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Knight Transportation, Inc. (NYSE:KNX)

Q2 2014 Earnings Conference Call

July 23, 2014 04:30 PM ET

Executives

Adam Miller - CFO, Principal Accounting Officer, Secretary and Treasurer

Dave Jackson - President

Kevin Knight - Chairman and CEO

Analysts

Bill Greene - Morgan Stanley

Scott Group - Wolfe Research

Brandon Oglenski - Barclays Capital

Rob Salmon - Deutsche Bank

Todd Fowler - KeyBanc Capital Markets

Allison Landry - Credit Suisse

John Larkin - Stifel Nicolaus

Brad Delco - Stephens Inc.

Tom Albrecht - BB&T Capital Markets

Operator

Good afternoon, ladies and gentlemen. This is the conference operator. Today’s conference will begin momentarily until that time your lines will again be placed on music hold. Thank you for your patience.

Good afternoon, my name is Tracy, and I will be your conference operator today. At this time, I would like to welcome everyone to the Knight Transportation Second Quarter 2014 Earnings Call. (Operator Instructions) Speakers for today's call will be Kevin Knight, Chairman and CEO; Dave Jackson, President; and Adam Miller, CFO. Mr. Miller, the meeting is yours.

Adam Miller

Thank you, Tracy. Good afternoon, everyone, and thank you to everyone who has joined the call today. We have slides to accompany this call, posted on our website at investors.knighttrans.com/events. Our call is scheduled to go until 5:30 PM Eastern Time.

Following our commentary, we hope to answer as many questions as time will allow. If we’re not able to get to your question due to time restrictions, you may call 602-606-6349 following the call and we will return your call. Again that number is 602-606-6349.

The rules for questions remain the same as in the past, one question per participant. We don't clearly answer the question, a follow-up question maybe asked.

Let’s begin, let’s move to Slide 2. I'll first refer you to the disclosure on Page 2 of the presentation. I'll also read the following. This conference call and presentation may contain forward-looking statements made by the company that involve risks, assumptions and uncertainties that are difficult to predict. Investors are directed to the information contained in item 1A Risk Factors or Part 1 of the Company's Annual Report on Form 10-K filed with the United States SEC for a discussion of the risks that may affect the Company's future operating results. Actual results may differ.

I'll now begin by covering some of the numbers in detail, including a brief recap of the second quarter results starting with Slide 3. For the second quarter of 2014, we earned $0.31 per diluted share versus $0.24 from the previous year.

Net income increased 36% year-over-year to $25.8 million, while our operating income increased 21.8% year-over-year to $38.9 million. Revenue excluding fuel surcharge increased 9.4% year-over-year to $218.9 million, and our total revenue increased 7.9% year-over-year to $264.2 million.

Now to Slide 4. Again our balance sheet remains solid. We ended the second quarter with over $600 million of stockholders equity and have returned just under 80 million to shareholders through dividends over the past two years. We continue to refresh our fleet with modern equipment and have an average tractor age of 1.8 years.

As of the end of the quarter, we had just 15.4 million of borrowings under our 300 million unsecured line of credit, which we believe provides us flexibility to pursue all opportunities including acquisitions and organic growth.

Now, on to Slide 5. Improving our return on invested capital remains a top priority for our company. Our internal initiatives centered around increasing our revenue per tractor, growing our logistic segment profitably and optimizing our network for efficiency has resulted in a 140 basis point improvement in our trailing 12 month return on invested capital since the third quarter of 2013.

Dave Jackson will now provide some additional insight to our second quarter results.

Dave Jackson

Thanks, Adam. Good afternoon, everyone. I’ll start with Slide 6. During the second quarter, we continued to experience strong demand for our truckload services. The flexibility and responsiveness of our service center network and operations enabled us to provide needed capacity to our customers.

In addition to our nationwide fleet, we're also able to provide meaningful capacity through the sourcing of third-party capacity by our non-asset logistics business. We grew our revenue, excluding trucking fuel surcharge by 9.4% compared to the second quarter of last year.

In our trucking segment, we were able to improve our revenue per tractor by 6% by increasing length of haul, operating with a lower empty mile percentage, and increasing our loaded rate per mile. This quarter marked the fourth consecutive quarter of year-over-year improvement in empty miles percent. When looking at our second quarter revenue growth over the last four years, we've averaged a compounded annual growth rate of 9% without any growth coming from acquisitions. This also marks the 18th consecutive quarter of year-over-year revenue growth since coming out of the downturn in 2009.

Onto Slide 7, our industry leading performance as a result of focused execution of our plan to provide a regular route capacity in the markets that needed most when they needed most. We do this with both our asset-owned capacity and capacity provided by our third-party carrier partners through our brokerage. We increased net income 36% when compared to the same quarter last year. When comparing second quarters over the last four years, our compounded annual growth rate for earnings is 12.9% which is illustrated by the graph. Since coming out of the downturn in 2009, we have now averaged 11.5% year-over-year growth in net income over the last 18 quarters again without any growth coming from acquisitions. With the combination of the improved trucking environment and our internal initiatives, our team produced a very solid quarter and we’re optimistic about continued positive results.

