10-Q 1 cvti10q.txt COVENANT TRANSPORT, INC. 1ST QUARTER 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2003 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission File Number 0-24960 COVENANT TRANSPORT, INC. (Exact name of registrant as specified in its charter) Nevada 88-0320154 -------------------------------- ------------------------------ (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 400 Birmingham Hwy. Chattanooga, TN 37419 37419 -------------------------------- ------------------------------ (Address of principal (Zip Code) executive offices) 423-821-1212 ------------ (Registrant's telephone number, including area code) 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. YES [X] NO [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES [X] NO [ ] Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date (May 5, 2003). Class A Common Stock, $.01 par value: 12,052,067 shares Class B Common Stock, $.01 par value: 2,350,000 shares Page 1 PART I FINANCIAL INFORMATION Page Number Item 1. Financial Statements Condensed Consolidated Balance Sheets as of March 31, 2003 (Unaudited) and December 3 31, 2002 Condensed Consolidated Statements of Operations for the three months ended March 31, 2003 and 2002 (Unaudited) 4 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2003 and 2002 (Unaudited) 5 Notes to Condensed Consolidated Financial Statements (Unaudited) 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 11 Item 3. Quantitative and Qualitative Disclosures about Market Risk 17 Item 4. Controls and Procedures 18
PART II OTHER INFORMATION Page Number Item 1. Legal Proceedings 19 Items 2, 3, 4, and 5 Not applicable 19 Item 6. Exhibits and reports on Form 8-K 19
Page 2 ITEM 1. FINANCIAL STATEMENTS COVENANT TRANSPORT, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except share data) March 31, 2003 December 31, 2002 ASSETS (unaudited) ------ -------------------- ---------------------- Current assets: Cash and cash equivalents $ 1,593 $ 42 Accounts receivable, net of allowance of $1,520 in 2003 and $1,800 in 2002 63,352 65,041 Drivers advances and other receivables 5,596 3,480 Inventory and supplies 3,180 3,226 Prepaid expenses 17,462 14,450 Deferred income taxes 11,109 11,105 Income taxes receivable 2,248 2,585 -------------------- ---------------------- Total current assets 104,540 99,929 Property and equipment, at cost 368,624 392,498 Less accumulated depreciation and amortization (146,784) (154,010) -------------------- ---------------------- Net property and equipment 221,840 238,488 Other assets 23,359 23,124 -------------------- ---------------------- Total assets $349,739 $361,541 ==================== ======================
LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Current liabilities: Current maturities of long-term debt - 43,000 Securitization facility 41,230 39,230 Accounts payable 7,214 6,921 Accrued expenses 19,332 17,220 Insurance and claims accrual 22,111 21,210 -------------------- ---------------------- Total current liabilities 89,887 127,581 Long-term debt, less current maturities 26,300 1,300 Deferred income taxes 57,072 57,072 -------------------- ---------------------- Total liabilities 173,259 185,953
Commitments and contingent liabilities Stockholders' equity: Class A common stock, $.01 par value; 20,000,000 shares authorized; 13,004,164 and 12,999,315 shares issued and 12,032,664 and 12,027,815 outstanding as of March 31, 2003 and December 31, 2002, respectively 130 130 Class B common stock, $.01 par value; 5,000,000 shares authorized; 2,350,000 shares issued and outstanding as of March 31, 2003 and December 31, 2002 24 24 Additional paid-in-capital 84,545 84,492 Treasury Stock at cost; 971,500 shares as of March 31, 2003 and December 31, 2002 (7,935) (7,935) Retained earnings 99,716 98,877 -------------------- ---------------------- Total stockholders' equity 176,480 175,588 -------------------- ---------------------- Total liabilities and stockholders' equity $ 349,739 $361,541 ==================== ====================== See accompanying notes to consolidated financial statements.
Page 3 COVENANT TRANSPORT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS THREE MONTHS ENDED MARCH 31, 2003 AND 2002 (In thousands except per share data) Three months ended March 31, (unaudited) 2003 2002 ---- ---- Freight revenue $ 128,024 $ 129,020 Fuel surcharge and other accessorial revenue 9,851 3,199 ---------------------- --------------------- Total revenue $ 137,875 $ 132,219 Operating expenses: Salaries, wages, and related expenses 53,810 55,756 Fuel expense 28,788 22,086 Operations and maintenance 9,994 8,863 Revenue equipment rentals and purchased transportation 14,818 14,803 Operating taxes and licenses 3,431 3,277 Insurance and claims 8,039 7,168 Communications and utilities 1,708 1,846 General supplies and expenses 3,173 3,511 Depreciation, amortization and impairment charge, including gains (losses) on disposition of equipment (1) 10,600 14,058 ---------------------- --------------------- Total operating expenses 134,361 131,368 ---------------------- --------------------- Operating income 3,514 851 Other (income) expenses: Interest expense 651 1,063 Interest income (38) (23) Other (15) (223) Early extinguishment of debt (2) - 1,434 ---------------------- --------------------- Other (income) expenses, net 598 2,251 ---------------------- --------------------- Income (loss) before income taxes 2,916 (1,400) Income tax expense 2,077 267 ---------------------- --------------------- Net income (loss) $ 839 $ (1,667) ====================== ===================== Net income (loss) per share: Total basic and diluted earnings (loss) per share: $ 0.06 $ (0.12) Weighted average shares outstanding 14,381 14,084 Weighted average shares outstanding adjusted for assumed conversions 14,670 14,084 (1) Includes a $3.3 million pre-tax impairment charge in 2002. (2) Reflects the reclassification of early extinguishment of debt due to the adoption of SFAS 145. The accompanying notes are an integral part of these condensed consolidated financial statements.
Page 4 COVENANT TRANSPORT, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTHS ENDED MARCH 31, 2003 AND 2002 (In thousands) Three months ended March 31, (unaudited) -------------------------------------------- 2003 2002 ---- ---- Cash flows from operating activities: Net income (loss) $ 839 $ (1,667) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Net provision for losses on accounts receivables (162) 209 Loss on early extinguishment of debt - 890 Depreciation, amortization and impairment of assets (1) 10,833 13,552 Provision for losses on guaranteed residuals - 324 Deferred income tax expense (4) 619 (Gain)/loss on disposition of property and equipment (234) 506 Changes in operating assets and liabilities: Receivables and advances (264) (1,208) Prepaid expenses (3,012) 1,025 Tire and parts inventory 46 147 Accounts payable and accrued expenses 3,643 (2,102) ------------------ ----------------- Net cash flows provided by operating activities 11,685 12,295 Cash flows from investing activities: Acquisition of property and equipment (2,103) (16,239) Proceeds from disposition of property and equipment 8,231 790 ------------------ ----------------- Net cash flows provided by (used in) investing activities 6,128 (15,449) Cash flows from financing activities: Deferred costs (315) - Exercise of stock options 53 475 Proceeds from issuance of long-term debt 5,000 38,000 Repayments of long-term debt (21,000) (35,338) ------------------ ----------------- Net cash flows provided by (used in) financing activities (16,262) 3,137 ------------------ ----------------- Net change in cash and cash equivalents 1,551 (17) Cash and cash equivalents at beginning of period 42 383 ------------------ ----------------- Cash and cash equivalents at end of period $ 1,593 $ 366 ================== ================= (1) Includes a $3.3 million pre-tax impairment charge in 2002. The accompanying notes are an integral part of these consolidated financial statements.
