Description

Investment Thesis

Allison Transmission (“Allison”) has been posted and discussed before so I’ll try to be brief. Lars did a good job several years ago and the message board is helpful. The timing here is not great considering the strong recent move in the shares and trading levels at a 52-week high but I think situation remains interesting.

My thesis is straightforward. At current prices, we are creating the company for ~14x adjusted 2017E trough-ish FCF for a market dominant business with optionality on fiscal stimulus, a European recovery and an improvement in energy + mining activity levels. I don’t believe this stock will gap higher near-term per se, but I view it as a decent compounder over the next few years as various segments recover and management continues to repurchases shares (pursuant to a recently announced $1 billion authorization over three years). 

Company Overview

Allison manufactures fully-automatic transmissions for medium and heavy duty commercial (63% market share) and US defense vehicles. Fully-automatic transmissions shift gears without a clutch which reduces driver input (requiring a lower driver skill set – like driving a big car) and results in enhanced acceleration (uninterrupted power to the wheels), better fuel efficiency and reduced operating costs*, particularly for "start and stop" activity.

*Payback period for premium Allison transmission averages less than three years.

The business is split into several segments: North American On-Highway (54% of sales), North American Hybrid Propulsion Systems for Transit Bus (3%), North America Off-Highway (1%), Defense (6%), Outside North America On-Highway (16%*), Outside North America Off-Highway (1%) and Service Parts, Support & Other (20%).

*Sales by region: EMEA (54%), Asia-Pacific (37%), South America (7%) and India (2%).

In the 10K and the recent investor presentation, there is a chart that provides a good summary of the company’s market position and end markets. The core business is the on-highway segment. This includes Class 4-5 (5% market share), Class 6-7 (77% market share) and Class 8 (61% market share) straight trucks, conventional transit, buses and motorhomes. The Class 8 straight truck* market comprises shorter haul-type vehicles rather than tractor-trailers more commonly used for long haulage. Unlike the Class 8 line haul market, Allison is not subject to price downs** and 30%-40% of volume is aligned with municipal spending (i.e. theoretically creating more stability).

*Straight trucks have a unified body whereas tractors use a chassis separable from the trailer (used for line haulage).

**Allison typically sees annual price increases of 50-100 bps.

Other segments include tracked defense products for medium & heavy-tactical wheeled platforms, hybrid transit buses and an off-highway* business tied to energy (hydraulic fracking, well stimulation and servicing rigs), mining and construction. The service parts, support equipment and other unit is a replacement parts business driven by normal maintenance and repairs (~20% tied to off-highway). The company’s network of ~1,400 independent distributors services and supports its transmissions in the aftermarket.

*Off-highway is more of a supply chain management business (buy, test and assemble) as Allison is not vertically-integrated.

Competitors across various business lines include Ford (vertical integration), ZF, Voith, Volvo, BAE Systems, Caterpillar, Komatsu, Twin Disc, L-3, Renk AG plus competing technologies (manual transmission and automated manual transmissions). Ford sources engines internally and its medium-duty line picked up some market share recently but management believes the market is close to its historical equilibrium.

The customer concentration here is significant. The top five customers account for over 50% of sales - Daimler, Navistar and Volvo equal 21%, 10% and 10% of sales.

Geographically, the business is broken down between North America (81%), Europe, Asia, South America and Africa. In North America, over 90% of on-highway volumes are sold pursuant to 3-5 year customer agreements.

Financials

Revenues in 2012-2015 were $2,142, $1,926, $2,127 and $1,986 million, respectively.

In 2016, revenues are expected to be ~$1.8 billion based on guidance of yoy declines of 8.5% to 9.5%. The decline in 2016 is related to continued off-highway end market challenges and lower on-highway demand for Rugged Duty and Pupil Transport/Shuttle models as OEMs seek to align inventory-sales ratios. Partially offsetting this weakness is strong on-highway demand in Europe and Japan. The service parts and support unit is also expected to be lower yoy although 3Q increased 8% sequentially. On a quarterly basis, 4Q revenue is expected to be down yoy but roughly flat relative to 3Q.

Despite a difficult top line, management guided to EBITDA margins in the 34%-35% range. These margins have grown from the low 30s in 2012 to the mid-30s percentage per 2016 guidance. Free cash flow is expected to come in at $435-$455 million.

Allison is a capital light business – capital expenditures averaged in the high $60 million area over the past several years. Development and engineering costs (pseudo capex) are captured on the income statement via R&D charges and typically range in the high $90 million region.

Earnings Upside Potential

The Class 8 straight truck + vocational market should outperform the line-haul sector in 2017. The expectation is that 4Q production shuts should reduce inventory to an appropriate level and set the stage for a decent 2017 but many still expect volumes to be lower yoy. For perspective, Allison’s core Class 8 straight truck market is ~40% below its peak and is likely starting to bottom out here. Bigger picture, North American production in Allison’s core addressable markets* (in units) ranged from ~262,000 to ~427,000 and averaged ~337,000 from 1999-2008. After bouncing from 2009-2010 lows, this number is expected to hit ~317,000 in 2016E (per ACT Research) – below the implied mid-cycle figure above. The 2016E-2018E CAGR is forecast to be +1.5%.

