COVENANT LOGISTICS GROUP, INC. - Quarter Report: 2018 September (Form 10-Q)

---

[X]	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

[  ]	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Nevada		88-0320154
(State or other jurisdiction of incorporation		(I.R.S. Employer Identification No.)
or organization)
400 Birmingham Hwy.
Chattanooga, TN		37419
(Address of principal executive offices)		(Zip Code)

Yes [X]

No [   ]

Yes [X]

No [   ]

Large accelerated filer [   ]		Accelerated filer [X]
Non-accelerated filer   [   ]		Smaller reporting company [   ]
		Emerging growth company [   ]

Yes [   ]

No [X]

PART I FINANCIAL INFORMATION
		Page Number
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets as of  September 30, 2018 and December 31, 2017 (unaudited)	3
	Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2018 and 2017 (unaudited)	4
	Condensed Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2018 and 2017 (unaudited)	5
	Condensed Consolidated Statement of Stockholders' Equity for the nine months ended September 30, 2018 (unaudited)	6
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2018 and 2017 (unaudited)	7
	Notes to Condensed Consolidated Financial Statements (unaudited)	8
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	24
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	40
Item 4.	Controls and Procedures	41
PART II OTHER INFORMATION
		Page Number
Item 1.	Legal Proceedings	42
Item 1A.	Risk Factors	42
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	42
Item 3.	Defaults Upon Senior Securities	42
Item 4.	Mine Safety Disclosures	42
Item 5.	Other Information	42
Item 6.	Exhibits	43

COVENANT TRANSPORTATION GROUP, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share data)
ASSETS		September 30, 2018 (unaudited)				December 31, 2017 (unaudited)
Current assets:
Cash and cash equivalents		$	19,612			$	15,356
Accounts receivable, net of allowance of $1,817 in 2018 and $1,460 in 2017			134,957				104,153
Drivers' advances and other receivables, net of allowance of $672 in 2018 and $496 in 2017			15,340				15,062
Inventory and supplies			4,337				4,232
Prepaid expenses			12,045				8,699
Assets held for sale			1,325				1,444
Income taxes receivable			1,585				11,551
Other short-term assets			2,333				1,817
Total current assets			191,534				162,314
Property and equipment, at cost			635,909				650,988
Less: accumulated depreciation and amortization			(187,144	)			(186,916	)
Net property and equipment			448,765				464,072
Goodwill			41,086				-
Other intangibles, net			33,269				-
Other assets, net			32,828				23,282
Total assets		$	747,482			$	649,668
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Checks outstanding in excess of bank balances			605				-
Accounts payable			21,488				11,857
Accrued expenses			47,797				26,520
Current maturities of long-term debt			27,643				24,596
Current portion of capital lease obligations			5,074				2,962
Current portion of insurance and claims accrual			24,785				15,042
Other short-term liabilities			-				243
Total current liabilities			127,392				81,220
Long-term debt			169,037				164,465
Long-term portion of capital lease obligations			33,877				21,777
Insurance and claims accrual			16,291				21,836
Deferred income taxes			73,347				63,344
Other long-term liabilities			1,388				1,825
Total liabilities			421,332				354,467
Commitments and contingent liabilities			-				-
Stockholders' equity:
Class A common stock, $.01 par value; 20,000,000 shares authorized; 15,996,066 shares issued and outstanding as of September 30, 2018 and 15,979,703 shares issued and outstanding as of December 31, 2017			171				171
Class B common stock, $.01 par value; 5,000,000 shares authorized; 2,350,000 shares issued and outstanding			24				24
Additional paid-in-capital			140,404				137,242
Accumulated other comprehensive income			1,487				293
Retained earnings			184,064				157,471
Total stockholders' equity			326,150				295,201
Total liabilities and stockholders' equity		$	747,482			$	649,668

		Three months ended September 30, (unaudited)								Nine months ended September 30, (unaudited)
		2018				2017				2018				2017
Revenue:
Freight revenue		$	214,623			$	159,500			$	535,721			$	445,212
Fuel surcharge revenue			28,680				19,131				77,466				56,489
Total revenue		$	243,303			$	178,631			$	613,187			$	501,701
Operating expenses:
Salaries, wages, and related expenses			86,249				60,732				211,621				178,639
Fuel expense			33,428				25,998				89,817				76,310
Operations and maintenance			16,457				13,046				40,783				37,504
Revenue equipment rentals and purchased transportation			47,445				36,361				115,525				90,719
Operating taxes and licenses			3,377				2,364				8,649				7,197
Insurance and claims			12,675				7,681				31,269				24,313
Communications and utilities			1,810				1,747				5,216				5,081
General supplies and expenses			6,391				3,729				16,833				10,919
Depreciation and amortization, including gains and losses on disposition of property and equipment			19,290				17,932				56,803				57,707
Total operating expenses			227,122				169,590				576,516				488,389
Operating income			16,181				9,041				36,671				13,312
Interest expense, net			2,460				2,174				6,360				6,216
Income from equity method investment			(2,142	)			(750	)			(5,407	)			(2,575	)
Income before income taxes			15,863				7,617				35,718				9,671
Income tax expense			4,249				2,985				9,716				3,530
Net income		$	11,614			$	4,632			$	26,002			$	6,141
Income per share:
Basic net income per share		$	0.63			$	0.25			$	1.42			$	0.34
Diluted net income per share		$	0.63			$	0.25			$	1.41			$	0.33
Basic weighted average shares outstanding			18,343				18,288				18,337				18,275
Diluted weighted average shares outstanding			18,497				18,404				18,448				18,366

		Three months ended September 30, (unaudited)								Nine months ended September 30, (unaudited)
		2018				2017				2018				2017
Net income		$	11,614			$	4,632			$	26,002			$	6,141
Other comprehensive income (loss):
Unrealized gain (loss) on effective portion of cash flow hedges, net of tax of $133 and $782 in 2018 and $1,050 and $796 in 2017, respectively			353				1,678				2,065				(1,271	)
Reclassification of cash flow hedges (gain) loss into statement of operations, net of tax of $155 and $330  in 2018 and $424 and $1,546 in 2017, respectively			(406	)			677				(868	)			2,469
Unrealized holding loss on investments classified as available-for-sale			(3	)			-				(3	)			-
Total other comprehensive income (loss)			(56	)			2,355				1,194				1,198
Comprehensive income		$	11,558			$	6,987			$	27,196			$	7,339

