2023-03-31 17:07:48 ET
Summary
- Allison possesses unparalleled expertise in the design and manufacturing of fully automatic transmissions, which are a highly engineered piece of hardware where performance and dependability are of utmost importance.
- The manufacturing of automatic transmissions constitutes a specialized and very profitable industry, in which essentially only two players compete on a global scale.
- Allison enjoys strong scale economies and also benefits from high switching costs, as customers are unlikely to switch from automatic transmissions.
- Fears regarding the adoption of electric vehicles have been exaggerated. ALSN's current valuation reflects impending doom coming from the electrification of the trucking fleet. Advancements in the electrification of trucks have been limited at most, and will be modest in the coming decades due to several structural impediments.
- Valuation is attractive: at $45 per share, the company has an EV of roughly $7.9bn., which implies EV/NOA ’22 and EV/NOI LTM multiples of 2x and 9.8x, respectively. I estimate a target price range of $60-$70, implying equity returns of 12-15% at perpetuity.
This is an article part of an ongoing primer series on great and undercovered companies at attractive valuations. These pieces will provide in-depth analysis of business models, financials and valuations. All figures in US dollars, unless otherwise noted.
Introduction
Allison Transmission (NYSE: ALSN ) is a US manufacturer of fully automatic transmissions for medium-and heavy-duty commercial vehicles, and defense vehicles. ALSN's end markets include refuse management, construction, fire, school and transit buses, motor homes, energy, and mining. Allison possesses unparalleled expertise in the design and manufacturing of fully automatic transmissions, which are a highly engineered piece of hardware where performance and dependability are of utmost importance. End-users, specifically truck drivers, encounter significant barriers to switching (once they switch to automatic transmissions, they are unlikely to revert to manual), making transmissions a critical element of their daily operations. Moreover, the manufacturing of automatic transmissions constitutes a specialized and very profitable industry, in which essentially only two players compete on a global scale.
The main point of the thesis can be summarised as follows:
- Trucking is the primary end market for ALSN, and it is a fragmented and cyclical industry. However, in its North America ((NA)) on-highway segment, municipalities constitute one of the primary customers of ALSN, accounting for approximately 30-40% of the segment's sales. This provides a high level of predictability to the business's top-line.
- Given the small size of the market, scale assumes a critical role in mitigating the expenses associated with research and SG&A costs. ALSN holds a dominant position in numerous segments, rendering the possibility of potential competition very unlikely. Using Helmer's 7 Powers framework, ALSN also benefits from high switching costs (customers are unlikely to switch from their automatic transmissions, and ALSN is the preferred option in many models) and process power.
- Concerns regarding the widespread adoption of electric vehicles have been overblown. ALSN's current valuation reflects impending doom coming from the electrification of the trucking fleet. Nonetheless, advancements in the electrification of the truck fleet have been limited at most. Truck electrification faces three obstacles (US electricity supply and demand, battery production requirements and truck charging requirements) that will take a long time to be resolved. Moreover, the economic viability of electrification for the heavy-duty segment of the fleet (Class 6-7 and 8) is not compelling whatsoever, and again this situation is unlikely to change anytime soon – if at all.
- ALSN’s valuation is very compelling. At $45 per share, the company has an EV of roughly 7.9bn., which implies EV/NOA ’22 and EV/NOI LTM multiples of 2x and 9.8x, respectively .((1)) On a levered basis, ALSN trades at 4.7x P/BV and at 7.1x PE. Given that ALSN’s average return on net operating assets (RNOA) usually clocks above 15% (with ROEs above 60%), and that it has been growing economic earnings (earnings after the cost of capital) per share at a healthy clip, the level of discount is too large to ignore it.((2)) An 8% (EV) discount rate and a 2% growth rate in residual earnings, assuming modest RNOAs (17%), would yield a target price of $61, implying equity returns of 12% at perpetuity.