Now to Slide 8. In the second quarter, our asset-based trucking businesses operated at a 79.0% operating ratio. This is an improvement of 270 basis points year-over-year. I just want to point out and remind you that that includes Knight Transportation, which is our dry van business; Knight Refrigerated, which is our temperature control business; and Knight Port & Rail Services, which is our triage business.

We continue to see positive results from tightening capacity, improve market demand, and our internal initiatives centered around improving yields, increasing productivity and managing our cost per mile. Our non-asset based logistics business is again experienced significant revenue growth year-over-year during the quarter. Our brokerage business continues to find opportunities to grow with new customers as well as our existing customer base.

Our brokerage business increased revenue 64.1%, and increased gross margin 69.5%. Consolidated our operating ratio for the second improved by a 180 basis points to 82.2%. It would be one to thing to achieve a low 80s or upper 70s along our drive van business alone, it’s saying something to do that also and simultaneously in the refrigerated business. But I think you can say that we’re beginning to really demonstrate the model of the future with strong brokerage top and bottom line growth in addition to the industry leading asset based performance. This is a model that brings efficiencies to the marketplace and represents a significant growth opportunity for our company.

Currently we are only capturing a small portion of the daily opportunities presented to us for brokerage. It seems as if we can't hire and train people fast enough to keep up with the brokerage opportunity. Our aggressiveness for growth in the brokerage business has increased as our confidence in our model has also increased.

Now onto slide nine. Our revenue per tractor continues to improve year-over-year and our efforts and focus on improved asset productivity has been effective. We've leveraged technology, our understanding of regional freight markets and customer needs with the strengthening trade environment have led to us achieving these results. We believe these levels of production are sustainable.

As for the growth in the trucking segment, we’ve increased drive pay meaningfully over the last three quarters, which has increased our cost but has enabled us to maintain our fleet size with some year-over-year growth. But most in the industry are downsizing their fleet -- their fleet size due to the difficulty in attracting and retaining drivers.

More importantly we believe we're positioned for additional organic growth. We expect to grow the fleet by 200 tractors as mentioned earlier in the year. We believe -- we expect to do this before the end of the year. We believe that the many efforts that have been underway in addition to the driver pay increases should enable us to achieve this target. Specifically, we expect to add approximately 75 tractors by providing additional services in three existing service centers. The remainder of the 200 tractor growth target will be achieved if we are successful in every service center adding a net of just a couple of tractors over last year’s tractor count.

Now the slide 10. Our team remains focused on executing at the highest levels in each of our businesses, departments and service centers. We have plans in place but we expect to continue to lead to improving results. Hiring and retaining quality driving associates remains the most significant challenge and represents a significant opportunity for our company. I am pleased to tell you that the driving job at night is improving. In the last 12 months we’ve significantly improved our driver pay and performance bonus all in conjunction with the benefits, our service center strategy creates for our driving associates.

We continue to make Knight the place of choice for professional drivers. The overall trucking environment has remained strong for three consecutive quarters since the fourth quarter of last year. We expect to see continued demand improvement for our services in the coming quarters.

I'll now turn it over to Kevin Knight.

Kevin Knight

Thanks, Dave and if we could now move to slide 11 and I’d like to discuss growth a little more than what Dave has touched on. Again as Dave outlined earlier, we have a solid plan to grow trucks in the back half of 2014 by a count of 200. On the logistics front, we are pleased with our model if it continues to grow and develop and we increase the number of customers utilizing this service offering. It’s become a very solid supporting business and it is also having positive impact on our overall capabilities with our customers. We expect the growth in this business to accelerate. We also continue to be more active on the acquisition front and are pursuing several high quality opportunities.

Now to slide 12. This month, we created COOLTRANS. Knight has a strong track record of successful start-up truck load businesses. We expect COOLTRANS to be like night transportation and night refrigerated in terms of growth trajectory and industry leading profitability. COOLTRANS is a full truck load temperature controlled transportation company created to be attractive to professional drivers while providing high quality consistent service to our customers. We hired Jon Isaacson, former CEO of large temperature-controlled truckload transportation company to lead and grow this business. We are excited about the combination of John’s leadership and experience with Knight’s established network and freight opportunities. We believe that leveraging the scale resources and network of Knight with the culture Jon will lead in COOLTRANS will be attractive to professional drivers and will lead to meaningful capacity creation in the refrigerated marketplace. The response in anticipation so far from customers and drivers has been very positive.

We are excited to have Jon as part of our team and actually this is the second time we’ve had an opportunity to work with Jon back in our Swift days. My brother Keith, I believe, hired Jon and they worked together in Swift’s Southern California operations. So we’re glad to be [indiscernible] to be reacquainted with Jon.

We believe we are in a long term positive environment for regular route truckload and this is an opportunity to leverage and experience an additional experienced leadership team to provide much needed capacity for our customers and generate meaningful returns for our stakeholders.

