The future is never clear; you pay a very high price in the stock market for a cheery consensus. – Warren Buffett

Allison: Keep on Trucking

We like to search for companies that are misunderstood, unloved, boring, and just generally overlooked by the media and Wall Street Bets. We believe that one such company is Allison Transmission. For many decades, they have built and sold fully automatic transmissions into the commercial vehicle market. And, in what is a traditionally cyclical market, they have earned outsized margins greater than almost any other industrial or manufacturing company. How? By selling a valuable product, in this case, one which provides a consumer advantage. Please see Our Creed to learn more about the nature of sustainable competitive advantages.

Anyway, let’s start with the most basic idea first. What’s a transmission? In simplest terms, it’s the way that power is transmitted from the engine to the wheels, rotors, or blades in a vehicle, aircraft, or other device. Historically, this has been important because the speed of the engine needs to be reduced to the the speed of the wheels (this process also creates torque). You can imagine what would happen if your car’s engine operated at 3000rpm and its wheels did as well.

The main categories of transmission that we’ll cover later are manual, automatic, and electric. There are many sub-categories (semi-automatic, CVT, DCT, etc) but we won’t delve too far into them and, in any case, it won’t change our assessment of Allison. I’d note that I am not an engineer so if I get something technical wrong, please correct me.

Before we get started, let’s watch a quick corporate PR video to see some of Allison’s products, facilities, and capabilities.

History

Allison Transmission has a long corporate history dating back almost as far as the first mass-produced automobiles with internal combustion engines. In 1915, James A. Allison, one of the four founders of the Indy Motor Speedway, created the Speedway Team Company to support his racing hobby. A few years later, at the start of WWI, the company provided upgrades to various pieces of military equipment; then, post-War, they focused on marine and aircraft engines. Allison himself died suddenly in 1928 and the company was purchased by General Motors in 1929.

It wasn’t until 1946 that they made their entry into the commercial transmission business. Almost 40 years later, GM separated Allison into two businesses – the commercial vehicle unit and the aircraft/marine unit, Allison Gas Turbine. AGT was later sold to Rolls Royce. It wasn’t until 2007 that Allison finally changed ownership again when Carlyle and Onex Corp. took it off of a distressed GM’s hands for $5.6 billion. GM sold the crown jewels to try to keep the lights on.

Private equity managed the business for 5 years before taking Allison public for the first time in 2012 with a pared down cost-structure. In the ten years since, the story has remained remarkably consistent while the earnings troughs through each cycle have been successively higher – we’ll talk about why.

Markets Served

Allison breaks out 6 distinct markets: North America On-Highway, North America Off-Highway, International On-Highway, International Off-Highway, Defense, and Service/Support.

North America On-Highway – This segment is the most important and accounts for almost half of Allison’s sales. They have a dominant share of the school bus, Class 6-7, and Class 8 Straight market. Over the last few years, they have also been growing share in the Class 4-5 market and have opportunities in the Class 8 market. For a quick refresher on truck classes, click here. The company claims that about 30-40% of their NA On-Highway revenues are driven by municipal spending (~15-20% of total revenues) thus reducing the amount of economic cyclicality they are exposed to. They have been touting significant wins in some of their underserved end markets which I’ll touch on later.
North America Off-Highway – This segment of the business might as well have been written off over the last few years but things are looking up. It addresses the mining and oil industries primarily which… up until recently were not heavily investing in capex. In fact from in the trailing 12 months of Q2 2021 the segment did $7mm in revenues. More recently, with higher commodity prices and hydraulic fracturing picking up again, sales have started to accelerate. Q1 2022 sales were 18mm alone and TTM sales were $74mm.
Defense – Allison has been producing automatic cross drive transmissions for the US Army since 1949. They produce conventional transmissions for this business but the real gem is for tracked vehicles like tanks or personnel carriers. In fact, the M1 Abrams tank has been using their X1100 since 1979. The Army recently re-upped with a $162mm contract in March 2020. Allison has parlayed this business into other allied nations including Japan and the UK. Revenues tend to follow defense budgets and whether we are at war or not. Given increased geopolitical uncertainty recently, this business seems unlikely to shrink in the near term. While only 7% of revenues, the margins tend to be higher than other segments.
Outside North-America On-Highway – At around 15% of sales, international on-highway sales are important to the business. They have had a longer term upward trend over the last decade driven by investing in a sales presence overseas, stricter fuel and emissions standards, and demand for higher uptime. ZF Group is their primary competitor for fully automatic transmissions and more dominant overseas. TTM sales reached $406mm which, despite a significant dropoff during the pandemic, I believe is a new record.