- Finally, the current management team understands very well the importance of capital allocation, and the company is currently involved in one of the most aggressive repurchase programs that I have ever seen. As I estimate that ALSN will repurchase approximately 5-10% of its market capitalization annually, the current buyback rates have the potential to juice expected returns to much higher levels.
ALSN’s history and description of the business
ALSN was founded in 1915 by James Allison when he established the Speedway Team Company in Indianapolis (its headquarters since then). James Allison is credited with inventing the world's first heavy-duty automatic transmission. In 1929, the company was acquired by General Motors. In 2007, ALSN was sold to a group of investors (Carlyle and Onex) for $5.6bn. In between, Allison kept developing automatic transmissions for several end markets: for instance, it developed its first-generation tank transmission system for the Department of Defense in 1946.
In 2012, ALSN's financial investors decided to IPO the company on the NYSE, and since then it has been a listed company. Although the business's growth has been modest, ALSN has optimized its corporate structure over time, resulting in a significant enhancement in profitability. Also, for the first time in its history, ALSN has engaged in some M&A, with two goals in mind: i) vertical integration, with the acquisition of Walker Die Casting (a supplier of aluminum transmission castings) in 2019, and ii) new opportunities for electric powertrains, with the acquisition of Vantage Power and AxleTech, both acquired in 2019.
David Graziosi assumed the position of CEO in June of 2018. He joined the company in 2007 as CFO and was named President in 2016. The management team of ALSN has a lengthy tenure within the organization, which I view as a positive aspect of the entity's corporate culture. The management team also owns a significant number of shares in the organization, and the remuneration package is reasonable. On the downside, there is room for improvement in the ownership stake of the management team, as well as in the performance-based compensation structure. It would be beneficial to incorporate metrics such as return on capital employed to enhance the alignment of interests. At present, it solely quantifies the revenue volume, adjusted EBITDA margins, and free cash flow volume.
Finally, lately ALSN has been introducing its solutions for the electric powertrain market, with the launches of eGen Flex and eGen Power (a zero-emission electric axle for medium and heavy-duty commercial trucks). As the market for electric powertrains is still nascent, it is premature to determine whether ALSN's efforts will bear fruit or not, but it is fair to say that ALSN's existing franchise in conventional powertrains is so attractive that it will be very hard to replicate in an electric world. Fortunately, as I aim to show later, the electrification of the truck fleet is presently a distant dream.
ALSN's business lines are as follows:
- North American on-highway: it includes Class 4-5, Class 6-7, and Class 8 straight trucks (but not Class 8 line-haul tractor ones), conventional transit, shuttle and coach buses, school buses and motorhomes. Most of the transmissions sold by ALSN in this segment are purchased by original equipment manufacturers (OEMs), who subsequently integrate the transmissions into their respective vehicles. ALSN enters into long-term agreements with the OEMs regarding volumes, promotional efforts, pricing and sharing of commodity costs. Penetration of automatic transmissions is already very strong in this segment (95%), therefore any potential growth is expected to be modest at best. NA on-highway accounted for 49% of revenues in 2022. Finally, it is worthwhile mentioning that inside this segment, 30% to 40% of sales come from municipalities (fire trucks, refuse packers, DOT, dumps transit and school buses). This book of business is very steady and not subject to fluctuations in the trucking industry.
- North American off-highway: transmissions used in vehicles and equipment that serve energy, mining, and construction applications. Off-highway energy applications encompass hydraulic fracturing, well-stimulation, and pumping equipment. Competition in this segment includes some OEMs, such as Caterpillar. Needless to say, this segment has been penalised by the lacklustre conditions prevailing in the oil services industry. However, ALSN expects higher sales in the future due to a combination of higher customer needs plus some new initiatives (like the introduction of FracTran in 2021, a growth opportunity of 100M.). NA off-highway accounted for 3% of revenues in 2022.