I'll now turn it back to Dave to discuss guidance. And before I do that Dave, I’d just like to tell everybody listening to the call, how pleased we are with the effort of our entire team. So with that, Dave I will turn it back to you.

Dave Jackson

Slide 13 is our final slide. Based on the strengthening market, we are updating our previously announced third quarter 2014 guidance from $0.23 to $0.26 per diluted share to $0.24 to $0.27 per diluted share. Our expected range for the fourth quarter of 2014 is $0.26 to $0.29 per diluted share. Some of the assumptions made by management include rates to continue to be positive year-over-year and for miles per tractor to be relatively in line with the year ago period. And for the used equivalent market to remain strong, yet also includes consideration for potentially volatile fuel prices. These estimates represent management’s best estimates based on current information available. Actual results may differ materially from these estimates; we would refer you to the risk factors sections of the company’s annual report for a discussion of the risks that may affect results.

This concludes our prepared remarks. We would like to remind you that the call will end at 5:30 Eastern. We will answer as many questions as time allows. Please keep it to one question, to allow us to get to more of those of you that have questions. If you are not able to get your question answered due to time constraints, please call 602-606-6349 and we'll do our best to follow up promptly.

Tracy, will now entertain questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question is from Bill Greene with Morgan Stanley.

Bill Greene - Morgan Stanley

Can I just ask since driver wages and driver shortages and all this just keep coming up, can you give us some sense for what the average kind of driver cost inflation is or what the wage increases you are giving or something some color around just so we can get a sense for what the kind of pressures are that you are seeing?

Kevin Knight

Yes, I'll go ahead and take that Bill. First off, it’s not the easiest question to answer. What we’ve done is we’ve improved our driver base pay two or three times here in the last year or so. And we’ve also improved bonus to a line pay with performance. And so that could equate to as much as five or six, seven, tenth a mile if a person hits it out of the park, but at a minimum it’s like $0.025 to $0.03 per mile. So when you look at that in conjunction with our driver pay, it would be somewhere in the 5% to 10% range over the last 12 months and we would expect for that number to continue to improve as the market for truckload and services continues to strengthen.

Bill Greene - Morgan Stanley

I think we’ve sometimes heard you say or maybe not -- it's not attributed to you but that roughly half of the rate increase is often passed along to the driver is that a fair ratio as you think about it?

Kevin Knight

No, I would say less than that, Bill. I don’t think we’ve given indication of half more like a third. So that’s basically the guideline that we use.

Operator

Your next question comes from Scott Group. If you could please state your company affiliation, your line is now open.

Scott Group - Wolfe Research

Hi, it’s Scott Group from Wolfe Research.

Kevin Knight

Hey, Scott.

Scott Group - Wolfe Research

So I wanted to ask about the guidance for the third quarter. Because if I look historically second quarter and third quarter are typically pretty similar and in the past couple of years I understand there was a big fuelled help in second quarter that turned into a drag in the third quarter. Why the big sequential drop in earnings that you are expecting from 2Q to 3Q?

Adam Miller

Hey, Scott, this is Adam. Maybe I'll just outline some of the factors that went into our guidance here. We’re expecting in the third quarter to start to pick up some of the tractor growth that Dave alluded to in the -- in our prepared remarks and so that would -- we would start to see a little bit of the year-over-year growth from a tractor basis.

Again probably see the similar type of rate improvement on a year-over-year basis that we’ve experienced here. Again miles are probably flat, maybe, could be potentially slightly up but now that we're lapping the hours of service regulations, but I wouldn’t expect that to be up more than a 100 basis points at the most. We see continued growth in our logistics business like we have been both sequential growth as well as year-over-year.

From an overall perspective, just looking at the past two years, we’ve seen typically a few 100 basis points increase in the operating ratio from second to third. And so we're kind of (penciling) [ph] that into our guidance here just without knowing exactly how this third quarter is going to play out. But we would expect to see the logistics, it’s not as subject to the volatility as our asset base business. So we’d expect that all to be positive on a year-over-year basis but probably similar to what we saw in the second quarter.

Kevin Knight

Yes, and I would add too Scott that in the past, third quarters were typically the same as second quarters. But since the downturn, we’ve experienced I think more third quarter that we weren’t that excited about in third quarters that we are excited about. But the momentum going into the third quarter seems strong. And so basically that’s how we’ve come up with our guidance. I think we earned $0.19 last year in the third quarter and the range we’ve given is an increase from where we were like a quarter ago. The $0.24 to $0.27 range and certainly we hope to be on the upper half of that and not on the lower half of that. So that’s how we look at it.

Bill Greene - Morgan Stanley

That’s all very helpful. So it sounds like that you think that the drop in margin from 2Q to 3Q over the past couple of years is more about seasonality and less about the impact of fuel?

Kevin Knight

Yes, absolutely. In recent history I would say pretty much the whole month of July and the half month of August seems like they haven’t been all that great. And so the good news is July here has started off very strong and they are stronger than what we’ve seen in the recent past and so we're optimistic about being in the kind of upper half of that range that Adam has given and hopefully we'll able to accomplish that.

