, 2016, from 9.6% in 2015. Depreciation, consisting primarily of depreciation of revenue equipment and excluding gains and losses, increased $9.6 million in 2016 from 2015, primarily as a result of more owned equipment and a significant reduction on the value of used tractors resulting in a change to residual values. Losses on the disposal of property and equipment, totaled $0.8 million in 2016, compared to gains of $0.6 million in 2015.

For the year ended December 31, 2015, depreciation and amortization increased $15.0 million, or 32.3%, compared with 2014.  As a percentage of total revenue, depreciation and amortization increased to 8.5% of total revenue for the year ended December 31, 2015 compared to 6.5% for 2014.  As a percentage of freight revenue, depreciation and amortization increased to 9.6% of freight revenue for the year ended December 31, 2015, from 8.0% in 2014. Depreciation, consisting primarily of depreciation of revenue equipment and excluding gains and losses, increased $13.0 million in 2015 from 2014, primarily as a result of new equipment and an increase in owned tractors of approximately 500 due to a reduction in use of operating leases to finance revenue equipment. Gains on the disposal of property and equipment, totaling $0.6 million in 2015, were $2.0 million lower than 2014 due to the number, type, and mileage of the equipment sold.  Additionally, depreciation increased and gains on the disposal of property and equipment decreased as a result of the softening of the used tractor market during the latter portion of the year.

We expect to see an increase in depreciation and amortization going forward, specifically as compared to the first and second quarters of 2016, as we continue to recognize the impact of the significant reductions in residual values, which should lessen on a comparative basis in the third quarter of 2017. Additionally, if the used tractor market were to decline further, we could have to adjust residual values again and increase depreciation or experience increased losses on sale.

 

 

Interest expense, net includes interest expense, interest income, and other miscellaneous non-operating items, which decreased approximately $0.2 million, or 2.6%, for the year ended December 31, 2016, compared with 2015.  As a percentage of total revenue, other expense, net remained flat with 2015 at 1.2% for the years ended December 31, 2016 and 2015.  As a percentage of freight revenue, other expense, net remained flat at 1.3% of freight revenue for the years ended December 31, 2016 and 2015. The dollar decrease is primarily the result of the decrease in debt at a lower average interest rate.

Interest expense, net, decreased approximately $2.3 million, or 21.8%, for the year ended December 31, 2015, compared with 2014.  As a percentage of total revenue, other expense, net remained relatively even with 2014 at 1.2% for the year ended December 31, 2015 compared to 1.5% for the year ended December 31, 2014.  As a percentage of freight revenue, other expense, net decreased to 1.3% of freight revenue for the year ended December 31, 2015 from 1.9% for the year ended December 31, 2014. These decreases are primarily the result of the repayments of debt and capital leases from the proceeds of our late November 2014 follow-on stock offering partially offset by the increase in debt at a lower average interest rate related to the August 2015 purchase of our corporate headquarters.

This line item will fluctuate based on our decision with respect to purchasing revenue equipment with balance sheet debt versus operating leases as well as our ability to continue to generate profitable results and reduce our leverage.

We have accounted for our investment in TEL using the equity method of accounting and thus our financial results include our proportionate share of TEL's net income. For the year ended December 31, 2015, the increase in TEL's contributions to our results was due to their growth in both leasing and tractor sales. Given TEL's growth during the three years preceding 2015 and volatility in the used and leased equipment markets in which TEL operates, including the recent softening of the used tractor market, the impact on our earnings resulting from our investment and TEL's profitability was more moderate in 2016.  Given the decline in the used and leased equipment markets in which TEL operates, we expect the impact on our earnings resulting from our investment in TEL to moderate over the next twelve months.

Income tax expense decreased approximately $11.4 million, or 52.4%, for the year ended December 31, 2016, compared with 2015.  As a percentage of total revenue, income tax expense decreased to 1.5% of total revenue for 2016 from 3.0% in 2015.  As a percentage of freight revenue, income tax expense decreased to 1.7% of freight revenue for 2016 compared to 3.4% in 2015. These decreases were primarily related to the $36.7 million decrease in pre-tax income in 2016 compared to 2015 resulting from the declines in operating income noted above, the decrease in the contribution from TEL's earnings, and the large non-recurring tax credit in fiscal year 2015.

Income tax expense increased approximately $7.0 million, or 47.7%, for the year ended December 31, 2015, compared with 2014.  As a percentage of total revenue, income tax expense increased to 3.0% of total revenue for 2015 from 2.1% in 2014.  As a percentage of freight revenue, income tax expense increased to 3.4% of freight revenue for 2015 compared to 2.6% in 2014. These increases were primarily related to the $31.3 million increase in the pre-tax income in 2015 compared to 2014 resulting from the improvements in operating income noted above, a one-time federal income tax credit of approximately $4.7 million, and the increase in the contribution from TEL's earnings.

 

 

The effective tax rate is different from the expected combined tax rate due primarily to permanent differences related to our per diem pay structure for drivers. Due to the partial nondeductible effect of the per diem payments, our tax rate will fluctuate in future periods as income fluctuates.

We have one reportable segment, truckload services, which we refer to as Truckload. In addition, our Solutions subsidiary has service offerings ancillary to our Truckload services, including: freight brokerage and logistics service directly and through freight brokerage agents who are paid a commission for the freight they provide and accounts receivable factoring. These operations consist of several operating segments, which neither individually nor in the aggregate meet the quantitative or qualitative reporting thresholds. As a result, these operations are grouped in "Other."  The operation of each of these businesses is described in our notes to Item 1 of Part 1 of this Annual Report on Form 10-K.

"Unallocated Corporate Overhead" includes costs that are incidental to our activities and are not specifically allocated to one of the segments. The following table summarizes financial and operating data by segment:

Comparison of Year Ended December 31, 2016 to Year Ended December 31, 2015

Our Truckload revenue decreased $54.7 million, as freight revenue decreased $30.4 million and fuel surcharge revenue decreased $24.3 million. The decrease in freight revenue relates to a decrease in average freight revenue per tractor per week of 2.2% compared to 2016, partially offset by a $1.7 million increase in freight revenue contributed by our temperature-controlled intermodal service offering, as well as a decrease in our average tractor fleet of 3.9% from 2015. The decrease in average freight revenue per tractor per week is the result of a 1.3% decrease, or 2.2 cents per mile, in average rate per total mile and a 0.6% decrease in average miles per unit when compared to 2015.  Additionally, team driven units increased approximately 5.3% to an average of approximately 1,000 teams in 2016 compared to approximately 950 in 2015.

