Small Public Float; International Potential
Allison Transmission (NYSE:ALSN) became an independent entity in 2007 when Carlyle and Onex purchased the company for $5.6 billion from General Motors. In March of 2012, Carlyle and Onex took the company public. Since the initial public offering, Allison Transmission has continued operating as a top developer and manufacturer of fully automatic transmissions for medium- and heavy-duty vehicles. Their financial performance is highly correlated to macroeconomic conditions. Although the stock has increased approximately 25% over the past year, the potential for additional growth exists. Onex and Carlyle are still heavily invested and control the operations of the firm. The two combined hold approximately 70% of the equity and have strong track records in the industry. With a strong tenured management team, robust automotive and trucking markets, and virtually untapped international markets, Allison Transmission is in a prime position to experience explosive growth.
Allison Transmissions is a global, United States based corporation operating in one main business segment: fully automatic transmission design and manufacturing. Their end product can be seen in vehicles and machinery used in trucking, construction, distribution, emergency vehicles, mining, and other major automatic machinery. This major segment can be broken into 5 main sub-segments based on end product use:
On-Highway segment (51% of total sales) designs and manufactures fully automatic transmissions for on-highway vehicles such as semi-trucks, emergency vehicles, motor homes, school buses, and rugged duty trucks.
Hybrid Transit Bus (5% of total sales) designs and manufactures fully automatic transmissions for hybrid transit vehicles such as metro and motor coach busses.
Off-Highway (13% of total sales) designs and manufactures fully automatic transmission for the industrial off-highway vehicles primarily used in construction and mining.
Military and Defense (14% of total sales) designs and manufactures fully automatic transmission for military and defense vehicles for countries such as The United States of America, England, Korea.
Parts, Support Equipment, and other (16% of total sales) produce necessary parts and equipment for the installation and maintenance of vehicles using the transmission.
Allison Transmission's Business Segments and Historical Performance
The table above shows the annual revenues for each segment and yearly growth rate
The table above shows the percentage of revenue for each segment in 2011 and 2012. 2013 data has been annualized by adding the first two quarters and multiplying by two.
Historical operational averages and current state of the business
We use a type of discounted cash flow analysis that normalizes all costs as a percentage of revenues. It uses simple balance sheet growth as a proxy to determine appropriate levels of capital expenditures. Our goal is not to forecast future earnings, but rather to determine what level of cash flows may be available to shareholders considering average conditions. These cash flows are discounted using a 10% rate over a 10 year period.
Management has done an exceptional job keeping the cost structure fairly stable. Sales have primarily increased through a cyclically improving North American market, specifically trucking and automotive sectors. They have also benefited from favorable conditions in the housing construction, and oil and gas industries. Management has also been able to improve operating margins both from costs of sales and selling, general and administrative expenses.
Cost of sales is the largest of the expenses; 70% of costs of sales consist of overhead costs, and 24% are from direct labor. The cost improvement has been driven by a favorable change in underlying material prices and improvement to manufacturing efficiencies. A decrease in selling general and administrative expenses has been moved by a decrease in General Motors receivables and a change in a certain warranty coverage program. Research and development costs have remained constant, and will likely remain that way moving forward.
Taxes have been much less steady over the past several years. As of year end 2012, Allison Transmission has $3.0 billion of unamortized intangible assets. Moving forward, the company will benefit from federal income tax deductions of $315 million through 2021, and $183 million in 2022. Additionally, Allison has $363 million in carried forward from previous net operating loss.
The balance sheet cash flow drivers have remained low; capital expenditures have been especially low. Allison is in a low capital expenditure business, thus it is expected these costs will remain low. The experienced management team, has kept the company's working capital has remained fairly constant. The increase in working capital experienced in 2012 is due to a decrease in cash balance.
Analysis of Operations
The most critical aspect of investing is to never lose money. Understanding current market expectations through the changes of costs and revenues allows an investor to determine what is baked into the stock price. An analyst can then decide the likelihood a company can achieve these levels of operation, and the ability for management to deviate from these expectations. Allison Transmission's stock price can be justified, using historical averages in both income statement and balance sheet value drivers.
One upside to this stock's cash flow is the opportunity to further expand an existing international presence. Although 78% of revenue is contributed by North American sales, Allison Transmission operates and generates revenue overseas. They currently have operations set up in China, Brazil, Hungary, and United Arab Emirates. The firm has reported current revenue in the United States, Canada, China, United Kingdom, Japan, Germany, India, and other countries around the world. Capitalizing on these seemingly untapped markets could enable Allison Transmission to grow revenues exponentially. Since manufacturing plants are already set up overseas, Allison is in position to produce transmissions for these 'local' markets, as their products are large and expensive to ship. The company is also in a prime position to continue growth in the oil and gas space. Even though over half of existing revenue is tied to the on-highway automotive and trucking sector, natural energy and mining may prove to be an additional macroeconomic phenomenon to propel Allison's revenue.