Operator

Your next question comes from Brandon Oglenski with Barclays.

Brandon Oglenski - Barclays Capital

Kevin, I just want to ask you, how sustainable is this pricing environment going to turn out to be? I mean I know in the past couple of calls you’ve talked about demand environment here that you thought was quite robust and is going to have some longevity. Is that still the case and are things even looking better at this point?

Kevin Knight

Well, I would say that we're feeling stronger Brandon about price than we were a quarter ago and so we had expected contract rates to increase at the beginning of the year, the end of the last year, maybe 2% to 3% and then we move that to 3% and then we move that to 3% plus. We're currently expected contract rates to be in the 4% to 5% range, which is a really good year for contract rate as those represent going through the bid process and dealing with many of our larger and more meaningful in terms of revenue customers. So basically, our bent towards rate improvement has strengthened again this quarter over the last quarter. And we really don’t see anything on the horizon that makes us still like what we produced is not sustainable.

We have a very unique model, one that really we started to modify the model that got us through the first 15 years of our existence. And we really started to modify that model back in 2005 and then we hit the downturn and we really didn’t ever get the chance to really make that whole thing work the way that a healthy freight environment can help make it work. So we believe that based on what we’ve seen in the fourth quarter and the first quarter, the second quarter and thus far into the third quarter, we feel like that what we’ve done over the last 10 years has positioned our Company to continue to make a headway in our return on invested capital, to give us significant additional growth revenues through the logistic side of our business, and really continue to maintain that premier position as far as growth and earnings from our truckload business.

That was the big risk for us going back. When I think of ’05 and ’06 timeframe, I had stepped out of the box and started Knight Refrigerated, which was a very good success. So we announced only two truckload entities, but we haven’t, we’ve never been in that logistics space, and especially with the heavy brokerage bend to it and so we’re really very pleased that our experience of the last however many years in determining the direction we wanted to take our business is paying dividend, and we think that it’s going to pay dividends for many years because it’s becoming fairly large.

And so it’s kind of like pushing the old flywheel. We've kind of got that thing moving now and you can tell based on Dave’s remarks, we're having a bit of tough time on the people side just keeping up with the opportunities. So I believe that it’s sustainable.

Brandon Oglenski - Barclays Capital

If you don’t mind just a quick follow-up. Your other large competitors are obviously pursuing similar strategies with brokerage. What is it about your model here that seems to be driving some outperformance relative to some of the other fleets?

Kevin Knight

Brandon, it’s just the way we do things. I don’t know how else to explain it without giving you maybe too much information. So just like in the truckload business where we’ve been able to be more efficient and more effective with the revenue dollars that the Company produces, operating in a market where we don’t set the price but where really the market sets the price. We’ve been able to leverage that expertise in conjunction with the non-asset side that really just put us in a different place at the end of the day. Without sharing anything specific, I mean we’re absolutely positive we going about this differently than any of our competitors. So you know -- and we are glad that we -- that it’s working. So that’s really all I have to. Do you have anything to…

Dave Jackson

No, I would say that it’s a strategy that’s working now. That doesn’t mean that it’s a strategy per se that would have worked as well in maybe the downturn, more recessionary years and -- but we -- it works for us. It's going to work for a long time and we think we’ve learned enough about it that we'll be ready for the next change in pace that will come hopefully several years down the road. So as I said earlier, I think it’s a space that we’ve gained a lot of confidence and so now we're growth investment mode there. That’s where we feel most comfortable is when we are in a growing type of a mode and a growing type of an environment. There are opportunities from a technology perspective that we are yet to leverage. So an example is our brokerage business. We’re hopefully about 30 days away, 37 days away from going live on a system we’ve spent a lot of time in preparing. And so the kind of technology that we’re using in our brokerage today was invented in the 1970s. And so it’s this is a business that we’re doing a lot with limited resources if you will. And so we think that there are several encores to be made.

We’re not content, we’re not happy with the volume frankly. Although we see revenue and margin up in the 60 percentile range, it could be better than that. And so we’re working through those barricades and that’s going to be a strong piece for us. And the good news -- I think the best news of all is that, this is all being done not at the expense of our asset based businesses. And so because of that and because of the way we’ve figured out how to weave that together, that business is able to leverage the strong support of this network we have across the country. So that’s where -- you will keep hearing us talk about it I guess is a safe assumption.

Operator

Your next question comes from Rob Salmon with Deutsche Bank.

Rob Salmon - Deutsche Bank

With regard to your fleet growth, is that incorporating COOLTRANS in the 200 net additions you are expecting to achieve and can you talk a little bit more about how you're planning to kind of grow COOLTRANS? Will it be leveraging the infrastructure of Knight Transportation or will this be completely separately run entity?

Dave Jackson

Well, I'll speak on part of that and maybe Kevin will chime in on another part of that. The 200 tractor growth that I talked about, we laid that out at the start of the year which was before COOLTRANS started and before that opportunity became available to us. So we expect to do 200 with the existing Knight suite, apart from the growth that we see at COOLTRANS.