Page 5 COVENANT TRANSPORT, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Basis of Presentation The consolidated financial statements include the accounts of Covenant Transport, Inc., a Nevada holding company, and its wholly-owned subsidiaries ("Covenant" or the "Company"). All significant intercompany balances and transactions have been eliminated in consolidation. The financial statements have been prepared, without audit, in accordance with accounting principles generally accepted in the United States of America, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the accompanying financial statements include all adjustments which 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, 2002 consolidated balance sheet was derived from the audited balance sheet of the Company for the year then ended. It is suggested that these consolidated financial statements and notes thereto be read in conjunction with the consolidated financial statements and notes thereto included in the Company's Form 10-K for the year ended December 31, 2002. Results of operations in interim periods are not necessarily indicative of results to be expected for a full year. Note 2. Basic and Diluted Earnings (Loss) per Share The following table sets forth for the periods indicated the calculation of net earnings (loss) per share included in the Company's consolidated statements of operations: (in thousands except per share data) Three months ended March 31, 2003 2002 ---- ---- Numerator: Net earnings (loss) $ 839 ($1,667) Denominator: Denominator for basic earnings per share - weighted-average shares 14,381 14,084 Effect of dilutive securities: Employee stock options 289 - --------- ------------ Denominator for diluted earnings per share - adjusted weighted-average shares and assumed conversions 14,670 14,084 =========== ============ Net income (loss) per share Total basic and diluted earnings (loss) per share: $ 0.06 $(0.12) =========== ============
Dilutive common stock options are included in the diluted EPS calculation using the treasury stock method. For the three month period ended March 31, 2002, approximately 211,000 shares were excluded in the diluted EPS computation because the options were anti-dilutive. At March 31, 2003, the Company had stock-based employee compensation plans. The Company accounts for the plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Under SFAS No. 123, fair value of options granted are estimated as of the date of grant using the Black-Scholes option pricing model and the following weighted average assumptions: risk-free interest rates ranging from 2.8% to 3.5%; expected life of 5 years; dividend rate of zero percent; and expected volatility of 53.2% for the 2003 period, and 53.3% for the 2002 period. Using these assumptions, the fair value of the employee stock options granted, net of the related tax effects, in the 2003 and 2002 periods are $0.5 million and $0.4 million respectively, which would be amortized as compensation expense over the vesting period of the options. The following Page 6 table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation. Three months ended March 31, (in thousands except per share data) 2003 2002 -------------------- ------------------- Net income (loss), as reported: $ 839 $(1,667) Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects (539) (430) -------------------- ------------------- Pro forma net income (loss) $ 300 $(2,097) ==================== =================== Basic earnings (loss) per share: As reported $.06 $(.12) Pro forma $.02 $(.15) Diluted earnings (loss) per share: As reported $.06 $(.12) Pro forma $.02 $(.15)
Note 3. Income Taxes Income tax expense varies from the amount computed by applying the federal corporate income tax rate of 35% 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. Note 4. Goodwill and Other Intangible Assets Effective January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, which requires the Company to evaluate goodwill and other intangible assets with indefinite useful lives for impairment on an annual basis, with any resulting impairment recorded as a cumulative effect of a change in accounting principle. Goodwill that was acquired in purchase business combinations completed before July 1, 2001, is no longer amortized after January 1, 2002. Furthermore, any goodwill that is acquired in a purchase business combination completed after June 30, 2001, is not amortized. During the second quarter of 2002, the Company completed its evaluation of its goodwill for impairment and determined that there was no impairment. At March 31, 2003, the Company has $11.5 million of goodwill. Note 5. Derivative Instruments and Other Comprehensive Income In 1998, the FASB issued SFAS No. 133 ("SFAS 133"), Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of SFAS Statement No. 133, an amendment of SFAS Statement No. 133, and SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an amendment of SFAS Statement No. 133. SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. Changes in the fair value of derivatives are recorded each period in current earnings or in other comprehensive income, depending on whether a derivative is designated as part of a hedging relationship and, if it is, depending on the type of hedging relationship. The Company adopted SFAS No. 133 effective January 1, 2001 but had no instruments in place on that date. In 2001, the Company entered into two $10.0 million notional amount cancelable interest rate swap agreements to manage the risk of variability in cash flows associated with floating-rate debt. Due to the counter-parties' imbedded options to cancel, these derivatives did not qualify, and are not designated as hedging instruments under SFAS No. 133. Consequently, these derivatives are marked to fair value through earnings, in other expense in the accompanying statement of operations. At March 31, 2003 and March 31, 2002, the fair value of these interest rate swap agreements was a liability of $1.6 million and $0.5 million, respectively, which are included in accrued expenses on the consolidated balance sheet. During the third quarter of 2001, the Company entered into two heating oil commodity swap contracts to hedge its cash flow Page 7 exposure to diesel fuel price fluctuations. These contracts were considered highly effective in offsetting changes in anticipated future cash flows and were designated as cash flow hedges under SFAS No. 133. At March 31, 2002 the cumulative fair value of these heating oil contracts was an asset of $0.2 million, which was recorded in accrued expenses with the offset to other comprehensive income, net of taxes. The contracts expired December 31, 2002. The derivative activity as reported in the Company's financial statements for the quarters ended March 31, is summarized in the following: Three months ended March 31, (in thousands) 2003 2002 --------------- ---------------- Net liability for derivatives at January 1, $ (1,645) $ (1,932) Gain on derivative instruments: Gain in value of derivative instruments that do not qualify as hedging instruments 20 223 Gain on fuel hedge contracts that qualify as cash flow hedges - 1,447 --------------- ---------------- Net liability for derivatives at March 31, $ (1,625) $ (262) =============== ================
The following is a summary of comprehensive income (loss) as of March 31: Three months ended March 31 (in thousands) 2003 2002 ----------------- ------------------ Net Income (loss) $ 839 ($1,667) Other comprehensive income: Gain on fuel hedge contracts that qualify as cash flow hedges - 1,447 Tax benefit - (550) ----------------- ------------------ Other comprehensive income- Unrealized gain on cash flow hedging derivatives, net of taxes - 897 ----------------- ------------------ Comprehensive income (loss) $ 839 $ (770) ================= ==================