- Defense: propulsion solutions for medium- and heavy-tactical wheeled vehicles used by the U.S. military, including the Joint Light Tactical Vehicle, Light Armored Vehicle, Stryker Armored Vehicle, the Family of Medium Tactical Vehicles, Heavy Expanded Mobility Tactical Trucks, Palletized Loading Systems, Heavy Dump Trucks and Heavy Equipment Transporters. Defense accounted for 5% of revenues in 2022.
- Rest of the world on-highway: similar to NA on-highway, but competition in this case is higher. This segment accounted for 17% of revenues in 2022. Most of the sales come from Asia (49%), followed by EMEA (42%) and South America (9%). Unlike North America, penetration of automatic transmissions is quite low (between 5% and 10%), so the international opportunity for ALSN can be quite substantial (it has already been growing nicely over the last few years). On top of that, as ALSN management team has pointed out:
I mean, it's been a focus of us, really, since we've been public. I mean growing that business outside North America. What's happened over time, is that the businesses that's addressable has expanded. And by that, I mean, we sell a product if it's more than say 10% of the total cost of the vehicle, we have a hard time getting the map to work on that two to three-year payback. So what's happened is the vehicles have moved up the emissions curves. So the engines and the emissions devices have got more expensive. They've added safety features. So the total, number of vehicles that we feel we can put that 2 to 3 year payback has expanded. So, you start with that. And then, like we see here in the states there's very few cars with manual transmissions you're seeing the same thing in the emerging markets where they're just moving away from manual transmissions. So then you have a group of drivers, that pool candidates for commercial vehicles that just don't have the experience. So that's also quickening the adoption from manuals to you know what we call automaticity. And the reason I say automaticity is we're not going to win all of that business. There are some duty cycles where automated manual transmissions will be successful and there's some work fully automatics will be successful. But that trend is in front of us.”
(Allison Transmission, 2022, Baird Conference Transcript)
- Rest of the world off-highway: This segment accounted for 5% of revenues in 2022 and will also benefit from the same trends as the NA off-highway segment, plus some ALSN’s specific initiatives (like the wide body mining dump truck opportunity in China, which according to ALSN can be up to 100M. in incremental annual revenue).
- Service parts: it includes Allison-branded service parts and transmission fluids, aluminum die cast components, extended transmission coverage, remanufactured transmissions, royalties, saleable engineering, and support equipment. It is a stable revenue stream (uninterrupted operation is vital for end users’ profitability) that depends on the size of the installed base. ALSN distributes its products through a network of approximately 1,600 independent distributor and dealer locations. This segment accounted for 21% of revenues in 2022.
The evolution of revenues can be seen in the following graph:
Finally, in terms of margins, as mentioned above, ALSN has streamlined the cost structure and margins sit now at healthy levels. I foresee margins at these levels for the coming years:
Understanding ALSN’s business model through the lens of the 7 Powers
At this point it is interesting to explain why I think ALSN is an excellent business and why it has not been recognized by the market so far.
Although the company operates in a niche industry, ALSN prowess has been recognised for a long time between in the analyst community. Rather than its current competitive positioning, ALSN's current valuation reflects fears of a future with electric trucks (discussed in a later section). I think that a rigorous strategic analysis can shed some light on the nature of ALSN’s current competitive positioning. I will use Helmer’s 7 Powers framework in order to answer the question: why is this a good business?
At the heart of Helmer’s framework, popularized in his 2016 book 7 Powers: The Foundations of Business Strategy , there is the concept of Power, defined as “the set of conditions creating the potential for persistent differential returns” . For Helmer, such returns are those obtained above the cost of capital, so his methodology links nicely with the valuation framework I will use later. It is worth mentioning that Helmer’s framework differs from Porter’s in that the former tries to answer the question of why this business is better than competitors ( “differential returns” ), whereas the latter focuses on the advantages and disadvantages of an overall industry.