Private Equity Overhang
As Allison Transmission produces quality operating numbers, justifying a stock price above the current price through free cash flow analysis, their share price continues to lag relative to competitors. The firm has been trading on the market for 18 months now, however the current public float may be part of the problem. Carlyle and Onex, who own a combined 70% of the equity, control the company. When the two private equity firms decided to take Allison Transmission public, they kept a large portion of the company for one of two reasons. As insiders and world-class investors, they potentially see room for additional returns. Alternatively, in efforts to keep the company stable, Carlyle and Onex have maintained a large ownership in the firm to control the public float. Although both can be seen as positive for long term growth, the ladder is the more likely scenario.
American Axle (NYSE:AXL) went through a similar transition. Blackstone took the company public in 1999 for $17 per share, holding roughly 75% of the company. With industry record operating metrics, and 18 months later, the firm's stock price dropped to $7. As Blackstone continued to sell more of the company's equity to the public, the stock began to flourish.
Assuming market conditions are right, it is likely that Carlyle and Onex will continue their exit and provide additional equity to the public. On November 12, the two private equity owners announced they would sell an additional 15 million shares. Since then, the stock has climbed 13%. As the market becomes more comfortable with the equity and a larger float, the idea of a single investor dictating the direction of the company will begin to diminish. This will allow the stock price to continue to increase.
Return of Cash to Shareholders
Allison transmission has attempted to show confidence in cash flow, through increasing dividend payments. In February of 2013, the firm declared a dividend of 12 cents per share, up from a previous 6 cents in all trailing quarters. Although this change does not directly impact the stock price, it provides signs of promising future cash flows.
Management has been able to pay off much of the company's debt over the past 6 years. When the company spun out of General Motors in 2007, it had $4.204 billion in net debt. They have reduced this number by $1.62 billion, bringing the number down to $2.582 billion. The reduction in net debt, defined as total debt minus cash, has freed up cash to reinvest into the firm and pay back to shareholders.
The firm's shares outstanding have continued to slowly increase, diluting the underlying claim to existing cash flow. Allison has purchased some of the additional shares back, however not enough to consider a large buyback.
The company's interest expense and debt balance is also important to look into, as it is a major lever in determining the intrinsic value of the firm. Allison has paid down a hefty chunk of debt dating back to the original purchase. In both 2017 and 2019, Allison will pay 1.2 billion in term loan outstanding. They have an additional 500 million in bond principal due in 2019.
A Number of Ways to Win
Allison Transmission is in a good spot to improve more than is discounted in the current $25 stock price. Discounting a cost structure based recent improved metrics averages and revenue growth in mid single digits, the stock is fairly valued.
Declining Interest Expenses -- Interest expense has been consistently decreasing, largely due to the fact that they have paid down large amounts of their debt. Moving forward, it seems reasonable to assume interest expense will likely be moving down or at least stay flat.
Tax shield-- The amortization of intangibles of $3.0 billion will provide a comfortable benefit through 2022; a present value of approximately $2.0 billion at a 10% discount rate. Discounting these cash flows through a discounted cash flow analysis significantly improves their cash flow. Additionally, the carryover of previous net operating losses will provide further benefits to cash flow for a few years to follow.
Continued Margin Improvement-- The table below shows a sensitivity analysis of the share priced based on revenue growth and EBITDA margin. These two deviations moving forward can vastly affect Allison's free cash flow and stock price. Allison Transmission's stock price can be justified with minimal revenue growth of 2%, and an EBITDA margin of 29%. This represent a 3% decline from its current level of 32%.
Sales Growth - As mentioned above today stocks levels can be justified with minimal sales growth. This is important as it leaves the key variables largely in hands of management. However, it seems reasonable the business grows organically at something close to nominal GDP. Extrapolating these last four years argues for a compound annual growth rate of 5%. Combined with the current margin structure a 5% revenue growth rate generates a $38 stock price in our DCF model.
From a multiples point of view, Allison is trading higher than many of their competitors. Allison has an average P/E of 28.7 since its initial IPO. The competitive set examined had an average P/E of 14. On a multiples basis, it seems Allison transmission is an expensive stock. We interpret this to mean investors are already anticipating some of the improvements we are outlining. However, these improvements are not fully reflected even after the large recent move upward in the stock price.
Allison Transmission is in a situation to experience solid growth in their stock price. Improved margins, interest expense, and tax shields have been the story of the short life of Allison Transmission. Moving forward, a continued exit by Carlyle and Onex should lend a hand to Allison's stock price, as the public float begins to become more liquid.
Disclosure: I am long ALSN.
Business relationship disclosure: Blue Jay Research is a team of financial industry professionals and students. This article was written by Ryan Guttridge, CFA and Alex Kelln. Ryan is a Fellow at the Johns Hopkins Institute for Applied Economics, Global Health and Study of Business Enterprise and Alex is a student at Johns Hopkins. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.