Kevin Knight

Yes. And I would just say for COOLTRANS, we expect to add 50 trucks very quickly and those trucks were taking delivery of them as we speak. We’ve got our first group of drivers in orientation this week as we speak and basically our goal for COOLTRANS is within the next 12 to 24 months to be operating hopefully a 150 to 200 units would be our goal. And basically that is separate from Knight. We also expect for COOLTRANS to be a contributor to our brokerage effort also.

So when we look at COOLTRANS, we don’t look at the COOLTRANS start exactly the same way as we do Knight Transportation and Knight Refrigerated. We look at what we’ve learned now with Knight Refrigerated and Knight Transportation and we're trying to make sure that we take advantage of all growth opportunity. So COOLTRANS should have a fairly significant brokerage component right from the get going as a matter of fact, we’ve already created some revenue there. Now we will have some startup cost as a result of the start of COOLTRANS. So I wouldn’t expect that it should be much of a bottom-line contributor until we get into next year and then certainly it will be more significant as we move forward. So we think that we’ve got a significant opportunity with COOLTRANS.

Rob Salmon - Deutsche Bank

That’s helpful. What should we be penciling in with regard to the startup cost in the third quarter?

Kevin Knight

Say that again, Rob.

Rob Salmon - Deutsche Bank

Kevin, what should we be modeling in terms of the startup cost related to just to getting the entity up and running?

Kevin Knight

Yes, I would just look at it neutral in the third quarter. Like whatever revenues create, we’ll probably have expenses to offset those. So, I'm not sure Rob we'll need to do any modeling. Now you could follow up with that after the call, if you want a little more detail. And then we would expect for it to start marking an ever so slight contribution as we get into the fourth quarter. But we’ll have to get that thing up to 200 trucks before we even start see some meaningful EPS contribution is how I would look at it Rob.

Operator

Your next question comes from Todd Fowler with KeyBanc Capital Markets.

Todd Fowler - KeyBanc Capital Markets

Kevin, I guess I'm curious to get your thoughts about the operating environment in the second quarter and maybe if you want to comment on what you’ve seen so far into July? I am curious if you felt that the second quarter was normal from a seasonality standpoint or if there was anything that benefited the environment either one way or another. I know there's been some moving parts with the first quarter weather and some other things going on with intermodal and some stuff like that. So I'm curious to get your perspective on the second quarter in July at this point?

Kevin Knight

Yes, what I would say Todd is really April felt stronger than we would have expected from a seasonality perspective and we haven’t really heard that from many, but for us that’s how I felt. It may seem to be kind of normal. It may seem to be a little late. The produce seem to be a little late. It just didn’t seem like things took off the way we would have expected in May and then June finished strong. And it seems like some of that June has carried over into July. I really expected things to be a little bit disappointing during and after the holiday, but we actually performed fairly well.

Now a lot of that has to do with the holiday falling on a Friday. So we can’t forget that July 4th was on Friday versus a Thursday of last year. So really I would say it kind of normal seasonality, although it seemed to us like there was more activity in April probably as a result of loads that maybe didn’t get moved as a result of the weather that was experienced in the first quarter. So then it seemed like once we got that cleaned up, then it seemed like it took a little longer for the second quarter seasonality to really kick in, but then it seems like it’s hung in there a little bit longer. So that’s basically how the seasonality has played out, to

Todd Fowler - KeyBanc Capital Markets

And as it produce Kevin, that's still carrying it into July or is there something else that I would think that in some of that go up…

Kevin Knight

Yes, I think it was just late. I think maybe the water was a little late. The average was a little late. I don’t know. It’s hard to explain. I think too some of it could have been the stuff around the Port of LA and the Port of the Long Beach and everybody trying to get stuff in here, certainly before the contract could have expired. And so we probably got a little bit of overhang from that. Stuff that hit the port at the end of June would have been getting still moved from a line haul perspective thereafter. And so I think from our customers’ perspective, they just wanted to make sure it was out of the port by the end of June and didn’t necessarily care whether they have it or not, probably didn’t want it because our sense is that are customers probably pull things forward a week or two or three just for any disruption that may have taken place. So at least in the customer meetings that I've been involved in, that seems to be what the general tone was. So that’s probably had a bit of an effect and…

Dave Jackson

Also the fact of the matter is the GDP for the first quarter was disappointing and dramatically different than what we had seen from a third quarter and the fourth quarter. So we may have felt a little of bit of that in May, but June was very, very strong and capacity was very, very scarce to find with expenses. And so certainly through the mid-half of July that pace continued which hopefully speaks well, the broader GDP as we -- for the overall economy and if that continues to keep up and given where supply is and I think it bodes well for what the back half third and fourth quarter of this year might look like.

Operator

Your next question comes from Allison Landry with Credit Suisse.

Allison Landry - Credit Suisse

Dave, you mentioned that you’re becoming more aggressive in growing the brokerage business as your confidence has increased. So I was just curious if we should interpret that as an indication that you are going after market share? And if that’s not the case, maybe if you could comment on what the strategy is for the business?