To qualify as a Power, it needs to have both a benefit to the powerholder and a barrier to the challenger. According to Helmer, the 7 Powers is a comprehensive framework that encompasses all potential competitive advantages that a business can possess. A company does not need to possess all the 7 Powers to generate differential returns: actually, it is virtually impossible to identify a business that exhibits all 7 Powers simultaneously. If the company possesses a significant amount of any one of them, shareholders can expect to benefit in the long run.
Helmer’s framework applied to ALSN yields the following conclusions:
- Scale economies: “a business in which per unit cost declines as production volume increases.” ALSN benefits from significant economies of scale compared to its competitors. ALSN is the incumbent player in a niche market. for instance, around 400-500k transmissions per year is the total addressable NA on-highway market, and in several subsegments ALSN holds market shares exceeding 80%. ALSN possesses sufficient scale to dilute the fixed costs of the business, primarily research and development expenses for new transmission models and general administrative costs (marketing expenses are negligible). Given the limited size of the market, it would be difficult for a new player to achieve sufficient scale.
- Network economies: “a business in which the value realized by a customer increases as the installed base increases.” ALSN’s business does not have any network economies.
- Counter-positioning: “ a newcomer adopts a new, superior business model which the incumbent does not mimic due to anticipated damage to their existing business.” ALSN is the incumbent player and thus, by definition, it cannot not have a differentiated business model versus the incumbent.
- Switching costs: “ the value loss expected by a customer that would be incurred from switching to an alternate supplier for additional purchases.” ALSN's customers face high switching costs. Customers in the US rely on automatic transmissions for their convenience and superior performance, and they would not switch to other alternatives in the Class 6-7 and Class 8 truck category. ALSN is the sole premium provider of automatic transmissions within this market. On the contrary, in the international on-highway segment, which constitutes a smaller fraction of ALSN's business, customers rely less on automatic transmissions, and ALSN also faces competition from ZF.
- Branding: “ the durable attribution of higher value to an objectively identical offering that arises from historical information about the seller .” Although ALSN has clear brand awareness between its customers, it does not price its transmissions in order to maximise gross margins, but rather to target a certain payback period for its customers.
- Cornered resource: “ preferential access at attractive terms to a coveted asset that can independently enhance value.” The business does not own material exclusive patents, preferential access to inputs or differential cost-saving manufacturing techniques.
- Process power: “embedded company organization and activity sets which enable lower costs and/or superior product, and which can be matched only by an extended commitment.” ALSN enjoys some process power. ALSN has been producing automatic transmissions for many years, and they have been tweaking them over time. Transmissions are typically optimized to enhance the performance of particular truck models.
The main conclusions from Helmer’s framework can be visualised as follows:
Source: Hamilton Helmer (2016), 7 Powers: The Foundations of Business Strategy, and own elaboration.
Fears of an electric future have been overblown
The electrification of the trucking fleet has been a major concern for investors when considering investing in ALSN. A future dominated by electric vehicles would leave limited space for automatic transmissions. For many investors, the terminal value of ALSN's business is fatally impaired. In my opinion, there are two pertinent questions regarding the future of ALSN: i) the pace at which this transition will occur, and ii) what segments of the trucking fleet will electrify sooner. Regarding the latter, ALSN does not sell to the Class 1-3 segment, which is obviously the most susceptible to electrification. While it manufactures transmissions for the Class 4-5 segment, their contribution to the overall profits is not as significant as the rest of the segments (Class 6-7, Class 8, motorhome, and school buses), as the price of transmissions is typically linked to the price of the vehicle.
Trucking is responsible for approximately 40% of the transportation industry's greenhouse gas emissions per the International Council on Clean Transportation, and the transportation industry as a whole is responsible for ~25-30% of U.S. and EU greenhouse gas emissions. So, it is quite natural that many countries have begun to take steps to limit carbon emissions from both passenger cars and commercial vehicles. Although some progress has been achieved in the light vehicle side of the equation, trucking has lagged far behind so far.