										Additional				Accumulated Other								Total
		Common Stock								Paid-In Capital				Comprehensive Income				Retained Earnings				Stockholders' Equity
		Class A				Class B
Balances at December 31, 2017		$	171			$	24			$	137,242			$	293			$	157,471			$	295,201
Net income			-				-				-				-				26,002				26,002
Effect of adoption of ASU 2014-09			-				-				-				-				591				591
Other comprehensive income			-				-				-				1,194				-				1,194
Stock-based employee compensation expense			-				-				2,868				-				-				2,868
Issuance of restricted shares			-				-				294				-				-				294
Balances at September 30, 2018		$	171			$	24			$	140,404			$	1,487			$	184,064			$	326,150

		Nine months ended September 30, (unaudited)
		2018				2017
Cash flows from operating activities:
Net income		$	26,002			$	6,141
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for losses on accounts receivable			168				241
Reversal of gain on sales to equity method investee			(185	)			(153	)
Depreciation and amortization			56,370				54,489
Amortization of deferred financing fees			111				206
Deferred income tax expense			9,172				16,437
Income tax benefit arising from restricted share vesting			19				96
Stock-based compensation expense			3,243				896
Equity in income of affiliate			(5,407	)			(2,575	)
Return on investment in affiliated company			-				1,960
Loss on disposition of property and equipment			433				3,217
Loss on investment in available-for-sale securities			(6	)			-
Changes in operating assets and liabilities:
Receivables and advances			(4,717	)			(19,975	)
Prepaid expenses and other assets			(2,763	)			1,439
Inventory and supplies			(102	)			(69	)
Insurance and claims accrual			1,553				837
Accounts payable and accrued expenses			17,723				(400	)
Net cash flows provided by operating activities			101,614				62,787
Cash flows from investing activities:
Acquisition of Landair Holdings, Inc., net of cash acquired			(106,060	)			-
Purchase of available-for-sale securities			(1,496	)			-
Acquisition of property and equipment			(44,528	)			(89,917	)
Proceeds from disposition of property and equipment			49,302				32,739
Net cash flows used in investing activities			(102,782	)			(57,178	)
Cash flows from financing activities:
Change in checks outstanding in excess of bank balances			605				1,325
Proceeds from issuance of notes payable			83,746				110,762
Repayments of  notes payable			(73,376	)			(101,717	)
Repayments of capital lease obligations			(2,608	)			(6,689	)
Proceeds under revolving credit facility			1,153,310				930,161
Repayments under revolving credit facility			(1,156,162	)			(938,667	)
Payment of minimum tax withholdings on stock compensation			(81	)			(257	)
Debt refinancing costs			(10	)			-
Net cash provided by (used in) financing activities			5,424				(5,082	)
Net change in cash and cash equivalents			4,256				527
Cash and cash equivalents at beginning of period			15,356				7,750
Cash and cash equivalents at end of period		$	19,612			$	8,277
Supplemental disclosure of cash flow information:
Cash paid during the year for:
Equipment purchased under capital leases		$	16,820			$	9,953

		Three Months Ended September 30, 2018
Financial Statement Line Item (in thousands)		As reported				Adjustments				Balances without adoption of Topic 606
Consolidated Balance Sheet
Accounts receivable, net of allowances		$	134,957			$	(1,276	)		$	133,681
Total assets			747,482				(1,276	)			746,206
Accrued expenses			47,797				(236	)			47,561
Deferred income taxes			73,347				(286	)			73,061
Total liabilities			421,332				(522	)			420,810
Retained earnings			184,064				(754	)			183,310
Total stockholders’ equity			326,150				(754	)			325,396
Total liabilities and stockholders’ equity			747,482				(1,276	)			746,206
Consolidated Statement of Operations
Freight revenue			214,623				49				214,672
Total revenue			243,303				49				243,352
Salaries, wages and related expenses			86,249				(1	)			86,248
Revenue equipment rentals and purchased transportation			47,445				(95	)			47,350
Total operating expenses			227,122				(96	)			227,026
Income tax expense			4,249				40				4,289
Net income			11,614				105				11,719
Consolidated Statement of Comprehensive Income
Net income			11,614				105				11,719
Comprehensive income			11,558				105				11,663
Consolidated Statement of Cash Flows
Operating Cash Flows
Net income			11,614				105				11,719
Deferred income tax expense			2,676				40				2,716
Change in: Receivables and advances			(16,537	)			(49	)			(16,586	)
Change in: Accounts payable and accrued expenses			16,087				(96	)			15,991
Net cash flows provided by operating activities			38,981				-				38,981

		Nine Months Ended September 30, 2018
Financial Statement Line Item (in thousands)		As reported				Adjustments				Balances without adoption of Topic 606
Consolidated Balance Sheet
Accounts receivable, net of allowances		$	134,957			$	(1,276	)		$	133,681
Total assets			747,482				(1,276	)			746,206
Accrued expenses			47,797				(236	)			47,561
Deferred income taxes			73,347				(286	)			73,061
Total liabilities			421,332				(522	)			420,810
Retained earnings			184,064				(754	)			183,310
Total stockholders’ equity			326,150				(754	)			325,396
Total liabilities and stockholders’ equity			747,482				(1,276	)			746,206
Consolidated Statement of Operations
Freight revenue			535,721				(266	)			535,455
Total revenue			613,187				(266	)			612,921
Salaries, wages and related expenses			211,621				13				211,634
Revenue equipment rentals and purchased transportation			115,525				(54	)			115,471
Total operating expenses			576,516				(41	)			576,475
Income tax expense			9,716				(62	)			9,654
Net income			26,002				(164	)			25,838
Consolidated Statement of Comprehensive Income
Net income			26,002				(163	)			25,838
Comprehensive income			27,196				(163	)			27,032
Consolidated Statement of Cash Flows
Operating Cash Flows
Net income			26,002				(163	)			25,838
Deferred income tax expense			9,172				(62	)			9,110
Change in: Receivables and advances			(4,717	)			266				(4,451	)
Change in: Accounts payable and accrued expenses			17,723				(41	)			17,682
Net cash flows provided by operating activities			101,613				-				101,612

