COVENANT LOGISTICS GROUP, INC. - Quarter Report: 2019 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

(Mark One)

 

For the quarterly period ended September 30, 2019

or

 

 

For the transition period from                        to

 

Commission File Number: 0-24960

COVENANT TRANSPORTATION GROUP, INC.

(Exact name of registrant as specified in its charter)

 

 

423-821-1212

(Registrant's telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

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.

 

 

Indicate by check mark whether the registrant has submitted electronically, 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).

 

 

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

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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).

 

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date (November 6, 2019).

 

Class A Common Stock, $.01 par value: 16,111,902 shares

Class B Common Stock, $.01 par value: 2,350,000 shares

 

 

 

TABLE OF CONTENTS

 

 

 

 

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

 

COVENANT TRANSPORTATION GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018

(In thousands, except per share data)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

COVENANT TRANSPORTATION GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018

(In thousands)

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

COVENANT TRANSPORTATION GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018

(Unaudited and in thousands)

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

COVENANT TRANSPORTATION GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2019 AND 2018

(In thousands)

 

 

 

The accompanying notes are an integral part of these condensed consolidated financial statements.

 

 

COVENANT TRANSPORTATION GROUP, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

 

Basis of Presentation

 

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.

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X promulgated under the Securities Act of 1933. In preparing financial statements, it is necessary for management to make assumptions and estimates affecting the amounts reported in the condensed consolidated financial statements and related notes. These estimates and assumptions are developed based upon all information available. Actual results could differ from estimated amounts. In the opinion of management, the accompanying financial statements include all adjustments that are necessary for a fair presentation of the results for the interim periods presented, such adjustments being of a normal recurring nature.

 

Certain information and footnote disclosures have been condensed or omitted pursuant to such rules and regulations. The December 31, 2018, condensed consolidated balance sheet was derived from our audited balance sheet as of that date. Our operating results are subject to seasonal trends when measured on a quarterly basis; therefore operating results for the three months ended September 30, 2019 are not necessarily indicative of the results that may be expected for the year ending December 31, 2019. These condensed consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in our Form 10-K for the year ended December 31, 2018. Results of operations in interim periods are not necessarily indicative of results to be expected for a full year.

 

Recent Accounting Pronouncements

 

Accounting Standards adopted

 

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, which establishes Topic 842 to replace Topic 840 regarding accounting for leases. Topic 842 requires lessees to recognize a right-of-use asset and a lease liability for most leases on the balance sheet. Leases that were previously described as capital leases are now called finance leases, and operating leases with a term of at least twelve months are now required to be recorded on the balance sheet. We adopted this standard on January 1, 2019 using the modified retrospective approach.

 

In July 2018, FASB issued ASU 2018-11, which provides an optional transition method allowing application of Topic 842 as of the adoption date and recognition of a cumulative-effect adjustment to the opening balance of retained earnings in the period of adoption, with no restatement of comparative prior periods. We have adopted the standard using this optional transition method.

 

Within Topic 842, FASB has provided a number of practical expedients for applying the new lease standard in relation to leases that commenced prior to the standard's effective date. We have elected the package of practical expedients which allowed us, among other things, to carry forward the operating and capital lease classifications from Topic 840 to the new operating and finance lease classifications under Topic 842.

 

The adoption of this ASU resulted in the initial recognition of operating lease assets of $40.1 million and liabilities totaling approximately $41.0 million, comprised of $15.3 million of current operating lease obligations and $25.7 million of long-term operating lease obligations.

 

Property and 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 have historically depreciated new tractors (excluding day cabs) over five years to salvage values of approximately 15% of their cost.  We generally depreciate 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. 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.

  

Leases

 

At the commencement date of a new lease agreement with contractual terms longer than twelve months, we recognize a right-of-use asset and a lease liability and categorize the lease as either finance or operating. Certain lease agreements have lease and nonlease components, and we have elected to account for these components separately.