According to a thorough research by the American Transportation Research Institute (which can be accessed here ), there are basically three challenges to electrify the trucking fleet. The main highlights are as follows:
- US electricity supply and demand: “ To supply the required amount of energy to the trucking industry, utilities will have to expand infrastructure to generate more electricity, and transmit and distribute that electricity to locations where trucks need to charge. With a shift toward electrification, trucking will be one of many new consumers of electricity, competing with passenger vehicle owners for access to low-cost, reliable electricity. This new energy consumption is set against the backdrop of an aging U.S. electricity infrastructure and instances where peak-period demand has exceeded available supply. Additionally, some states are better equipped to implement electrification than others. Since trucking operates across all states and in both rural and urban settings, the industry will need affordable and reliable access to electricity in myriad locations throughout the country.”
- Electric vehicle production: “ there are more than 12 million freight trucks registered in the U.S. These vehicles are almost exclusively equipped with a diesel or gasoline internal combustion engine ((ICE)). A move toward industry electrification requires the replacement of ICE trucks with BEV trucks. This, of course, also requires a major ramp-up of lithium-ion battery production. Suppliers of the raw materials utilized in batteries, for instance, will need to expand mining operations to meet demand, and battery manufacturers will likewise need to grow.”
- Truck charging requirements: “ Vehicle refueling is accomplished today through a relatively quick transfer of gasoline or diesel that is sourced from well-established private fueling facilities. This model would change substantially through vehicle electrification due to recharging times and vehicle trip ranges. At the very least, an entirely new set of infrastructure – in the form of vehicle charging stations – will be required. ”
In addition to the aforementioned challenges highlighted by ATRI, there are other noteworthy data points to consider. Currently, the economic viability of new powertrain technologies is significantly questionable. For a Class 8 truck, upfront costs are as follows: $150,000 for a diesel powertrain, $200,000 for natural gas, $240,000 hydrogen fuel cell, and $300,000 for an electric powertrain. This analysis fails to account for the varying ranges of each powertrain, with internal combustion engine ((ICE)) powertrains having a range of approximately 2,000 miles compared to only 600 miles for electric powertrains. Additionally, the payload capacity of electric powertrains is heavily penalised by the heavy weight of the battery, which can weigh up to 14,000 pounds.
Even for operators who are willing to electrify their medium-duty fleets, there is another challenge to consider, which is how to restructure the grids at depot buildings to accommodate overnight charging. The challenge is substantial since freight vehicles typically charge at similar times to optimize asset uptime, requiring fleet operators to collaborate with utilities to ensure that there is sufficient capacity to sustain their fleet's transition to electric power. In the majority of cases, current structures are unable to provide sufficient energy to support an entire fleet simultaneously. Resolving this issue will require costly enhancements to the power grid, ranging from a few dollars to millions of dollars depending on the scale of the undertaking. Without subsidies, fleet operators will bear the cost of these upgrades, which is likely to impede the rate of adoption.
According to Bernstein's research, approximately 80% of short-haul vehicles are owned by non-listed companies with small fleets (less than 50 vehicles). For these players, there are no incentives (nor resources) to electrify their cargo vans until they can achieve complete cost parity with the diesel counterparts. It is plausible that regulations may artificially increase the cost of noncompliance but given the multitude of small carriers and the potential risk of overloading the electricity grid without coordinated efforts, such regulations are likely to encounter obstacles.
In conclusion, I anticipate that ALSN will maintain its dominant position in the heavy-duty segment of the market for at least the next decade without any significant challenge. As previously elucidated, I also think that the impact on their medium-duty book of business will be minimal.
Valuation
ALSN’s stock has languished over the last five years as investors have worried about the terminal value of the business. The stock price has barely changed over the last five years, and because the company is engaged in an aggressive share repurchase program, this means that ALSN’s market cap (and enterprise value) has fallen quite a bit: at the end of 2017, ALSN had a market cap of $6bn. versus $3.8bn. at the end of 2022 (net debt has been roughly constant at $2.3bn, so ALSN’s enterprise value has dropped by the same magnitude).
