Description

Disclaimer:

This report is for information purpose only and does not serve as investment advice.

ALSN has been written up a few times on VIC. I think it is interesting here given the FCF outlook and rapidly shrinking share count. If you are familiar with the company and its attractive investment characteristics, you can skip ahead to the section on why I think it is mispriced.  

Introduction

             Allison Transmission (ALSN) has a near monopoly in fully automatic transmissions for medium- and heavy-duty vehicles which enables exceptionally high profit margins and excellent free cash flow generation. The company has reduced its share count by 16% over the past year and is expected to continue to aggressively repurchase stock. The current price represents ~9x forward free cash flow and provides an opportunity to invest in a dominant market leader while collecting a double-digit total shareholder yield.

What does the company do?

             Allison Transmission (ALSN) is the world’s largest manufacturer of fully-automatic transmissions for medium and heavy- duty commercial vehicles and medium- and heavy-duty tactical U.S. defense vehicles. ALSN introduced the world’s first fully automatic transmission for commercial vehicles over 60 years ago. Since that time, the Allison brand has become one of the most recognized in the industry because of performance, reliability, and fuel efficiency and is associated with high quality, durability and technological leadership. The company has developed over 100 different models that are used in more than 2,500 different vehicle configurations. The products are highly engineered, requiring advanced manufacturing processes and employ complex software algorithms for transmission controls to maximize end user performance.

             The company was founded in Indianapolis, Indiana in 1915 and was an operating unit of General Motors from 1929 until 2007. Onex and Carlyle Group purchased ALSN in 2007 and took the company public in March of 2012.

What are ALSN’s end markets?

             ALSN sells into a variety of end markets globally. The below chart provides a break down of 2017 sales.

·        North America On-Highway- 49% of sales. ALSN’s core on-highway market includes Class 4-5, Class 6-7, and Class 8 straight trucks, conventional transit, shuttle and coach buses, school buses and motorhomes. The company sells substantially all its on-highway transmissions to OEMs.

·        North America Hybrid-Propulsion Bus- 3% of sales. ALSN manufactures transmissions for electric hybrid transit buses sold to city, state, and federal government entities.

·        Global Off-highway- 4% of sales (2% in North America and 2% ex-North America). ALSN provides products used in equipment for energy, mining, and construction applications. Energy-related applications are the main driver of the segment and include hydraulic fracturing equipment, well-stimulation equipment, pumping equipment, and well servicing rigs.

·        Outside North America On-highway- 15% of sales. Fully-automatic transmission penetration outside of North America is significantly lower and represented less than 5% of vehicles and is concentrated in certain vocational end markets. ALSN’s outside North America exposure is composed of 41% APAC, 7% South America, and 52% EMEA.

·        Defense- 5% of sales. ALSN has a long-standing relationship with the DoD dating back to 1946. Today, the company sells substantially all the transmissions for medium- and heavy tactical wheeled vehicle platforms. ALSN is also the supplier on two of the three key tracked vehicle platforms, the Abrams tanks and the M113 family of vehicles.

·        Service Parts, Support, and Other-24% of sales. ALSN sells branded parts and fluids, remanufactured transmissions, and support equipment through a world-wide network of approximately 1,400 independent distributor and dealer locations. The aftermarket provides the company with a relatively stable source of high margin revenue as the installed base continues to grow. Uninterrupted operation is critical for end user’s profitability which often results in aftermarket purchase decisions being less price sensitive.

Quick Note on Track Classifications

Commercial vehicles are categorized into classes based on gross vehicle weight rating, or the maximum weight a vehicle can carry. In the US, these range from Class 1 to Class 8. Class 1-3 are standard pickup trucks (e.g. Ford F150-F350) and are considered light duty. Class 4 through 6 are larger medium duty trucks and can carry between 14,000lbs and 26,000lbs (e.g. medium-sized box truck). Class 7 and 8 are considered heavy duty and can carry over 26,000lbs (e.g. large construction or dump truck). Class 8 is further broken down into Class 8 straight and Class 8 tractor. Straight refers to trucks with a unified body (e.g. refuse, construction, and dump trucks) while tractor refers vehicles with a chassis that is separable from the trailer they pull. ALSN’s core on-highway market includes Class 4-5, Class 6-7, Class 8 straight trucks, conventional transit, shuttle, and coach buses, school busses, and motorhomes. The company has virtually no exposure to Class 8 tractor.

