By The Valuentum Team
Allison (NYSE:ALSN) is the largest maker of fully-automatic transmissions for commercial (refuse, construction, fire, buses) and tactical US defense vehicles (wheeled and tracked) at 60%+ share. Its brand is well-recognized, and the better productivity and reduced operating costs of a fully-automatic transmission relative to manual and auto-manual (AMTs) ones are well-known. Allison's aftermarket business on a large installed base is one of its most attractive attributes.
Allison's core business rests on cyclical demand for North America on-highway Class 6-7 truck and Class 8 straight trucks, which account for 70%+ of net sales. Allison bumps heads with Ford Motor (NYSE:F), ZF, Voith and other OEMs in the North American on-highway market. The firm's ties to the US defense market are tight (~6% of sales), but it is also exposed to budgetary pressures. Allison sells substantially all of the transmissions for medium- and heavy-tactical wheeled vehicle platforms, including MRAPs, JLTVs (Humvee), the Abrams tank and the M113 family. Issues related to adoption of fully automatic transmissions outside of North America may inhibit the pace of long-term growth. Daimler is a ~20% customer, by sales; Navistar (NYSE:NAV) and Volvo (OTCPK:VLVLY) are each ~10%.
Allison's dividend resilience is not as attractive as we would like in light of it being tied to a cyclical end market, but a dividend yield north of 2% isn't that bad. Its Dividend Cushion ratio of -0.5 speaks to some concerns down the road, but this is more so a result of the punitive nature of the ratio that considers the health and leverage of its balance sheet (see image below). Total indebtedness of ~$2.4 billion weighs heavily in this regard, but the company is significantly free cash flow positive, generating ~$475 million on average during the past three years, well in excess of yearly run-rate cash dividend obligations (~$100 million). With free cash flow generation like this, however, dividend health isn't bad provided it keeps its financial leverage contained and refinancing risk doesn't become an issue.
Image Source: Valuentum Securities, Allison's stock landing page
Allison Transmission's Investment Considerations
• Allison Transmission is the world's largest manufacturer of fully automatic transmissions for medium- and heavy-duty commercial vehicles, medium- and heavy-tactical U.S. military vehicles and hybrid propulsion systems for transit buses. Formerly known as Clutch Holdings, it was founded in 1915.
• Allison Transmission owns more than 60% global market share of on-highway, fully-automatic transmissions. The company is expanding rapidly in emerging markets (including China), which today are predominantly manual.
• The company has one of the most respected and recognized brand names in the business. The firm's EBITDA margin stands above those of other autoparts suppliers, including Roper (NYSE:ROP), Gentex (NASDAQ:GNTX), Graco (NYSE:GGG), Sensata, Rockwell, Donaldson (NYSE:DCI), WABCO (NYSE:WBC), Cummins (NYSE:CMI), Eaton (NYSE:ETN), and Parker Hannifin (NYSE:PH). This speaks volumes of its efficiency.
• Despite having significant market share and a material efficiency advantage, Allison Transmission sees an ongoing need for productivity improvement. Better acceleration in its products will allow for increased miles and revenue for the firm. The company also remains focused on reducing life-cycle costs.
• Allison Transmission is raising its dividend, buying back stock, and paying down debt, but its long-term debt totals ~$2.3 billion, much higher than its cash position. If its robust free cash flow generation falters for any reason, financial health could be in jeopardy. We're keeping an eye on the situation.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Allison Transmission's 3-year historical return on invested capital (without goodwill) is 21.3%, which is above the estimate of its cost of capital of 8.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Allison Transmission's free cash flow margin has averaged about 22.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Allison Transmission, cash flow from operations increased about 34% from levels registered two years ago, while capital expenditures fell about 22% over the same time period.
We think Allison Transmission is worth $26 per share with a fair value range of $17-$35.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 1.2% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of 1%.
Our model reflects a 5-year projected average operating margin of 26.3%, which is above Allison Transmission's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.9% for the next 15 years and 3% in perpetuity. For Allison Transmission, we use a 8.9% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $26 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Allison Transmission. We think the firm is attractive below $17 per share (the green line), but quite expensive above $35 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Allison Transmission's fair value at this point in time to be about $26 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Allison Transmission's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $33 per share in Year 3 represents our existing fair value per share of $26 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.