(in thousands)		Three Months ended September 30,								Nine Months ended September 30,
		2018				2017				2018				2017
Total Revenues:
Truckload: Covenant Transport		$	108,223			$	95,100			$	309,583			$	272,387
Truckload: SRT			47,866				41,382				134,163				123,905
Truckload: Star Transportation			19,887				16,584				57,489				50,030
Truckload: Landair			21,077				-				21,077				-
Managed Freight			46,250				25,565				90,875				55,379
Total		$	243,303			$	178,631			$	613,187			$	501,701

(in thousands except per share data)		Three Months ended September 30,								Nine Months ended September 30,
		2018				2017				2018				2017
Numerator:
Net income		$	11,614			$	4,632			$	26,002			$	6,141
Denominator:
Denominator for basic earnings per share – weighted-average shares			18,343				18,288				18,337				18,275
Effect of dilutive securities:
Equivalent shares issuable upon conversion of unvested restricted stock			154				116				111				91
Denominator for diluted earnings per share – adjusted weighted-average shares and assumed conversions			18,497				18,404				18,448				18,366
Basic income per share:		$	0.63			$	0.25			$	1.42			$	0.34
Diluted income per share:		$	0.63			$	0.25			$	1.41			$	0.33

(in thousands)		Three months ended September 30,								Nine months ended September 30,
		2018				2017				2018				2017
Total Revenues:
Truckload		$	197,053			$	153,066			$	522,312			$	446,322
Managed Freight			46,250				25,565				90,875				55,379
Total		$	243,303			$	178,631			$	613,187			$	501,701
Operating Income:
Truckload		$	11,960			$	6,573			$	29,055			$	7,812
Managed Freight			4,221				2,468				7,616				5,500
Total		$	16,181			$	9,041			$	36,671			$	13,312

●	Level 1. Observable inputs such as quoted prices in active markets;
●	Level 2. Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and
●	Level 3. Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

(in thousands)
Hedge derivatives		September 30, 2018				December 31, 2017(1)
Net Fair Value of Derivatives		$	2,055			$	393
Quoted Prices in Active Markets (Level 1)		$	-			$	-
Significant Other Observable Inputs (Level 2)		$	2,055			$	393
Significant Unobservable Inputs (Level 3)		$	-			$	-

 

(1)	Includes derivative liabilities of $487 at December 31, 2017.

 

(in thousands)
Available-for-sale securities		September 30, 2018				December 31, 2017
Net Fair Value of Derivatives		$	1,493			$	-
Quoted Prices in Active Markets (Level 1)		$	1,493			$	-
Significant Other Observable Inputs (Level 2)		$	-			$	-
Significant Unobservable Inputs (Level 3)		$	-			$	-

Our financial instruments consist primarily of cash and cash equivalents, certificates of deposit, accounts receivable, commodity contracts, accounts payable, debt, and interest rate swaps. The carrying amount of cash and cash equivalents, certificates of deposit, accounts receivable, accounts payable, and current debt approximates their fair value because of the short-term maturity of these instruments.  Included in accounts receivable is $46.2 million and $31.9 million of factoring receivables at September 30, 2018 and December 31, 2017, respectively, net of a $0.4 million and $0.2 million allowance for bad debt for each respective date. We advance approximately 85% to 95% of each receivable factored and retain the remainder as collateral for collection issues that might arise.  The retained amounts are returned to the clients after the related receivable has been collected, net of accrued interest. At September 30, 2018 and December 31, 2017, the retained amounts related to factored receivables totaled $2.4 million and $0.6 million, respectively, and were included in accounts payable in the condensed consolidated balance sheets.  Our clients are smaller trucking companies that factor their receivables to us for a fee to facilitate faster cash flow.  We evaluate each client's customer base under predefined criteria.  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 September 30, 2018, as the weighted average interest rate on these notes approximates the market rate for similar debt. Borrowings under our revolving Credit Facility (as defined herein) approximate fair value due to the variable interest rate on that facility.  Additionally, commodity contracts, which are accounted for as hedge derivatives, as discussed in Note 6, 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.

Note 6.    Derivative Instruments

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.  Specifically, we enter into hedging contracts with respect to ultra-low sulfur diesel ("ULSD"). Under these contracts, we pay a fixed rate per gallon of ULSD and receive the monthly average price of Gulf Coast ULSD. The retrospective and prospective regression analyses provided that changes in the prices of diesel fuel and ULSD were deemed to be highly effective based on the relevant authoritative guidance. We do not engage in speculative transactions, nor do we hold or issue financial instruments for trading purposes.

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 as described in Note 7. 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 and 2017, we also entered into several interest rate swaps, which were designated to hedge against the variability in future interest rate payments associated with the purchase of certain trailers.  Because the critical terms of the swaps and hedged items 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 all interest rate swap agreements that were in effect at September 30, 2018, of approximately $1.2 million, is included in other short and long-term assets in the condensed consolidated balance sheet and is included in accumulated other comprehensive income, net of tax. Additionally, less than $0.1 million was reclassified from accumulated other comprehensive income into our results of operations as additional interest expense for the three months ended September 30, 2018, related to changes in interest rates during such period. Based on the amounts in accumulated other comprehensive income as of September 30, 2018, we expect to reclassify gains of approximately $0.1 million, net of tax, on derivative instruments from accumulated other comprehensive income 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.

We recognize all derivative instruments at fair value on our condensed consolidated balance sheets.  Our derivative instruments are designated as cash flow hedges, thus the gain or loss on the derivatives is reported as a component of accumulated other comprehensive income and will be reclassified into earnings in the same period during which the hedged transaction affects earnings.  The change in fair value of the hedge offsets the change in fair value of the hedged item.

At September 30, 2018, we had fuel hedge contracts on approximately 1.9 million gallons for the remainder of 2018, or approximately 17.1% of our projected remaining 2018 fuel requirements.

