Description

Allison Transmission Holdings (ALSN)

Conclusion:

ALSN is a broken IPO of a very high quality company.  The stock is off more than 20% since its IPO at the end of March.  A weak market is causing investors to overemphasize the cyclicality, leverage, and natural gas exposure in the business, and underemphasize the company’s dominant market position, strong free cash flow characteristics, and valuable tax asset.  Using assumptions that I think could be conservative, I see the stock delivering a ~25% IRR over the next three years.

Business description:

ALSN is the world’s largest manufacturer of fully-automatic transmissions for medium and heavy-duty commercial vehicles.  The company’s main markets are North American on-highway (17% of 2011 revenue), non-North American sales (17% of 2011 revenue, split roughly 75/25 on/off highway), service and parts (16% of 2011 revenue), military (14% of 2011 revenue), North American off-highway (13% of 2011 revenue), and hybrid bus (6% of 2011 revenue).  Within ALSN’s core North American on highway market the company generates 42% from the class 8 straight truck market (refuse, construction, fire, etc.), 30% from the class 6-7 market (distribution, commercial lease, ambulance, etc.), 12% from the school bus market, 6% from the transit/shuttle/coach market, 4% from motorhomes, 3% from the class 4-5 market, and 3% from other markets. 

Compared to manual transmissions, or automated manual transmissions, the benefits of fully-automatic transmissions include fuel efficiency, maintenance savings, lower driver skill-set requirements, safety, and increased residual values.  The relative benefits of fully-automatic transmissions are particularly pronounced in vocations where there is a high degree of start-and-stop activity.

ALSN has 100% market share in approximately 35-40% of its non-service revenue base (virtually all of N.A. on-highway except for motorhomes and class 4-5 trucks), and holds the number one position in roughly 85%.  ALSN’s competition varies by end market and no other competitor has close to their scale of product offering.  In the North American class 8 straight truck, class 6-7 truck, and school bus markets ALSN faces little to no competition from other fully-automatic transmission suppliers (they have 100% share of fully-automatic in these markets), so competition can be thought of in the form of manual and automated manual transmissions manufactured by Eaton.  In the non-hybrid bus market, ALSN is the market leader and competes mainly with European companies Voith and ZF.  In the hybrid bus market the company holds the number one position and competes mainly with BAE.  In the class 4-5 and motorhome markets, the company holds the number two position behind Ford, who sources its own fully-automatic transmissions.  In the off-highway market the company competes with Caterpillar and Twin Disc.  In the military market the company competes against Renk, L-3 and ZF.  In truck markets outside of North America competition comes mainly from manual and automated manual transmissions, as these markets have yet to be materially penetrated (roughly 5% penetration in western Europe, and negligible in emerging markets).  The company is the leader in Western Europe, but penetration has been slow given the vertical integration of the truck market has lead to OEMs offering their own manuals and automated manuals.  The company is the market leader in China, with an installed base of 35k units.

Roughly 80% of 2011 revenues were generated in North America.  Outside of North America, 2011 revenues were 49% EMEA, 30% China, 12% Japan, 8% South America, and 1% India.

The company is headquartered in Indianapolis, Indiana.

Why ALSN is cheap / misunderstood:

ALSN is an broken IPO.  I believe the company is cheap and misunderstood as a result of a) the timing of its offering, b) its cash tax characteristics that obscure the valuation, and c) its exposure to the North American natural gas pressure pumping market.  I believe the market is overlooking the fact that this business generates very strong cash returns on capital, the fact that those returns are sustainable, and that ALSN is less cyclical than other commercial truck suppliers.

The company went public in mid-March just before concerns over China and Europe began to accelerate.  The company was taken public by Carlyle and Onex, who bought the business from General Motors in 2007 for $5.75b.  The financial sponsors sold roughly 27m shares in the offering, so continue to own ~83% of the company.  With a financial sponsor “overhang”, 4x net leverage, and cyclical end markets, the company has not screened attractive to most investors as credit markets tighten in response to concerns over Greece exiting the Eurozone.

Due to the asset purchase nature of the 2007 Carlyle and Onex transaction, the company has $3.3b in assets that are amortizable for tax purposes over the next eleven years ($315m per year through 2021 and $183m in 2022).  This tax asset is worth ~$850m, but obscures ALSN’s valuation when looking at the company on an EV/EBITDA basis.  These cash tax savings should be particularly meaningful over the next few years as the company is focused on de-levering the balance sheet from its current level of 4x, to 3.5x within the next twelve months, and below 2.5x by the end of 2013.