ALSN’s historical financial statements are presented in detail at the end of the article. I have also reorganised the accounts to give a clear view of the operating and financial activities. In order to frame the inputs of the valuation, the following table gives a nice sketch of what the company has delivered since 2011:
From 2010 until 4Q'22, ALSN has grown revenues at a 3% CAGR, whereas net operating assets have been decreasing at 2%. Although the business has roughly the same size, the strong improvements in operating margins, together with a more efficient use of assets, have translated into much better profitability. Both the RNOA and the ROE of the last three years sit comfortably above their long-term averages, even though the last three years have not been particularly kind to the company.
Source: Allison Transmission filings and own elaboration. Numbers in millions. Rate of discount assumed: 8%.
ALSN’s historical metrics can give us a valuation range for the business. For an (EV) discount rate of 8%, a growth rate in residual earnings of 2%, and a return on net operating assets of 17% (or $ 280M of economic profits annually) on ALSN’s asset base of 3.1bn., the EV would be around $7.9bn., implying an 36% upside, or $61 per share. At that price, ALSN would trade at 2.5x EV/NOA and 14.7x EV/NOI. It must be emphasised that the previous assumptions are rather conservative: first, ALSN’s economic profits in 2022 have been $349M (the number I use for the bull case), and second, growth in residual earnings per share has been much higher than 2%, given the aggressive buyback program in place. For the next few years I envision ALSN buying back between 5% and 10% of its market cap every year (depending, of course, on the share price and general economic conditions), boosting thus the growth in residual earnings per share.
On the other hand, if we assume economic profits of $200M, well below what ALSN has been yielding under tough economic conditions, the target price would drop to $50 per share – which means that the margin of safety is ample:
Source: Allison Transmission filings and own elaboration. Numbers in millions. Rate of discount assumed: 8%. Growth rate assumed: 2%.
There is another useful way to frame the current valuation discount: in terms of internal rates of return. Given the current EV of $6.5bn. (EV/NOA of 2x), and assuming that our forward RNOAs are correct (15% for the bear case, 17% for the base case, and 19% for the bull case), future unlevered returns will annualise 8.4%, 9.4%, and 10.4%, respectively; which after taking into account the leverage of the company, will raise to 11%, 12%, and 14%, offering thus strong return prospects for long-term investors. At risk of being too repetitive, the current accretive share buyback program will only boost those returns:
Source: Allison Transmission filings and own elaboration. Numbers in millions. Growth rate assumed: 2%.
Downside risks
- Electric trucks make inroads before they are expected, especially in Class 6-7 and Class 8 trucks.
- Labour is an important chunk of total costs. Additional wage pressures could impact ALSN’s profitability down the road.
- ALSN's financial leverage is manageable, but relatively high, which may exacerbate fluctuations in the stock price during an extended downturn in ALSN's end markets.
- ALSN's other end markets, such as mining, fracking and defense, decelerate and may require a significant amount of time to recover.
Upside risks
- ALSN’s international opportunities (mining in China, international on-highway, etc.) gather momentum and keep increasing from current levels.
- Commodity prices (i.e., steel and aluminum) revert back to average levels, boosting ALSN’s margins in the short term.
- Adoption of automatic transmissions outside North America gains momentum, especially if there is a shortage of truck drivers.
- Share buybacks continue at the same pace – and are carried out at appealing valuations.
((1)) EV/NOA: Enterprise value to net operating assets. EV/NOI: Enterprise value to net operating income. Net operating assets are computed as equity (including minority interests) plus net financial debt. Net operating income is computed as EBIT after statutory taxes, less other comprehensive income operating items (such as currency translation adjustments). EV/NOA and EV/NOI, are, in effect, the unlevered measures of P/BV, and P/E, respectively.
((2)) Return on net operating assets (RNOA): net operating income divided by net operating assets.
For further details see:
Primer Series: Allison Transmission - A Superb Manufacturing Business At An Attractive Valuation