 

Right-of-use assets and lease liabilities are initially recorded based on the present value of lease payments over the term of the lease. When the rate implicit in the lease is readily determinable, this rate is used for calculating the present value of remaining lease payments; otherwise, our incremental borrowing rate is used. Right-of-use assets also include prepaid lease expenses and initial direct costs of executing the leases, which are reduced by landlord incentives. Options to extend or terminate a lease agreement are included in or excluded from the lease term, respectively, when those options are reasonably certain to be exercised. Right-of-use assets are tested for impairment in the same manner as long-lived assets.

 

Right-of-use assets are included in net property and equipment. For finance leases, right-of-use assets are amortized on a straight-line basis over the shorter of the expected useful life or the lease term, and the carrying amount of the lease liability is adjusted to reflect interest expense, which is recorded in interest expense, net. Operating lease right-of-use assets are amortized over the lease term on a straight-line basis, and the lease liability is measured at the present value of the remaining lease payments. Variable lease payments not included in the lease liability for mileage charges on leased revenue equipment are expensed as incurred. Operating lease costs are recognized on a straight-line basis over the term of the lease within operating expenses.

  

 

Basic (loss) income per share excludes dilution and is computed by dividing earnings available to common stockholders by the weighted-average number of common shares outstanding for the period. Diluted (loss) income per share reflects the dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in our earnings. There were approximately 261,000 anti-dilutive shares for the three months ended September 30, 2019. There were no outstanding stock options at September 30, 2019. Income per share is the same for both Class A and Class B shares.

 

The following table sets forth, for the periods indicated, the calculation of net (loss) income per share included in the condensed consolidated statements of operations:

 

 

 

 

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

 

The Truckload segment consists of four service offerings that are aggregated because they have similar economic characteristics and meet the aggregation criteria.  The four service offerings that comprise our Truckload segment are as follows: (i) Expedited, provided primarily by Covenant Transport, our historical flagship operation; (ii) Dedicated, provided by all of our operating fleets; (iii) Refrigerated, provided primarily through our Southern Refrigerated Transport, Inc. ("SRT") subsidiary; and (iv) over-the-road ("OTR"), provided primarily by our Landair Transport, Inc. subsidiary.

 

In addition, our Managed Freight segment has service offerings ancillary to our Truckload services, including: freight brokerage, transportation management services ("TMS"), and shuttle and switching services. These service offerings are aggregated due to similar margins and customers. Also included within Managed Freight are our warehousing and accounts receivable factoring businesses, neither of which meets the quantitative or qualitative reporting thresholds individually or in the aggregate.

 

The accounting policies of the segments are the same as those described in the summary of significant accounting policies in our 2018 Annual Report on Form 10-K. Substantially all intersegment sales prices are market based. We evaluate performance based on operating income of the respective business units.

 

The following table summarizes our revenue by our two reportable segments, Truckload and Managed Freight, disaggregated to the operating fleet level as used by our chief operating decision maker in making decisions regarding allocation of resources and assets, organized first by reportable segment (i.e. Truckload and Managed Freight) and then by operating fleet for the three and nine months ended September 30, 2019 and 2018:

 

 

 

 

Income tax expense in both 2019 and 2018 varies from the amount computed by applying the federal corporate income tax rates of 21% to income before income taxes, primarily due to state income taxes, net of federal income tax effect, adjusted for permanent differences, the most significant of which is the effect of the per diem pay structure for drivers.  Drivers who meet the requirements to receive per diem receive non-taxable per diem pay in lieu of a portion of their taxable wages.  This per diem program increases our drivers' net pay per mile, after taxes, while decreasing gross pay, before taxes.  As a result, salaries, wages, and related expenses are slightly lower and our effective income tax rate is higher than the statutory rate.  Generally, as pre-tax income increases, the impact of the driver per diem program on our effective tax rate decreases, because aggregate per diem pay becomes smaller in relation to pre-tax income, while in periods where earnings are at or near breakeven the impact of the per diem program on our effective tax rate is significant.  Due to the partially nondeductible effect of per diem pay, our tax rate will fluctuate in future periods based on fluctuations in earnings.

