ALSN - Allison Transmission: Still Relatively Less Attractive

2023-06-16 16:23:50 ET

Summary

• Allison Transmission shares have returned 8.6% in the past four months, with financials improving and a reasonable argument for the stock being well-priced.
• However, the relative yield between the low-risk government instrument and the higher-risk stock makes it less desirable for investors seeking risk-adjusted returns.
• I am neither adding to nor selling my Allison Transmission position due to the current market environment and relative yields.

It’s been four months to the day since I sold off the lion’s share of my Allison Transmission Holdings Inc. ( ALSN ) stock, and in that time, the shares I still own have returned about 8.6% against a gain of about 8.35% for the S&P 500. I can’t complain too loudly about my lost upside, because I sold for a 26% profit four months ago. I’m obviously comfortable with the investment, so I thought I’d review the name again to see if it’s worth buying or not. I’ll make that determination by looking at the financials, and by looking at the valuation, and comparing the two. Additionally, I want to make this decision in the context of a world where an investor can clip a risk-free return of about 5.25 %.

Each of my articles has a “thesis statement” attached. This is to allow you, the reader, to get into the article, quickly get the gist of my thesis, and then get out again before you’re exposed to too much of my thinly disguised bragging or tiresome jokes. You’re welcome. While I’m not selling my small stake in this company, I’m not adding to it either. The financials have improved very nicely, and a reasonable argument could be made to suggest that the shares are well priced, the problem is the relative yield. We investors constantly seek higher risk adjusted returns. In a world where an investor takes on virtually no risk to earn a 5.25% return, the relative desirability of stocks goes way down in my estimation. For that reason, I must continue to preserve capital by parking it in much less risky investments. In case you hadn’t noticed, this is no longer 2019, and there very much is an alternative today, so the notion of “TINA” is done for the moment.

Financial Snapshot

The latest financial results have been quite good in my estimation. Revenue and net income were up by 9.5% and just under 32% from the year ago period, which I consider to be extraordinarily good. Although some of the ongoing expenses rose by about $36 million between them (COGS was up $23 million, SG&A was up $12 million, and Engineering was up $1 million), revenue rose much higher (by $64 million), so this profitability came from organic sources. In other words, there were no one-time events that created a deceptively rosy perspective. The company did very well relative to the same period a year ago. Finally, it should be said that that’s not nothing. Beating 2022 was a feat, given that sales last year were at a record high.

At the same time, the capital structure improved fairly dramatically, with long term debt down by about $3 million, while cash and equivalents are higher by about $199 million. In my view, this dramatically reduces the level of risk present. Finally, it should be said that at a payout ratio of only about 12%, I think the dividend is very secure, and I’d like to see management pay down debt substantially, and then increase the dividend.

In any case, the factors that attracted me to Allison Transmission years ago are still intact, and for that reason I’d be happy to buy back in at the right price.

The Stock

The phrase “at the right price” has cost me some gains over the years, and so I can understand why some of my readers are skeptical of my abundance of caution. In my view, though, I’d rather miss out on some future gains than risk capital, and I’m of the view that the current market is particularly at risk of reducing capital for a great many investors. With that perspective disclosed, I feel compelled to remind investors yet again that I consider the stock and the company to be very different things. The company designs, manufactures, and sells medium and heavy automatic transmissions for civilian and military use. The stock, on the other hand, is a scrap of virtual paper that gets traded around and moves up and down based on the ever-changing whims of the crowd. The stock can move because of what some popular analyst says about the overall economy. It can be affected by interest rate changes. It can also be affected by the demand for “stocks” as an asset class. I’m going to use Allison Transmission as an example of this phenomenon. If an investor happened to have bought this wonderful business on February 16, they would have made a 7% gain as of June 16. Had they bought exactly one month later, they would be up by about 29%. Not enough changed at the company in one month to warrant a 22% difference in returns. The returns for the very same cash flows were a function of the stock’s volatility. We need to pay attention to the stock.

Obviously, we’d rather be the person who bought in March. The investors who bought in March did so at a time when the market was less optimistic. The expectations were lower, which is why I seek out investments where the crowd has driven expectations to unreasonably low levels. A less verbose way of writing “expectations to unreasonably low levels'' is “cheap.” I like to buy investments only when they’re cheaply priced.

I measure cheapness in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at the ratio of price to some measure of economic value like earnings, free cash flow, and the like. When I last reviewed Allison Transmission, the shares were trading at a PE multiple of about 8.8 times, and the dividend yield was about 1.85%. Fast-forward to the present and the valuation has barely budged, largely as a function of the improved performance here. At the same time, the 360 basis points spread between the risk-free government instrument and the risky stock is alarmingly high in my estimation. None of this compels me to add to my position here.

Source: YCharts

Source: YCharts

I may have reached new lows of rhetorical clumsiness when I wrote that “I seek out investments where the crowd has driven expectations to unreasonably low levels.” The point is made, though, I think. I want to buy when expectations about the future of a given company are on the low side. This is why I think it’s worthwhile to review expectations, and assumptions about the future again. The way I try to work out the assumptions embedded in the current stock price is by turning to works like Penman's "Accounting for Value" and Mauboussin and Rappaport's "Expectations Investing." The approach taken by all of these writers is to treat the stock price itself as a great source of information about what the market is currently "thinking." This exercise involves a bit of high school algebra, where the "g" (growth) variable is isolated in a standard finance formula. Applying this approach to Allison Transmission today suggests the market is assuming that earnings will grow at a rate of about 2.5% from current levels. I consider that to be fairly reasonable, actually.

There are many reasons to buy at current levels, but I can’t get over the relative yields between the very low risk government instrument and the much higher risk stock. We investors are constantly searching for risk adjusted returns, and in that world, being compensated with less income for taking on more risk is not ideal. For that reason, I’m neither adding to, nor selling my Allison Transmission position.

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