Allison Transmission - Great Share, But A Lot Of Debt And Cyclicality

By Stephen D. Simpson, CFA | January 16, 2013 AAA

There are a lot of things that make Allison Transmission (NYSE:ALSN) an interesting company. A long-time pioneer in fully automatic transmissions, the company estimates that it sold 62% of all medium-to-heavy duty fully automatic commercial vehicle transmissions globally in 2011. While the company stays well clear of the passenger vehicle market, it's not a typical commercial vehicle supplier either, as the company does not participate in the Class 8 "line-haul" market (intercity trucks). While the company has uncommonly good margins and ample opportunities for growth, investors need to consider the sizable private equity ownership stakes and the large debt of this company.

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Bringing the Advantages of Automatics to Select Markets
Gearheads love to debate the merits and drawbacks of automatic and manual transmissions in passenger vehicles, but it's a somewhat different situation in commercial vehicles. In these markets, particularly in vehicles that require frequent stops and starts (buses, mining trucks, intracity trucks, etc.), the arguments for fuel efficiency, safety and driver comfort/convenience have led to nearly 79% market penetration in North America. On the other hand, these systems are also more expensive, and penetration outside of North America is less than 5%.

Allison competes in multiple market categories, with the largest being the North American On-Highway market. Within this business, Allison has virtually 100% share of school buses, two-thirds of Class 6-7 trucks, nearly half of the "straight" Class 8 market and about 15% of the Class 4-5 market. To put that in plainer English, Allison Transmission features prominently in applications such as emergency vehicles, garbage trucks, delivery trucks, construction vehicles and so on.

Outside of these markets, Allison is also active in hybrid buses, off-highway markets (including mining equipment and fracking rigs for oil and gas), military, and non-North American highway and off-highway businesses.

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What Will Drive the Growth?
Allison has two primary opportunities for growth in my view - expanding its addressed markets in North America and attempting to sell non-North American customers on the advantages of automatic transmissions. Certainly, improved vehicle sales will help drive growth as well, but there is not much that Allison can do as a supplier to influence that.

Within North America, Allison has started targeting the Class 8 "metro" and Class 4-5 markets for more growth. Class 8 metro trucks are basically heavy-duty trucks that rarely leave cities, while Class 4-5 trucks are basically "super pickups" like the Ford (NYSE:F) F-450, and medium-duty trucks like those you might see used as tow trucks or delivery vehicles.

Certainly, competitors like Eaton (NYSE:ETN) and Ford will fight to hold on to the business they have, and Caterpillar (NYSE:CAT) has started to show more interest in moving further into on-highway vehicle components. Nevertheless, I give Allison the benefit of the doubt in its ability to penetrate these markets further. The bigger long-term question in my mind is whether the company will ultimately seek to compete in the line haul Class 8 market.

Don't Forget the Risks
There's a lot to like about Allison Transmission. The company has used strong engineering, product development and product quality to build impressive shares across most of its targeted markets. What's more, there should be solid growth opportunities in areas such as energy, assuming that regulators don't crack down on fracking. Still, there are risks that investors must consider.

Allison operates in a cyclical business, and the company can do little to impact end-user demand. Along similar lines, Allison can't do much when major customers such as Navistar (NYSE:NAV) struggle due to their own internal operating mistakes. What's more, there is a risk of customers such as Daimler and Volvo (OTC:VOLVY) becoming competitors at some point.

Allison's corporate history also factors into the risk profile. This company was purchased from GM (NYSE:GM) by private equity investors who still hold more than 80% of the shares post-IPO. Not only do those stakes give them significant influence, but the possibility of eventual secondaries could weigh on the shares down the road. In addition, these private equity owners saddled the company with a very large amount of debt (almost $15 per share), and the company also carries a large chunk of goodwill and intangible assets on the balance sheet - the amortization of which should produce tax benefits, but could be altered by future changes to tax laws and policies.

The Bottom Line
I'm not bothered by the fact that Allison's most recent quarterly results weren't all that strong. Investors in the commercial vehicle space likely already know quite well that this market has been cyclically down lately. What's more, Allison has actually been showing better, and quite high, margins.

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My issue with the company is that it's hard to get to an attractive fair value on the basis of discounted cash flow. For Allison to work as stock, investors have to believe that not only will the company post exceptional cash flow margins (not so hard to believe, given the margins and tax benefits), but must also demonstrate uncommonly high revenue growth (consistently in the mid-to-high single digits). Assume all of that, and the stock is still only 10-15% undervalued. Consequently, I think investors already expect quite a lot from this company, and I don't see a lot of value in the stock at this moment.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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