Our Truckload operating income was $37.1 million less in 2016 than 2015 due to the abovementioned decrease in freight revenue.  Additionally, operating costs per mile, net of fuel surcharge revenue, increased primarily due to increased salaries, wages, and related expenses (which was primarily due to a higher percentage of our fleet being comprised of team-driven tractors, as well as driver and non-driver employee pay increases since the same 2015 period), increased net fuel expense, and increased capital costs, partially offset by reduced workers’ compensation expense and operations and maintenance expense.

Other total revenue increased $1.1 million in 2016 compared to 2015 and operating income increased $1.9 million for the same period. These improvements are primarily the result of improved coordination with our Truckload segment, additional business from new customers added during the year, and the full year effect of a large customer added in 2015.

 

 

Unallocated corporate overhead remained relatively flat as a result of a $3.2 million reduction in incentive compensation in 2016, primarily as a result of decreased profitability, partially offset by the 2015 period including the $3.6 million in return of previously expensed insurance premiums for the commutation of our primary auto liability policy for the period of April 1, 2013, through September 30, 2014.

Comparison of Year Ended December 31, 2015 to Year Ended December 31, 2014

Our Truckload revenue decreased $7.1 million, as freight revenue increased $49.6 million and fuel surcharge revenue decreased $56.7 million. The increase in freight revenue relates to an increase in average freight revenue per tractor per week of 5.0% compared to 2014 and a $4.6 million increase in freight revenue contributed by our temperature-controlled intermodal service offering, as well as an increase in our average tractor fleet of 3.5% from 2014. The increase in average freight revenue per tractor per week is the result of a 5.7% increase, or 9.1 cents per mile, in average rate per total mile partially offset by a 0.6% decrease in average miles per unit when compared to 2014.  Additionally, team driven units increased approximately 13.6% to an average of approximately 950 teams in 2015 compared to approximately 840 in 2014.

Our Truckload operating income was $20.0 million higher in 2015 than 2014 due to the abovementioned increase in freight revenue.  Additionally, operating costs per mile, net of fuel surcharge revenue, decreased primarily due to reduced workers’ compensation expense and operations and maintenance expense partially offset by increased salaries, wages, and related expenses (which was primarily due to a higher percentage of our fleet being comprised of team-driven tractors, as well as driver and nondriver employee pay increases since the same 2014 period), increased net fuel expense, and increased capital costs.

Other total revenue increased $12.3 million in 2015 compared to 2014 and operating income increased $1.9 million for the same period. These improvements are primarily the result of additional peak season freight opportunities during the fourth quarter of 2015, improved coordination with our Truckload segment, and additional business from new customers added during the year.

The reduction in unallocated corporate overhead primarily includes $3.6 million in return of previously expensed insurance premiums for the commutation of our primary auto liability policy for the period of April 1, 2013, through September 30, 2014, and the $1.4 million reduction in fuel expense related to the ineffective fuel hedge contracts fulfilled in 2015 that were deemed to be ineffective on a prospective basis in 2014.

LIQUIDITY AND CAPITAL RESOURCES

Our business requires significant capital investments over the short-term and the long-term.  Recently, we have financed our capital requirements with borrowings under our Credit Facility, cash flows from operations, long-term operating leases, capital leases, secured installment notes with finance companies, and proceeds from the sale of our used revenue equipment. We had working capital (total current assets less total current liabilities) of $47.9 million and $46.6 million at December 31, 2016 and 2015, respectively.  Based on our expected financial condition, net capital expenditures, results of operations, related net cash flows, installment notes, and other sources of financing, we believe our working capital and sources of liquidity will be adequate to meet our current and projected needs and we do not expect to experience material liquidity constraints in the foreseeable future.

As of December 31, 2016, we had $12.2 million of borrowings outstanding, undrawn letters of credit outstanding of approximately $27.2 million, and available borrowing capacity of $55.6 million under the Credit Facility.  Fluctuations in the outstanding balance and related availability under our Credit Facility are driven primarily by cash flows from operations and the timing and nature of property and equipment additions that are not funded through notes payable, as well as the nature and timing of collection of accounts receivable, payments of accrued expenses, and receipt of proceeds from disposals of property and equipment.

With an average tractor fleet age of 1.8 years, we believe we have flexibility to manage our fleet and we plan to regularly evaluate our tractor replacement cycle, new tractor purchase requirements, and financing options.

Cash Flows

Net cash flows provided by operating activities were $102.4 million in 2016 compared with $85.5 million in 2015 primarily due to the change in receivables and advances as a result of increased cash collected during 2016 related to increased 2015 year-end revenues, and the fluctuation in tax benefit/expense due to the reversal of deferred tax effects on amounts in other comprehensive income.  This improvement is partially offset by net income of $16.8 million in 2016 compared to net income of $42.1 million in 2015, depreciation and amortization increasing $9.6 million in 2016, primarily as the result of the reduced residual revenue equipment value projections due to the softened used equipment market and the 2015 purchase of our previously leased Chattanooga headquarters property, and the 2015 return of $5.0 million which was previously provided by us to certain of our derivative counterparties related to the net liability position of certain of our fuel derivative instruments.  The fluctuations in cash flows from accounts payable and accrued expenses primarily related to the timing of payments on our accrued expenses and trade accounts in the 2016 period compared to the 2015 period.

 

 

Net cash flows used by investing activities were $47.3 million in 2016 compared with $147.7 million in 2015.  The $100.4 million decrease in net investing activities was attributable primarily to the purchase of our corporate headquarters property in Chattanooga, Tennessee during 2015 for approximately $35.5 million, as well as a $22.9 million decrease in assets held for sale due to the timing of dispositions of used revenue equipment.  During 2017 we plan to take delivery of approximately 485 new company tractors and dispose of approximately 460 used tractors.  This compares to the approximately 650 new company tractors we took delivery of and the approximately 1,074 used tractors we disposed of during 2016, including 365 recorded as assets held for sale at December 31, 2015.  Going forward, cash flows from disposals of equipment could be more volatile given the weakness in the used tractor market.