Dave Jackson

Yes. I would say that market share is just a term that I'm not share it has a place at all in truckload transportation, just given how things work. I think we don’t look at things in terms of market share, especially because that’s usually code for its not profitable. And so we are interested in growing that business profitably. And what you’ve noticed over the last several quarters is very strong top line but a bottom line that is keeping pace with an aggressive top line. So that’s how we want to do it. We want to build it right. It’s a variable based business and so it’s a very difficult concept to try and argue that in a variable based business you cannot be profitable today but somehow with size you're going to turn it into profitability. At least we’re not smart enough to figure that piece of it out. So we’re just going to build it profitably one step at a time as we grow.

When we talk about aggressively growing that business, that’s a business we’re giving more resources to, not only in terms of just adding new headcount, but technology, resources, also experience within the Knight business. And so we’ve made some people -- we’ve moved some folks around to continue to give that business people that are talented, managers that are proven on the Knight side of things. So for us, that’s kind of a -- that’s a big deal, because these are folks that are productive in whatever role they do and sort of put them into brokerage, we’re beefing up the horsepower if you will.

And that’s space a where on any given day, we’re still turning down way too many loads. And we’re turning down loads that with more resources, we could find an appropriate double-digit gross margin that we’re able to convert into a 93% to a 94% operating ratio and grow that business significantly.

So to say nothing for the fact that it positions us well with our customers, we're able to alleviate and help them, especially in a time like they’ve seen over the last three quarters, we’re able to help them find capacity when it can be sometimes the most difficult to find. And so this hybrid model if you will, of us doing a lot on our assets, it’s great for us to get to know the customer, understand what they have going on. And when our customers allow us to leverage the brokerage side of it, everybody wins.

Allison Landry - Credit Suisse

And then just my follow up question. One of your competitors noted that driver challenges are intensifying as carriers of all sorts of sizes are potentially poaching drivers from one another, with sign on bonuses and other short-term benefits, and [indiscernible] that suggests that conditions are almost becoming desperate for some companies. I was just curious to get your thoughts on this and if you are seeing similar trends and what Knight might be doing in response?

Dave Jackson

Yes, I think the immediate response would be what else is new. This has always been an environment where drivers trade from one to another. It’s an industry known for having high turnover. And so in terms of desperation, I think there are definitely inflationary pressures that every single trucking carrier faces.

I think the reality is most carriers have not been able to raise their rates to a level that allows them to give back to the driver to make it more attractive job. We don’t just compete with which other for drivers, but we have to be attracting individuals into the space that want to come and get a CDO and gain experience and be a truck driver. We’ve relied maybe too much on the baby boomer generation for many years. And so we find ourselves with a problem that’s been growing and brewing for many, many years.

And so I think when we talk about rates and how where contract rates are up, our spot rates are probably a bigger deal this year than we’ve seen in maybe five or six or seven years, and probably will be part of a norm in terms of just there is this intense need and the capacity is scarce.

What this all comes down to is carriers need to raise rates in order to cover these costs that haven’t been covered sufficiently for several years now. And on top of that, we’ve got to find a way to get another $0.12 or $0.15 to the driver. And so it’s going to take a while. I think shippers are recognizing this need and recognizing that the driver and attracting drivers is really the driving factor in this whole piece and rates are going to continue to increase until we have plenty of drivers and we're a long, long ways from there.

So in terms of desperation, I think it’s just a difficult business to be in right now and the folks -- it doesn’t appear that there is new folks getting into it except for COOLTRANS and it feels like more players continue to leave the space and established largest players seem to be running less and less trucks year-over-year. And so and I don’t know if that’s desperation, but it certainly is a challenging environment in general. I think for a business like ours, this is -- we do pretty well in this. We view this type of a time as very much an opportunistic time for us to grow. Kevin?

Kevin Knight

Yes. And I would say Allison, first off we used to get all of our drivers through experience and we over the last couple of years have intensified our training initiatives, which is definitely paying dividends, allowing us to grow few trucks year-over-year, not as many as what we would like but I'm in strong agreement with Dave. I think this type of environment is exactly what we thrive on.

And we look forward to continue to lead and be ahead of the group with regard to our driver initiative. So certainly we're investing in our driving associates, we’re investing in the programs that develop those driving associates. COOLTRANS is a perfect example of thinking outside of the box. Driving associates like to be part of something new. They like to be part of a smaller team, as compared to a larger team.

And when you have somebody like Jon, that's got that much experience in our industry, it’s a very appropriate way to go about. Instead of adding to our refrigerated business, which already has a good management group, we get to add another good management group and typically two good management groups are going to hire more driving associates than one good management group.

And so really we're doing a lot in that area. COOLTRANS is part of that and we'll continue to push the edges in that area. But like Dave said, we’ve just got to improve our rates as an industry in order to make sure that it’s a job that definitely attracts people and we’ve taken some significant steps this year and we expect to continue.

