ALSN - Allison Transmission: TINA Doesn't Live Here Anymore

2023-10-18 17:07:47 ET

Summary

• Allison Transmission's stock has returned about 11.25% in the past 4 months, outperforming the S&P 500.
• The company's recent financial results have been strong, with revenue, gross profit, and net income all showing significant growth.
• The dividend would need to grow at a CAGR of over 24% to match cash flows from risk free Treasury Notes. The risk adjusted investment choice is obvious.

It’s been about four months since I recommended investors continue to avoid Allison Transmission Holdings Inc ( ALSN ), and in that time the shares have returned about 11.25% against a loss of about 1% for the S&P 500. “Granny Doyle” strikes again. My caution has cost me some gains. Today I want to decide whether or not it makes sense to swallow my pride and buy this stock or continue to avoid it. I’ll make that determination by looking at the most recent financial results, and by reviewing the relative merits of the dividend. In particular, I think there’s room for the dividend to grow from current levels. I want to quantify at what rate the dividend will need to grow to match the cash flows an investor would receive from the risk free 10-Year Treasury Note.

I know my writing can be a bit “extra”, as the young people say, so I like to put a thesis statement at the beginning of each of my articles. This gives you the chance to quickly get the gist of my thinking before you’re exposed to too much of my juvenile humour or proper spelling. You’re welcome. I think the most recent financial results have been spectacular compared to the year ago period. The company has grown revenues and profits very nicely. Additionally, the balance sheet is much stronger than it was last year. Although margins have shrunk from the pre-pandemic era, the dividend is very well covered and there’s certainly room to grow. The problem, from my perspective, is the spread between the dividend yield and the risk free rate. Rather than deal in the realm of ambiguous narratives, I decided to quantify what it would take for the dividend to match the risk free rate. The dividend would need to grow at a CAGR of about 24% over the next decade to match the cash received by the investor in the risk free Treasury Note. That’s ludicrous in my view, particularly in light of the fact that the dividend has grown at a (very impressive) CAGR of 8.2% over the past decade. Given the relative risk-returns merits of the alternatives available, I think it would be prudent for investors to opt for the Treasury Note and continue to eschew these shares. TINA doesn’t live here anymore.

Financial Snapshot

The most recent financial results have been pretty close to spectacular relative to the same period last year in my view. For the first six months of 2023, revenue, gross profit, and net income were up by 13.7%, 17.6%, and 37.5% respectively. Additionally, EPS is up a whopping 46.5% because of a fairly massive buyback which dropped share count by 7%. Additionally, the capital structure improved fairly substantially. While debt only fell by about $3 million, or 0.12%, cash and equivalents have ballooned by about $229 million, or 187%. I may quip that I would have preferred the company pay down debt, rather than buy back shares, but that would reach levels of nitpicking that even I rarely reach.

The narrative changes when we take a wider view, though, particularly in the income statement. Revenue for the first half of 2023 was about 8% greater than it was in 2019, but net income is actually lower in 2023 than it was in 2019. Unsurprisingly, rising input costs have hampered profitability. This leads me to conclude that this is another victim of rising costs along the supply chain, and that margins peaked prior to the pandemic.

That written, I think it prudent to keep some perspective here. The company spent $43 million on dividends, and net income for the first half of the year was $345 million. Using the arithmetic skills I learned many, many decades ago indicates to me that that represents a payout ratio of about 12.5%. If anything, there’s room for continued growth in the dividend.

Equalizing The Dividend And 10-Year Treasury Note

We’re sometimes victimized by our tendency to tell ourselves stories that are not anchored to mathematical reality. For instance, in response to my relative preference for Treasury investments at the moment, an investor might quip that the Treasury will never boost its payments to you, while a common stock investor might enjoy ever rising dividend payments. That’s a fair point, especially in light of the fact that Allison has grown its dividend payments at a CAGR of about 8.2% over the past decade. I think it would be a worthwhile exercise to answer the question “at what rate would the dividend need to grow for an investor to receive identical cash flows from the stock and a Treasury over the next decade?” I’ll compare the answer to that question to come to some conclusions about the relative attractiveness of the stock or the Treasury.

While there’s room for the dividend to grow, obviously, the yield remains well below the current yield on the 10-Year Treasury Note. By how much is the yield below, you might ask? I’m glad you asked me that question, my rhetorically convenient friend. The current dividend yield of 1.5% is about 322 basis points below the 10-Year Treasury Note . I’ve answered the question I posed above, and I present it here for your enjoyment and edification. Please note the row labeled “Req’d Rate” below. This is the rate at which Allison dividends will need to grow from current levels in order to match the cash flows received from the Note over the next decade. I’m assuming the investor can invest the same $6,000 of capital in either purchasing 100 shares of stock or a Treasury Note.

We see from the above that in order to match the cash flows the investor would receive from the Treasury, the common stock dividend would need to grow at a CAGR of just over 24% over the next several years. In my view, this is excessive, given that the past decade saw dividend growth of just over a third of this rate. I do expect the dividend to grow, but matching the cash from the Treasury would be a very heavy lift indeed.

Of course, the above comparison assumes that these investments are otherwise equal, and of course they’re not. The dividend of this common stock is much more risky than the cash flows from the Treasury. Given this, I would actually demand more cash from the risky stock, which would, of course, mean an even more excessive growth rate.

We investors aren’t seeking “returns.” We’re seeking “risk adjusted returns.” If you spend your capital on lottery tickets, and happen to win that doesn’t justify your decision. If I can earn a much greater stream of cash flows from an investment that is less risky than any stock, why would I buy the stock?

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