Note 6. Impairment of Equipment and Change in Estimated Useful Lives During 2001, the market value of used tractors was significantly below both historical levels and the carrying values on the Company's financial statements. The Company extended the trade cycle of its tractors from three years to four years during 2001, which delayed any significant disposals into 2002 and later years. The market for used tractors did not improve by the time the Company negotiated a tractor purchase and trade package with Freightliner Corporation for calendar years 2002 and 2003 covering the sale of model year 1998 through 2000 tractors and the purchase of an equal number of replacement units. The significant difference between the carrying values and the sale prices of the used tractors combined with the Company's less profitable results during 2001 caused the Company to test for asset impairment under SFAS No. 121, "Accounting for the Impairment of Long Lived Assets and of Long Lived Assets to be disposed of". In the test, the Company measured the expected undiscounted future cash flows to be generated by the tractors over the remaining useful lives and the disposal value at the end of the useful life against the carrying values. The test indicated impairment and the Company recognized the pre-tax charges of approximately $15.4 million and $3.3 million in 2001 and 2002, respectively, to reflect an impairment in tractor values. The Company incurred a loss of approximately $324,000 on guaranteed residuals for leased tractors in the first quarter of 2002, which was recorded in revenue equipment rentals and purchased transportation in the accompanying statement of operations. The Company accrued this loss from January 1, 2002, to the date the tractors were purchased off lease in February 2002. The Company's approximately 1,400 model year 2001 tractors were not affected by the charge. The Company adjusted the depreciation rate of these model year 2001 tractors to approximate its recent experience with disposition values and expectation Page 8 for future disposition values. The Company also increased the lease expense on its leased units since it expects to have a shortfall in its guaranteed residual values of approximately $1.4 million. The Company is recording its additional lease expense ratably over the remaining lease term. Although management believes the additional depreciation and lease expense will bring the carrying values of the model year 2001 tractors in line with future disposition values, the Company does not have trade-in agreements covering those tractors. These assumptions represent management's best estimate and actual values could differ by the time those tractors are scheduled for trade. Management estimates the impact of the change in the estimated useful lives and depreciation on the 2001 model year tractors to be approximately $1.5 million pre-tax or $.06 per share annually. Note 7. Long-term Debt and Securitization Facility Outstanding debt consisted of the following at March 31, 2003 and December 31, 2002: (in thousands) March 31, 2003 December 31, 2002 ---------------------- ---------------------- Borrowings under credit agreement $ 25,000 $ 43,000 Securitization Facility 41,230 39,230 Note payable to former SRT shareholder, bearing interest at 6.5% with interest payable quarterly 1,300 1,300 ---------------------- ---------------------- Total Long-Term Debt 67,530 83,530 Less current maturities 41,230 82,230 ---------------------- ---------------------- Long-term debt, less current portion $ 26,300 $ 1,300 ====================== ======================
In December 2000, the Company entered into the Credit Agreement with a group of banks. The facility matures in December 2005. Borrowings under the Credit Agreement are based on the banks' base rate or LIBOR and accrue interest based on one, two, or three month LIBOR rates plus an applicable margin that is adjusted quarterly between 0.75% and 1.25% based on cash flow coverage. At March 31, 2003, the margin was 1.0%. The Credit Agreement is guaranteed by the Company and all of the Company's subsidiaries except CVTI Receivables Corp. and Volunteer Insurance Limited. The Credit Agreement has a maximum borrowing limit of $100.0 million with an accordion feature which permits an increase up to a maximum borrowing limit of $160.0 million. Borrowings related to revenue equipment are limited to the lesser of 90% of net book value of revenue equipment or the maximum borrowing limit. Letters of credit are limited to an aggregate commitment of $50.0 million. The Credit Agreement includes a "security agreement" such that the Credit Agreement may be collateralized by virtually all assets of the Company if a covenant violation occurs. A commitment fee, that is adjusted quarterly between 0.15% and 0.25% per annum based on cash flow coverage, is due on the daily unused portion of the Credit Agreement. As of March 31, 2003, the Company had borrowings under the Credit Agreement in the amount of $25.0 million with a weighted average interest rate of 2.2%. In October 1995, the Company issued $25 million in ten-year senior notes to an insurance company. On March 15, 2002, the Company retired the remaining $20 million in senior notes with borrowings from the Credit Agreement and incurred a $0.9 million after-tax extraordinary item ($1.4 million pre-tax) to reflect the early extinguishment of this debt. Upon adoption of SFAS 145 in 2003, the Company reclassified the charge and it is no longer classified as an extraordinary item. At March 31, 2003 and December 31, 2002, the Company had unused letters of credit of approximately $32.1 and $19.2 million, respectively. In December 2000, the Company entered into a $62 million revolving accounts receivable securitization facility (the "Securitization Facility"). On a revolving basis, the Company sells its interests in its accounts receivable to CVTI Receivables Corp. ("CRC"), a wholly-owned bankruptcy-remote special purpose subsidiary incorporated in Nevada. CRC sells a percentage ownership in such receivables to an unrelated financial entity. The transaction does not meet the criteria for sale treatment under SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities and is reflected as a secured borrowing in the financial statements. The Company can receive up to $62 million of proceeds, subject to eligible receivables and will pay a service fee recorded as interest expense, as defined in the agreement. The Company will pay commercial paper interest rates plus an applicable margin of 0.41% per annum and a commitment fee of 0.10% per annum on the daily unused portion of the Facility. The Securitization Facility includes certain significant events that could cause amounts to be immediately due and payable in the event of certain ratios. The proceeds received are reflected as a current liability on the consolidated financial statements because the committed term, subject to annual renewals, is 364 days. As of March 31, 2003 and December 31, 2002, the Company had received $41.2 million and $39.2 million, respectively, in proceeds, with a weighted average interest rate of 1.4% and 1.5%, respectively. Page 9 The Credit Agreement and Securitization Facility contain certain restrictions and covenants relating to, among other things, dividends, tangible net worth, cash flow, acquisitions and dispositions, and total indebtedness and are cross-defaulted. As of March 31, 2003, the Company was in compliance with the Credit Agreement and Securitization Facility. Note 8. Recent Accounting Pronouncements In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS 143 provides new guidance on the recognition and measurement of an asset retirement obligation and its associated asset retirement cost. It also provides accounting guidance for legal obligations associated with the retirement of tangible long-lived assets. The Company adopted SFAS 143 effective January 1, 2003. The adoption did not have a material impact on the Company's consolidated financial statements. In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS 145 amends existing guidance on reporting gains and losses on extinguishment of debt to prohibit the classification of the gain or loss as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS 145 also amends SFAS 13 to require sale-leaseback accounting for certain lease modifications that have economic effects similar to sale-leaseback transactions. The provisions of the Statement related to the rescission of Statement No. 4 is applied in fiscal years beginning after May 15, 2002. The provisions of the Statement related to Statement No. 13 were effective for transactions occurring after May 15, 2002. The Company adopted SFAS 145 effective January 1, 2003, which resulted in the reclassification of the fiscal year 2002 loss on extinguishment of debt. In November 2002, the FASB issued Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34. This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued. Interpretation No. 45 also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken. The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002, and are not expected to have a material effect on the Company's financial statements. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. The Company has guarantees which are disclosed in the notes to these consolidated financial statements. In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation/Transition and Disclosure, an amendment of FASB Statement No. 123. SFAS 148 amends SFAS 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements. Certain of the disclosure modifications are required for fiscal years and interim periods ending after December 15, 2002 and are included in the notes to these consolidated financial statements. Page 10 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The consolidated financial statements include the accounts of Covenant Transport, 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 Transport, Inc. and its consolidated subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Except for the historical information contained herein, the discussion in this quarterly report contains forward-looking statements that involve risk, assumptions, and uncertainties that are difficult to predict. Statements that constitute forward-looking statements are usually identified by words such as "anticipates," "believes," "estimates," "projects," "expects," or similar expressions. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements are based upon the current beliefs and expectations of our management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. The following factors, among others, could cause actual results to differ materially from those in forward-looking statements: excess capacity in the trucking industry; decreased demand for our services or loss of one or more or our major customers; surplus inventories; recessionary economic cycles and downturns in customers' business cycles; strikes or work stoppages; increases or rapid fluctuations in fuel prices, interest rates, fuel taxes, tolls, and license and registration fees; increases in the prices paid for new revenue equipment; the resale value of our used equipment and the price of new equipment; increases in compensation for and difficulty in attracting and retaining qualified drivers and owner-operators; increases in insurance premiums and deductible amounts or claims relating to accident, cargo, workers' compensation, health, and other matters; seasonal factors such as harsh weather conditions that increase operating costs; competition from trucking, rail, and intermodal competitors; regulatory requirements that increase costs or decrease efficiency; and the ability to identify acceptable acquisition candidates, consummate acquisitions, and integrate acquired operations. Readers should review and consider these factors along with the various disclosures we make in press releases, stockholder reports, and public filings, as well as the factors explained in greater detail in the Company's annual report on Form 10-K. We generate substantially all of our revenue by transporting freight for our customers. We also derive revenue from fuel surcharges, loading and unloading activities, equipment detention, and other accessorial services. Generally, we are paid by the mile or by the load for our services. The main factors that affect our revenue are the revenue per mile we receive from our customers, the percentage of miles for which we are compensated, and the numbers of miles we generate with our equipment. These factors relate, among other things, to the U.S. economy, inventory levels, the level of truck capacity in our markets, specific customer demand, the percentage of team-driven tractors in our fleet, and our average length of haul. Since 2000 we have held our fleet size relatively constant. An overcapacity of trucks in our fleet and the industry generally as the economy slowed has contributed to lower equipment utilization and pricing pressure since 2000. In addition to constraining fleet size, we reduced our number of two-person driver teams to better match the demand for expedited long-haul service. Our single driver fleets generally operate in shorter lengths of haul, generate fewer miles per tractor, and experience more non-revenue miles, but the additional expenses and 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. We expect operating statistics and expenses to shift with the mix of single and team operations. The trucking industry has experienced a significant increase in operating costs. The main factors for the industry as well as for us have been an increased annual cost of tractors due to higher initial prices and lower used truck values, a higher overall cost of insurance and claims, and elevated fuel prices. Other than those categories, our expenses have remained relatively constant or have declined as a percentage of revenue. Looking forward, our profitability goal is to return to an operating ratio of approximately 90%. We expect this to require additional improvements in revenue per tractor per week to overcome expected additional cost increases of new revenue equipment (discussed below), and other general increases in operating costs, as well as to expand our margins. Because a large percentage of our costs is variable, changes in revenue per mile affect our profitability to a greater extent than changes in miles per tractor. We operate approximately 3,717 tractors and 7,516 trailers. Of our tractors at March 31, 2003, approximately 2,438 were owned, 916 were financed under operating leases, and 363 were provided by owner-operators, who own and drive the tractors. Of our trailers at March 31, 2003, approximately 4,697 were owned and approximately 2,819 were financed under operating leases. Between 1999 and 2001, the market value of used equipment deteriorated. In recognition of this fact, we recognized pre-tax impairment charges of $15.4 million in the fourth quarter of 2001 and $3.3 million in the first quarter of 2002 in relation to the reduced value of our model year 1998 through 2000 tractors. In addition, we increased the depreciation rate/lease expense on our remaining tractors to reflect our expectations concerning market value at disposition. We estimate the impact of the change in the estimated useful lives and depreciation on the 2001 model year tractors to be approximately $1.5 million pre-tax or $.06 per share annually. Although we believe Page 11 the additional depreciation will bring the carrying values of the model year 2001 tractors in line with future disposition values, we do not have trade-in agreements covering those tractors. Our assumptions represent our best estimate, and actual values could differ by the time those tractors are scheduled for trade. Because of the adverse change from historical purchase prices and residual values, the annual expense per tractor on model year 2003 and 2004 tractors is expected to be higher than the annual expense on the model year 1999 and 2000 units being replaced. We believe the increase in depreciation expense was approximately one-half cent per mile pre-tax during 2002 and will grow to approximately one cent per mile pre-tax in 2003 as all of these new units are delivered. By the time the model year 2001 tractors are traded and the entire fleet is converted in 2004, we expect the total increase in expense to be approximately one and one-half cent pre-tax per mile. The timing of these expenses could be affected if we change our tractor trade cycle to three years, which we are considering. If the tractors are leased instead of purchased, the references to increased depreciation would be reflected as additional lease expense. We finance a portion of our tractor and trailer fleet with off-balance sheet operating leases. These leases generally run for a period of three years for tractors and seven years for trailers. With our tractor trade cycle currently at approximately four years, we have been purchasing the leased tractors at the expiration of the lease term, although there is no commitment to purchase the tractors. The first trailer leases expire in 2005, and we have not determined whether to purchase trailers at the end of these leases. Owner-operators 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 the tractor. The payments to owner-operators 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, are not incurred, and for owner-operator tractors, driver compensation, fuel, and other expenses are not incurred. Because obtaining equipment from owner-operators and under operating leases effectively shifts financing expenses from interest to "above the line" operating expenses, we evaluate our efficiency using net margin rather than operating ratio. Freight revenue excludes $9.9 million of fuel and accessorial surcharge revenue in the 2003 period and $3.2 million in the 2002 period. For comparison purposes in the table below, we use freight revenue when discussing changes as a percentage of revenue. We believe removing this sometimes volatile source of revenue affords a more consistent basis for comparing the results of operations from period to period. The following table sets forth the percentage relationship of certain items to freight revenue: Three Months Ended March 31, 2003 2002 --------------- -------------- Freight revenue (1) 100.0% 100.0% Operating expenses: Salaries, wages, and related expenses (1) 40.6 42.1 Fuel expense (1) 16.6 16.1 Operations and maintenance (1) 7.4 6.5 Revenue equipment rentals and purchased transportation 11.5 11.5 Operating taxes and licenses 2.7 2.6 Insurance and claims 6.3 5.6 Communications and utilities 1.3 1.4 General supplies and expenses 2.5 2.7 Depreciation and amortization (2) 8.3 10.9 --------------- -------------- Total operating expenses 97.2 99.4 --------------- -------------- Operating income 2.8 0.6 Other (income) expense, net 0.5 1.7 --------------- -------------- Income (loss) before income taxes 2.3 (1.1) Income tax expense 1.6 0.2 --------------- -------------- Net income (loss) 0.7% (1.3%) =============== ==============