Net cash flows used in financing activities were $51.9 million in 2016, compared with net cash flows provided by financing activities of $45.4 million in 2015.  The change in net cash flows used in financing activities was primarily a function of net repayments of notes payable and the balance under our Credit Facility.  These changes primarily relate to the trade cycle of our revenue equipment, including the impact of deferring receipt of proceeds of 350 tractors held for sale that were under contract to be sold in the first quarter of 2016, and cash flows from investing and operating activities discussed above.  Going forward, our cash flows may fluctuate depending on the resolution of the 2008 cargo claim, future stock repurchases, and the extent of future income tax obligations.

Material Debt Agreements

We and substantially all of our subsidiaries (collectively, the "Borrowers") are parties to a Third Amended and Restated Credit Facility (the "Credit Facility") with Bank of America, N.A., as agent (the "Agent") and JPMorgan Chase Bank, N.A. ("JPM," and together with the Agent, the "Lenders").

The Credit Facility is a $95.0 million revolving credit facility, with an uncommitted accordion feature that, so long as no event of default exists, allows us to request an increase in the revolving credit facility of up to $50.0 million, subject to Lender acceptance of the additional funding commitment.  The Credit Facility includes, within our $95.0 million revolving credit facility, a letter of credit sub facility in an aggregate amount of $95.0 million and a swing line sub facility in an aggregate amount equal to the greater of $10.0 million or 10% of the Lenders' aggregate commitments under the Credit Facility from time-to-time.

In 2015, we entered into an eleventh amendment to the Credit Facility, which, among other things, (i) amended the "Applicable Margin" to improve the interest rate grid, (ii) improved the unused line fee pricing to 0.25% per annum, retroactive to July 1, 2015 (previously the fee was 0.375% per annum when availability was less than $50.0 million and 0.5% per annum when availability was at or over such amount), (iii) required each of Driven Analytic Solutions, LLC ("DAS") and Covenant Properties, LLC ("CPI") to be joined to the Credit Agreement as guarantors, (iv) required each of DAS, CPI and Star Properties Exchange, LLC, a Tennessee limited liability company, to pledge certain of its assets as security, (v) contained conditional amendments increasing the borrowing base real estate sublimit and lowering the amortization of the real estate sublimit, (vi) made technical amendments to a variety of sections, including without limitation, permitted investments, permitted stock repurchases, permitted indebtedness, and permitted liens, (vii) consented to our purchase of our headquarters, including related financing, and (viii) extended the maturity date from September 2017 to September 2018.  In exchange for these amendments, we agreed to pay fees of $0.2 million. In 2016, we entered into the twelfth and thirteenth amendments to the Credit Facility, which among other things (i) increases the approved amount for share repurchases to $45.0 million, subject to certain limitations based on the available borrowing capacity under the Credit Facility, and (ii) permitted the formation of Heritage Insurance, Inc., and substituted certain language to ensure the federal funds rate or LIBOR would not be less than zero.

Borrowings under the Credit Facility are classified as either "base rate loans" or "LIBOR loans."  Base rate loans accrue interest at a base rate equal to the greater of the Agent’s prime rate, the federal funds rate plus 0.5%, or LIBOR plus 1.0%, plus an applicable margin ranging from 0.5% to 1.0%; while LIBOR loans accrue interest at LIBOR, plus an applicable margin ranging from 1.5% to 2.0%.  The applicable rates are adjusted quarterly based on average pricing availability.  The unused line fee is the product of 0.25% times the average daily amount by which the Lenders' aggregate revolving commitments under the Credit Facility exceed the outstanding principal amount of revolver loans and the aggregate undrawn amount of all outstanding letters of credit issued under the Credit Facility.  The obligations under the Credit Facility are guaranteed by us and secured by a pledge of substantially all of our assets, with the notable exclusion of any real estate or revenue equipment pledged under other financing agreements, including revenue equipment installment notes and capital leases.

 

 

Borrowings under the Credit Facility are subject to a borrowing base limited to the lesser of (A) $95.0 million, minus the sum of the stated amount of all outstanding letters of credit; or (B) the sum of (i) 85% of eligible accounts receivable, plus (ii) the lesser of (a) 85% of the appraised net orderly liquidation value of eligible revenue equipment, (b) 95% of the net book value of eligible revenue equipment, or (c) 35% of the Lenders' aggregate revolving commitments under the Credit Facility, plus (iii) the lesser of (a) $25.0 million or (b) 65% of the appraised fair market value of eligible real estate.  We had $12.2 million of borrowings outstanding under the Credit Facility as of December 31, 2016, undrawn letters of credit outstanding of approximately $27.2 million, and available borrowing capacity of $55.6 million.  The interest rate on outstanding borrowings as of December 31, 2016, was 2.3% on $9.0 million of base rate loans and 4.3% on $3.2 million of LIBOR loans. Based on availability as of December 31, 2016 and 2015, there was no fixed charge coverage requirement.

The Credit Facility includes usual and customary events of default for a facility of this nature and provides that, upon the occurrence and continuation of an event of default, payment of all amounts payable under the Credit Facility may be accelerated, and the Lenders' commitments may be terminated.  If an event of default occurs under the Credit Facility and the Lenders cause all of the outstanding debt obligations under the Credit Facility to become due and payable, this could result in a default under other debt instruments that contain acceleration or cross-default provisions. The Credit Facility contains certain restrictions and covenants relating to, among other things, debt, dividends, liens, acquisitions and dispositions outside of the ordinary course of business, and affiliate transactions.  Failure to comply with the covenants and restrictions set forth in the Credit Facility could result in an event of default.

Capital lease obligations are utilized to finance a portion of our revenue equipment and are entered into with certain finance companies who are not parties to our Credit Facility.  The leases in effect at December 31, 2016 terminate in January 2017 through December 2022 and contain guarantees of the residual value of the related equipment by us. As such, the residual guarantees are included in the related debt balance as a balloon payment at the end of the related term as well as included in the future minimum capital lease payments. These lease agreements require us to pay personal property taxes, maintenance, and operating expenses.

Pricing for the revenue equipment installment notes is quoted by the respective financial affiliates of our primary revenue equipment suppliers and other lenders at the funding of each group of equipment acquired and include fixed annual rates for new equipment under retail installment contracts. The notes included in the funding are due in monthly installments with final maturities at various dates ranging from January 2017 to January 2022. The notes contain certain requirements regarding payment, insuring of collateral, and other matters, but do not have any financial or other material covenants or events of default except certain notes totaling $166.1 million are cross-defaulted with the Credit Facility. Additionally, certain of our fuel hedge contracts totaling $3.6 million at December 31, 2016, are cross-defaulted with the Credit Facility.  Additional borrowings from the financial affiliates of our primary revenue equipment suppliers and other lenders are expected to be available to fund new tractors expected to be delivered in 2017, while any other property and equipment purchases, including trailers, are expected to be funded with a combination of available cash, notes, operating leases, capital leases, and/or from the Credit Facility.