The fair value of the fuel hedge contracts that were in effect at September 30, 2018, of approximately $0.9 million is included in other short-term assets in the consolidated balance sheet and is included in accumulated other comprehensive income, net of tax.  Changes in the fair values of these instruments can vary dramatically based on changes in the underlying commodity prices. For example, during the third quarter in 2018, market "spot" prices for ULSD peaked at a high of approximately $2.31 per gallon and hit a low price of approximately $2.02 per gallon. During the same 2017 quarter, market "spot" prices ranged from a high of $1.83 per gallon to a low of $1.41 per gallon. Market price changes can be driven by factors such as supply and demand, inventory levels, weather events, refinery capacity, political agendas, the value of the U.S. dollar, geopolitical events, and general economic conditions, among other items.

 

Additionally, $0.6 million and $1.3 million were reclassified from accumulated other comprehensive income into our results of operations as a reduction to fuel expense for the three and nine months ended September 30, 2018, respectively, related to gains on contracts that expired.  Based on the amounts in accumulated other comprehensive income as of September 30, 2018, and the expected timing of the purchases of the diesel hedged, we expect to reclassify gains of approximately $0.6 million, net of tax, on derivative instruments from accumulated other comprehensive income into our results of operations during the next twelve months due to actual diesel fuel purchases.  The amounts actually realized will be dependent on the fair values as of the date of settlement.

We perform both a prospective and retrospective assessment of the effectiveness of our fuel hedge contracts at inception and quarterly, including assessing the possibility of counterparty default.  If we determine that a derivative is no longer expected to be highly effective, we discontinue hedge accounting prospectively and recognize subsequent changes in the fair value of the hedge in earnings.  As a result of our effectiveness assessment at inception and at September 30, 2018, we believe our hedge contracts have been and will continue to be highly effective in offsetting changes in cash flows attributable to the hedged risk.

Outstanding financial derivative instruments expose us to credit loss in the event of nonperformance by the counterparties to the agreements. We do not expect any of the counterparties to fail to meet their obligations.  Our credit exposure related to these financial instruments is represented by the fair value of contracts reported as assets.  To manage credit risk, we review each counterparty's audited financial statements, credit ratings, and obtain references as we deem necessary.

Note 7.   Debt

Current and long-term debt consisted of the following at September 30, 2018 and December 31, 2017:

(in thousands)		September 30, 2018								December 31, 2017
		Current				Long-Term				Current				Long-Term
Borrowings under Credit Facility; interest rate of 5.8% at September 30, 2018		$	-			$	6,155			$	-			$	-
Revenue equipment installment notes with finance companies; weighted average interest rate of 3.6% and 3.3% at September 30, 2018 and December 31, 2017, respectively, due in monthly installments with final maturities at various dates ranging from October 2018 to July 2023, secured by related revenue equipment			26,752				139,044				23,732				130,946
Real estate note; interest rate of 3.8% and 3.1% at September 30, 2018 and December 31, 2017, respectively, due in monthly installments with a fixed maturity at August 2035, secured by related real estate			1,037				24,029				1,004				24,810
Deferred loan costs			(146	)			(191	)			(140	)			(298	)
Total debt			27,643				169,037				24,596				164,465
Principal portion of capital lease obligations, secured by related revenue equipment			5,074				33,877				2,962				21,777
Total debt and capital lease obligations		$	32,717			$	202,914			$	27,558			$	186,242

 

We and substantially all of our subsidiaries 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. (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.  The Credit Facility matures in September 2021.

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) 75% of the appraised fair market value of eligible real estate, as reduced by a periodic amortization amount.  As of September 30, 2018, there were undrawn letters of credit outstanding of approximately $35.1 million, available borrowing capacity was $59.9 million, and $6.2 million in outstanding borrowings under the Credit Facility. The interest rate on outstanding borrowings under the Credit Facility as of September 30, 2018, was 5.8% on $6.2 million of base rate loans, and there were no outstanding LIBOR loans. Based on availability as of September 30, 2018 and December 31, 2017, 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 or have the ability to 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 September 30, 2018 terminate in October 2018 through September 2023 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 October 2018 to July 2023. 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 $133.0 million are cross-defaulted with the Credit Facility. Additionally, the abovementioned fuel hedge contracts totaling $0.9 million at September 30, 2018, 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 for the remainder of 2018, 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.

Note 8.    Stock-Based Compensation

Our 2006 Omnibus Incentive Plan, as amended (the "Incentive Plan") governs the issuance of equity awards and other incentive compensation to management and members of the board of directors.  In February 2013, the Compensation Committee re-approved, subject to stockholder re-approval, the material terms of the performance-based goals under the Incentive Plan so that certain incentive awards granted thereunder would continue to qualify as exempt "performance-based compensation" under Internal Revenue Code Section 162(m).  Our stockholders re-approved the material terms of the performance-based goals under the Incentive Plan at our 2013 Annual Meeting held on May 29, 2013.

The Incentive Plan permits annual awards of shares of our Class A common stock to executives, other key employees, consultants, non-employee directors, and eligible participants under various types of options, restricted stock awards, or other equity instruments.  At September 30, 2018, 49,405 of the abovementioned 1,550,000 shares were available for award under the Incentive Plan.  No participant in the Incentive Plan may receive awards of any type of equity instruments in any calendar-year that relates to more than 200,000 shares of our Class A common stock.  No awards may be made under the Incentive Plan after March 31, 2023. To the extent available, we have issued treasury stock to satisfy all share-based incentive plans.

Included in salaries, wages, and related expenses within the condensed consolidated statements of operations is $1.1 million and $0.3 million of stock-based compensation expense for the three months ended September 30, 2018 and 2017, and $2.9 million and $0.6 million of stock-based compensation expense for the nine months ended September 30, 2018 and 2017, respectively. All stock compensation expense recorded in 2018 and 2017 relates to restricted shares.  An additional $0.4 million and $0.3 million of stock-based compensation was recorded in general supplies and expenses in the condensed consolidated statements of operations for each of the three- and nine-month periods ended September 30, 2018 and 2017, respectively, as this amount relates to the issuance of restricted stock to non-employee directors.