Why does a fully-automatic transmission matter?

    Commercial vehicles typically use one of three types of transmissions: manual, automated manual (AMT) or fully-automatic. Manual is the most prevalent type used in Class 8 tractors in North America and in medium- and heavy-duty commercial vehicles outside North America. Manual transmissions utilize a disconnect clutch causing power to be interrupted during each gear shift. This results in energy loss-related inefficiencies and less work accomplished for a given amount of fuel. In long-distance trucking this power interruption is not a significant factor since the manual transmission provides the best fuel economy in steady-state cruising. However, in truck applications that require a high degree of start and stop activity, manual transmissions can result in lower fuel efficiency, reduced performance, inferior ride quality, and lower average speed for a given amount of fuel consumed. Additionally, clutches must be replaced regularly resulting in maintenance expenses and vehicle downtime. Finally, manual transmissions require skilled drivers to operate which can limit a fleet operator’s potential talent pool. This is an important consideration given the on-going nationwide truck driver shortage. Additionally, as of three years ago, one can now receive a commercial driver license that only qualifies you to drive with an automatic transmission.

             AMTs are manual transmissions that offer automated operation of the disconnect clutch. By contrast, fully-automatic transmissions utilize technology that smoothly shifts gears instead of a disconnect clutch, which delivers uninterrupted power to the wheels. While AMTs offer some advantages relative to manual transmissions, they still offer inferior acceleration, lower productivity, higher maintenance costs, and reduced fuel efficiency in vocations with a high degree of start and stop activity relative to fully automatic.     

             Given the benefits, ALSN can charge a premium price, especially in its heavier duty products. Its transmissions sell for between $3,000 and $11,000 versus AMTs in the $3,000- $7,000 range. While the initial price tag is higher, total cost of ownership is lower since it requires less frequent maintenance, no need to replace the clutch, and higher productivity. ALSN estimates the average payback period for a premium transmission is less than 3 years. The product’s durability and long lifetime can also materially benefit resale value, which is an important consideration for end customers who periodically upgrade their fleets. ALSN’s fully automatic transmission’s value proposition is evident in the company’s North America Class 8 Straight market share which has steadily increased from 50% in 2012 to 68% in 2017.

Why own the stock?

             ALSN is the dominant market leader in fully-automatic transmissions for medium and heavy-duty vehicles. Its products are the “de-facto” standard for end users who want fully-automatic. In Class 8 Straight (23% of total revenue), the company’s market share (defined by units with an ALSN divided by total units produced) has steadily increased from 50% in 2012 to 68% in 2017. There are no other heavy duty fully-automatic competitors and the company has succeeded in taking share from manual and AMT due to the productivity and fuel efficiency benefits. The market share numbers are even higher in Class 6 and 7 (71% share and 14% of total revenue) and school buses (88% share and 5% of total revenue). In my diligence I interviewed a number of truck dealerships and the constant refrain were statements like: “I am not aware of any other competitors”, “They are the 800lbs gorilla”, and “Allison in the only option.” A parts director at one dealership even said, “They can sometimes be difficult to deal with because they know they are the only game in town.” The company’s technological leadership, long-term OEM relationships, dominant niche market position, and reputation for quality serve as substantial barriers to entry to any potential competitors. The company’s IR deck highlights the virtuous market leadership fly-wheel:

ALSN’s enviable competition position and pricing power is evident through its exceptional EBITDA margins. The company compares very favorably to other industrial companies:

While last year’s 38.4% EBITDA margin benefited from a strong revenue year, the company has consistently been in the mid 30%s since coming public in 2012. I believe this demonstrates the company’s structurally advantaged competitive positioning rather than just fixed cost operating leverage. Between 2014 and 2016, ALSN’s revenue declined 13.5% due primarily to challenges in the energy end market. During the same period EBITDA declined only slightly more, 14.5%, which highlights the company’s flexibility in controlling costs.  