In August 2015, we financed a portion of the purchase of our corporate headquarters, a maintenance facility, and certain surrounding property in Chattanooga, Tennessee by entering into a $28.0 million variable rate note with a third party lender.  Concurrently with entering into the note, we entered into an interest rate swap to effectively fix the related interest rate to 4.2%. See Note 13 for further information about the interest rate swap.

 

 

Contractual Obligations and Commercial Commitments

The following table sets forth our contractual cash obligations and commitments as of December 31, 2016:

Off-Balance Sheet Arrangements

Operating leases are an important source of financing for our revenue equipment and certain real estate.  At December 31, 2016, we had financed 135 tractors and 1,695 trailers under operating leases. Vehicles held under operating leases are not carried on our consolidated balance sheets, and lease payments, in respect of such vehicles, are reflected in our consolidated statements of operations in the line item "Revenue equipment rentals and purchased transportation."  Our revenue equipment rental expense was $10.6 million in 2016, compared with $12.4 million in 2015. The total value of remaining payments under operating leases as of December 31, 2016, was approximately $17.5 million. In connection with various operating leases, we issued residual value guarantees, which provide that if we do not purchase the leased equipment from the lessor at the end of the lease term, we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the equipment and an agreed value. The residual guarantees expire between August 2018 and February 2019 and had an undiscounted value of approximately $4.0 million at December 31, 2016.  The discounted present value of the total remaining lease payments and residual value guarantees were approximately $18.7 million at December 31, 2016.  We expect our residual guarantees to approximate the market value at the end of the lease term. We believe that proceeds from the sale of equipment under operating leases would equal or exceed the payment obligation on substantially all operating leases.

 

 

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires us to make decisions based upon estimates, assumptions, and factors we consider as relevant to the circumstances. Such decisions include the selection of applicable accounting principles and the use of judgment in their application, the results of which impact reported amounts and disclosures. Changes in future economic conditions or other business circumstances may affect the outcomes of our estimates and assumptions. Accordingly, actual results could differ from those anticipated. A summary of the significant accounting policies followed in preparation of the financial statements is contained in Note 1, "Summary of Significant Accounting Policies," of the consolidated financial statements attached hereto. The following discussion addresses our most critical accounting policies, which are those that are both important to the portrayal of our financial condition and results of operations and that require significant judgment or use of complex estimates.

Revenue Recognition

Revenue, drivers' wages, and other direct operating expenses generated by our Truckload reportable segment are recognized on the date shipments are delivered to the customer. Revenue includes transportation revenue, fuel surcharges, loading and unloading activities, equipment detention, and other accessorial services.

Revenue generated by our Solutions subsidiary is recognized upon completion of the services provided.  Revenue is recorded on a gross basis, without deducting third party purchased transportation costs, as we act as a principal with substantial risks as primary obligor, except for transactions whereby equipment from our Truckload segment perform the related services, which we record on a net basis in accordance with the related authoritative guidance. Solutions revenue includes $2.6 million, $2.4 million, and $2.3 million of revenue in 2016, 2015, and 2014, respectively, related to an accounts receivable factoring business. Revenue for this business is recognized on a net basis, given we are acting as an agent and are not the primary obligor in these transactions.

Depreciation of Revenue Equipment

Property and equipment is stated at cost less accumulated depreciation. Depreciation for book purposes is determined using the straight-line method over the estimated useful lives of the assets, while depreciation for tax purposes is generally recorded using an accelerated method. Depreciation of revenue equipment is our largest item of depreciation. We generally depreciate new tractors (excluding day cabs) over five years to salvage values of approximately 15% of their cost and new trailers over seven years for refrigerated trailers and ten years for dry van trailers to salvage values of approximately 25% of their cost. We annually review the reasonableness of our estimates regarding useful lives and salvage values of our revenue equipment and other long-lived assets based upon, among other things, our experience with similar assets, conditions in the used revenue equipment market, and prevailing industry practice. Over the past several years, the price of new tractors has risen dramatically and there has been significant volatility in the used equipment market.  As a result of the progressive decline in the market value of used tractors and our expectations that used tractor prices will not rebound in the near term, effective July 1, 2016 we reduced the salvage values on our tractors and, thus, prospectively increased depreciation expense. Estimates around the salvage values and useful lives for trailers remain unchanged. The impact in the third and fourth quarters of 2016 is approximately $2.0 million of additional depreciation expense per quarter or approximately $1.2 million per quarter net of tax, which represents approximately $0.06 per common or diluted share. Based on the prospective nature of this change, we expect depreciation and expense, including gains and losses, to approximate those levels of the third and fourth quarters of 2016.  Changes in the useful life or salvage value estimates, or fluctuations in market values that are not reflected in our estimates, could have a material effect on our results of operations. Gains and losses on the disposal of revenue equipment are included in depreciation expense in the consolidated statements of operations.

In 2016 we had a net loss on revenue equipment of $0.8 million, and in 2015 and 2014 we generated net gains on revenue equipment, including assets held for sale, of $0.6 million and $2.7 million, respectively.  We review salvage values of our revenue equipment annually and make adjustments periodically, based on trends in the used equipment market, to reflect updated estimates of fair value at disposal.

We lease certain revenue equipment under capital leases with terms of approximately 60 to 84 months. Amortization of leased assets is included in depreciation and amortization expense.

Pursuant to applicable accounting standards, revenue equipment and other long-lived assets are tested for impairment whenever an event occurs that indicates impairment may exist. Expected future cash flows are used to analyze whether an impairment has occurred. If the sum of expected undiscounted cash flows is less than the carrying value of the long-lived asset, then an impairment loss is recognized. We measure the impairment loss by comparing the fair value of the asset to its carrying value. Fair value is determined based on a discounted cash flow analysis or the appraised value of the assets, as appropriate.

 

 

Although a portion of our tractors are protected by non-binding indicative trade-in values or binding trade-back agreements with the manufacturers, some tractors and substantially all of our owned trailers continue to be subject to fluctuations in market prices for used revenue equipment. Moreover, our trade-back agreements are contingent upon reaching acceptable terms for the purchase of new equipment. Further declines in the price of used revenue equipment or failure to reach agreement for the purchase of new tractors with the manufacturers issuing trade-back agreements could result in impairment of, or losses on the sale of, revenue equipment. Historically, only a de minimus percentage of our equipment has been sold back to the dealers pursuant to the trade back agreements as we have generally found that market prices exceeded the trade back allowances, although in recent years, trade back allowances have increased as a result of the increasing cost of the underlying equipment.

