Description

Summary

There is a reason we see basically no electric aircraft and almost no electric trucks: the power to weight ratio of batteries is still far inferior to petroleum products. For this reason, a bet on Allison is a bet that the transition to electric trucks takes longer than what is priced into the stock (and longer than people hope).

For that you’re paying 7.2x 2022E earnings (FCF approximates earnings, though note that in the past FCF > earnings because of a tax shield) and perhaps 5.5-6.5x mid-cycle earnings.

Business

Allison has dominant market share of medium duty transmissions in the US and growing share abroad. Medium duty just means a truck that is larger than a pickup and smaller than a tractor trailer. You essentially have three options when choosing a transmission: manual, automated manual, and fully automatic. Even with costs of $3-$11k for automatic transmissions, the majority of medium duty trucks in the US use an automatic for a variety of reasons including higher productivity, easier training, better fuel efficiency, and cheaper maintenance costs. In vocations with frequent starts and stops automatic transmissions make the job faster and easier. The reason you don’t see automatic transmissions in tractor trailers is that long hauls see infrequent shifting and therefore a manual transmission can be slightly more fuel efficient than anything else.

In North America On-Highway, which is ~50% of Allison’s business, share has grown in most categories over time:

In other markets, especially On-Highway markets outside of the US, Allison has low share of all transmissions but high share within the automatic transmission category. They've grown share and I expect that to continue.

With high 30s EBITDA margins and very high returns on capital, Allison is not your standard vehicle supplier (if you can put it in that category). For many vehicles, Allison is the standard configuration. Allison’s brand is such that Allison transmissions are often a prominent part of the OEM customer’s promotional materials. There are thousands of unique calibrations used in the transmission control modules, and transmissions are tailored to specific vehicles and further to specific vocations. For that reason it makes no sense for an OEM to develop automatics in-house. Further, Allison encourages long term agreements with OEMs such that volume is incentivized across product lines. Meritor and Caterpillar have both tried an failed to enter the North American automatic transmission market. I see the risk of harder competition in automatic transmissions as almost zero. Allison’s dominant share and margins should persist for as long as medium duty ICE vehicles are sold. The big question is really how long we have until ICE trucks are replaced by electric.

Transition to Electric Trucks

As I mentioned in the summary, weight is a key consideration in aircraft and trucks, and the fact that we don’t see many electric trucks and basically no aircraft is enough to prove my point. Batteries have improved a lot, but its clear that current batteries are far less energy dense than diesel. Battery costs have declined a lot over recent years, but battery energy density hasn’t seen as much improvement.

Currently, the cost and energy density (i.e. less cargo) make these vehicles uneconomic without subsidies. For example, a class 8 truck might achieve 2 kWh/mile. If you need a 500 mile range (which isn't great for a class 8 truck), you require a 1,000 kWh battery. If the energy density is 160 Wh/kg, you’re talking about over 6 tons of weight in battery, which is a small fraction as energy dense as diesel. The vehicle is significantly more expensive and the residual value is less clear. Class 6-7 requires less range but still has the same weight trade-offs. 

Charging speed and availability is another issue. Imagine a small business owner with a fleet of 10 electric vehicles. If each of those vehicles travels only 100 miles a day and gets 1.4 kWh/mile (similar to figures Kenworth has talked about recently for a Class 6 truck), you would require 1,410 kWh of charging ability. If you did that over a 10 hour period, you would draw 141 kW of power. If you lose power, you need to be able to produce that with a generator, and that kind of power is only available in large/expensive commercial generators. So a small business would have to commit to more expensive vehicles with a more uncertain residual value plus they would have to install charginging capability and backup generators to make it work.

I don’t think our grid is ready for medium and heavy duty truck electrification either, and much ink has been spilled to that effect. This makes sense intuitively if you simply look at how much transportation fuel we use and then convert that into the necessary electric generating and transmission capacity. If the recent experience of Europe is any guide, pushing too fast on an energy transition can be disastrous. I don’t doubt this transition will happen eventually, but it wont happen overnight.

There are obvious categories where electric vehicles make sense sooner. Allison bears point to the electrification of school buses, where weight isn’t as important, distances are low, and charging times are predictable. I have no doubt that these factors plus subsidies will make buses one of the early categories to electrify, but buses are ~$100mm of sales to Allison. Other categories wont be so easy.

Valuation

I take average industry units for North America On-Highway over 10 years and compare those to industry units in 2021 to adjust Allison’s 2021 sales to “normal”/mid-cycle. This assumes 2021 price and market share are accurate. For other categories, I use 10 year average sales except for service parts where I use 2021 sales and Outside North America On-Highway where I linearly extrapolate.

I use EBITDA margins of 37%, which is higher than recent times with cost pressures, but lower than the past with similar sales levels and cost structure.

You can see from this Allison graphic that my assumptions are close to 2021 results and consistent with longer term averages:

With these assumptions I get earnings power of $5.90/share. If we strip out ~$70mm of R&D going towards e-axles, earnings power is more like $6.40. On those scenarios, the multiple is 6.4x and 5.8x.

I don’t doubt that we will eventually see a transition to electric medium duty vehicles. If you thought Allison would have flat cash flows for 10 years and then cash flows declining linearly to zero in the following 10, the warranted multiple would be 8.3x at 8%. This isn’t an exact science, but in something approximating that scenario Allison stock would be worth 30-40% more today. I think you’re more likely to see growing cash flows over that time as Allison penetrates foreign markets for the same reason that automatic transmissions have high adoption in the States. Meanwhile you get a dividend yield of >2% and buybacks which in recent times shrunk the cap about 8% a year (5 year average buyback spend is 14% of the current market cap).

I see very little threat from existing competition. Nobody will get into a business that will enter decline in the medium term. The two big risks are that electric truck penetration happens faster than I think and that management does dumb things with free cash flow in an attempt to reinvent the business. I don’t like the e-axle initiatives, but I have no evidence that management will do much more than they already are on that front. I think status quo is more likely, or I think others will recognize the stream of cash flows that I see here and do something about it.

Catalyst

No hard catalysts. Big buybacks.