I also think, Allison, that the logistics systems that exist today really only address the needs of our customer, the shipper and the consignee and pretty much the rest of it lands on our shoulders, to either buy more trailers so we can drop and hook or try to negotiate with the grocery store warehouse a reasonable appointment based on when our driver picked up. What you’re going to see start to take place is it becomes apparent that we're in an environment like this as we’re going to end up having more control over when we're able to deliver. And the customers that we have that are able to figure out, okay when would be the best time for your driver to deliver based on the hours of service, based on all the regulations that you have. And when they’re able to fill that requirement for us, then basically that’s going to work well. If you are a customer and you don’t have the ability to control that or don’t take the initiative to control that then basically your price will go up more so than the other people competing for capacity, so long answer but I hope we answered your question, Allison.

Allison Landry - Credit Suisse

Absolutely, that was extremely helpful and it sounds like the COOLTRANS is going to be an interesting little business. So looking forward to seeing how that goes. Thank you for the question.

Kevin Knight

We are excited about it. So thank you.

Operator

Your next question comes from John Larkin. If you could please state your company affiliation. Your line is open.

John Larkin - Stifel Nicolaus

Sure thing. It’s John Larkin from Stifel Nicolaus. A little clarification if you don’t mind on the non-asset based side of the business. You stated at couple of times that the brokerage piece is growing like wildfire up 64%. If the overall business is up just 22% on the asset light side, I would have thought that brokerage was a bigger component of the total non-asset based business?

David Jackson

Yes, well first off, John, it is and you’ll see that more so as we move into third and fourth quarter. We have three components in logistic. We have sourcing, we have intermodal and we have brokerage. And we had some revenues in second quarter of last year, significant revenues in intermodal that are not repeating this year. So what I think you will -- and our sourcing business is not a high growing -- is not a fast growing business. It may be growing by some months a little and some months not so much.

Our actual intermodal business revenues were down 40% year-over-year, as we cycled off the onetime stuff that we did in second quarter of last year. So I think John, the picture will become much clearer as far as what our logistics business is really doing as we move into the second half of this year.

John Larkin - Stifel Nicolaus

Fair enough on that one. And then Dave you’ve talked about the new operating system that will be put into place I guess 37 days from now to bring the brokerage operation into the modern era. Is there anything similar that’s been rolled out on the trucking side? It’s interesting how successful you’ve been at taking revenue per loaded mile up while reducing empty miles. I'm wondering if there is some technology application that you’re using to help make better decisions because I'm guessing that not all of that 5% plus revenue for loaded mile increase is rate. Some of it is probably better freight selection?

David Jackson

Yes, I think the technology reviews on the truck side has helped us go or improve the revenue per total mile, which is greater than the 5.6% because of the reduced empty miles. We have an optimization system that we use. I would say that most largely it’s ready use it. What makes it different for every carrier as it doesn’t tell you intuitively or natively where to go, what to do. You have to populate all kind of assumptions and thinking, and so take it as quite a while to do that and take our approach into -- yes, two or three years now to load that with all the preferences and how we want to look at freight.

And so we are now leveraging that tool more than ever -- more than we ever had before and the vast majority of our loads feed through this modeling and of course it takes into account a number of factors, which -- empty miles of course is one major factor there. So I think the combination of I would say three things are leading to that.

One is the when you're in an environment that’s got more loads, combined with an optimizer that gives it more flexibility on what to choose, that those two things help right? And you don’t just get there overnight. We’ve paid the price to get to that point. I think the third piece that’s really helped us doesn’t have to do with technology, but it has to do with some changes we’ve made over the last year or two on approaching markets and pricing.

And so we have just a great deal of analysis that goes into lanes we haul, what the rates are and so the discipline that we have for building density in lanes throughout the country, which enables us to create a little bit better driving job with a little more predictability and then it allows us as we go through these massive bids the opportunity to comb through and find things that really work for us. So when you combine all three of those things, that’s what’s made a big difference on the empty miles.

Operator

Your next question comes from Brad Delco with Stephens Inc.

Brad Delco - Stephens Inc.

I wanted to ask you a little bit, kind of following up on couple of other questions, but maybe to pull down to it, the cadence of these contractual rates that you saw come into the second quarter. When were a majority of those recently negotiated contracts put in place and what percentages of your freight do you feel like have these new rates in place during the second quarter?

Kevin Knight

Brad, I'll take that one. I mean first off, it’s such a moving target. We’re still working bids that we thought would be finalized months ago. So basically it is absolutely an ongoing process. I would say the initiative typically starts in November-December and you would expect to be completely done by now, but certainly in some cases, we are not. We’ve also -- I have customers where they don’t bid and basically their rates become old once a year has gone by.

And so we have to take the initiative to work through those and sometimes that takes a little bit longer than we would like for too. But I would say that, a greater percentage -- call it 20% maybe went into effect in first quarter and call it maybe 30% or 35% or 40% went into effect second quarter and maybe 30% will go in third quarter and then maybe the less in fourth quarter. And that’s just totally, Brad, shooting from the hip. But it’s an ever ongoing process. And it’s important in this environment for customers not to get behind. And so we’re always, our systems evaluate all of the loads that we haul on lanes and basically we’re being fed information on a regular basis that basically tells us where each of our customers are in certain areas, certain lanes et cetera. So it’s a never ending process Brad. It was probably biggest jump happening in second and third quarter and not quite so much in first and fourth quarter.

Brad Delco - Stephens Inc.

Got you, that’s the color. And maybe just a follow up on that. Back to one of Adam’s comments earlier. He said you expect similar rate increases on a year-over-year basis. That sort of implies flat sequential rates and my sense is that we're hearing, and to your comments earlier Kevin that rates did accelerated from where you thought they were three months ago that we might see some sequential improvement in rates and tying that into your 3% to 5% common, rates per loaded mile were already up 5.6%. So I am trying to make…

Kevin Knight

Yes, and Brad you’ve got a big market component there. There's what we call market loads that basically come to you real time and so that can be a significant factor. Our 5.9% was more driven by contract rates than whatever we got in the first quarter that you still don’t know what that market component is going to be when some of the large third-party guys release. It will be interesting to see what’s happened to rates and that will give us a feel there a little bit more as far as direction is concerned. But hey, Brad, it could be a little bit stronger. It could be maybe not as strong depending on what's actually happening in the market that day.

Operator

Your next question comes from Tom Albrecht. If you could state you company affiliation? Your line is open.

Tom Albrecht - BB&T Capital Markets

BB&T Capital Markets. I guess Kevin and Dave and everyone, my question is kind of two prong. Number one, I'm still a little confused why you’re launching COOLTRANS? I'm not saying it’s a negative development, but it seems like it has the potential to maybe cannibalize a little bit of your existing business, although I'm sure you’ve thought that through. But I'd like to hear you talk about that? And then in your release you’ve talked a little bit about Dedicated had started experienced meaningful revenue in earnings growth. Historically I kind of view Dedicated as not being an 80 to 82 OR business. Are you finding that that is becoming that now? So I’ll throw it back to you?

Kevin Knight

First, I'll talk about COOLTRANS and then we’ll talk about Dedicated, Tom, and keep me on course if you will. So basically when you think of COOLTRANS, John ran a refrigerated company before he came to work for us and he wanted to -- the option was he wanted to run a refrigerated company. He didn’t want to work for somebody that ran a refrigerated company. He wanted to run one. So basically we took that opportunity and as we thought though the process, we came to the conclusion that the refrigerated market is strong enough that we shouldn’t have to worry.

As a matter of fact, John has very strong customer relationships with a different group of customers than what we have and so we actually expect that the top customers eventually for both of those companies may be somewhat different. John's strategy will be just a little bit different than ours, but in really sitting down with John and working through what we hope to accomplish, we think we can generate the same amount of profitability. Our refrigerated group has been very open and worked very closely with John in this initial initiative.

And so really Tom, it’s very well thought through. And really, we’re just very pleased that John picked us. If you want -- if I can explain, I mean, it’s really -- John had a relationship with us long ago and when he became available, he wanted to go back to that thought and he wanted it to be with Knight. And he really was the bus driver there so to speak. Once the opportunity was presented to us Tom then of course we jumped on it. And that’s basically where it is and I really believe that John and his team are going to do a really good job of developing our driver base.

And so we’re really excited about that and really if you step back Tom and look at our model, we really do run several companies. They all start with Knight. But even in our dry van business, it’s broken into four parts. So, John is like another part of our refer business and we currently have four parts to our dry van business. So I think that over time I think everybody will understand the madness behind our thinking so to speak.

As far as Dedicated is concerned, Tom, we’re not what I would call a “Dedicated” carrier. Again, we have to do things in a way that create uniqueness in our model. And so probably much of the Dedicated staff that you see many of our competitors going after, we’re not going necessarily after that. It’s something that works great for them but it might not work so much for us. It’s also not really a separate enterprise. We use Decided to support our truckload operations and vice versa and our goal is for every service center to have a meaningful amount of that activity, but it’s just different.

So from our perspective, dedicated has been very good, it’s been growing rapidly. It’s not -- its maybe $60 million, $70 million, $80 million in revenues as far as total, but you really see that in our refrigerated business, dry van business, port services business reports. So we just have somewhat of a different approach there that works for us and probably wouldn’t work the same for anybody else.

Operator

We have now come to the end of the Q&A session. I’ll turn the call back over to Mr. Kevin Knight.

Kevin Knight

Well, we appreciate everybody, and if any of you were unable to get in, again let me just give you that number, what is it, 602-606-6349. You won’t get me but you will get Dave or Adam. So anyway we appreciate your interest and appreciate you all being on the call. Thanks.

Operator

Thank you for joining ladies and gentlemen. This concludes today's conference call. You may now disconnect.

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Source: Knight Transportation's (KNX) CEO Kevin Knight on Q2 2014 Results - Earnings Call Transcript
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