 

Our liability recorded for uncertain tax positions as of September 30, 2019 has decreased by $0.8 million since December 31, 2018 as the result of the settlement of our uncertain tax position and the reversal of any interest accrued.

 

The net deferred tax liability of $81.4 million primarily relates to differences in cumulative book versus tax depreciation of property and equipment, partially off-set by net operating loss carryovers and insurance claims that have been reserved but not paid. The carrying value of our deferred tax assets assumes that we will be able to generate, based on certain estimates and assumptions, sufficient future taxable income in certain tax jurisdictions to utilize these deferred tax benefits.  If these estimates and related assumptions change in the future, we may be required to establish a valuation allowance against the carrying value of the deferred tax assets, which would result in additional income tax expense.  On a periodic basis, we assess the need for adjustment of the valuation allowance.  Based on forecasted taxable income resulting from the reversal of deferred tax liabilities, primarily generated by accelerated depreciation for tax purposes in prior periods, and tax planning strategies available to us, a valuation allowance has been established at September 30, 2019, for $0.1 million related to certain state net operating loss carry-forwards.  If these estimates and related assumptions change in the future, we may be required to modify our valuation allowance against the carrying value of the deferred tax assets.

  

 

Current and long-term debt and lease obligations consisted of the following at September 30, 2019 and December 31, 2018:

 

 

We and substantially all of our subsidiaries are parties to 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.  We had $13.7 million of borrowings outstanding under the Credit Facility as of September 30, 2019, undrawn letters of credit outstanding of approximately $35.2 million, and available borrowing capacity of $46.0 million. The interest rate on outstanding borrowings as of September 30, 2019, was 5.8% on $13.7 million of base rate loans and there were no outstanding LIBOR loans. Based on availability as of September 30, 2019 and 2018, 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.

 

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 2019 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 $212.5 million 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 2020, 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%.

 

 

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. On May 8, 2019, the stockholders, upon recommendation of the board of directors, approved the First Amendment (the “First Amendment”) to the Third Amended and Restated Incentive Plan. The First Amendment (i) increases the number of shares of Class A common stock available for issuance under the Incentive Plan by an additional 750,000 shares, (ii) implements additional changes designed to comply with certain shareholder advisory group guidelines and best practices, (iii) makes technical updates related to Section 162(m) of the Internal Revenue Code in light of the 2017 Tax Cuts and Jobs Act, (iv) re-sets the term of the Incentive Plan to expire with respect to the ability to grant new awards on March 31, 2029, and (v) makes such other miscellaneous, administrative and conforming changes as were necessary.

 

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. As of September 30, 2019, there were 439,370 remaining of the 2,300,000 shares 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 the recognition of approximately $0.6 million and $1.1 million stock-based compensation expense for the three months ended September 30, 2019 and 2018, respectively, and the recognition of less than $0.1 million and approximately $2.9 million for the nine months ended September 30, 2019 and 2018, respectively. All stock compensation expense recorded in 2019 and 2018 relates to restricted shares, as no unvested options were outstanding during these periods. An additional $0.4 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, 2019 and 2018, 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, 2019, certain participants elected to forfeit receipt of an aggregate of 35,735 shares of Class A common stock at a weighted average per share price of $21.33 based on the closing price of our Class A common stock on the dates the shares vested in 2019, in lieu of the federal and state minimum statutory tax withholding requirements. We remitted $0.8 million to the proper taxing authorities in satisfaction of the employees' minimum statutory withholding requirements.

  

 

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.

 

Our subsidiary Covenant Transport, Inc. (“Covenant Transport”) is a defendant in a lawsuit filed on November 9, 2018, in the Superior Court of Los Angeles County, California.  The lawsuit was filed on behalf of Richard Tabizon (a California resident and former driver) who is seeking to have the lawsuit certified as a class action.  The complaint asserts that the time period covered by the lawsuit is from October 31, 2014 to the present and alleges claims for failure to properly pay for rest breaks, failure to provide accurate itemized wage statements and/or reimbursement of business related expenses, unlawful deduction of wages, failure to pay proper minimum wage and overtime wages, failure to provide all wages due at termination, and other related wage and hour claims under the California Labor Code.  Since the original filing date, the case has been removed from the Los Angeles Superior Court 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 where the case is now pending. We do not currently have enough information to make a reasonable estimate as to the likelihood, or amount of a loss, or a range of reasonably possible losses as a result of this claim, as such there have been no related accruals recorded as of September 30, 2019.    

