A quarterly earnings report in the middle of a company transition can always be tricky, as the short-term focus on earnings and revenue can obscure that management is trying to implement a plan to get to a different place.
In that sense, the third-quarter report of Covenant Logistics could be viewed as a success. An adjusted earnings per share of 56 cents beat consensus by 1 cent, according to SeekingAlpha. And revenue of $210.8 million was better than consensus by $3.36 million. And it was accomplished even as Covenant was operating with some of its plans in place, like a smaller fleet, that could have served as a drag on revenue.
Still, the stock plummeted Tuesday, at a rate far beyond the overall downturn in equity markets. At the close of trading, Covenant was down 11.82% to $15.44 per share.
On the company’s earnings call, the outlook was mostly positive but with an acknowledgement that some of the cost cutting that Covenant has been able to undertake in recent quarters, including the third, may not be able to continue into next year due to the upward pressure from driver compensation.
In reviewing the company’s earnings, Covenant CFO Paul Bunn said the company did have some cost reductions related to the pandemic that would return as the company gets back to normal. And while higher contract rates in both its Dedicated and Expedited segments are likely over the next several months, “I think with cost increases coming before rate[s], [and] a lot of those costs coming back in the first quarter … our OR will go backwards in 2021 from the third quarter of 2020,” Bunn said.
On the call, Co-president Joey Hogan called the driver market the most difficult he’s seen in 20 years.
Bunn added that there was a “good list of things” Covenant could continue to do on the cost containment side of the business. “But I think it’s safe to say we think that OR will deteriorate some into next year from the adjusted OR you’re seeing in Q3,” he added.
But whether the OR is larger or smaller next year was seen as secondary by the executives on the call compared to the company’s implementation of a plan to get leaner. Hogan said that despite the strong freight market, Covenant is not going to go on a growth spree.
He said as much as a fifth of the Covenant fleet has been eliminated and some facilities have been closed. “We’ve reduced the fleet significantly,” he said. “We’ve made some really tough decisions. And so the enterprise has been through a tremendous amount of change.”
The long-term goal of this strategy is to get the company away from the wild swings in profitability, or lack thereof, that have been an issue with Covenant. Part of that for now is to limit capital expenditures, which Bunn said would be kept at a “low” rate of $35 million to $45 million next year. That should generate additional free cash flow to pay debt.
But even the year after, Bunn said capex spending would be at a “maintenance” level and would not “boomerang” to a higher number.
Bunn said one reason the company can tighten up its spending is that there’s less strain put on the fleet, given Covenant’s plans to shift more toward dedicated operations. That comes with a shorter length of haul, Bunn said, “so they’re getting more time out of the trucks.”
David Parker, the company’s chairman and CEO, said a key goal of the company is to reduce its traditional volatility. For example, he said several years ago, the more volatile Expedited division was 75% of the Covenant business. Now, it’s about 35%.
In the past, Covenant might have made 70 to 80 cents per share during a peak quarter like the fourth quarter “because it’s peak, that is not going to be as much.”
But the other side of that, Parker said, is that “we’re not going to go back to saying, boy, I hope I make money in the first quarter. We’re eliminating that side of it. So you’re going to start seeing more of the volatility leave and consistency come back.”
Parker said Covenant is about 50% of the way through implementing its plan. Bunn said the cost-cutting that has gone on in the company has been “low-hanging fruit.” But there’s more to do, with a list of products that “we are actively working … that will continue to take costs out of the business and reduce overhead.”
On the call, Hogan was asked about the company’s OR target for the Expedited and Dedicated segments and the levels needed to justify the cost of capital for them.
For Expedited, Hogan said, “year-in, year-out” the OR should be mid-80s “to justify the cost of capital.” But for Dedicated, Hogan said, a 92% OR could result in a “good” return on capital. One reason: Dedicated is pulling some percentage of customer trailers, unlike most of the work on the Expedited side. “So your invested capital is much less on the Dedicated side,” he said, “plus you’re running trucks longer so your average invested capital is lower than on the Expedited side.”
The Expedited segment had an adjusted OR of 92.1% for the quarter. In Dedicated, it was 94%.
Covenant’s plans aren’t just a cost-cutting strategy. For example, John Tweed, Covenant’s co-president, said the company’s plan is to double its warehouse division by the end of 2023. The warehousing segment had operating revenue of $13.6 million in the quarter, up from $12 million a year ago, and an adjusted OR of 87.7%. Tweed said the pipeline of new warehousing deals to close in early 2021 was valued at about $70 million.