Assets Held For Sale

Assets held for sale include property and revenue equipment no longer utilized in continuing operations which are available and held for sale. Assets held for sale are no longer subject to depreciation, and are recorded at the lower of depreciated book value or fair market value less selling costs. We periodically review the carrying value of these assets for possible impairment. We expect to sell these assets within twelve months.

Goodwill and Other Intangible Assets

We classify intangible assets into two categories: (i) intangible assets with definite lives subject to amortization and (ii) goodwill. We have no goodwill on our consolidated balance sheet for the years ended December 31, 2016 and 2015.  We test intangible assets with definite lives for impairment if conditions exist that indicate the carrying value may not be recoverable. Such conditions may include an economic downturn in a geographic market or a change in the assessment of future operations. We record an impairment charge when the carrying value of the definite lived intangible asset is not recoverable by the cash flows generated from the use of the asset.

We determine the useful lives of our identifiable intangible assets after considering the specific facts and circumstances related to each intangible asset. Factors we consider when determining useful lives include the contractual term of any agreement, the history of the asset, our long-term strategy for the use of the asset, any laws or other local regulations which could impact the useful life of the asset, and other economic factors, including competition and specific market conditions. Intangible assets that are deemed to have definite lives are amortized, generally on a straight-line basis, over their useful lives, ranging from 4 to 20 years. We have no identifiable intangible assets on our consolidated balance sheet at December 31, 2016, and $0.2 million at December 31, 2015, which was recorded in other assets.

Insurance and Other Claims

The primary claims arising against us consist of auto liability (personal injury and property damage), workers' compensation, cargo, commercial liability, and employee medical expenses. Our insurance program involves self-insurance with the following risk retention levels (before giving effect to any commutation of an auto liability policy):

Due to our significant self-insured retention amounts, we have exposure to fluctuations in the number and severity of claims and to variations between our estimated and actual ultimate payouts. We accrue the estimated cost of the uninsured portion of pending claims and an estimate for allocated loss adjustment expenses including legal and other direct costs associated with a claim. Estimates require judgments concerning the nature and severity of the claim, historical trends, advice from third-party administrators and insurers, the size of any potential damage award based on factors such as the specific facts of individual cases, the jurisdictions involved, the prospect of punitive damages, future medical costs, and inflation estimates of future claims development, and the legal and other costs to settle or defend the claims. We have significant exposure to fluctuations in the number and severity of claims. If there is an increase in the frequency and severity of claims, or we are required to accrue or pay additional amounts if the claims prove to be more severe than originally assessed, or any of the claims would exceed the limits of our insurance coverage, our profitability could be adversely affected.

 

 

In addition to estimates within our self-insured retention layers, we also must make judgments concerning claims where we have third party insurance and for claims outside our coverage limits. Upon settling claims and expenses associated with claims where we have third party coverage, we are generally required to initially fund payment to the claimant and seek reimbursement from the insurer. Receivables from insurers for claims and expenses we have paid on behalf of insurers were $0.7 million and $0.1 million at December 31, 2016 and 2015, respectively, and are included in drivers' advances and other receivables on our consolidated balance sheet. Additionally, we accrue claims above our self-insured retention and record a corresponding receivable for amounts we expect to collect from insurers upon settlement of such claims. We have less than $0.1 million and $0.6 million at December 31, 2016 and 2015, respectively, as a receivable in other assets and as a corresponding accrual in the long-term portion of insurance and claims accruals on our consolidated balance sheet for claims above our self-insured retention for which we believe it is reasonably assured that the insurers will provide their portion of such claims. We evaluate collectability of the receivables based on the credit worthiness and surplus of the insurers, along with our prior experience and contractual terms with each. If any claim occurrence were to exceed our aggregate coverage limits, we would have to accrue for the excess amount. Our critical estimates include evaluating whether a claim may exceed such limits and, if so, by how much. If one or more claims were to exceed our then effective coverage limits, our financial condition and results of operations could be materially and adversely affected.

We also make judgments regarding the ultimate benefit versus risk to commuting certain periods within our auto liability policy.  If we commute a policy, we assume 100% risk for covered claims in exchange for a policy refund. In April 2015, we commuted two liability policies for the period from April 1, 2013 through September 30, 2014, such that we are now responsible for any claim that occurred during that period up to $20.0 million, should such a claim develop.  We recorded a $3.6 million reduction in insurance and claims expense in the second quarter of 2015 related to the commutation. The insurer did not remit the premium refund directly to the Company, but rather applied a credit to the current auto liability insurance policy, such that we recorded the policy release premium refund as a prepaid asset at June 30, 2015.

Effective April 2015, we entered into new auto liability policies with a three-year term. As a result of the commutation and the Company’s improved safety statistics over the prior policy, the Company received favorable premium pricing for the policy period, which we expect will reduce the fixed portion of insurance expense during such period.  The policy includes a limit for a single loss of $9.0 million, an aggregate of $18.0 million for each policy year, and a $30.0 million aggregate for the three-year period ended March 31, 2018. The policy includes a policy release premium refund of up to $13.6 million, less any future amounts paid on claims by the insurer, from October 1, 2014 through March 31, 2018, if we were to commute the policy for the entire three years. A decision with respect to commutation of the policy cannot be made before April 1, 2018, unless both we and the insurance carrier agree to a commutation prior to the end of the policy term. Management cannot predict whether or not future claims or the development of existing claims will justify a commutation, and accordingly, no related amounts were recorded at December 31, 2016.

If claims development factors that are based upon historical experience change by 10%, our claims accrual as of December 31, 2016, would change by approximately $1.1 million.

Lease Accounting and Off-Balance Sheet Transactions

We issue residual value guarantees in connection with the operating leases we enter into for certain of our revenue equipment. These leases provide that if we do not purchase the leased equipment from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the equipment and an agreed value. To the extent the expected value at the lease termination date is lower than the residual value guarantee, we would accrue for the difference over the remaining lease term.  We believe that proceeds from the sale of equipment under operating leases would equal or exceed the payment obligation on substantially all operating leases. The estimated values at lease termination involve management judgments. As leases are entered into, determination as to the classification as an operating or capital lease involves management judgments on residual values and useful lives.

