Changing your mind as investor can be surprisingly hard to do, but it’s an important skill if you’re going to generate consistent returns. While I haven’t typically been all that bullish on Allison Transmission (ALSN), largely due to what I saw as underinvestment in electrification and, thus, meaningful long-term risk from EV adoption, today’s valuation and relative performance makes less and less sense to me. That’s particularly so in the context of a commercial truck market that still offers share growth potential and increased efforts at highlighting its R&D efforts.
An “Is That All You’ve Got?” Reaction To A Tough Quarter
The reaction to Allison’s quarter was curious, although I suppose understandable. Allison came in a little light on revenue (about 5% light), whereas other commercial vehicle suppliers like Cummins (CMI) and Dana (DAN) reported modest beats. And while Allison did beat at the EBITDA line (by about 5%), other commercial vehicle suppliers like Cummins (and PACCAR (PCAR)) had noticeably better results relative to expectations. That Allison’s numbers weren’t lowered to quite the same extent seems to have been lost along the way.
Revenue declined 49% from the prior year, a little better than Dana, but weaker than Cummins, with sharp declines across the business. North American On-Highway declined 59%, while Service declined 40%, and Outside-North America On-Highway declined 43%. Collectively, these segments make up over 80% of sales, though the 13%-plus growth in the small Defense business was a welcome positive.
As an asset-light industrial, Allison’s margin performance stands out, but the company isn’t immune to the pressures created by the COVID-19 decline. Gross margin decline fell nine points from the year-ago level, while adjusted EBITDA fell 63% and adjusted operating income fell 72%, with a decremental margin in the 50%s (compared 24% at Dana). Even so, I think it’s well worth mentioning that Allison’s trough margins are well above the peak margins of most of its commercial vehicle supplier peers.
Uncertainty Remains The Word Of The Day
Investors may have also been less impressed with Allison, given relatively subdued commentary about near-term market trends and no explicit guidance. Uncertainty remains the ongoing trend, with many suppliers flagging risks of inconsistent recovery trajectories and little visibility into end user demand or liquidity.
For its part, Allison management did point to healthy trends in construction, refuse, rescue, pickups, and delivery trucks, while noting more weakness in food/beverage, municipal, and Class 8 markets. I’m not particularly bullish on the near-term outlook for construction, nor infrastructure, and I believe the strains created by COVID-19 municipal budgets could show themselves in weaker orders for refuse, rescue, and buses in the near future. Delivery trucks should remain a source of relative strength, as there are still meaningful capex expansion plans for last-mile infrastructure. I’d also note that it is quite possible that the COVID-19 recession will stretch into 2021, and that won’t be good for any vehicle supplier.
Beyond the near-term turbulence created by COVID-19, I’m not as concerned. While electrification does remain a very real threat in segments like refuse trucks, I also see meaningful share growth opportunities on the lower end of medium-duty trucks (Class 3 to 4), particularly as last mile truck demand grows. While Ford (F) has long been a force in this market, Allison has steadily improved its offerings here, and I believe some share growth is likely.
Flipping The Switch On Electrification
Allison has been relatively quiet in the past about the extent of its efforts in electrification, and that has lent more credibility to bearish arguments that the company is going to be left holding the bag as electrification infiltrates its core markets and takes away business.
More recently, though, management has been shedding some light on its product development efforts here. Allison has developed integrated e-axle products that include fully integrated motors, gearboxes, and oil pumps, and has designed them as “bolt-in” products. Allison has also been working on multi-speed centrally-located EV drives, system/battery management products, power distribution products, and electric hybrid propulsion systems. On the latter point, Allison has been involved in the electric hybrid bus market since 2003, and I think there are credible arguments that it may be electric hybrids (rather than pure electrics) that become more common in the vocational markets where Allison currently dominates.
Allison remains difficult to model because of the lack of clarity on how the commercial vehicle market will look in 2030. While Allison may be more active in developing products for hybrid and electric vehicles than it gets credit for (at least from the bears), it seems unlikely to me that the company is going to hold the same sort of market share (70%-plus in straight Class 8 and Class 6/7) in its core markets, so I do still expect erosion in the business. Nevertheless, Allison still looks meaningfully undervalued on the basis of low single-digit revenue growth through 2030 (mid-single-digit from 2020 onward) and steady FCF margins on a long-term average basis.
Allison also looks undervalued on the basis of its margins and returns on capital, but given that the company is in the vehicle component space, it’s unlikely to ever get the sort of valuation for its margins that it would if it were a “regular” industrial company (Allison likes to include a presentation slide comparing its EBITDA margin to industrials like Roper (ROP)).
The Bottom Line
I do have long-term concerns about whether Allison’s competitive moat will dry up as electric commercial vehicles come onto the market, but I think the shares more than reflect that risk. I do see a likelihood of a turbulent 2021 on weaker municipal budgets, but I think the share growth opportunity in lighter-duty trucks over the next five or so years is meaningful, and I likewise believe that Allison has the resources to build a meaningful presence in systems and components for hybrids and electrics. I prefer Dana overall, but I think Allison is undervalued below $40 and worth a look.
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.