The Incentive Plan allows participants to pay the federal and state minimum statutory tax withholding requirements related to awards that vest or allows participants to deliver to us shares of Class A common stock having a fair market value equal to the minimum amount of such required withholding taxes. To satisfy withholding requirements for shares that vested through September 30, 2018, certain participants elected to forfeit receipt of an aggregate of 2,753 shares of Class A common stock at a weighted average per share price of $29.57 based on the closing price of our Class A common stock on the dates the shares vested in 2018, in lieu of the federal and state minimum statutory tax withholding requirements. We remitted less than $0.1 million to the proper taxing authorities in satisfaction of the employees' minimum statutory withholding requirements.

Note 9.    Equity Method Investment

We own a minority investment in Transport Enterprise Leasing, LLC ("TEL"). TEL is a tractor and trailer equipment leasing company and used equipment reseller. We have not guaranteed any of TEL's debt and have no obligation to provide funding, services, or assets. In May 2016, the operating agreement with TEL was amended to, among other things, remove the previously agreed to fixed date purchase options.  TEL’s majority owners are generally restricted from transferring their interests in TEL, other than to certain permitted transferees, without our consent.  We sold approximately $0.1 million of tractors or trailers to TEL during each of the nine months ended September 30, 2018 and 2017, and we received $5.9 million and $4.2 million respectively, for providing various maintenance services, certain back-office functions, and for miscellaneous equipment.  We recognized a net reversal of previously deferred gains totaling approximately $0.2 million for each of the nine months ended September 30, 2018 and 2017, representing 49% of the gains on units sold to TEL less any gains previously deferred and recognized when the equipment was subsequently sold to a third party.  Deferred gains, totaling $0.2 million at September 30, 2018, are being carried as a reduction in our investment in TEL.  At September 30, 2018 and December 31, 2017, we had accounts receivable from TEL of $5.7 million and $7.8 million, respectively, related to cash disbursements made pursuant to our performance of certain back-office and maintenance functions on TEL’s behalf.

 

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 2018 net income through September 30, 2018, or $5.4 million. Our investment in TEL, totaling $25.7 million and $20.1 million at September 30, 2018 and December 31, 2017, respectively, is included in other assets in the accompanying condensed consolidated balance sheets.

See TEL’s summarized financial information below:

(in thousands)		As of September 30, 2018				As of December 31, 2017
Current Assets		$	23,276			$	19,660
Non-current Assets			255,352				183,905
Current Liabilities			15,451				53,981
Non-current Liabilities			219,878				117,135
Total Equity		$	43,299			$	32,449

		For the three months ended September 30, 2018				For the three months ended September 30, 2017				For the nine months ended September 30, 2018				For the nine months ended September 30, 2017
Revenue		$	25,437			$	18,299			$	74,152			$	64,543
Operating Expenses			19,061				15,439				58,060				55,753
Operating Income			6,376				2,860				16,092				8,790
Net Income		$	4,369			$	1,499			$	10,850			$	5,188

Note 10.  Commitments and Contingencies

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 condensed consolidated financial statements.

On May 8, 2017, the U.S. District Court for the Southern District of Ohio issued a pre-trial decision against our Southern Refrigerated Transport, Inc. ("SRT") subsidiary relating to a cargo claim incurred in 2008. The court had previously ruled in favor of the plaintiff in 2014, and the prior decision was reversed in part by the Sixth Circuit Court of Appeals and remanded for further proceedings in 2015.  As a result of this decision, we increased the reserve in respect of this case by $0.9 million in the first quarter of 2017 in order to accrue additional legal fees and pre-judgment interest since the time of the previously noted appeal.  On September 25, 2018, the Sixth Circuit Court of Appeals ruled in favor of the plaintiff and against SRT.  While considering its further appeal to the U.S. Supreme Court, SRT will likely pay this claim, related accrued interest and legal fees totaling approximately $6.8 million within the next six months.

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 as well as various state claims.  The case was removed from state court in February, 2017 to the U.S. District Court in the Central District of California, and subsequently, SRT moved the District Court to transfer venue of the case to the U.S. District Court sitting in the Western District of Arkansas.  The motion to transfer was approved by the California District Court in July, 2017, and the case will now be heard in the U.S. District court in the Western District of Arkansas.

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 reasonably possible to have a materially adverse effect on our consolidated financial statements.

We had $35.1 million and $32.9 million of outstanding and undrawn letters of credit as of September 30, 2018 and December 31, 2017, respectively. The letters of credit are maintained primarily to support our insurance programs.

See Note 12 for a discussion of contingencies related to our acquisition of Landair Holdings, Inc.

Note 11. Other comprehensive income (loss) ("OCI")

OCI is comprised of net income and other adjustments, including changes in the fair value of certain derivative financial instruments qualifying as cash flow hedges.

The following table summarizes the change in the components of our OCI balance for the periods presented (in thousands; presented net of tax):

Details about OCI Components		Amount Reclassified from OCI for the three months ended September 30, 2018				Amount Reclassified from OCI for the nine months ended September 30, 2018			Affected Line Item in the Statement of Operations
Losses (gains) on cash flow hedges
Commodity derivative contracts		$	(580	)		$	(1,312	)	Fuel expense
			160				361		Income tax expense
		$	(420	)		$	(951	)	Net of tax
Interest rate swap contract		$	19			$	114		Interest expense
			(5	)			(31	)	Income tax benefit
		$	14			$	83		Net of tax

Note 12.  Acquisition of Landair Holdings, Inc.

The allocation of the preliminary purchase price detailed below is subject to change based on finalization of the valuation of long-lived and intangible assets, as well as our ongoing evaluation of Landair’s accounting principles for consistency with ours.

(in thousands)
Cash paid						$	106,700
Allocated to:
Historical book value of Landair’s assets and liabilities		$	25,589
Adjustments to recognize assets and liabilities at acquisition-date fair value:
Property, plant, and equipment			(7,450	)
Other assets			(1,094	)
Liabilities			(829	)
Fair value of tangible net assets acquired							16,216
Post-acquisition goodwill adjustments							(114	)
Identifiable intangibles at acquisition-date fair value							34,000
Debt paid at closing							15,512
Excess of consideration transferred over the net amount of assets and liabilities recognized						$	41,086
Cash paid pursuant to Stock Purchase Agreement						$	106,700
Cash acquired included in historical book value of Landair assets and liabilities							(754	)
Net purchase price						$	105,946

Deferred income taxes arising from the acquisition are immaterial because of our 338(h)(10) election.