Accounting for Income Taxes

Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We believe the future tax deductions will be realized principally through future reversals of existing taxable temporary differences and future taxable income, except for when a valuation allowance has been provided.

 

 

In the ordinary course of business there is inherent uncertainty in quantifying our income tax positions. We assess our income tax positions and record tax benefits for all years subject to examination based upon management's evaluation of the facts, circumstances, and information available at the reporting dates. For those tax positions where it is more likely than not that a tax benefit will be sustained, we have recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information.  For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. Potential accrued interest and penalties related to unrecognized tax benefits are recognized as a component of income tax expense.

Stock-Based Employee Compensation

We issue several types of stock-based compensation, including awards that vest based on service and performance conditions or a combination of the conditions. Performance-based awards vest contingent upon meeting certain performance criteria established by the Compensation Committee. All awards require future service and thus forfeitures are estimated based on historical forfeitures and the remaining term until the related award vests.  For performance-based awards, determining the appropriate amount to expense in each period is based on likelihood and timing of achieving the stated targets and requires judgment, including forecasting future financial results. The estimates are revised periodically based on the probability and timing of achieving the required performance targets and adjustments are made as appropriate. Awards that are only subject to time vesting provisions are amortized using the straight-line method.

Fair Value of Financial Instruments

Our financial instruments consist primarily of cash and cash equivalents, accounts receivable, commodity contracts, accounts payable, debt, and interest rate swaps. The carrying amount of cash and cash equivalents, accounts receivable, accounts payable, and current debt approximates their fair value because of the short-term maturity of these instruments. The carrying value of the factored receivables approximates the fair value, as the receivables are generally repaid directly to us by the client's customer within 30-40 days due to the combination of the short-term nature of the financing transaction and the underlying quality of the receivables. Interest rates that are currently available to us for issuance of long-term debt with similar terms and remaining maturities are used to estimate the fair value of our long-term debt, which primarily consists of revenue equipment installment notes. The fair value of our revenue equipment installment notes approximated the carrying value at December 31, 2016, as the weighted average interest rate on these notes approximates the market rate for similar debt. Borrowings under our revolving Credit Facility approximate fair value due to the variable interest rate on the facility. Additionally, commodity contracts, which are accounted for as hedge derivatives, as discussed in Note 13, are valued based on the forward rate of the specific indices upon which the contract is being settled and adjusted for counterparty credit risk using available market information and valuation methodologies. The fair value of our interest rate swap agreements is determined using the market-standard methodology of netting the discounted future fixed-cash payments and the discounted expected variable-cash receipts. The variable-cash receipts are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves. These analyses reflect the contractual terms of the swap, including the period to maturity, and use observable market-based inputs, including interest rate curves and implied volatilities. The fair value calculation also includes an amount for risk of non-performance of our counterparties using "significant unobservable inputs" such as estimates of current credit spreads to evaluate the likelihood of default, which we have determined to be insignificant to the overall fair value of our interest rate swap agreements.

Derivative Instruments and Hedging Activities

We periodically utilize derivative instruments to manage exposure to changes in fuel prices and interest rates.  At inception of a derivative contract, we document relationships between derivative instruments and hedged items, as well as our risk-management objective and strategy for undertaking various derivative transactions, and assess hedge effectiveness.  We record derivative financial instruments in the balance sheet as either an asset or liability at fair value.  If it is determined that a derivative is not highly effective as a hedge, or if a derivative ceases to be a highly effective hedge, we discontinue hedge accounting prospectively. The effective portion of changes in the fair value of derivatives are recorded in other comprehensive income and reclassified into earnings in the same period during which the hedged transaction affects earnings. The ineffective portion is recorded in other income or expense.

 

 

Recent Accounting Pronouncements

Accounting Standards adopted

In April 2015, the Financial Accounting Standards Board ("FASB") issued ASU 2015-03, and in August 2015, issued ASU 2015-15.  These ASUs require debt issuance costs related to a recognized debt liability to be presented in the balance sheet as a direct deduction from the carrying amount of that debt consistent with debt discounts.  The presentation and subsequent measurement of debt issuance costs associated with lines of credit, may be presented as an asset and amortized ratably over the term of the line of credit arrangement, regardless of whether there are outstanding borrowings on the arrangement.  The recognition and measurement guidance for debt issuance costs are not affected by these ASUs.  These ASUs are effective for financial statements issued for fiscal years beginning after December 15, 2015 and interim periods within those years with early adoption permitted.  We have adopted this standard for the fiscal year 2016.

In March 2016, the FASB issued ASU 2016-09, which changes the accounting for certain aspects of share-based payments to employees.  The guidance requires the recognition of the income tax effects of awards in the income statement when the awards vest or are settled, thus eliminating additional paid-in-capital pools.  The guidance also allows for the employer to repurchase more of an employee’s shares for tax withholding purposes without triggering liability accounting.  In addition, the guidance is effective in 2017 with early adoption permitted.  We have adopted this standard effective for the fiscal year 2016 resulting in the recording of $2.2 million to retained earnings as of the beginning of 2016, and $1.1 million of additional income tax benefit in 2016 as a result of previously unrecognized tax benefits resulting from our net operating loss carryovers.  The statement of cash flows has not been adjusted for prior periods, as we have adopted the statement of cash flow guidance prospectively.

Accounting Standards not yet adopted

In April 2015, the FASB issued ASU 2015-14, which defers the effective date of ASU 2014-09.  The new standard introduces a five-step model to determine when and how revenue is recognized.  The premise of the new model is that an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  The new standard will be effective for the Company for its annual reporting period beginning January 1, 2018, including interim periods within that reporting period.  Early application is permitted for annual periods beginning January 1, 2017.  Entities are allowed to transition to the new standard by either recasting prior periods or recognizing the cumulative effect.  We are in the process of evaluating the new standard, but we believe our revenue recognized under the new standard will generally approximate revenue under current standards and, while we expect an impact to both revenue and certain variable expenses as a result of the adoption, we expect that the net impact to equity or earnings on a prospective basis will not be material.  We plan to complete our evaluation in 2017, including an assessment of the new expanded disclosure requirements and a final determination of the transition method we will use to adopt the new standard.