In addition to poor timing, and a complicated cash tax situation, the company has exposure to the North American natural gas pressure pumping market which in the context of collapsing natural gas prices, has given investors another reason to either sell or ignore the company.  13% of 2011 revenues were from the North American off-highway market, and the bulk of this exposure is the market for natural gas pressure pumping (ALSN’s transmissions go on pressure pumping rigs).  With the boom in shale gas over the past few years, this business grew +250% in 2010 and +100% in 2011.  Recently however, collapsing natural gas prices have caused customers such as Halliburton and BJ Services to materially scale back their capex plans.  As such, this business should be very weak for the foreseeable future.  After being up 16% in Q1, I model the business down 20% for the full year and another 30% in 2013.  Despite this steep decline, I believe the company is still cheap on future earnings, and there is the additional possibility that this decline is temporary (natural gas prices have already rallied significantly off of their lows).

Despite the above concerns, ALSN is a very high quality company.  The company boasts EBITDA margins of close to 35%, and maintenance capex is only 3% of sales (higher this year as the company finishes building out new facilities in Hungary and India).  When adjusting ALSN’s capital base for these tax assets, ALSN generates cash returns on capital above 30%.  These cash flow margins and returns are sustainable because of ALSN’s extremely strong competitive position.  I mentioned previously ALSN’s dominant position in nearly every market it serves.  I believe this is the case because of product quality / brand awareness, as well as economies of scale.  In terms of product quality / brand awareness, many OEM customers specify ALSN transmissions within their vehicles, and some OEMs advertise ALSN transmissions (for example, Freightliner puts an Allison badge on their vehicles) as they believe this creates pull-through demand for their product.  Regarding economies of scale, there is significant product complexity and initial capital intensity in the business.  In terms of complexity, ALSN uses multiple software algorithms to configure their transmissions to different vehicle and engine specifications.  Consider that in 2011 ALSN produced >10k unique calibrations that were used in more than 2.5k vehicle configurations and with more than 500 engines types.  The capital and technological expertise for this level of complexity needs to be scaled over high volumes.  In addition to time and technical expertise, it would take more than $1b to build capacity to compete with ALSN.  That is a lot at risk in the context that ALSN dominates the market yet has only ~$2b of annual revenue.  To compete with that $2b of revenue one would undoubtedly need to lower price, and expect a slow ramp of market share, further lowering the expected return.  I think that truck OEMs have shied away from developing their own automatic transmissions due to these economies of scale issues.  Whereas ALSN generates very attractive returns, a truck OEM cannot justify the investment given that it will likely only be monetized across their own market share.  Volvo is an interesting case study in this regard.  Volvo developed a fully automatic transmission but it had poor success, is now relevant only in a limited capacity in Europe, and has not seen the necessary investment in order to keep the product competitive.

In addition to its attractive margin characteristics, ALSN is also less cyclical than most commercial truck suppliers.  For example, whereas other truck suppliers like CMI and ETN saw revenues decline roughly 25% in 2009, ALSN saw its revenues decline only 15% (despite GM’s 2009 exit from the class 4-5 truck market, and GM represented roughly two thirds of ALSN’s share in this market).  In addition to ALSN’s breadth of end market exposure, a large part of their lower cyclicality is their lack of exposure to the highly cyclical class 8 linehaul market.

Earnings power:

I expect ALSN to generate revenue, EBITDA and cash EPS of $2.29b/$2.34b/$2.4b, $780m/$807m/$845m, and $2.29/$2.42/$2.63 in 2012/2013/2014.