(1) Freight revenue is total revenue less fuel surcharge and accessorial revenue. In this table, fuel surcharge and other accessorial revenue are shown netted against the appropriate expense category (Salaries, wages, and related expenses, $1.8 million in the 2003 period and $1.4 million in the 2002 period; Fuel expense, $7.5 million in the 2003 period and $1.3 million in the 2002 period; Operations and maintenance, $0.5 million in the 2003 period and $0.4 million in the 2002 period.) (2) Includes a $3.3 million pre-tax impairment charge or 2.6% of revenue in 2002. Page 12 COMPARISON OF THREE MONTHS ENDED MARCH 31, 2003 TO THREE MONTHS ENDED MARCH 31, 2002 For the quarter ending March 31, 2003, revenue increased $5.7 million (4.3%), to $137.9 million, from $132.2 million in the 2002 period. Freight revenue excludes $9.9 million of fuel and accessorial surcharge revenue in the 2003 period and $3.2 million in the 2002 period. For comparison purposes in the discussion below, we use freight revenue when discussing changes as a percentage of revenue. We believe removing this sometimes volatile source of revenue affords a more consistent basis for comparing the results of operations from period to period. Freight revenue (total revenue less fuel surcharge and accessorial revenue) decreased $1.0 million (0.8%), to $128.0 million in the three months ended March 31, 2003, from $129.0 million in the same period of 2002. Our revenue was affected by a 2.2% decrease in miles per tractor and an increase in non revenue miles, which were partially offset by 2.5% increase in rate per loaded mile. Revenue per tractor per week decreased to $2,667 in the 2003 period from $2,680 in the 2002 period. Weighted average tractors increased to 3,726 in the 2003 period from 3,713 in the 2002 period. Due to a weak freight environment, we have elected to constrain the size of our tractor fleet until fleet production and profitability improve. Salaries, wages, and related expenses, net of accessorial revenue of $1.8 million in the 2003 period and $1.4 million in the 2002 period, decreased $2.3 million (4.2%), to $52.0 million in the 2003 period, from $54.3 million in the 2002 period. As a percentage of freight revenue, salaries, wages, and related expenses decreased to 40.6% in the 2003 period, from 42.1% in the 2002 period. The decrease was largely attributable to our utilizing a larger percentage of single-driver tractors, with only one driver per tractor to be compensated and implementing changes in our pay structure. Our payroll expense for employees other than over the road drivers increased to 7.6% of freight revenue in the 2003 period from 7.0% of freight revenue in the 2002 period due to growth in headcount and a larger number of local drivers in the dedicated fleet. Health insurance, employer paid taxes, workers' compensation, and other employee benefits remained essentially constant at 6.9% of freight revenue in the 2003 and 2002 periods. Fuel expense, net of fuel surcharge revenue of $7.5 million in the 2003 period and $1.3 million in the 2002 period, increased $0.5 million (2.3%), to $21.3 million in the 2003 period, from $20.8 million in the 2002 period. As a percentage of freight revenue, net fuel expense increased to 16.6% in the 2003 period from 16.1% in the 2002 period. Fuel surcharges amounted to $.072 per loaded mile in the 2003 period compared to $.012 per loaded mile in the 2002 period. Fuel prices have increased sharply during the first quarter of 2003 because of reasons such as unrest in Venezuela and the Middle East and low inventories. Higher fuel prices will increase our operating expenses. Fuel costs may be affected in the future by volume purchase commitments, the collectibility of fuel surcharges, and lower fuel mileage due to government mandated emissions standards that were effective October 1, 2002, and will result in less fuel efficient engines. We did not have any fuel hedging contracts at March 31, 2003. Operations and maintenance, net of accessorial revenue of $0.5 million in the 2003 period and $0.4 million in the 2002 period, consisting primarily of vehicle maintenance, repairs and driver recruitment expenses, increased $1.1 million (13.2%), to $9.5 million in the 2003 period, from $8.4 million in the 2002 period. As a percentage of freight revenue, operations and maintenance increased to 7.4% in the 2003 period, from 6.5% in the 2002 period. We extended the trade cycle on our tractor fleet from three years to four years, which resulted in an increase in the number of required repairs. Revenue equipment rentals and purchased transportation remained essentially constant at $14.8 million and 11.5% as a percentage of freight revenue in the 2003 and 2002 periods. The owner-operators fleet increased slightly to an average of 367 units in the 2003 period compared to an average of 348 units in the 2002 period. Over the past couple of years, it has become more difficult to retain owner-operators due to the challenging operating conditions. Owner-operators are independent contractors, who provide a tractor and driver and cover all of their operating expenses in exchange for a fixed payment per mile. Accordingly, expenses such as driver salaries, fuel, repairs, depreciation, and interest normally associated with Company-owned equipment are consolidated in revenue equipment rentals and purchased transportation when owner-operators are utilized. The revenue equipment rental expense remained essentially constant in the two periods at approximately $5.1 million, as lease rates fell while we added equipment under leases. As of March 31, 2003, we had financed approximately 916 tractors and 2,819 trailers under operating leases as compared to 636 tractors and 2,564 trailers under operating leases as of March 31, 2002. On April 14, 2003, we engaged in a sale-leaseback transaction involving approximately 1,266 dry van trailers. We sold the trailers to a finance company for approximately $15.5 million in cash and leased the trailers back under three year walkaway leases. Our revenue equipment rental expense is expected to increase in the future to reflect this transaction. We will no longer recognize depreciation and interest expense with respect to these trailers. Operating taxes and licenses increased $0.2 million (4.7%), to $3.4 million in the 2003 period, from $3.3 million in the 2002 period. As a percentage of freight revenue, operating taxes and licenses remained essentially constant at 2.7% in the 2003 period and 2.6% in the 2002 period. Insurance and claims, consisting primarily of premiums and deductible amounts for liability, physical damage, and cargo damage insurance and claims, increased $0.9 million (12.2%), to $8.0 million in the 2003 period from $7.2 million in the 2002 period. As a percentage of freight revenue, insurance increased to 6.3% in the 2003 period from 5.6% in the 2002 period. The increase is a result Page 13 of an industry-wide increase in insurance rates, which we addressed by adopting an insurance program with significantly higher deductible exposure that is partially offset by lower premium rates. The retention level for our primary insurance layer increased from $250,000 in 2001 to $500,000 in March of 2002, to $1.0 million in November of 2002, and to $2.0 million on March 1, 2003. We also have a $2.0 million self-insured layer between $5.0 million and $7.0 million per occurence. Our insurance program for liability, physical damage, and cargo damage involves self-insurance with varying risk retention levels. Claims in excess of these risk retention levels are covered by insurance in amounts which management considers adequate. We accrue the estimated cost of the uninsured portion of pending claims. These accruals are based on management's evaluation of the nature and severity of the claim and estimates of future claims development based on historical trends. Insurance and claims expense will vary based on the frequency and severity of claims, the premium expense, and the level of self-insured retention. Because of higher self-insured retentions, our future expenses of insurance and claims may be higher or more volatile than in historical periods. Communications and utilities expense decreased $0.1 million (7.5%), to $1.7 million in the 2003 period, from $1.8 million in the 2002 period. As a percentage of freight revenue, communications and utilities remained essentially constant at 1.3% in the 2003 period as compared to 