Allison Transmission Is (Still) A Buy

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About: Allison Transmission Holdings, Inc. (ALSN)
by: Patrick Doyle
Summary

There's not much I don't like about Allison Transmission at these levels. The shares are very inexpensive relative to the free cash flow generated.

Recent insider buying activity is also a positive sign in my view.

For those who are nervous about technological changes, slowing demand, etc., I think there is a very compelling options trade here also.

Since putting out my bullish piece on Allison Transmission (ALSN) just under a year ago, the shares are up about 9.5%, outperforming the market by about 3%. Since then, the company has obviously published several financial statements, and the shares have risen and fallen in price. I thought I’d check in to see if it’s still reasonable to remain bullish on the name. In my previous article, I suggested people sell the November put with a strike price of $40. That was obviously a profitable trade, as the shares rallied into the fall. At the risk of spoiling the surprise, I’ll be suggesting a similar strategy today as I still like the shares a great deal. In spite of the fact that shares are nearly 10% higher now than they were a year ago, the company remains inexpensive in my estimation. I’ll go through my bullish reasoning below.

Company Background

I covered this much more extensively in my previous article on the company, but for those who are not aware of Allison Transmissions, they are the world’s largest manufacturer of fully automatic transmissions for medium and heavy duty commercial vehicles, and medium and heavy tactical defense vehicles. Although the company is truly global, fully 79% of their revenue is generated in North America.

The company’s transmissions can be found in a host of vehicle applications, as the company’s 100 different transmission models can be found in over 2,500 vehicle configurations worldwide. They build everything from on road commercial medium and heavy duty trucks, to off-road vehicles, to school buses, motorhomes, and defense vehicles.

Of greatest interest to me is the fact that the company dominates the electric hybrid market for transit buses in the world. Per the slide from the most recent investor presentation, the company has delivered approximately 9,000 units worldwide to date, up from 8,000 a year ago:

Source: Investor presentation April 2019

Financial Snapshot

A quick look at the financial history here indicates that Allison Transmission has been a growth company. For instance, revenue and net income have grown at a CAGR of 6% and 25.5% respectively over the past six years. In addition, the company has grown free cash flow at an even more impressive rate. Finally, EPS has grown at an even faster rate of 33%, thanks to a relatively aggressive share buyback program. The number of shares outstanding has dropped at a CAGR of about 6.5% since 2013.

In regard to management, I prefer to avoid making subjective claims about their skill or quality, and judge them by measurable metrics. In that regard, I would characterise management here as being very shareholder friendly. Specifically, since 2013, they have returned just over $3 billion to shareholders ($560 million of which was in the form of dividends, the balance from stock buybacks). Nothing’s perfect, though, and Allison Transmission is no exception. I would like the company to boost the dividend. In my view, they can afford to do it as the payout ratio is currently around 12%.

Source: Company filings, FCF information from Morningstar

The Stock

Although I like the company a great deal for the host of reasons I mentioned above (and in the previous article), I think a great company can be a terrible investment if you overpay for it. I think Allison Transmission is actually a great test case for this thesis. For example, I put out a bullish piece on the company in July of last year, when the shares happened to be trading near a trough. The shares are up about 9% since then. If someone took a couple of months to buy the shares, they’d be sitting on a 14% loss today. Thus, the price you pay massively impacts your future return. The price you pay for the stock determines whether you’re insulated against or exposed to the vagaries of the overall market and to the business itself. For that reason, I need to spend some time looking at the stock as a thing distinct from the business.

In my previous article, I liked the fact that the stock was trading near a multi year low. It’s back to that level again, as per the chart below.

Source: Gurufocus

Insider Buying

In addition to the cheap valuation, I’m encouraged by insider activity. I like to make note of insider buys, because, in my view, if the people who know this company better than anyone else ever will (including Wall Street analysts) are willing to put their own capital to work in the business, it might be a good idea to follow suit. With that in mind, I’d point out that this past April, CFO Frederick Bohley purchased 5,000 shares. This makes me feel somewhat better about my long position here.

In fairness, I should also point out that director William Harker sold just under half of his position in the business in May of this year. I think sales have less informational value than buys, though. People sell for a host of reasons (divorce, diversification, drama), while they buy simply because they have confidence in the future of the business. Thus, on balance, the insider activity makes me somewhat more comfortable with my long thesis.

Options As an Alternative

In my previous article on Allison Transmission, I suggested that people who are nervous about the stock sell the November put with a strike price of $40. The premium on offer at the time was ~$1.80, but that was when the stock was 9.5% lower in price, so we should expect a smaller time premium now. At the moment, the November 2019 put with a strike of $40 is bid-asked at $.9-1.1, which is not excessively wide in my view.

So if an investor simply takes the bid and takes on the obligation to buy a lot of these shares 12% below their current level, they will pocket $90. If, as I suspect, the shares rise in price, the investor simply pockets this premium. If these already inexpensive shares (in my view) fall, the investor will buy at a net price about 14% below the current level. At this price, the dividend yield is about 1.5%. Thus, the short put strategy seems a great option (forgive the pun) for those who are interested in gaining exposure to this great company, and who also want to receive income immediately.

Conclusion

I remain firmly bullish on this company over the medium term for a host of reasons. Management seems very shareholder friendly, and seems to be very conservative with shareholder capital. The company continues to grow nicely, and shows no evidence of slowing down in my estimation. Possibly as importantly, the shares are trading at a very safe valuation in my view. Perhaps all of this is why an insider recently put $230,000 of his own capital to work in the company. For those still nervous at these levels, I think put options offer an excellent alternative. As I’ve said countlessly (and no doubt tiresomely), price and value can remain unmoored for long stretches. I think investors would be wise to buy this name before price rises to match value.

Disclosure: I am/we are long ALSN. 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.

Additional disclosure: I'll also be selling the puts mentioned in this article.