My expectations for low to mid single-digit revenue growth are built up through what I believe are conservative assumptions.  I already mentioned my expectations for down 20% and down 30% for North American off-highway sales in 2012 and 2013.  I also have military sales declining 10%/40%/20% in 2012/2013/2014 as key programs like the FMTV wind down.  I have hybrid bus continuing to decline 10%/8%/5% in 2012/2013/2014 despite already being down 23% in 2010 and 14% in 2011.  I also have non-NAFTA off-highway declining 10% in 2012 and 15% in 2013 as a result of my bearish view on commodities.  I have non-NAFTA on-highway growing 10% per year, which is lower than the past two years of 19% and 16%, and should be supported by very low penetration levels and leading market positions in these markets.  The primary growth driver for the company will be the core North American on-highway market.  The three main legs of growth in this market are 1) a cyclical recovery, 2) penetration of the class 8 metro truck market, and 3) increased market share in the class 4-5 market.  With regard to the cyclical recovery in the North American on-highway market, while the well-followed class 8 linehaul market has seen a significant rebound and has started to slow, ALSN’s core markets have typically lagged class 8 linehaul by 12-18 months.  Additionally, while volumes have rebounded significantly off of the 2009 bottom, 2012 expectations for production in ALSN’s markets of 252k units is still below the ’98-’08 cycle average of 337k, and even still below the ’98-’08 cycle trough of 274k in ’03.  Regarding the class 8 metro truck market, this market refers to the 30% of the class 8 tractor (as opposed to straight truck) market that spends a significant portion of the time in metro markets (as opposed to linehaul) and therefore exhibits a significant amount of start-stop activity.  The company has developed a new transmission called the TC-10 that has been designed specifically for the duty cycle of this market.  Regarding the class 4-5 market, the company currently holds approximately 13% of this market, which is down significantly since GM exited that portion of the truck market in 2009.  The company expects this share to increase to 20% as they get placement on new entrants who aim to compete with Ford who inherited the bulk of the GM business.  The most notable driver right now is Navistar’s Terrestar entrant into the market.  All of the aforementioned revenue growth rates should also be taken in the context of ALSN having taken consistent pricing increases over its history, which I estimate to be low single digits.

In terms of incremental EBITDA margins, I model them in the 50s (were +60% in Q1, showing the powerful operating leverage on strong volumes).  In addition to its pricing power which is very accretive to margins, the business naturally has significant operating leverage on its fixed cost base, and it also should steadily benefit from the continued positive effects of the tiered wage structure that it negotiated with the UAW during the downturn.  Tier 2 employees (currently 25% of all employees, and 100% of new hires) cost ALSN 30-40% less than legacy tier 1 employees.  In addition, approximately 55% of ALSN’s workforce is eligible for retirement, so the shift from tier 1 to tier 2 workers should continue steadily over the coming years.

Valuation:

I expect ALSN shares to deliver a ~25% 3-year IRR at current prices.

I’m using a 9x trailing EBITDA multiple to arrive at this valuation, which translates into roughly 12x cash earnings.  For comps, I use high-quality industrials like BWA, ROP, ST and WBC.  These companies currently trade, on average, at 11x ’11 EBITDA.  While ALSN’s revenue growth profile is slightly lower, they also have the highest margins in that peer group.  Pushback on this valuation would be that ALSN should trade more in-line with other truck suppliers like CMI and ETN, who currently trade at an average EBITDA multiple of 7x.  I would point out that these are more cyclical businesses with lower returns on capital (as evidenced by margins roughly 20 points lower than ALSN).  Another piece of pushback on the multiple is that 9x is a rich multiple to give a cyclical company three more years into a business cycle.  I would typically agree, except for the fact that my earnings model assumes that three years out the company’s main market (North American on highway) is only back to roughly the average volume level of the prior cycle (’98-’08)

I’m also using a ’12 tax asset (including the amortization from the asset purchase structure of the 2007 acquisition, as well as the company’s $382m NOL) valuation of $855m.

Balance sheet and liquidity:

While ALSN looks highly levered for a cyclical machinery company at 3.9x net debt / EBITDA, that level of leverage is very manageable given the makeup of the balance sheet and the strong cash generation of the business (high margin, low capital intensity, large tax shield).  The company’s main pieces of debt are a $1.8b term loan due ’14, an $800m term loan due ’17, and $470m in senior notes due in ’19.  The company’s most restrictive covenant is a senior secured leverage ratio of 5.5x, and they exited 2012 at 3.2x.  The company’s focus for free cash flow is deleveraging the balance sheet, and they expect to be under 3.5x net debt / EBITDA within twelve months, and 2.5x by the end of ’13.

Catalysts:

Like other broken IPOs, I think the main catalyst for this stock will be getting out on the road and giving investors a greater appreciation for the quality of the business.

Risks:

Exposure to North American natural gas pressure pumping – This is a risk that is clearly impacting the business, but I have reflected this in my forward earnings estimates, and I think a lot of it has been priced into the stock at this point.

Exposure to military market – While a risk to the business, I have reflected it in my forward earnings estimates, and I believe investors are already anticipating significant declines in this business.

Leverage – While substantial, I don’t believe it is a significant risk given the makeup of the balance sheet and the cash flow generation of the business.

Catalyst

Catalysts:

Like other broken IPOs, I think the main catalyst for this stock will be getting out on the road and giving investors a greater appreciation for the quality of the business.