1.4% in the 2002 period. General supplies and expenses, consisting primarily of headquarters and other terminal facilities expenses, decreased $0.3 million (9.6%), to $3.2 million in the 2003 period, from $3.5 million in the 2002 period. As a percentage of freight revenue, general supplies and expenses decreased to 2.5% in the 2003 period from 2.7% in the 2002 period. Depreciation, amortization and impairment charge, consisting primarily of depreciation of revenue equipment, decreased $3.5 million (24.6%), to $10.6 million in the 2003 period from $14.1 million in the 2002 period. As a percentage of freight revenue, depreciation and amortization decreased to 8.3% in the 2003 period from 10.9% in the 2002 period. The decrease is the result of an impairment charge, partially offset by increased depreciation expense. In the 2002 period, we recognized a pre-tax charge of approximately $3.3 million to reflect an impairment in tractor values. See "Impairment of Equipment and Change in Estimated Useful Lives," in Note 6 to the Consolidated Financial Statements for additional information. We expect our annual cost of tractor and trailer ownership and/or leasing to increase in future periods. The increase is expected to result from a combination of higher initial prices of new equipment, lower resale values for used equipment, and increased depreciation/lease payments on some of our existing equipment over their remaining lives in order to better match expected book values or lease residual values with market values at the equipment disposal date. To the extent equipment is leased under operating leases, the amounts will be reflected in revenue equipment rentals and purchased transportation. To the extent equipment is owned or obtained under capitalized leases, the amounts will be reflected as depreciation expense and interest expense. Those expense items will fluctuate with changes in the percentage of our equipment obtained under operating leases versus owned and under capitalized leases. Depreciation and amortization expense is net of any gain or loss on the disposal of tractors and trailers. Gain on the disposal of tractors and trailers was approximately $0.2 million in the 2003 period compared to a loss of $0.5 million in the 2002 period. Amortization expense relates to deferred debt costs incurred and covenants not to compete from five acquisitions. Goodwill amortization ceased beginning January 1, 2002, in accordance with SFAS No. 142, and we evaluate goodwill and certain intangibles for impairment, annually. During the second quarter of 2002, we tested our goodwill for impairment and found no impairment. Other expense, net, decreased $1.7 million (73.4%), to $0.6 million in the 2003 period, from $2.3 million in the 2002 period. As a percentage of freight revenue, other expense decreased to 0.5% in the 2003 period from 1.7% in the 2002 period. Included in the other expense category are interest expense, interest income, pre-tax non-cash gains related to the accounting for interest rate derivatives under SFAS No. 133 which amounted to approximately $20,000 in the 2003 period and approximately $0.2 million in the 2002 period and an early extinguishment of debt charge. During the first quarter of 2002, we prepaid the remaining $20 million in previously outstanding 7.39% ten year, private placement notes with borrowings from the Credit Agreement. In conjunction with the prepayment of the borrowings, the Company recognized an approximate $1.4 million pre-tax charge to reflect the early extinguishment of debt. The losses related to the write off of debt issuance and other deferred financing costs and a premium paid on the retirement of the notes. Our income tax expense was $2.1 million and $0.3 million in the 2003 and 2002 periods, respectively. The effective tax rate is different from the expected combined tax rate due to permanent differences related to a per diem pay structure implemented in 2001. Due to the nondeductible effect of per diem, our tax rate will fluctuate in future periods as income fluctuates. Primarily as a result of the factors described above, net earnings increased $2.5 million (150.3%), to $0.8 million income in the 2003 period (0.7% of revenue), from $1.7 million loss in the 2002 period (1.3% of revenue). As a result of the foregoing, our net margin increased to 0.7% in the 2003 period from (1.3%) in the 2002 period. Page 14 LIQUIDITY AND CAPITAL RESOURCES Historically our growth has required significant capital investments. We historically have financed our expansion requirements with borrowings under a line of credit, cash flows from operations and long-term operating leases. Our primary sources of liquidity at March 31, 2003, were funds provided by operations, proceeds under the Securitization Facility (as defined below), borrowings under our primary credit agreement, which had maximum available borrowing of $100.0 million at March 31, 2003 (the "Credit Agreement") and operating leases of revenue equipment. We believe our sources of liquidity are adequate to meet our current and projected needs for at least the next twelve months. Net cash provided by operating activities was $11.7 million in the first quarter of 2003 and $12.3 million in the first quarter of 2002. Our primary sources of cash flow from operations in the 2003 period were net income and depreciation and amortization. Depreciation and amortization in the 2002 period included a $3.3 million pre-tax impairment charge. Net cash provided by investing activities was $6.1 million in the first quarter of 2003 and was derived from the sale of revenue equipment during the quarter. The cash used in the 2002 period related to the financing of tractors, which were previously financed through operating leases, using proceeds from the Credit Agreement. Anticipated capital expenditures are expected to increase in 2003 as the Company has agreed to purchase and trade a significant number of tractors and trailers. We expect capital expenditures, primarily for revenue equipment (net of trade-ins), to be approximately $80.0 million in 2003, exclusive of acquisitions, if we remain on a four-year trade cycle for tractors. If we change our trade cycle back to three years, our capital expenditures could increase significantly. We also are considering alternatives for accelerating our trailer disposition schedule, which could affect our capital expenditures or lease commitments. Net cash used in financing activities was $16.3 million in the first quarter of 2003, and $3.1 million was provided by financing activities in the first quarter of 2002. During the first quarter of 2003, we reduced outstanding balance sheet debt by $16.0 million. At March 31, 2003, we had outstanding debt of $67.5 million, primarily consisting of $41.2 million in the Securitization Facility, $25.0 million drawn under the Credit Agreement, and a $1.3 million interest bearing note to the former primary stockholder of SRT. Interest rates on this debt range from 1.4% to 6.5%. During the first quarter of 2002, we prepaid the remaining $20.0 million in previously outstanding 7.39% ten year private placement notes with borrowings from the Credit Agreement. In conjunction with the prepayment of the borrowings, we recognized an approximate $0.9 million after-tax extraordinary item to reflect the early extinguishment of debt. Upon adoption of SFAS 145 in 2003, we reclassified the charge and it is no longer classified as an extraordinary item. In December 2000, we entered into the Credit Agreement with a group of banks, which expires in December, 2005. Borrowings under the Credit Agreement are based on the banks' base rate or LIBOR and accrue interest based on one, two, or three month LIBOR rates plus an applicable margin that is adjusted quarterly between 0.75% and 1.25% based on cash flow coverage. At March 31, 2003, the margin was 1.00%. The Credit Agreement is guaranteed by the Company and all of the Company's subsidiaries except CVTI Receivables Corp. and Volunteer Insurance Limited. At December 31, 2002, the Credit Agreement had a maximum borrowing limit of $120.0 million. When the facility was extended in February 2003, the borrowing limit was reduced to $100.0 million with an accordion feature which permits an increase up to a borrowing limit of $160.0 million. Borrowings related to revenue equipment are limited to the lesser of 90% of net book value of revenue equipment or the maximum borrowing limit. Letters of credit were limited to an aggregate commitment of $20.0 million at December 31, 2002, and were increased to a limit of $50.0 million in February 2003. The Credit Agreement includes a "security agreement" such that the Credit Agreement may be collateralized by virtually all of our assets if a covenant violation occurs. A commitment fee, that is adjusted quarterly between 0.15% and 0.25% per annum based