In February 2016, the FASB issued ASU 2016-02, which requires lessees to recognize a right-to-use asset and a lease obligation for all leases.  Lessees are permitted to make an accounting policy election to not recognize an asset and liability for leases with a term of twelve months or less.  Lessor accounting under the new standard is substantially unchanged.  Additional qualitative and quantitative disclosures, including significant judgments made by management, will be required.  This new standard will become effective for us in our annual reporting period beginning January 1, 2019, including interim periods within that reporting period and requires a modified retrospective transition approach.  We are currently evaluating the impacts the adoption of this standard will have on the consolidated financial statements.

INFLATION, NEW EMISSIONS CONTROL REGULATIONS, AND FUEL COSTS

Most of our operating expenses are inflation-sensitive, with inflation generally producing increased costs of operations. During the past five years, the most significant effects of inflation have been on revenue equipment prices and the related depreciation, health care, and driver and non-driver wages.  New emissions control regulations and increases in wages of manufacturing workers and other items have resulted in higher tractor prices, while the decline in the market value of used equipment significantly reduced the residual values of units in fiscal 2015 and 2016.  The cost of fuel has been extremely volatile over the last several years, with costs decreasing significantly in both 2016 and 2015 after trending upward in 2010 through 2014. We believe at least some of this volatility reflects the fluctuations in the U.S. dollar and global demand for petroleum products, unrest in certain oil-producing countries, improved fuel efficiency due to technological advancements, and an increase in domestic supply.  Health care prices have increased faster than general inflation, primarily due to the rapid increase in prescription drug costs and more people on our health plan in order to comply with the individual healthcare mandate.  The nationwide shortage of qualified drivers has caused us to raise driver wages per mile at a rate faster than general inflation for the past four years, and this trend may continue as additional government regulations constrain industry capacity. Additionally, competition and the related cost to employ non-drivers have increased, especially for the more skilled or technical positions, including mechanics, those with information technology related skills, and degreed professionals.

 

 

SEASONALITY

Over the past three years, we have experienced marked surges in business and profitability during the fourth quarter holiday season, due to our team drivers and customer base. After this surge, revenue generally decreases as customers reduce shipments following the holiday season and as inclement weather impedes operations. At the same time, operating expenses generally increase, with fuel efficiency declining because of engine idling and weather, creating more physical damage equipment repairs. For the reasons stated, first quarter results historically have been lower than results in each of the other three quarters of the year, excluding charges.  In recent years, we have seen the duration of the fourth quarter holiday "peak" season become compressed as consumers have come to expect shorter and shorter shipping times and our customers’ networks have adjusted accordingly.  If this trend continues, our ability to take advantage of this surge in business and our fourth quarter profitability could be negatively affected.

ITEM 7A.          QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We experience various market risks, including changes in interest rates and fuel prices.  We do not enter into derivatives or other financial instruments for trading or speculative purposes, or when there are no underlying related exposures. Because our operations are mostly confined to the United States, we are not subject to a material amount of foreign currency risk.

COMMODITY PRICE RISK

We engage in activities that expose us to market risks, including the effects of changes in fuel prices and in interest rates.  Financial exposures are evaluated as an integral part of our risk management program, which seeks, from time-to-time, to reduce the potentially adverse effects that the volatility of fuel markets and interest rate risk may have on operating results.

In an effort to seek to reduce the variability of the ultimate cash flows associated with fluctuations in diesel fuel prices, we periodically enter into various derivative instruments, including forward futures swap contracts (which we refer to as "fuel hedging contracts").  Historically diesel fuel has not been a traded commodity on the futures market so heating oil has been used as a substitute, as prices for both generally move in similar directions.  Recently, however, we have been able to enter into hedging contracts with respect to both heating oil and ULSD. Under these contracts, we pay a fixed rate per gallon of heating oil or ULSD and receive the monthly average price of New York heating oil per the NYMEX and Gulf Coast ULSD, respectively. The retrospective and prospective regression analyses provided that changes in the prices of diesel fuel and heating oil and diesel fuel and ULSD were each deemed to be highly effective based on the relevant authoritative guidance except for a small portion of our hedging contracts, which we determined to be ineffective on a prospective basis in 2014 and 2015.  Consequently, we recognized a reduction in fuel expense of $1.4 million in 2015 to mark the related liability to market. At December 31, 2016 and 2015, there were no remaining ineffective fuel hedge contracts and, thus, all remaining fuel hedge contracts continue to qualify as cash flow hedges.  We do not engage in speculative transactions, nor do we hold or issue financial instruments for trading purposes.

A one dollar increase in the price of heating oil or diesel per gallon would decrease our net income by $1.3 million. This sensitivity analysis considers that we expect to purchase approximately 45.6 million gallons of diesel annually, with an assumed fuel surcharge recovery rate of 68.8% of the cost (which was our fuel surcharge recovery rate during the year ended December 31, 2016).  Assuming our fuel surcharge recovery is consistent, this leaves 14.2 million gallons that are not covered by the natural hedge created by our fuel surcharges.  Because the majority of our fuel hedging contracts were established prior to the recent decline in diesel fuel prices, we have not been able to realize the cost savings resulting from such decline to the same extent we would have had we not entered into our hedging contracts.

INTEREST RATE RISK

In August 2015, we entered into an interest rate swap agreement with a notional amount of $28.0 million, which was designated as a hedge against the variability in future interest payments due on the debt associated with the purchase of our corporate headquarters. The terms of the swap agreement effectively convert the variable rate interest payments on this note to a fixed rate of 4.2% through maturity on August 1, 2035.  In 2016, we also entered into several other interest rate swaps, which were designated to hedge against the variability in future interest rate payments due on rent associated with the purchase of certain trailers.  Because the critical terms of the swap and hedged item coincide, in accordance with the requirements of ASC 815, the change in the fair value of the derivative is expected to exactly offset changes in the expected cash flows due to fluctuations in the LIBOR rate over the term of the debt instrument, and therefore no ongoing assessment of effectiveness is required. The fair value of the swap agreements that were in effect at December 31, 2016 and 2015, of approximately $0.7 million and $1.1 million, respectively, is included in other liabilities in the consolidated balance sheet, and is included in accumulated other comprehensive loss, net of tax. Additionally, $0.6 million and $0.3 million was reclassified from accumulated other comprehensive loss into our results of operations as additional interest expense for the year ended December 31, 2016 and 2015, respectively, related to changes in interest rates during such periods. Based on the amounts in accumulated other comprehensive loss as of December 31, 2016, we expect to reclassify losses of approximately $0.3 million, net of tax, on derivative instruments from accumulated other comprehensive loss into our results of operations during the next twelve months due to changes in interest rates. The amounts actually realized will depend on the fair values as of the date of settlement.

