Florin Patrunjel/iStock via Getty Images
Despite stronger near-term results, the “now versus then” debate on Allison Transmission (NYSE:ALSN) won’t go away, as analysts and investors continue to argue over the adoption curve of electrified trucks, what role Allison will play in electrified vehicles, and what the profitability of that role may be. In the meantime, Allison is looking forward to multiple potential growth drivers in its established business, but also faces the prospect of further cost ramps for electrification-related R&D.
I liked these shares back in August of 2021, and the stock has done alright since then – rising close to 10% and roughly doubling the return of the market, while also outperforming other commercial truck suppliers like American Axle (AXL), Cummins (CMI), and Dana (DAN). The valuation now is more “good” than “compelling”, and I’d lean more toward other names like Dana, but that’s largely splitting hairs.
An Extended Cycle Drives Better Results
In my last article, I had expressed my view that 2022 would be the next cycle peak for commercial vehicles. Component shortages have hampered production and deliveries more than I’d expected in 2022, though, and that’s pushing the peak out into 2023. At the same time, Allison has managed margin challenges quite well, but should still stand to benefit from improving cost and production efficiency opportunities in 2023.
In the third quarter, Allison reported 25% year-over-year revenue growth, beating expectations by about 4%. North American On-Highway sales remained strong, driving 24% revenue growth, and North American Off-Highway was also strong (and stronger than expected) at 20% growth. In the overseas markets, on-highway sales improved 27%, while off-highway sales grew 157% (but contribute a fairly modest 5% of sales). Defense sales declined 10%, while Service revenue rose 25%.
As I said, management has done a better job of managing cost inflation and operating inefficiencies (tied to chaotic OEM production schedules gated by component availability). Gross margin rose 20bp yoy and declined 60bp qoq to 46.2%, with around 500bp of pricing helping offset cost inflation and inefficiencies, beating by 70bp. Adjusted EBITDA rose 30%, beating by 5%, with margin of 34.5%, while adjusted operating profit rose 45% (beating by 7%), with margin up 400bp to 29.6%.
Healthy Today …
Although management did guide revenue modestly lower for the third quarter (and guided EBITDA about 3% lower), I’d nevertheless say that business trends are quite good for Allison. The company continues to benefit from trends like expanded last-mile delivery fleets and growing regional haul demand, as well as limited availability of more experienced drivers, which makes the availability of automatic transmissions even more useful to end-customers.
Comparables are challenging because the commercial automatic transmission market is concentrated and Ford (F), Voith, and ZF Group don’t disclose much. Nevertheless, I’d say Allison’s results compare well to the 13% heavy-duty and 22% medium-duty engine growth at Cummins, and quite well to the 3% off-highway engine contraction, as well as the 28% on-highway and 11% off-highway growth at Dana.
Demand in 2023 should remain healthy, as component suppliers are carrying meaningful backlogs into the year truck order rates remain strong, even if artificially boosted by the timing of OEMs opening their order books for 2023. Beyond this, the company has new product portfolio launches to support growth, including new regional haul products for customers like Daimler (OTCPK:DTRUY) and new hydraulic fracking products for customers like Calfrac (CFW:CA).
Beyond this, ongoing growth in e-commerce and last-mile fulfillment should be supportive, and a new defense program (the Army’s MPF program) could contribute $250M over the next decade-plus, not to mention the possibility of increased military sales to countries in Europe.
… But What About Tomorrow?
No matter how well Allison performs in the short term, bearish analysts are always going to point to the risk that electrification presents to the long-term health of the business and the stock. This is entirely fair to a point, as most electric trucks (or “electrucks” as I call them) will likely not need conventional transmissions.
Allison is developing its own suite of technologies and products aimed at electrucks, with the company focusing on building outs its own e-axle offerings (a powertrain option that includes motors, axles, and other components). Bears argue that Allison is overestimating the amount of addressable content it can win in electrucks (management has talked about addressable content of $20K-plus, while many comparable e-axle programs talk about $5K-$10K), as well as the future margins on this content.
Given that over a dozen companies have thrown their hat into the e-axle ring (including American Axle, Cummins, and Dana), it seems unlikely that Allison will be able to get EBITDA margins in the 30%’s like they have been, and will likely see margins fall more toward the range of well-run commercial vehicle suppliers (low double-digits) unless they can clearly demonstrate inarguable superiority for their systems (which is possible, but by no means certainty).
As far as counter-arguments go, content value in future electrucks may well exceed current expectations and Allison’s R&D efforts may lead to differentiated technologies. It’s also worth remembering that Allison could pick up business in long-haul trucks (Class 8 trucks using fuel cells) that will never be automatic transmission customers. Last and not least, there’s ample uncertainty about the pace and magnitude of electrification in trucks – I believe much of Allison’s core market (vocation trucks like garbage trucks) will electrify comparatively quickly, but how (fuel cells versus battery) and how quickly is certainly debatable.
The Outlook
Modeling is always an exercise in guesswork at some point, but that’s even more true of Allision given the significant potential headwinds to revenue and margins from electrification in 2030 and beyond.
I’m looking for low single-digit long-term revenue growth, as I do believe Allison will see significant headwinds in its business but will nevertheless participate in electrification (as well as a long twilight for traditional diesel-powered trucks). I expect margins to weaken over time – first as the company invests in its electrification portfolio and later as the company sees lower margins on those products. I expect long-term free cash flow margins to shrink from the low-to-mid-20%’s to the mid-to-high teens before compressing further into the mid-teens, driving gradual long-term erosion in FCF.
The Bottom Line
Even if Allison is destined to see low single-digit long-term FCF erosion, the shares still look undervalued and priced for a mid-to-high single-digit annualized total return, and I would once again highlight that there is significant modeling uncertainty. Taking a shorter-term approach, valuing companies on an EV/revenue approach based in margins usually works in this sector, and Allison’s low-to-mid-30%’s EBITDA margins over the next few years should support a forward revenue multiple of 2.4x and a fair value in the high $40’s.
Allison will remain a controversial name, and that usually means elevated volatility, so investors should go in with their eyes open. I do like Allison as a hedge for slower electrification adoption, but I also like it on its own merits at the right price – I don’t think we’re quite there when there are other players in the sector that look more interesting to me, but it’s a name well worth watching.
Be the first to comment