Allison Transmission: One Of ValueAct's Underrated Holdings With Strong Free Cash Flow

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  • Activist fund ValueAct owns a large chunk of Allison Transmission.
  • Despite the strong price performance of late, there could be more upside.
  • The company is a strong free cash flow generator, and could be increasing returns to shareholders in the near future.

ValueAct Capital has 4% of its portfolio invested in Allison Transmission (NYSE:ALSN), owning nearly 19mm shares - close to 11% of the company. And the fund has been adding to its position of late.

ValueAct founder, Jeff Ubben is the real deal. He is a "soft" activist and owns shares for the longer term. Meaning, he doesn't take his fight to the public, and works behind the scenes - sometimes for a number of years. Most notable was his recent role at getting Steve Ballmer ousted from Microsoft (MSFT).

He's a soft spoken fund manager who keeps his public appearances to a minimum. I had the privilege of seeing Ubben in Chicago at the Invest for Kids conference a couple years ago. He pitched Moody's (MCO) and CBRE (CBG) as longs. The shares are up 110% and 85%, respectively, over the last two years. ValueAct also has an activist campaign over at 21st Century Fox.

For management, most activists are "persona non grata" when it comes to having an activist buying up shares of your company. That's not the case when it comes to Jeff Ubben. He's a welcome face, especially compared to the likes of Carl Icahn. Ubben's investment horizon averages around five years.

As far as ALSN goes, the transmission maker generates nearly 80% of its profits from North America. The commercial on-highway truck market is slowly recovering, but still down from the yearly production averages from 1998 to 2008 - and down 30% or so from previous peak levels.

Its business is leveraged across the non-residential, housing and municipal spending markets. ALSN's transmissions can be found in construction trucks, fire/emergency vehicles, buses, etc.

But with the stock trading at 52-week highs, how much upside is left?

Management has a target leverage ratio of under 3.5x, and it's now at 3.57x. This means ALSN investors could be in store for some capital returns in 2015 and beyond as ALSN gets increasingly close to its target leverage ratio. ALSN currently offers a 1.8% dividend yield. And over the last year, it has repurchased $350mm worth of stock. Debt was upwards of $3.3bn in 2011, and ALSN has worked that down by $600mm since then.

Despite trading at 22x forward earnings, ALSN is a cash flow generating machine. Its 7% free cash flow yield is one of the best in the business. It has a FCF-to-income conversion of 2.2x over the last twelve months. Assuming free cash flow grows to $500mm over the next couple of years - a pro forma FCF yield of 10% - the returns to shareholders should increase nicely.

This comes as there will be a runoff of debt payments. Thus, assuming ALSN chooses to return three-quarters of FCF to investors (somewhat modest considering ALSN has returned 100% of FCF to investors over the trailing twelve months), around a third via dividends and two-thirds via buybacks, which means that the total yield could be 6.3%.

We feel that 15x FCF is a justified multiple for ALSN. That puts our 12-18 month price target for ALSN at around $42/share. Couple the stock appreciation potential with the total yield returns, and the upside is over 30% for the next year or so.

The reason ALSN isn't getting more respect in the market is that management has been lackluster in laying out its capital returns plan. And the other part is that ALSN is a relatively new capital returns story. It is just now working its debt down to a level that the company can focus more on its dividend and buybacks.

We think ALSN is worth adding to portfolios. Although ValueAct isn't the typical hard-nosed activist, we still have ALSN in our mid-cap activist portfolio.

This article was written by

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At Activist Stocks we use hedge funds and activist investors to find actionable investing ideas. That is, stocks with catalysts to unlock and generate shareholder value. Activist Stocks also offers a catalyst and event-driven idea forum for investors looking for unique idea generation, Catalyst-Driven Small-Caps, where I share daily activist and turnaround insights and deep dives.

Disclosure: The author is long ALSN. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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