Outside North America Off Highway – Mining, construction, and energy are the big drivers here and the business makes up less than 5% of overall sales. The negative is that these sectors tend to be highly cyclical and go through significant boom-bust periods. The positive is that we are recovering from trough levels in 2020 and there is pent-up demand along with aging fleets.
Parts/Support & Other – Parts & Support is the second largest segment at Allison at just over 20%. It includes things like extended transmission coverage, fluids, remanufacturing, and royalties. Allison has built a global network of 1,400 independent distributor and dealer location to support their solutions. It is also highly profitable. Competition here comes from smaller companies providing unauthorized replacement parts.

Product Offerings

Below is a table from the 10K listing their main product offerings and applications.

Value Proposition

It is important to understand why a fleet owner would pay a premium for a fully-automatic transmission in their vehicle. The willingness of a customer to pay a premium price is a very good indicator that a business has a competitive advantage and will be able to sustain high returns on capital.

Fuel Efficiency

Allison claims that their transmissions use anywhere from 5-20% less fuel than competing options. Those are very big numbers when you consider that commercial vehicles on average use anywhere from 2,000 to 13,000 gallons of fuel per year – many multiples of what an individual consumer vehicle would use. On the low end, 100-650 gallons of reduction would save anywhere from $500 to $3,000+ in costs per year. The increase in fuel prices also gives Allison room to increase their own price for transmissions given their value-based pricing methodology.

A comparison of FuelSense technology with an Eaton DCT

Driver comfort, acceleration, and productivity

Allison Transmissions provide significant amounts of relief to drivers who are continually shifting gears. Thousands of incremental gear shifts are removed and lead to happier, healthier drivers. Additionally, the ability to control acceleration is much better and allows for more precision and productivity than a manual transmission could.

Driver skillset/wages/safety

The number of truck drivers that are skilled with manual transmissions is declining – some driving schools don’t even teach on manuals anymore! Simultaneously, the demand for truck drivers has gone up over the last few years exacerbated by the pandemic and inflation. Automatic transmissions allow more junior or novice drivers to join the labor pool and at lower risk of damaging a vehicle with a mistimed gear shift. Because of the full-power shifting nature of automatics (manuals and AMTs have power interrupts during shifts), automatics offer a smoother and more comfortable ride. With both hands and both eyes on the road, better maneuverability, and nimbleness, Allisons also can provide a higher level of safety in tighter spaces.
Maintenance savings

Allison Transmissions have fewer maintenance requirements vs. manual and AMT transmissions. They use a torque converter instead of a dry clutch so clutch repairs and replacements are eliminated. They claim that routine oil and filter changes are the only maintenance requirements. Of course, electrified vehicles have almost zero maintenance due to fewer moving parts and that is a significant advantage they have and a risk that we will address below.
Residual Value

For fleet owners, a significant piece of the finance puzzle is the resale value premium that an automatic transmission would garner. Allison claims that trucks with their transmissions are in higher demand. While, intuitively, it makes sense, I have been unable to find definitive evidence of these claims through web searches besides commentary from manufacturers.