ALSN’s strong profitability, attractive income tax attributes, and relatively capital-light manufacturing footprint lead to significant free cash flow generation. Since coming public, ALSN has paid hardly any cash income taxes due to a large NOL and the structure of the deal from its acquisition from General Motors. While the NOL ran out in 2016, the company continues to benefit from a step up in basis in intangible assets. As of 12/31/2017, ALSN has $1.4bn of unamortized intangible assets. This should result in annual cash tax savings of $72m from 2018 to 2021 and $42m in 2022.

             Over the past 5 years, capex has averaged 3.5% of sales. The company guided to capex equal to ~3.5% of revenue next year and has stated that the existing manufacturing footprint is sufficient to meet all current growth objectives. The below chart shows FCF generation and FCF margin since 2012. Once again, the performance has been very stable despite some variability in revenue. 2017 FCF margin was down slightly due to the exhaustion of an NOL in 2016.

Free cash flow is only valuable when management uses it properly. In ALSN’s case, management is using it to aggressively reduce the share count. In the past year, the company bought back $885m worth of stock and reduced the share count by 16%. ALSN has another ~$550m left under the current authorization (~10% of mkt cap) versus 2018 FCF guidance of $550-600m. I would expect the board to reload on the buyback once the current authorization is finished if the multiple remains depressed. A representative from the company’s 3rd largest shareholder is on the board of directors. The acceleration in repurchases appears to have coincided with his appointment.  

Why is it mispriced?

Concerns around the North American truck cycle

             The trucking end market is undeniably cyclical, and it seems that concerns around the cycle peaking are weighing on ALSN’s multiple. For instance, in JP Morgan’s recent downgrade note, the analyst stated, “the Class 8 is expected to reach cyclical peak in 2018.” When evaluating ALSN’s cyclical exposure, it is important to differentiate between the company’s core market, Class 5-7 and Class 8 Straight, versus Class 8 Tractor. Looking at net orders data going back to 1996, suggests that ALSN’s markets are less cyclical than the volatile Class 8 tractor space. **Note all data from ACT Research**

Another way to cut the data is by looking at YoY % change in net orders. The blue line corresponds to Class 8 Tractors and exhibits significantly larger peaks and valleys than the dashed orange Class 5-7 and Class 8 Straight line. Over this period, Class 8 Tractor net order volumes declined over 40% three times versus Class 5-7 and Class 8 Straight’s maximum drawdown of 35% in 2009. Between 30-40% of ALSN’s North American On-highway market volume is driven by municipal spending which contributes to the relative stability.

The leading truck market forecaster, ACT Research, estimates 2.5% unit volume CAGR in ALSN’s markets from 2017 to 2020. Supporting this growth is pent up demand from deferred purchases and continued demand for fuel efficient vehicles. To frame the pent-up demand point, the below chart shows the 10-year cumulative net orders for Class 5-7 and Class 8 Straight (in orange) and Class 8 Tractor (blue) for 1998-2007 versus 2008-2017. While 2008-2017 Class 8 Tractor orders surpassed the previous 10-year cumulative total, Class 5-7 and Class 8 Straight orders trailed by ~530k orders. Given this backdrop, ACT’s growth projections seem reasonable.

In sum, ALSN’s North American On-highway end market (~50% of total revenue) is less cyclical than the Class 8 tractor market and looks to be in good shape for continued growth over the near term.

EV threat

             The bear case on ALSN assumes rapid adoption of electric medium- and heavy-duty trucks. While this is a longer-term consideration, I believe the current valuation overly discounts EV uncertainty. Internal combustion engines require transmissions and gears to vary the RPM at the wheels to accelerate from a stop and obtain high speeds. By contrast, electric motors create usable torque throughout the RPM range which eliminates the need for a transmission for most driving applications. While electric cars can offer some clear benefits, like not having to buy gas, the tradeoffs for medium and heavy duty commercial vehicles remain significantly less clear. Some considerations include upfront cost, battery weight, range, and lifecycle, impact on payload, resale value, and charging station infrastructure.