The following table summarizes the preliminary fair values of the assets acquired and liabilities assumed at the acquisition date.

(in thousands)
		July 3, 2018
Cash and cash equivalents		$	754
Accounts receivable			12,610
Driver advances and other receivables			4,295
Inventory and supplies			3
Prepaid expenses			1,010
Assets held for sale			128
Net property and equipment			26,164
Other assets, net			22
Other intangibles, net			34,000
Total identifiable assets acquired			78,986
Accounts payable			(5,475	)
Accrued expenses			(5,015	)
Insurance and claims accrual			(2,645	)
Other short-term liabilities			(123	)
Total liabilities assumed			(13,258	)
Net identifiable assets acquired			65,728
Goodwill			40,972
Net assets acquired			106,700

The goodwill recognized is attributable primarily to expected cost synergies in the areas of insurance and claims, workers compensation, fuel, and purchases of revenue equipment. Additionally, Landair and the historical Company have limited customer overlap, and as such we expect to be able to cross-sell services between historical customers and those of Landair.

The amounts of revenue and earnings of Landair included in the Company’s consolidated results of operations from the acquisition date to the period ended September 30, 2018 are as follows:

(in thousands)		Three months ended
		September 30, 2018
Total revenue		$	41,490
Net income		$	1,956

 

The following unaudited pro forma consolidated results of operations for the three and nine months ended September 30, 2018 and 2017 assume that the acquisition of Landair occurred as of January 1, 2017:

(in thousands)		Three months ended September 30,								Nine months ended September 30,
		2018				2017				2018				2017
Total revenue		$	243,303			$	208,842			$	687,937			$	592,333
Net income		$	11,614			$	4,882			$	28,886			$	6,892
Basic net income per share		$	0.63			$	0.27			$	1.58			$	0.38
Diluted net income per share		$	0.63			$	0.27			$	1.57			$	0.38

For the nine months ended September 30, 2018, the pro forma results include an immaterial amount of adjustments to conform Landair to the accounting policies of the Company related to operations and maintenance and insurance and claims. In addition, salaries, wages, and related expenses decreased by a net of $2.1 million related to sale bonuses and non-recurring compensation paid to a prior owner of Landair, partially offset by restricted shares granted to key retained employees. General supplies and expenses decreased by $3.4 million related to non-recurring acquisition-related expenses. Depreciation and amortization increased by $1.1 million due to the amortization of intangible assets as detailed in Note 13, partially offset by a net decrease resulting from the depreciation of property, plant, and equipment using useful lives consistent with those utilized by the Company. Interest expense, net increased by approximately $2.0 million as a result of the financing obtained by the Company to fund the Landair acquisition. Income tax expense was adjusted by approximately $0.1 million for the effect of each of the aforementioned adjustments. Results for the three and nine months ended September 30, 2018 exclude two days of Landair’s operations that occurred between the period ended June 30, 2018 and our acquisition on July 3, 2018, but this effect is immaterial.

For the three and nine months ended September 30, 2017, the pro forma results include an immaterial amount of adjustments to conform Landair to the accounting policies of the Company related to operations and maintenance and insurance and claims. Depreciation and amortization increased by approximately $0.6 million and $1.7 million for the quarter and nine months, respectively, due to the amortization of intangible assets as detailed in Note 13, partially offset by a net decrease resulting from the depreciation of property, plant, and equipment using useful lives consistent with those utilized by the Company. Interest expense, net increased $1.0 million and $3.0 million for the quarter and nine months, respectively, as a result of the financing obtained by the Company to fund the Landair acquisition. Income tax expense was adjusted by an immaterial amount for the effect of each of the aforementioned adjustments.

The pro forma adjustments have been made solely for informational purposes. The actual results reported by the consolidated company in periods following the acquisition may differ significantly from that reflected in the unaudited pro forma consolidated results of operations for a number of reasons, including but not limited to cost savings from operating efficiencies, synergies and the impact of the incremental costs incurred in integrating the two companies. As a result, the unaudited pro forma consolidated results of operations are not intended to represent and does not purport to be indicative of what the combined company’s results of operations would have been had the acquisition been completed on the applicable dates of this unaudited pro forma consolidated results of operations. In addition, the unaudited pro forma consolidated results of operations do not purport to project the future results of operations of the consolidated company.

Note 13.  Intangible Assets

Based on the preliminary allocation of the purchase price for Landair, the following amounts have been allocated to identifiable intangible assets along with the respective amortization periods:

(in thousands)		September 30, 2018
		Gross intangible assets				Accumulated amortization				Net intangible assets				Life (months)
Trade name		$	4,400			$	(73	)		$	4,327				180
Non-Compete agreement			1,400				(70	)			1,330				60
Customer relationships			28,200				(588	)			27,612				144
Total		$	34,000			$	(731	)		$	33,269

 

The above intangible assets have a weighted average life of 145 months. The expected amortization of these assets for the next five successive years is as follows:

		(In thousands)
2018		$	731
2019			2,923
2020			2,923
2021			2,923
2022			2,923
2023			2,783
Thereafter			18,063

 

Note 14.  Available-for-sale Securities

We have purchased certain investments to meet dual objectives of capital preservation and maintenance of sufficient resources to fund insurance losses. As such, the investments are not held for the purpose of trading. Furthermore, due to the uncertain nature of insurance losses, the investments are not held-to-maturity, and are thus classified as available-for-sale securities. Unrealized holding gains and losses on these investments are excluded from earnings and reported in other comprehensive income until realized. Unrealized holding losses below, which are comprised of ten investments in an unrealized loss position, are not considered other-than-temporary, as both the duration and amount of unrealized losses have been insignificant.