 

Also, in February, 2019, Covenant Transport was named in a separate (but related) lawsuit filed in the Superior Court of Los Angeles County, California requesting civil penalties under the California Private Attorneys’ General Act for the same underlying wage and hour claims at issue in the putative class action case noted above. On August 1, 2019, the Los Angeles Superior Court entered an order staying the action pending completion of the earlier-filed action that is pending in the United States District Court for the Eastern District of Tennessee. We do not currently have enough information to make a reasonable estimate as to the likelihood, or amount of a loss, or a range of reasonably possible losses as a result of this claim, as such there have been no related accruals recorded as of September 30, 2019.

 

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.

 

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.

 

We had $35.2 million and $36.3 million of outstanding and undrawn letters of credit as of September 30, 2019 and December 31, 2018, respectively. The letters of credit are maintained primarily to support our insurance programs.

 

 

We finance a portion of our revenue equipment, office and terminal properties, computer and office equipment, and other equipment using leases. A number of these leases include one or more options to renew or extend the agreements beyond the expiration date or to terminate the agreement prior to the lease expiration date, and such options are included in or excluded from the lease term, respectively, when those options are reasonably certain to be exercised. Our lease obligations do not typically include residual value guarantees or material restrictive covenants. A summary of our lease obligations at September 30, 2019 are as follows:

 

 

Right-of-use assets of $53.4 million for operating leases and $35.3 million for finance leases are included in net property and equipment in our Condensed Consolidated Balance Sheets. Operating lease right-of-use asset amortization is included in revenue equipment rentals and purchased transportation, communication and utilities, and general supplies and expenses, depending on the underlying asset.

 

Our future minimum lease payments as of September 30, 2019, summarized as follows by lease category:

 

 

(1) Excludes the nine months ended September 30, 2019

 

 

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 no and $0.1 million tractors or trailers to TEL during the nine-months ended September 30, 2019 and 2018, respectively, and we received $7.1 million and $5.9 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 less than $0.1 million and $0.2 million for the nine-months ended September 30, 2019 and 2018, respectively, 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, 2019, are being carried as a reduction in our investment in TEL.  At September 30, 2019 and December 31, 2018, we had accounts receivable from TEL of $1.2 million and $5.1 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 2019 net income through September 30, 2019, or $7.5 million. We received an equity distribution from TEL of $1.2 million during the nine-months ended September 30, 2019 and none for the same 2018 period.  Our investment in TEL, totaling $32.4 million and $26.1 million, at September 30, 2019 and December 31, 2018, 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, 2019				As of December 31, 2018
Total Assets		$	388,116			$	299,864
Total Liabilities			331,219				254,919
Total Equity		$	56,897			$	44,945

 

 

 

On July 3, 2018, we acquired 100% of the outstanding stock of Landair Holdings, Inc., a Tennessee corporation (“Landair”). Landair is a dedicated and for-hire truckload carrier, as well as a supplier of transportation management, warehousing and logistics inventory management services. Landair’s results have been included in the consolidated financial statements since the date of acquisition. Landair’s trucking operations’ results are reported within our Truckload segment, while Landair’s logistics operations’ results are reported within our Managed Freight segment.