Battery technology has improved significantly over the past five years; however, the costs are still too high for many medium and heavy-duty applications. Wired Magazine, in June 2017, estimated a Class 8, 14-ton battery, would cost between $290k and $450k. That is two to four times what many Class 8 trucks sell for today. Weight is another major consideration for commercial vehicles. Electric batteries are extremely heavy, and every pound of battery takes away from payload capacity. A 20,000+lbs battery is likely a non-starter in applications where freight equals revenue.

In a recent interview, Roger Nielsen, Daimler Trucks North America CEO, highlighted the battery lifetime tradeoff with EVs, “What (fleet managers) really want to know is, ‘what is the lifecycle of a battery?’ They are quickly learning that the faster you charge a battery, the fewer times you can charge that battery. You might get 2,000 charges out of a battery that takes eight hours to charge, but you might only get 500 charges out of a battery you charge in four hours.” Given the significant price tag for large batteries, lifecycle is an important consideration in total cost of ownership. Battery lifecycle also can have implications on resale value, which is a significant factor for managers who periodically upgrade their fleets.

I will concede that there are commercial vehicle applications where EVs make sense. These might include light duty and short-distance distribution or terminal yard trucks where the vehicles never travel far from their source of power. Given the uncertain adoption across different use cases, I think it is important to consider ALSN’s North America On-highway revenue mix. The company is fairly well diversified with Class 8 straight making up 22.5% of total revenue, Class 6-7 at 13.7% of total revenue, school buses at 5% of total revenue, and transit/shuttle/coach at 3% of total revenue. I am comfortable betting that EVs are not rapidly adopted across all these applications. Speaking at the ACT Truck Seminar in February, Brian Cota, VP of Sales at Daimler, opined, “Will electric ever be 30% of the market? I don’t think so.”

        Another point often ignored by bears is ALSN’s progress in electrification. To date, the company has sold more electric hybrid systems for commercial vehicles than any other company in the world. Recently, ALSN announced several developments in its fully electric initiatives. In October 2017, the company revealed that Volkswagen in Brazil will be using an Allison automatic transmission in its fully electric e-delivery truck to multiply torque and allow for a lighter and less expensive electric motor. In February 2018, the European electric vehicle manufacturer EMOSS announced the development of an Allison transmission-equipped electric semi-truck with a range exceeding 300 miles. The transmission provides torque multiplication and allows the electric motor to operate within an optimal efficiency range for a larger portion of the drive cycle. Without the transmission, the truck would need a battery twice as large to achieve the same performance. ALSN’s 2018 guidance includes a 15% increase in R&D spend, much of which will go to electric and hybrid propulsion initiatives. While the electric vehicle picture remains murky, it is clear that ALSN is not standing still. The company’s solutions address some of the most important issues with electric motors including battery size and range.

Balance sheet

             ALSN has some leverage. As of 4Q17, the company had $2.3bn of net debt which equates to 2.6x trailing twelve-month EBITDA. The company has said it is comfortable in the 3-3.5x range over the course of a cycle. This does not mean that the company intends to lever up to get to 3x but rather that the company will take active steps to reduce leverage if it breaks through the 3.5x level. While this level of debt may strike some as high, I do not think it is imprudent given the company’s financial profile. ALSN has exceptionally high EBITDA margins, favorable cash tax attributes, and limited maintenance capex requirements. While owned by private equity during the 2009 recession, ALSN had 60% more debt ($3.7bn), paid 2x what it pays today in interest expense, and still generated close to $100m in FCF.

             The below table shows the company’s long-term debt. There are no maturities until 2022.

Why now?

             ALSN issued conservative guidance for 2018 when the company reported in February. Guidance included net sales of +3% to +7%, adj EBITDA margin of 37.5% to 39.5% (mid-point flat YoY), and FCF of $550m to $600m. Management has historically been conservative with initial guidance- the 2017 guide started with revenue increasing 1.5% to 4.5% and the full year ended +23%. While I do not expect the same magnitude of outperformance, I do think there is some opportunity for upside. The stock sold off after earnings on the conservative guide and slightly light 4Q margins. I think the market is providing an attractive entry point for a high-quality company trading at an ~9x forward free cash flow.