on cash flow coverage, is due on the daily unused portion of the Credit Agreement. As of March 31, 2003, we had borrowings under the Credit Agreement in the amount of $25.0 million with a weighted average interest rate of 2.2%. In December 2000, we entered into a $62 million revolving accounts receivable securitization facility (the "Securitization Facility"). On a revolving basis, we sell our interests in our accounts receivable to CRC, a wholly-owned bankruptcy-remote special purpose subsidiary incorporated in Nevada. CRC sells a percentage ownership in such receivables to an unrelated financial entity. We can receive up to $62 million of proceeds, subject to eligible receivables and will pay a service fee recorded as interest expense, based on commercial paper interest rates plus an applicable margin of 0.41% per annum and a commitment fee of 0.10% per annum on the daily unused portion of the Facility. The net proceeds under the Securitization Facility are required to be shown as a current liability because the term, subject to annual renewals, is 364 days. As of March 31, 2003, there were $41.2 million in proceeds received. The transaction did not meet the criteria for sale treatment under Financial Accounting Standard No. 140 and is reflected as a secured borrowing in the financial statements. Page 15 The Credit Agreement and Securitization Facility contain certain restrictions and covenants relating to, among other things, dividends, tangible net worth, cash flow, acquisitions and dispositions, and total indebtedness. All of these agreements are cross-defaulted. The Company is in compliance with these agreements as of March 31, 2003. Contractual Obligations and Commitments - We had commitments outstanding related to equipment, debt obligations, and diesel fuel purchases as of January 1, 2003. These purchases are expected to be financed by debt, proceeds from sales of existing equipment, and cash flows from operations. We have the option to cancel commitments relating to equipment with 60 days notice. The following table sets forth our contractual cash obligations and commitments as of January 1, 2003. Payments Due By Period There- (in thousands) Total 2003 2004 2005 2006 2007 after ------------------------------------------------------------------------------------- Long Term Debt $ 1,300 $ - $ 1,300 $ - $ - $ - $ - Short Term Debt 82,230 82,230 - - - - - Operating Leases 62,308 21,017 12,502 10,852 6,823 4,665 6,449 Lease residual value guarantees 56,802 25,699 - 9,910 3,553 5,590 12,050 Purchase Obligations: Diesel fuel 52,477 48,020 4,457 - - - - Equipment 85,986 85,986 - - - - - ------------------------------------------------------------------------------------- Total Contractual Cash Obligations $341,103 $262,952 $18,259 $20,762 $10,376 $10,255 $18,499 =====================================================================================
CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make decisions based upon estimates, assumptions, and factors we consider as relevant to the circumstances. Such decisions include the selection of applicable accounting principles and the use of judgment in their application, the results of which impact reported amounts and disclosures. Changes in future economic conditions or other business circumstances may affect the outcomes of our estimates and assumptions. Accordingly, actual results could differ from those anticipated. A summary of the significant accounting policies followed in preparation of the financial statements is contained in Note 1 of the financial statements contained in the Company's annual report on Form 10-K. Other footnotes describe various elements of the financial statements and the assumptions on which specific amounts were determined. Our critical accounting policies include the following: Property and Equipment - Depreciation is calculated using the straight-line method over the estimated useful lives of the assets. Historically, we depreciated revenue equipment over five to seven years with salvage values ranging from 25% to 33 1/3%. During 2000, we extended our estimate for the useful life of our dry van trailers acquired between July 2000 and March 2001 from seven to eight years and increased the salvage value to approximately 48% of cost. We based this decision on market experience at that time. We are re-evaluating the salvage value, useful life, and annual depreciation of these trailers based on the current market environment. Any change could result in greater annual expense in the future. In September 2001, we changed our estimated useful life and salvage value to seven years and 43% of cost for new trailers. Gains or losses on disposal of revenue equipment are included in depreciation in the statements of income. Impairment of Long-Lived Assets - We evaluate the carrying value of long-lived assets by analyzing the operating performance and future cash flows for those assets, whenever events or changes in circumstances indicate that the carrying amounts of such assets may not be recoverable. We adjust the carrying value of the underlying assets if the sum of the expected cash flows is less than the carrying value. Impairment can be impacted by our projection of future cash flows, the level of cash flows and salvage values, the methods of estimation used for determining fair values and the impact of guaranteed residuals. Insurance and Other Claims - Our insurance program for liability, property damage, and cargo loss and damage, involves self- insurance with high risk retention levels. We have increased the self-insured retention portion of our insurance coverage from $12,500 for each claim in 2000 to $1.0 million plus an additional layer from $4.0 million to $7.0 million for each claim at November 2002. Page 16 Effective March 2003, we increased our primary coverage to $5.0 million with a $2.0 million retention level, plus an additional layer from $5.0 million to $7.0 million for each claim. We accrue the estimated cost of the uninsured portion of pending claims. These accruals are based on our evaluation of the nature and severity of the claim and estimates of future claims development based on historical trends. The rapid and substantial increase in our self-insured retention makes these estimates an important accounting judgment. Insurance and claims expense will vary based on the frequency and severity of claims, the premium expense and the lack of self-insured retention. From 1999 to present, we carried excess coverage in amounts that have ranged from $15.0 million to $49.0 million in addition to our primary insurance coverage. On July 15, 2002, we received a binder for $48.0 million of excess insurance coverage over our $2.0 million primary layer. Subsequently, we were forced to seek replacement coverage after the insurance agent retained the premium and failed to produce proof of insurance coverage. If one or more claims from the period July to November 2002 exceeded $2.0 million in amount, we would be required to accrue for the potential or actual loss and our financial condition and results of operations could be materially and adversely affected. We are not aware of any such claims at this time. At December 31, 2002, we maintained a workers' compensation plan and a group medical plan for our employees with a deductible amount of $500,000 for each workers' compensation claim and a deductible amount of $225,000 for each group medical claim. In the first quarter of 2003, we adopted a workers' compensation plan with a self-insured retention level of $1.0 million per occurrence and renewed our group medical plan with a deductible amount of $250,000. Lease Accounting - We lease a significant portion of our tractor and trailer fleet using operating leases. Substantially all of the leases have residual value guarantees under which we must insure that the lessor receives a negotiated amount for the equipment at the expiration of the lease. In accordance with SFAS No. 13, Accounting for Leases, the rental expense under these leases is reflected as an operating expense under "revenue equipment rentals and purchased transportation." To the extent the expected value at the lease termination date is lower than the residual value guarantee, we accrue for the difference over the remaining lease term. The estimated values at lease termination involve management judgments. Operating leases are carried off balance sheet in accordance with SFAS No. 13. INFLATION AND FUEL COSTS Most of our operating expenses are inflation-sensitive, with inflation generally producing increased costs of operations. During the past three years, the most significant effects of inflation have been on revenue equipment prices and the compensation paid to the drivers. Innovations in equipment technology and comfort have resulted in higher tractor prices, and there has been an industry-wide