 

The allocation of the purchase price has been subject to change based on finalization of the valuation of long-lived and intangible assets and self-insurance reserves, as well as our ongoing evaluation of Landair's accounting principles for consistency with ours. The assignment of goodwill and intangible assets to our reportable segments was completed as of June 30, 2019. A summary of the changes in carrying amount of goodwill is as follows:

 

 

 

A summary of other intangible assets as of September 30, 2019 and December 31, 2018 is as follows:

 

 

 

The above intangible assets have a weighted average remaining life of  131 months as September 30, 2019. The expected amortization of these assets for the next five successive years is as follows:

 

 

 

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 losses arising from derivative instruments and the performance of counterparties to such instruments, future impact of accounting standards, future results at SRT, future third party transportation provider expenses, future tax rates, expenses, and deductions, expected freight demand and volumes and trucking industry conditions, 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, allocations, and requirement, future customer relationships, expected debt reduction, future driver market conditions, expected cash flows, expected operating income and earnings per share improvements, future investments in and growth of our segments and services, 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, expected effects and mix of our solo and team operations, future fleet size, management, and upgrades, 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), future effects of the Landair acquisition, our internal control remediation plan, the anticipated impact of our investment in TEL, and anticipated levels of and fluctuations relating to insurance, claims, and litigation expenses, 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, 2018.  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, 2018, 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

 

The freight environment third quarter was much weaker than the 2018 quarter, as excess industry-wide trucking capacity and weak shipping demand combined to pressure both freight rates and volumes.  In addition, new and incumbent freight brokers placed additional pressure on the irregular route truckload market by competing for market share based on what we view as unsustainable pricing. In general, our dedicated Truckload and Managed Freight operations were profitable and exhibited moderate year-over-year market volatility.   Our irregular route expedited and refrigerated truckload operations exhibited significant volatility and swung to being unprofitable for the quarter, with the largest factors being lower rate per mile and combined insurance and capital cost increases versus the prior year quarter.

 

The main positives in the third quarter were 1) consistent demand and profitability from our Landair dedicated and managed freight businesses in a difficult freight economy, 2) steady earnings contributed from our investment in Transport Enterprise Leasing, and 3) increasing our percentage of operating trucks with automatic transmissions to over 95%. The main negatives in the quarter were 1) the operating margin declines of our expedited and solo refrigerated service offerings, 2) an approximate 9.5% year-over-year decrease in average freight revenue per truck for our Truckload segment, 3) increased Truckload operating costs on a per mile basis, most notably from unfavorable group health, workers’ compensation and casualty insurance expense, net fuel costs, and capital costs, and 4) the $34.3 million quarterly increase in our total net indebtedness primarily related to the delay of proceeds from disposals of used revenue equipment to adequately offset the expenditures for a large portion of our annual new tractor deliveries during the quarter.

  

Additional items of note for the third quarter of 2019 include the following:

 

 

For the fourth quarter of 2019, we expect to remain an important provider in our customers’ peak season supply chains.  However, given the current imbalance of capacity and demand, we expect pricing and volume levels to remain subdued compared with the last several holiday peak seasons. Our focus will be on identifying opportunities to improve the performance of our one-way truckload service offerings and adding more predictable long-term contracts in our dedicated truckload, transportation management and warehousing service offerings.

 

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. 

 

		Three Months Ended September 30,																Nine Months Ended September 30,
GAAP Operating Ratio:		2019				OR %				2018				OR %				2019				OR %				2018				OR %
Total revenue		$	222,914							$	243,303							$	661,393							$	613,187
Total operating expenses			224,845				100.9	%			227,122				93.3	%			649,054				98.1	%			576,516				94.0	%
Operating (loss) income		$	(1,931	)						$	16,181							$	12,339							$	36,671
Adjusted Operating Ratio:			2019			Adj. OR %					2018			Adj. OR %					2019			Adj. OR %					2018			Adj. OR %
Total revenue		$	224,914							$	243,303							$	661,393							$	613,187
Fuel surcharge revenue:			(23,082	)							(28,680	)							(70,882	)							(77,466	)
Freight revenue (total revenue, excluding fuel surcharge)			199,832								214,623								590,511								535,721
Total operating expenses			224,845								227,122								649,054								576,516
Adjusted for:
Fuel surcharge revenue			(23,082	)							(28,680	)							(70,882	)							(77,466	)
Amortization of intangibles			(731	)							(731	)							(2,192	)							(731	)
Adjusted operating expenses			201,032				100.6	%			197,711				92.1	%			575,980				97.5	%			498,319				93.0	%
Adjusted operating (loss) income		$	(1,200	)						$	16,912							$	14,531							$	37,402

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. Our four service offerings within the Truckload segment are primarily truckload based 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 and logistics services, warehousing, and accounts receivable factoring.