Competition

Allison’s competition in the North America on-highway space is primarily vs. manual transmissions, AMTs, electric, and fully automatic transmissions. In the fully automatic space, their competition consists of Ford (vertically integrated), ZF Group, and Voith. The way I’ve thought about it is that Allison is dominant in North America while ZF captures a larger share of Europe and rest of world. Allison has been attempting to encroach on ZF’s markets and vice versa but no significant market share shifts have occurred recently. In fact, ZF tried to acquire Allison in 1992 for $525 million and the deal was blocked by the FTC in 1993 because the government said it “would create a near monopoly.” Eaton and Cummins are formidable competitors in the AMT space but the Allison name and quality have so far withstood the attack – and, again, the smoother, more comfortable ride is a big factor.

In the EV space, there are numerous competitors. Allison’s position here is by no means assured and this is the primary reason that the company’s stock trades at a significant discount to the market. Dana, Bosch, Meritor (now acquired by Cummins), vertically integrated OEMs, a host of startups and others all have entrants into the e-axle and electrified propulsion category. Even if Allison is able to maintain design wins during the transition, it is very unclear how they would be able to maintain their current fat margins. And, the risk to the maintenance and parts business cannot be overstated – this business would essentially disappear if the claims of EV uptime and reliability prove to be true.

In off-highway, depending on the application, Allison competes with either vertically integrated OEMs or smaller competitors. Construction: Caterpillar, Dana, ZF, and Volvo. Mining: Caterpillar and Komatsu. Energy: Caterpillar, Danyang Winstar, and Twin-Disc.

For defense, we can separate competitors into tracked and wheeled vehicles. Renk, SAPA, S&T Dynamics, and QinetiQ all compete in the tracked space. And, again, ZF shows up in wheeled vehicle fully automatic transmissions.

For the most part, Allison is competing with OEMs that have in-house manual transmissions and/or AMTs, particularly outside of North America. Allison has to break the hold that the OEM has and convince a customer to transition or offer their fully automatic trans as an option. Manual transmissions still dominate in Asia-Pacific and South America so the opportunity is there over time.

Management & Board

Chairman and CEO – David S. Graziosi – joined Allison in 2007. David became CEO after being promoted from CFO/finance roles. I prefer my leaders to come from operational roles within a business rather than financial ones but there’s no red flags per se.

CFO – G Frederick Bohley – joined Allison in 2001. I DO like that this CFO has marketing and sales experience at Allison. He has worked directly in almost every part of the business.

SVP, Marketing/Sales – John Coll – joined Allison in 2016. 14 years of experience at Eaton.

VP, Product Engineering – Ryan Millburn – joined in 1990.

The most notable thing about Allison’s management team is their longevity. There are numerous “lifers” in the upper ranks of the business. This both speaks to the relationship-driven and specialized knowledge nature of the business and also the risk that they may be unable to adapt to disruptive change. Upper management has been around for decades and are unlikely to rock the boat while their cash cow business is still generating significant returns. While it is true that they have increased R&D spending and capex for EV initiatives, it’s unclear how effectively those dollars have been spent and whether they will ultimately generate a return.

The Board is made up of current and former industrial company executives and is mostly unremarkable. Notably, Thomas Rabaut has been a director since 2007 and is currently an Operating Executive for Carlyle.

Members of management own sizable stakes in Allison stock and options. The CEO has ~20x his base salary in exposure to RSUs and options.

Capital Allocation

See this article for a refresher on ways a company can allocate capital.

Walker Die Casting – acquired in September 2019 – opportunistic acquisition of a supplier for $103mm.
EV deals – Vantage Power and AxleTech – acquired in April 2019 – allowed for better entry into a crowded e-axle space – price tag $132mm
AVTEC – paid $27mm to CK Birla Group in India for transmission portfolio in the hopes of accelerating entry into India off-highway business
JJE – strategic equity investment of $42mm into a Chinese partner’s IPO.

The jury is out on whether their M&A will generate a sufficient return. My best guess is that the non-EV related deals will show better ROI and the EV ones will have a venture capital feel to them.