             I expect the company to come in at the high-end of 2018 guidance driven by:

·        10% growth in North America On-highway due to continued strength in end market production and share gains. Based on 1Q strength of ACT net order data this could be conservative.

·        40% growth in North America Off-highway due to rebound in energy sector. This is still well below 2014 revenue and may end up being conservative given the strength in 4Q17.

·        8% growth in Outside North America On-highway. Fully-automatic transmission penetration outside of North America is still very low- less than 5% of units in medium and heavy duty. This revenue line has grown double digits the past two years. High single digit should be achievable given the significant white space.

·        EBITDA margin of 39%. Volume is the primary determinant of where in the range the company ends up. If revenue is at the high end, EBITDA margin should be as well.

·        FCF of $600mn and 13.75m shares repurchased. I assume the current authorization is fully utilized (~$550m) at an average price of $40, slightly above where the stock trades today.

If ACT Research’s trucking estimates prove to be correct and the energy end market continues to rebound, 2019 will be another growth year. 2019 will also benefit from GM re-entering the medium-duty space exclusively equipped with ALSN products. Before exiting this market in 2009 due to the company’s financial troubles, GM had ~30% share in Class 4-5. If GM were to regain 10% share, it would generate 2% incremental revenue growth for ALSN.

To be conservative, my valuation base case assumes 2019 FCF of $575m which would be flat with the midpoint of 2018 guidance. My bull case assumes $625m and my bear case is at $500m. My scenario FCF multiples go from 10x to 13x. Over the past five years shares have traded at an average of 12x.

Picking the “right” multiple is undoubtedly more art than science. In my view, current price provides a very attractive risk/reward for a business with excellent free cash flow generation, dominant competitive position, and shareholder friendly capital allocation. In the event the multiple remains depressed, management is likely to continue aggressively repurchasing shares. The current price allows an opportunity to collect a ~11% shareholder yield while we wait for intrinsic value to emerge. For reference, the last time the forward FCF multiple was this low was in early 2016 and the stock returned ~50% over the following 12 months.

             In the below comp table, I include a mix of trucking and auto-component companies. ALSN is by far the cheapest of the group on FCF despite having the highest margins. I don’t think this makes sense. The comp group has similar cyclical end market exposure and, in some cases, higher operating leverage. At the current price, the market appears to be pricing in a perpetually declining FCF trajectory. In my view, that is highly unlikely given ALSN’s dominant market position, growth initiatives, and high free cash flow conversion.

Where could I be wrong?

             I discussed my views on EVs and the on-highway truck cycle in the “why is it mispriced?” section. If I am very wrong on either of those points the stock is not going to perform well.

R&D efforts come up short

             The company guided to a 15% increase in R&D spend in 2018 to address emerging propulsion technologies. While I think this is the right approach to address potential changes in the commercial vehicle industry, the company’s track record at breaking into new product markets has not been stellar. In 4Q17, ALSN took a $32m impairment charge on long-lived assets related to the production of the TC-10 transmission. The TC-10 is a ten-speed fully automatic transmission targeted at the Class 8 tractors that primarily serve urban markets. The product has not achieved the success originally forecasted due to problems with an OEM partner and general difficulty breaking into the tractor market. Management still believes the product has potential and last year PACCAR announced its availability in Kenworth and Peterbilt models. Nonetheless, it has been much slower out of the gates than expected. If future product introductions or R&D efforts fail to gain market acceptance, investors will likely question management’s internal investment strategy.  

Negative Sentiment on Industrials

    Negative sentiment on the industrials group could continue to drive weak short term price action. The stock is down ~7% over the past couple days. I don’t really have a view on the broader macro narratives that seem to be dinging multiples. I think ALSN’s free cash flow generation, dominant market position, and shareholder friendly capital allocation is likely to lead to at least an adequate return over a longer time horizon.

Catalyst

Earnings 

Potential for new buyback authorization in 2H18

Announcements regarding R&D initiatives (including around EVs)