 

 

Our market risk is also affected by changes in interest rates. Historically, we have used a combination of fixed-rate and variable-rate obligations to manage our interest rate exposure. Fixed-rate obligations expose us to the risk that interest rates might fall. Variable-rate obligations expose us to the risk that interest rates might rise. Of our total $215.8 million of debt and capital leases, we had $48.7 million of variable rate debt outstanding at December 31, 2016, including our Credit Facility, a real-estate note and certain equipment notes, of which the real-estate note of $26.8 million was hedged with the interest rate swap agreement noted above at 4.2% and certain of our equipment notes totaling $6.4 million were hedged at a weighted average interest rate of 1.7%. Our earnings would be affected by changes in these short-term interest rates. Risk can be quantified by measuring the financial impact of a near-term adverse increase in short-term interest rates. At our December 31, 2016 level of borrowing, a 1% increase in our applicable rate would reduce annual net income by less than $0.1 million. Our remaining debt is fixed rate debt, and therefore changes in market interest rates do not directly impact our interest expense.

ITEM 8.          FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The consolidated financial statements of Covenant Transportation Group, Inc. and subsidiaries, including the consolidated balance sheets as of December 31, 2016 and 2015, and the related statements of operations, statements of comprehensive income, statements of stockholders' equity, and statements of cash flows for each of the years in the three-year period ended December 31, 2016, together with the related notes, and the report of KPMG LLP, our independent registered public accounting firm as of December 31, 2016 and 2015, and for each of the years in the three year period ended December 31, 2016 are set forth at pages 65 through 92 elsewhere in this report.

ITEM 9.          CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

There has been no change in or disagreement with accountants on accounting or financial disclosure during our two most recent fiscal years.

ITEM 9A.          CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

We have established disclosure controls and procedures to ensure that material information relating to us and our consolidated subsidiaries is made known to the officers who certify our financial reports and to other members of senior management and the Board of Directors.

Based on their evaluation as of December 31, 2016, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Exchange Act) are effective at a reasonable assurance level to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in SEC rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer, as appropriate, to allow timely decisions regarding required disclosure.

Management's Annual Report on Internal Control Over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting.  Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) promulgated under the Exchange Act as a process designed by, or under the supervision of, the principal executive and principal financial officers and effected by the board of directors, management, and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

We have confidence in our internal controls and procedures. Nevertheless, our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure procedures and controls or our internal controls will prevent all errors or intentional fraud. An internal control system, no matter how well-conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of such internal controls are met.  Further, the design of an internal control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. As a result of the inherent limitations in all internal control systems, no evaluation of controls can provide absolute assurance that all our control issues and instances of fraud, if any, have been detected.

Management assessed the effectiveness of our internal control over financial reporting as of December 31, 2016. Management based this assessment on the framework in the Internal Control- Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Tread way Commission.  Based on its assessment, management believes that, as of December 31, 2016, our internal control over financial reporting is effective based on those criteria.

KPMG LLP, the independent registered public accounting firm who audited the Company's Consolidated Financial Statements included in this From 10-K, has issued a report on the Company's internal control over financial reporting which is included herein.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2016, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

ITEM 9B.          OTHER INFORMATION

None.

PART III

ITEM 10.          DIRECTORS, EXECUTIVE OFFICERS, AND CORPORATE GOVERNANCE

We incorporate by reference the information respecting executive officers and directors set forth under the captions "Proposal 1 - Election of Directors", "Corporate Governance – Section 16(a) Beneficial Ownership Reporting Compliance", "Corporate Governance – Our Executive Officers", "Corporate Governance – Code of Conduct and Ethics", and "Corporate Governance – Committees of the Board of Directors – The Audit Committee" in our Proxy Statement for the 2017 annual meeting of stockholders, which will be filed with the Securities and Exchange Commission in accordance with Rule 14a-6 promulgated under the Securities Exchange Act of 1934, as amended (the "Proxy Statement"); provided, that the section entitled "Corporate Governance – Committees of the Board of Directors – The Audit Committee – Report of the Audit Committee" contained in the Proxy Statement is not incorporated by reference.

ITEM 11.          EXECUTIVE COMPENSATION

We incorporate by reference the information set forth under the sections entitled "Executive Compensation", "Corporate Governance – Committees of the Board of Directors – The Compensation Committee – Compensation Committee Interlocks and Insider Participation", and "Corporate Governance – Committees of the Board of Directors – The Compensation Committee – Report of the Compensation Committee" in the Proxy Statement; provided, that the section entitled "Corporate Governance – Committees of the Board of Directors – The Compensation Committee – Report of the Compensation Committee" contained in the Proxy Statement is not incorporated by reference.

ITEM 12.          SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The following table provides certain information, as of December 31, 2016, with respect to our compensation plans and other arrangements under which shares of our Class A common stock are authorized for issuance.

Equity Compensation Plan Information

We incorporate by reference the information set forth under the section entitled "Security Ownership of Certain Beneficial Owners and Management" in the Proxy Statement.

ITEM 13.          CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

We incorporate by reference the information set forth under the sections entitled "Corporate Governance – Board of Directors and Its Committees" and "Certain Relationships and Related Transactions" in the Proxy Statement.

ITEM 14.          PRINCIPAL ACCOUNTING FEES AND SERVICES

We incorporate by reference the information set forth under the section entitled "Relationships with Independent Registered Public Accounting Firm – Principal Accountant Fees and Services" in the Proxy Statement.

PART IV

ITEM 15.          EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

 

 

 

 

References:

ITEM 16.          FORM 10-K SUMMARY

None.

 

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

The Board of Directors and Stockholders

Covenant Transportation Group, Inc.:

We have audited the accompanying consolidated balance sheets of Covenant Transportation Group, Inc. and subsidiaries as of December 31, 2016 and 2015, and the related consolidated statements of operations, comprehensive income, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2016. We also have audited Covenant Transportation Group, Inc.’s internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Covenant Transportation Group Inc.’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Annual Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Covenant Transportation Group, Inc. and subsidiaries as of December 31, 2016 and 2015, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2016, in conformity with U.S. generally accepted accounting principles. Also in our opinion, Covenant Transportation Group, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2016, based on criteria established in Internal Control – Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

/s/ KPMG LLP

Nashville, Tennessee

March 14, 2017