Dividends

Allison has maintained a steady increase in their dividend per share since 2013 from 42c to 84c now but, because of buybacks, the actual cash outlay has remained relatively consistent around $65-85mm/year.

Buybacks

One of the main benefits of having a low capital intensity business with high returns on capital is that there is a LOT of cash left over to buy back your stock. Allison has had a voracious appetite for share repurchases. Share count has been reduced by 50% since IPO. They recently increased their buyback authorization by another billion dollars. (Current market cap $3.6B)

Overall, I think the company is a good steward of capital. They also seem to be more aggressive purchasers of their shares at lower prices which I always like to see.

Financials

Here’s a lovely chart:

Those margins tell us that Allison is providing something that is highly valued by customers, so much so that they are willing to pay premium prices for it. In my view, higher diesel prices should drive Allison’s ability to take price with customers. The fully automatic transmission market has very low competitive intensity and few players which is another benefit to pricing.

On the cost side, Allison has been restructuring union contracts over the years allowing for more variability and flexibility in their workforce cost base. They’ve been encouraging voluntary retirements as well. Raw materials makes up about 60% of COGS with steel and aluminum making up 20% of that.

As part of preparation for electrification, R&D expenses have been elevated for the last few years (costing almost $1 per share in EPS). Again, it is unclear what, if anything, will come from those dollars being spent.

Along with R&D, capital expenditures have also been elevated the last couple years for electrification initiatives.

They have maintained net leverage around 3x or less and I would expect that to continue to be the case. They extended maturities during the pandemic and have nothing significant due until 2026.

In my view, over the next few years combined with buybacks, I think Allison can generate FCF of $7-12/share. The closing price as I write this is $37.

Risks and Opportunities

Electrification

So, why is the stock so cheap? Quite simply, the market is ascribing no terminal value to their transmission business. The assumption is that electrification will make the need for a fully automatic transmission disappear. Yet, in the calls I did with competitors and former Allison employees, I did not hear that story. Unlike passenger vehicles, commercial vehicles have very different requirements and the barriers to adoption of electrification are significant.

Fleet owners are very, very risk averse. There is a large gap between what the market is saying and what the operators are actually doing. Everyone wants to say they are moving towards electrification but without significant subsidies and government mandates, it is unlikely that the large upfront cash outlays will occur.

Costs are extremely prohibitive for the vehicles still. And, even if you have the money to purchase an EV, there’s the question of infrastructure like chargers and electricity upgrades for a fleet. It doesn’t exist! See this conversation I had with an exec from Thomas Built Buses on the ROI for an EV school bus.

Here’s another exec talking about the lack of infrastructure for battery electric vehicles but then goes on to complain about battery weight, energy density, range and price. He then follows it up by saying that reliability has not been tested yet either. There’s no

And what are Allison’s chances if electrification does happen much sooner than expected? I wouldn’t put a ton of weight on it but Allison does have a “tribal knowledge” advantage vs. new start-ups. There is a lot of know-how that goes into energy efficiency and use cases for customers. Ultimately, the winner in electrification is still going to be the company that provides the most uptime to fleet owners at the lowest cost. The flip side as I mentioned above is the lack of agility that comes from having so much longevity in your management team – if all you’ve got is a hammer, every problem is a nail.

New programs and expansion of addressable market

A major opportunity for Allison is their expansion into new addressable markets. One example is their recently launched Regional Series which gives them another 25-30k Class 8 Daycabs to go after over the next couple years. Here’s the CFO talking about the opportunity – it’s notable that Allison is being added as an option alongside these vertically integrated OEMs. To me, that’s a strong indication that customers request the product and functionality by name.

Other opportunities include an expansion of the the Mack medium duty product portfolio, the FracTran for the oil industry, and international widebody mining dump trucks.

Let me know in the comments if you want to discuss anything that I may not have covered here.