 

We have two reportable segments, our truckload services ("Truckload") and freight brokerage, transportation management services, and shuttle and switching services (“Managed Freight”).

 

The Truckload segment consists of four service offerings that are aggregated because they have similar economic characteristics and meet the aggregation criteria.  The four service offerings that comprise our Truckload segment are as follows: (i) Expedited; (ii) Dedicated; (iii) Temperature-Controlled; and (iv) OTR.

 

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.

 

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, divided by total revenue, less fuel surcharge revenue (or freight revenue) and amortization of intangibles. See page 22 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.

 

Managed Freight is comprised primarily of freight brokerage, transportation management services ("TMS"), and shuttle and switching services. These service offerings are aggregated due to similar margins and customers. Also included within Managed Freight are our warehousing and accounts receivable factoring businesses, neither of which meets the quantitative or qualitative reporting thresholds individually or in the aggregate. but only accounted for $25.1million and $6.6 million of our revenue, respectively, during the nine months ended September 30, 2019.

 

Revenue Equipment

 

At September 30, 2019, we operated 3,004 tractors and 6,822 trailers. Of such tractors, 1,878 were owned, 812 were financed under operating leases, and 314 were provided by independent contractors, who provide and drive their own tractors.  Of such trailers, 5,203 were owned and 1,619 were financed under finance type leases.  We finance a small portion of our tractor fleet and larger portion of our trailer fleet with operating leases, which generally run for a period of three to five years for tractors and five to seven years for trailers.  At September 30, 2019, our fleet had an average tractor age of 2.0 years and an average trailer age of 4.1 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 income margin as well as operating ratio.

 

 

 

COMPARISON OF THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2019 TO THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2018

 

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

 

 

 

For the quarter ended September 30, 2019, total revenue decreased approximately $20.4 million, or 8.4%, to $222.9 million from $243.3 million in the 2018 quarter. Freight revenue decreased approximately $14.8 million, or 6.9%, to $199.8 million for the quarter ended September 30, 2019, from $214.6 million in the 2018 quarter, while fuel surcharge revenue decreased $5.6 million quarter-over-quarter. The decrease in freight revenue resulted from a $16.5 million decrease in freight revenue from our Truckload segment and a $1.7 million increase in freight revenue from our Managed Freight segment.

 

The $16.5 million decrease in Truckload revenue relates to a 9.5% decrease in average freight revenue per tractor per week from the 2018 quarter.  The decrease in average freight revenue per tractor per week for the quarter ended September 30, 2019 is the result of a 10.9 cents per mile (or 5.5%) decrease in average rate per total mile and a 4.2% decrease in average miles per unit compared to the 2018 quarter.  Team-driven trucks decreased to an average of 829 teams in the third quarter of 2019, a decrease of approximately 5.9% from the average of 881 teams in the third quarter of 2018.

 

For the nine-month period ended September 30, 2019, total revenue increased $48.2 million, or 7.9% to $661.4 million from $613.2 million in the 2018 period.  Freight revenue increased $54.8 million, or 10.2%, to $590.5 million for the nine months ended September 30, 2019, from $535.7 million  in the 2018 period, while fuel surcharge revenue decreased $6.6 million period-over-period. The increase in freight revenue resulted from a $47.0 million increase in freight revenue from our Managed Freight segment, as well as a $7.8 million increase in freight revenue from our Truckload segment.