(in thousands)		September 30, 2018
		Amortized cost basis				Gross unrealized losses (less than 12 months)				Fair value
US corporate securities, maturing within one to five years		$	396			$	(2	)		$	394
Certificates of deposit, maturing in less than one year			600				(0	)			600
Certificates of deposit, maturing within one to five years			500				(1	)			499
Total available-for-sale securities		$	1,496			$	(3	)		$	1,493

ITEM 2.          MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The condensed consolidated financial statements include the accounts of Covenant Transportation Group, Inc., a Nevada holding company, and its wholly owned subsidiaries. References in this report to "we," "us," "our," the "Company," and similar expressions refer to Covenant Transportation Group, Inc. and its wholly owned subsidiaries.  All significant intercompany balances and transactions have been eliminated in consolidation.

This report contains certain statements that may be considered forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and Section 27A of the Securities Act of 1933, as amended (the "Securities Act") 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 Form 10-Q, statements relating to future reclassification of gains arising from derivative instruments and the performance of counterparties to such instruments, future impact of new accounting standards, future results of SRT, future third-party transportation provider expenses, future tax rates, expenses, and deductions, expected freight demand and volumes, potential results of a default and testing of our fixed charge covenant under the Credit Facility or other debt agreements, expected sources of working capital and liquidity (including our mix of debt, capital leases, and operating leases as means of financing revenue equipment), expected capital expenditures, future customer relationships, future use of dedicated contracts,  future mix of team versus solo drivers, expected debt reduction, future driver market conditions, expected cash flows, expected operating income and earnings per share improvements, future trucking capacity, future rates and prices, future utilization, future depreciation and amortization, future salaries, wages, and related expenses, including driver compensation and management bonuses, expected net fuel costs, strategies for managing fuel costs, the effectiveness and impact of, and cash flows relating to, our fuel hedging contracts and fuel surcharge programs, future fluctuations in operations and maintenance expenses, future fleet size and management, the market value of used equipment, including equipment subject to operating or capital leases relative to our payment obligations under such operating leases (including residual value guarantees and the proceeds from the sale thereof), the anticipated impact of our investment in Transport Enterprise Leasing, LLC, the anticipated impact of our acquisition of Landair, and anticipated levels of and fluctuations relating to insurance, claims, and litigation expenses, including with respect to the 2008 cargo claim and the California wage and hour claim, among others, are forward-looking statements. Forward-looking statements may be identified by the use of terms or phrases such as "believe," "may," "could," "expects," "estimates," "projects," "anticipates," "plans," "intends," and similar terms and phrases.  Such 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 in our Form 10-K for the year ended December 31, 2017.  Readers should review and consider the factors discussed in "Item 1A. Risk Factors," set forth in our Form 10-K for the year ended December 31, 2017, 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 Form 10-Q.  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.

Executive Overview

With continued economic growth in the U.S. we are encouraged by the year-over-year improvement in our operating margins for the third quarter of 2018. The main positives in the third quarter were 1) the successful strategic addition of Landair, meeting our stated objective of entering into closer relationships with our customers and getting deeper in the supply chain, 2) improvement in the operating profitability at each of our Truckload segment operating fleets, 3) an approximate 10% increase in average freight revenue per tractor for our Truckload segment, excluding Landair’s truckload operations, versus the same quarter of 2017, and 4) improved year-over-year earnings from our investment in TEL. The main negative in the quarter was the increased Truckload operating costs on a per mile basis, most notably the unfavorable employee wages and casualty insurance claims costs, partially offset by lower net fuel costs and improved net depreciation expense.

Additional items of note for the third quarter of 2018 include the following:

●	Total revenue of $243.3 million, an increase of 36.2% compared with the third quarter of 2017 and freight revenue (which excludes revenue from fuel surcharges) of $214.6 million, an increase of 34.6% compared with the third quarter of 2017;
●	Operating income of $16.2 million, an operating ratio of 93.3%, and an adjusted operating ratio of 92.1%, compared with operating income of $9.0 million, an operating ratio of 94.9%, and an adjusted operating ratio of 94.3% in the third quarter of 2017;
●	Net income of $16.2 million, or $0.63 per diluted share, compared with net income of $4.6 million, or $0.25 per diluted share, in the third quarter of 2017;
●	With available borrowing capacity of $59.9 million under our Credit Facility as of September 30, 2018, we do not expect to be required to test our fixed charge covenant in the foreseeable future;
●	Our Managed Freight segment’s total revenue increased by 80.9% to $46.3 million, compared to $25.6 million for the third quarter of 2017, and their operating income increased to $4.2 million compared to the 2017 quarter at $2.5 million;
●	Our equity investment in TEL provided $2.1 million of pre-tax earnings compared to $0.8 million in the third quarter of 2017;
●	Since December 31, 2017, aggregate lease-adjusted indebtedness (which includes the present value of off-balance sheet lease obligations), net of cash, increased by $22.2 million to $242.4 million; and
●	Stockholders’ equity at September 30, 2018 was $326.2 million, and tangible book value was $251.8 million, or $13.72 per basic share.

We expect the overall balance of business conditions to remain favorable through the fourth quarter of 2018 and into 2019.  Freight demand has been, and remains, strong across our business units and indications from our holiday peak season customers indicate robust expectations for the fourth quarter.  From a capacity perspective, attracting and retaining highly qualified, over the road professional truck drivers remains our largest challenge.  Low unemployment, alternative careers, and an aging driver population are creating an increasingly competitive environment. In this environment, we continue to work actively with our customers to improve driver compensation, efficiency, and working conditions while providing a high level of service and generating acceptable financial returns.  We intend to continue to allocate our assets where the returns are justified and use our managed freight units to supplement our internal capacity.

Along with the Landair acquisition, we have increased our capital allocation to organically grow our dedicated truckload, transportation management services, and other managed freight solutions. As of September 30, 2018, we had 1,535 tractors from our truckload fleet operating under dedicated contracts, representing 50% of the fleet. This compares to a year ago when only approximately 827 of our tractors, or 32% of our fleet, operated under dedicated contracts. We believe the dedicated contract fleet provides a stronger partnership with our customers as we integrate deeper into their supply chains, offers more consistent and seasonally-manageable freight volumes, reduces earnings volatility of the cyclical freight economy, and provides a favorable drivers’ experience for professional drivers who desire greater consistency.