increase in wages paid to attract and retain qualified drivers. We historically have limited the effects of inflation through increases in freight rates and certain cost control efforts. In addition to inflation, fluctuations in fuel prices can affect profitability. Fuel expense comprises a larger percentage of revenue for us than many other carriers because of our long average length of haul. Most of our contracts with customers contain fuel surcharge provisions. Although we historically have been able to pass through most long-term increases in fuel prices and taxes to customers in the form of surcharges and higher rates, increases usually are not fully recovered. Fuel prices have remained high throughout most of 2000, 2001, and 2002, which has increased our cost of operating. The elevated level of fuel prices has continued into 2003. SEASONALITY In the trucking industry, revenue generally decreases as customers reduce shipments during the winter holiday season and as inclement weather impedes operations. At the same time, operating expenses generally increase, with fuel efficiency declining because of engine idling and weather creating more equipment repairs. For the reasons stated, first quarter net income historically has been lower than net income in each of the other three quarters of the year. Our equipment utilization typically improves substantially between May and October of each year because of the trucking industry's seasonal shortage of equipment on traffic originating in California and our ability to satisfy some of that requirement. The seasonal shortage typically occurs between May and August because California produce carriers' equipment is fully utilized for produce during those months and does not compete for shipments hauled by our dry van operation. During September and October, business increases as a result of increased retail merchandise shipped in anticipation of the holidays. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to market risks from changes in (i) certain commodity prices and (ii) certain interest rates on its debt. COMMODITY PRICE RISK Prices and availability of all petroleum products are subject to political, economic, and market factors that are generally outside our Page 17 control. Because our operations are dependent upon diesel fuel, significant increases in diesel fuel costs could materially and adversely affect our results of operations and financial condition. Historically, we have been able to recover a portion of long-term fuel price increases from customers in the form of fuel surcharges. The price and availability of diesel fuel can be unpredictable as well as the extent to which fuel surcharges could be collected to offset such increases. For the first quarter of 2003, diesel fuel expenses net of fuel surcharge represented 15.8% of our total operating expenses and 16.6% of freight revenue. At March 31, 2003, we had no derivative financial instruments to reduce our exposure to fuel price fluctuations. We do not trade in derivatives with the objective of earning financial gains on price fluctuations, on a speculative basis, nor do we trade in these instruments when there are no underlying related exposures. INTEREST RATE RISK The Credit Agreement, provided there has been no default, carries a maximum variable interest rate of LIBOR for the corresponding period plus 1.25%. During the first quarter of 2001, we entered into two $10 million notional amount interest rate swap agreements to manage the risk of variability in cash flows associated with floating-rate debt. At March 31, 2003, we had drawn $25.0 million under the Credit Agreement. Approximately $5.0 million was subject to variable rates and the remaining $20 million was subject to interest rate swaps that fixed the interest rates at 5.16% and 4.75% plus the applicable margin per annum. The swaps expire January 2006 and March 2006. These derivatives are not designated as hedging instruments under SFAS No. 133 and consequently are marked to fair value through earnings, in other expense in the accompanying statement of operations. At March 31, 2003, the fair value of these interest rate swap agreements was a liability of $1.6 million. Assuming the March 31, 2003 variable rate borrowings, each one-percentage point increase or decrease in LIBOR would affect our pre-tax interest expense by $50,000 on an annualized basis, excluding the portion of variable rate debt covered by cancelable interest rate swaps, and the effect of changes in fair values resulting from those swaps. We do not trade in derivatives with the objective of earning financial gains on price fluctuations, on a speculative basis, nor do we trade in these instruments when there are no underlying related exposures. ITEM 4. CONTROLS AND PROCEDURES Within 90 days prior to the date of this report, an evaluation was performed under the supervision and with the Company's management, including its Chief Executive Officer and its Chief Financial Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on that evaluation, the Company's management, including its Chief Executive Officer and Chief Financial Officer, concluded that the Company's disclosure controls and procedures were effective as of March 31, 2003. There have been no significant changes in the Company's internal controls or in other factors that could significantly affect internal controls subsequent to March 31, 2003, including any corrective actions with regard to significant deficiencies and material weaknesses. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in the Company's reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in Company reports filed under the Exchange Act is accumulated and communicated to management, including the Company's Chief Executive Officer as appropriate, to allow timely decisions regarding disclosures. The Company has confidence in its internal controls and procedures. Nevertheless, the Company's management, including the Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure procedures and controls or our internal controls will prevent all errors or intentional fraud. An internal control system, no matter how well-conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of such internal controls are met. Further, the design of an internal control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all internal control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. Page 18 PART II OTHER INFORMATION Item 1. Legal Proceedings. None Items 2, 3, 4 and 5. Not applicable Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits Exhibit Number Reference Description 3.1 (1) Restated Articles of Incorporation. 3.2 (1) Amended Bylaws dated September 27, 1994. 4.1 (1) Restated Articles of Incorporation. 4.2 (1) Amended Bylaws dated September 27, 1994. 10.1 # Amendment No. 2 to Credit Agreement dated August 28, 2001, among Covenant Asset Management, Inc., Covenant Transport, Inc., Bank of America, N.A., and each other financial institution which is a party to the Credit Agreement. -------------------------------------------------------------------------------------------------------------------
References: (1) Incorporated by reference from Form S-1, Registration No. 33-82978, effective October 28, 1994. # Filed herewith. (b) There were no reports on Form 8-K filed during the first quarter ended March 31, 2003. Page 19 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. COVENANT TRANSPORT, INC. Date: May 14, 2003 /s/ Joey B. Hogan ----------------- Joey B. Hogan Senior Vice President and Chief Financial Officer, in his capacity as such and on behalf of the issuer. Page 20 CERTIFICATIONS I, David R. Parker, certify that: 1. I have reviewed this quarterly report on Form 10-Q for the quarterly period ended March 31, 2003, of Covenant Transport, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board or directors: a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize, and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/ David R. Parker ------------------------ David R. Parker Chief Executive Officer Page 21 I, Joey B. Hogan, certify that: 1. I have reviewed this quarterly report on Form 10-Q for the quarterly period ended March 31, 2003, of Covenant Transport, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations, and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures for the registrant and we have: a. designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b. evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c. presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board or directors: a. all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize, and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b. any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: May 14, 2003 /s/ Joey B. Hogan ------------------------ Joey B. Hogan Chief Financial Officer Page 22