 

The  $7.8 million  increase in Truckload freight revenue relates to a 344, or 12.5%, increase in average number of units compared to the 2018 period, partially offset by a 9.6%  decrease in average freight revenue per tractor per week from the 2018 period.  The decrease in average freight revenue per tractor per week for the nine months ended September 30, 2019 is the result of a 9.1% decrease in average miles per unit and a 0.8 cent per mile decrease in average rate per total mile.  Team driven units decreased approximately 4.4% to an average of 845 teams for the nine-month period ended September 30, 2019 compared to an average of 884 teams during the same 2018 period.

 

Managed Freight total revenue increased  $1.7 million comparing the 2019 and 2018 quarters, and $47.5 million comparing the 2019 period and 2018 period, primarily as a result of growth in Landair’s contribution to combined Managed Freight operations compared with 2018. Additionally, our brokerage subsidiary contributed $1.6 million more revenue for the nine months ended September 30, 2019 compared to the same 2018 period.

 

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 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.

 

 

 

Salaries, wages, and related expenses decreased approximately $2.2 million, or 2.5%, for the three months ended September 30, 2019, compared with the same quarter in 2018. As a percentage of total revenue, salaries, wages, and related expenses increased to 37.7% of total revenue for the three months ended September 30, 2019, from 35.4% in the same quarter in 2018. As a percentage of freight revenue, salaries, wages, and related expenses increased to 42.1% of freight revenue for the three months ended September 30, 2019, from 40.2% in the same quarter in 2018.  The decrease of $2.2 million is the result of reduced non-driver wages related to lower variable incentive compensation mostly offset by increases in driver wages, workers' compensation insurance, and group health insurance for the three months ended September 30, 2019. 

 

For the nine months ended September 30, 2019, salaries, wages, and related expenses increased approximately $27.8 million, or 13.1%, compared with the same period in 2018.  As a percentage of total revenue, salaries, wages, and related expenses increased to 36.2% of total revenue for the nine months ended September 30, 2019, from 34.5% for the nine months ended September 30, 2018.  As a percentage of freight revenue, salaries, wages, and related expenses increased to 40.5% of freight revenue for the nine months ended September 30, 2019, from 39.5% in the same period in 2018. These increases are primarily due to increased headcount from the 2018 Landair acquisition, driver and non-driver pay increases since the first quarter of 2018, and increases in workers' compensation insurance and group health insurance compared to the nine months ended September 30, 2018.

 

When compared to periods prior to the Landair acquisition, we expect salaries, wages and related expenses will be higher as a result of the increased headcount resulting from the Landair acquisition. We believe salaries, wages, and related expenses will increase going forward as a result of a tight driver market, which continues to offer significant challenges, 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, as freight market rates continue to increase, 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 Managed Freight segment, for which payments are reflected in the purchased transportation line item.

 

 

 

Total fuel expense decreased $4.6 million to $28.8 million for the three months ended September 30, 2019, compared with $33.4 million the same quarter in 2018. As a percentage of total revenue, total fuel expense decreased to 12.9% of total revenue for the three months ended September 30, 2019, from 13.7% in the same quarter in 2018. As a percentage of freight revenue, total fuel expense decreased to 14.4% of freight revenue for the three months ended September 30, 2019, as compared to 15.6% for the 2018 quarter. 

 

For the nine months ended September 30, 2019, total fuel expense decreased approximately $4.0 million, or 4.4%, compared with the same period in 2018.  As a percentage of total revenue, total fuel expense decreased 1.7% to 13.0% of total revenue for the nine months ended September 30, 2019, from 14.6% in the 2018 period.  As a percentage of freight revenue, total fuel expense decreased to 14.5% of freight revenue from 16.8% for the nine months ended September 30, 2019, compared to the 2018 period. 

 

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 Department of Energy ("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 decreased $0.21 per gallon in the third quarter of 2019 compared with the same quarter in 2018, and decreased $0.12 per gallon for the nine months ended September 30, 2019 compared to the same period in 2018.

 

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 revenue, the percentage of miles driven by company tractors, our fuel economy, our percentage of deadhead miles, for which we do not receive material fuel surcharge revenues, and the net impact of fuel hedging gains and losses.  Net fuel expense is shown below: