An Ugly Quarter At Covenant Transport

| About: Covenant Transportation (CVTI)

Summary

On October 13th CVTI pre-announced an earnings miss and the stock dropped 17%.

The culprit was a combination of continued soft demand in trucking coupled with a decrease in the value of their used truck inventory.

Looking forward pricing should remain soft and deprecation expense will significantly impact 2017 earnings.

We continue to look for signs of improvement in the trucking industry but aren't finding them yet.

This morning Covenant Transport (NASDAQ:CVTI) reported disappointed earnings as expected but the stock is up about 5%. Revenue came in at $164.5mil, down 5.2% yoy and EPS was 16c vs 42c last year. CVTI had pre-announced on October 13th that earnings would disappoint and the stock reacted very negatively at that time dropping about 17%. Today's move higher has only recovered a portion of the original move lower when they pre-announced.

Pricing Remains Difficult:

The trucking industry is currently experiencing a very difficult environment as we explained in detail here. Anemic economic growth has led to high business inventories and low demand for shipping. This has left truckers with excess capacity and lower truckload rates. CVTI specified lower rates as one of the reasons for weak results. Average revenue per tractor was down 1.2% for the quarter.

They expect pricing to remain soft saying that it "will be down" but they couldn't, or wouldn't say how much. Ultimately they believe in 2017 pricing will start to move up as smaller operators come under pressure and ultimately begin leaving the market. They are anticipating an industry shakeout for the smaller players that will amount to somewhere between 8-14% of operator miles. So as pressure mounts on smaller operators they anticipate pricing will begin to improve.

SRT Is The Bad Apple:

CVTI has three asset based divisions, Covenant Transportation, Southern Refrigerated Transport (NYSE:SRT) and Star Transport. Those divisions represent 62%, 28% and 10% of trucking revenue respectively. SRT has been specifically weak, with revenue down 16% yoy. Average freight revenue in this division was down 11% yoy and reported an operating loss. CVTI has been having difficulty with SRT during this downturn as they re-engineer their freight network. They appear focused on improving SRT and look to transition to new leadership, enhance the culture and employee morale, build lane density, remove excess equipment and improve customer service. They warned this should not be expected to occur quickly. An internet search for Southern Refrigerated resulted in several sites full of disgruntled employees. This is just one example. It looks like CVTI has a lot of work to do in this division.

Pockets of Strength:

In the expedited and dedicated portion of their business they are seeing signs of improving supply/demand dynamics sequentially. quarterly miles per tractor were up 3% for expedited and 2.1% for dedicated vs. Q2. Expedited also had a qoq rate improvement of 1.1%. CVTI's non-asset based or logistics division was another pocket of strength for the company with revenue up 14.4% yoy. Unfortunately this only represents about 10% of total revenue.

Depreciation Kills Earnings:

Perhaps the biggest surprise in CVTI's disappointing pre-announcement was the increased level of depreciation expense they were forced to take and will be taking going forward. Depreciation expense increased $4.6mil and slashed 15c per share off of EPS. The depreciation expense was the direct result of a weak market for used trucks. As salvage values had to be lowered, this increased their depreciation. CVTI said in the call that at the beginning of 2016 used truck prices were assumed to be down $10-12k. That increased in Q2 to $16-17k. Now those same trucks are worth $19-20k less than they were at the beginning of the year. This is why they were forced to increase depreciation. This is directly related to the slowdown in trucking that began around June/July of 2015. They expect to see a tailwind on depreciation expense by Q3 2017.

The company expects to dispose of an additional 140 used tractors for 2016. In the first 3 Q's of 2016 they purchased 650 new tractors. For the remainder of the year they will take zero new tractors. CVTI's fleet remains very young at 1.7 years. They see that peaking around 2.5 years and likely won't need new trucks for most of 2017.

Takeaways:

The increased depreciation seems to have caught the market off guard. It's likely other operators will have to take similar depreciation increases that will likely hurt earnings. The company did note that July was the weakest month of freight in the quarter, down 4% yoy. August was up 1.1% and September saw further improvement up 2.3% yoy. Unfortunately we can't apply that anecdotal evidence to the rest of the industry because they cited company specific reasons for the improvement.

CVTI expects to have a good peak season with flat pricing and higher utilization but it will be softer than they would like it to be. Overall pricing will be down. The peak season had a slow start for them noting that the past 5-6 days have seen improvement, but this is a about two weeks later than normal.

Management stated that "nobody is buying new trucks now." The used truck glut looks like it will be longer than expected. At the beginning of the year it was expected to improve in the back half. Now they are assuming no improvement in the used truck market for 18-24 months. If smaller operators start going under, as they are anticipating, the oversupply of used trucks could extend to 3-4 years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.