*Classes 4-8 excluding Class 8 tractors and Class 8 straight with sleeper.

The off-highway and defense units appear to be at or near trough levels. It is hard to imagine the North American off-highway business getting any worse as sales were off 92% in 3Q. Internationally, the off-highway segment declined 50% yoy. Predicting a recovery in energy and mining is tricky but I am guessing we should start to see traction towards 2H 2017 as the oil services space rebounds a bit and rig counts continue to rise. As a point of reference, total (NA + international) off-highway sales (ex. service parts) are running sub-$20 million relative to $271 million in 2012 and $183 million in 2014. On the defense side, the business peaked at 23% of revenue compared to <6% today. Allison should benefit from the JLTV program ramp up with Oshkosh* and presumably more defense spending as a result of the Trump presidency.

*Oshkosh delivery forecasts of 750, 2,000 and 3,000 units in 2017-2019 should add mid-$20s revenue over the 3-yr period.

 Mgmt referenced a $250 million revenue opportunity over the life of the program but this is more of an outer year opportunity.

Outside the US, there is low penetration (~5%) of automatic transmissions, mostly for niche market vocational equipment compared to 79% penetration in North America. In Western Europe, OEMs use manual transmissions or purchase devices from 3rd parties to automate manual transmissions. Allison is reasonably well-penetrated in refuse, fire and emergency but is under-represented in transit bus, construction and distribution. Similarly, China (#1 supplier of fully-automatic transmissions), India and Brazil represent potential growth markets if adoption is increased. The company is targeting high-single digit to low double-digit volume growth over time. On its 3Q call, management mentioned Allison was seeing good traction in targeted locations and a disproportionate uptake (i.e. increased release with MAN Group) for certain products.

On the cost side, management mentioned further material cost benefits and future labor cost reductions as higher-cost UAW employees retire and are replaced with lower compensated workers. There are ~1,500 UAW Tier 1 employees. As these employees retire, the estimated annual savings range from $20,000-$30,000. Currently there are ~700 retiree-eligible Tier 1 employees implying $14 to $21 million of potential savings.

Valuation

I calculate that Allison trades at 11x EBITDA, 12x unlevered FCF and 14.5x FCF using 2017 numbers. These figures strip out the value of tax assets. At the end of 2016, Allison's NOLs will be exhausted but unamortized intangible assets of $2.1 billion provide an annual shield* of $315 million until 2022. I value this at $550 million (company valuation on tax shield is $578-$676 million) and strip it out from enterprise value and market cap when running the aforementioned ratios. This shield should result in near-term FCF exceeding $400 MM annually which should accrue to shareholders in the form of dividends (yield of 1.9%) and share repurchases.

*Management suggests deduction of $500 million from EBITDA and then applying a 38% tax rate to compute cash taxes.

For 2017E, consensus revenue and EBITDA is $1.8 billion and ~$625 million, respectively. On a mid-cycle basis, I believe revenue and EBITDA* should approach $2 billion and $700 million (conservatively) after capturing some of the secular and cyclical opportunities mentioned above, although I do not factor in any “Trump” benefit. These assumptions result in over $2.40/share of fully-taxed FCF which implies 12.5x FCF.

*To the extent the company is able to drive revenue growth incremental margins have historically been in the 50% area.

Risks:

The big risk is a shift from fully-automatic to manual or automated manual transmissions (AMTs), more specifically if Daimler or Volvo brings its medium-duty AMT to North America. My understanding is that fully automatic transmissions have higher upfront costs but are superior for stop and go duty cycles for driver comfort, fuel efficiency and long term performance. On the 1Q conference call, management noted that AMTs are an improvement over manual transmissions but penetration in the medium duty space receded back to low-single digits from low-double digits. Similarly, vertical integration is a concern but high development costs and low ASPs spread over a single integrated-customer, as opposed to several in Allison’s case, likely dissuades OEMs from going this route.

Other risks include pressures on government spending (federal, state and local levels - municipal spending drives an estimated 30%-40% of Allison’s North American on-highway volumes), China’s subsidization of electric buses, continued energy and mining weakness, declines in defense spending, reduced usage of hybrid propulsion systems for transit buses as the market shifts to natural gas, among other things.

Lastly, I would note ValueAct has been selling.

Catalyst

-Share buybacks (repurchased $77 million in 3Q); recently announced a $1 billion buyback over 3yrs

-End market growth – recovery in energy and mining; yoy earnings improvements

-Fiscal stimulus; Trump infrastructure plan which likely has greater benefit to straight trucks than line haul?

-Corporate tax reform (benefit partially offset by reduced value of tax assets)