For the fourth quarter, we will remain a major participant in the holiday peak shipping season and anticipate our consolidated adjusted operating ratio and consolidated adjusted earnings per diluted share to improve compared with the fourth quarter of 2017.  However, due to changes in team versus solo-driver mix, dedicated versus irregular route capacity, and managed freight capacity, as well as the impact of the Landair transaction, we are not offering more specific earnings guidance.

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 and amortization of intangibles, 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.

Operating Ratio ("OR") For Three and Nine Months Ended September 30, 2017 and 2018, respectively
		Three months ended September 30,																Nine months ended September 30,
GAAP Operating Ratio:		2018(1)(2)				OR %				2017(2)				OR %				2018(1)(2)				OR %				2017(2)				OR %
Total revenue		$	243,303							$	178,631							$	613,187							$	501,701
Total operating expenses			227,122				93.3	%			169,590				94.9	%			576,516				94.0	%			488,389				97.3	%
Operating income		$	16,181							$	9,041							$	36,671							$	13,312
Adjusted Operating Ratio:			2018			Adj. OR %					2017			Adj. OR %					2018			Adj. OR %					2017			Adj. OR %
Total revenue		$	243,303							$	178,631							$	613,187							$	501,701
Less: Fuel surcharge revenue:			(28,680	)							19,131								(77,466	)							56,489
Revenue (excluding fuel surcharge revenue)			214,623								159,500								535,721								445,212
Total operating expenses			227,122								169,590								576,516								488,389
Less: Fuel surcharge revenue			(28,680	)							19,131								(77,466	)							56,489
Less: Amortization of intangibles(3)			(731	)							-								(731	)							-
Total operating expenses (net of fuel surcharge revenue)			197,711				92.1	%			150,459				94.3	%			498,319				93.0	%			431,900				97.0	%
Operating income		$	16,912							$	9,041							$	37,402							$	13,312
(1) Includes impact of adoption of ASU 2014-09. See Note 1. for the related impact to total revenue and operating expenses. (2) The reported results do not include the results of operations of Landair on and prior to its acquisition by the Company on July 3, 2018 in accordance with the accounting treatment applicable to the transaction. (3) “Amortization of intangibles” reflects the non-cash amortization expense relating to intangible assets identified in the July 3, 2018 acquisition of Landair.

Revenue and Expenses

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.  We also generate revenue through providing ancillary services, including freight brokerage and accounts receivable factoring.

We have two reportable segments, Truckload, which is comprised of our truckload services, and Managed Freight, which provides freight brokerage, logistics, and transportation management services.

The Truckload segment at September 30, 2018 consisted of four operating fleets that are aggregated because they have similar economic characteristics and meet the aggregation criteria.  The four operating fleets that comprise our Truckload segment are as follows: (i) Covenant Transport, our historical flagship operation, which provides expedited long haul, dedicated, temperature-controlled, and regional solo-driver service; (ii) SRT, which provides primarily long-haul, regional, and dedicated service; (iii) Star Transportation, Inc., which provides regional solo-driver and dedicated services, primarily in the southeastern United States; and (iv) Landair trucking operations, which provides primarily dedicated service.

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 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.

Our Truckload segment also derives revenue from fuel surcharges, loading and unloading activities, equipment detention, and other accessorial services.  We measure revenue before fuel surcharges, or "freight revenue," because we believe that fuel surcharges tend to be a volatile source of revenue.  We believe the exclusion of fuel surcharges affords a more consistent basis for comparing the results of operations from period-to-period.  Nonetheless, freight revenue represents a non-GAAP financial measure.  Accordingly, undue reliance should not be placed on the discussion of freight revenue, and discussions of freight revenue should be considered in combination with discussions of total revenue.  For each expense item discussed below, we have provided a table setting forth the relevant expense first as a percentage of total revenue, and then as a percentage of freight revenue.

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.  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.

Our main measures of profitability are operating ratio and adjusted operating ratio, which we define as operating expenses, net of fuel surcharge revenue and amortization of intangibles, divided by total revenue, less fuel surcharge revenue, or freight revenue. See page 28 for the uses and limitations associated with adjusted operating ratio.

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.

In addition, our Managed Freight segment has service offerings ancillary to our Truckload services, including: freight brokerage service directly and through freight brokerage agents, who are paid a commission for the freight they provide, and transportation management services.  The operations consist of several operating segments, which are aggregated due to similar margins and customers.  Included in Managed Freight are our accounts receivable factoring and warehousing businesses, which do not meet the aggregation criteria, but only account for $3.4 million and $11.7 million of our revenue, respectively, during the nine months ended September 30, 2018.

 

Revenue Equipment

At September 30, 2018, we operated 3,077 tractors and 6,849 trailers. Of such tractors, 2,417 were owned, 345 were financed under operating leases, and 315 were provided by independent contractors, who provide and drive their own tractors.  Of such trailers, 5,121 were owned, 570 were financed under operating leases, and 1,158 were financed under capital leases.  We finance a small portion of our tractor fleet and larger portion of our trailer fleet with off-balance sheet operating leases. These leases generally run for a period of three to five years for tractors and five to seven years for trailers.  At September 30, 2018, our fleet had an average tractor age of 2.3 years and an average trailer age of 3.8 years.

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 or leasing the tractor.  The payments to independent contractors and the financing of equipment under operating leases are recorded in revenue equipment rentals and purchased transportation.  Expenses associated with owned equipment, such as interest and depreciation, and expenses associated with employee drivers, including driver compensation, fuel, and other expenses, are not incurred with respect to independent contractors.  Obtaining equipment from independent contractors and under operating leases effectively shifts financing expenses from interest to "above the line" operating expenses, and as such, we evaluate our efficiency using net margin as well as operating ratio.

COMPARISON OF THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2018 TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2017

The following tables set forth the percentage relationship of certain items to total revenue and freight revenue, where applicable (dollars in thousands):

		Three months ended September 30,								Nine months ended September 30,
		2018				2017				2018				2017
Revenue:
Freight revenue		$	214,623			$	159,500			$	535,721			$	445,212
Fuel surcharge revenue			28,680				19,131				77,466				56,489
Total revenue		$	243,303			$	178,631			$	613,187			$	501,701