Allison Transmission Holdings (ALSN) is the world’s leading manufacturer of fully automatic transmissions for commercial vehicles. For much of its 100-year existence, Allison was part of General Motors, but it was purchased in 2007 by private equity investor The Carlyle Group, which subsequently took it public in 2012. Because of its long history of providing reliable transmissions for demanding commercial and military applications, the Allison brand maintains a premium cachet. In marketing materials, commercial vehicle makers frequently display the Allison Transmission name prominently along with the engine manufacturer.
Allison products are distinguished from traditional manual and automated manual transmissions, or AMTs, in that they have a fluid coupling called a torque converter, which enables smoother shifting and allows the powertrain to continuously power the vehicle, without momentary gaps, throughout the gear range. Automatic transmissions have grown more efficient and reliable in recent decades, but most research and development outside of Allison has focused on light passenger vehicles.
Allison currently has no other large-scale competitor that makes such products for commercial vehicles. Of the global on-highway market for fully automatic transmissions, Allison commands 60% market share. In developed economies, the main competition to Allison’s on-highway products comes from AMT manufacturers, such as Eaton (ETN), and truck manufacturers that make their own AMTs. In much of the developing world, manual transmissions are used in commercial vehicles due to their low cost. For off-highway applications, Allison’s principal competition comes from vertically integrated original equipment manufacturers such as Caterpillar (CAT) and Komatsu (KMTUY).
Two factors are driving the adoption of Allison’s products. First, its fully automatic transmissions improve operator efficiency, as they eliminate the need for operators skilled at shifting manual transmissions. Second, its products provide better fuel efficiency. Because of these benefits, Allison’s products can pay back the $3,000-$11,000 up-front premium over manual transmissions in less than three years.
Commanding Market Share
Allison has a number of intangible assets that give it a narrow economic moat, including a large patent portfolio, a strong brand name, and solid customer relationships. Evidence of Allison’s moat is revealed by the total absence of significant competitors that produce commercial automatic transmissions, which allows Allison to command 60% of the global on-highway commercial automatic transmission market. The bulk of its competition comes from manufacturers of manual transmissions, makers of automated manual transmissions, and vehicle manufacturers that have enhanced their internally developed automatic transmissions originally designed for consumer vehicles. Because of Allison’s unique position, it has achieved operating metrics, such as gross margins above 50%, that are superior to those of other equipment manufacturers. Allison’s return on invested capital when including goodwill and intangible assets, which originated from Carlyle’s original purchase of Allison, averaged 12.9% between 2009 and 2018. Eliminating goodwill and all intangible assets leads to returns on invested capital that average 137% over the same period. In either case, these figures exceed Allison’s cost of capital, which is approximately 8%.
The underlying demand for Allison products is driven by measurable benefits, including enhanced operator efficiency and improved fuel economy. Because of previous fuel price shocks and the current labor shortage in North America, users are increasingly aware of the total cost of ownership of commercial vehicles, including equipment maintenance expenditures and lost operator productivity caused by vehicle downtime. As such, transmission reliability is paramount. The Allison brand name conveys quality and reliability, which gives risk-averse commercial vehicle manufacturers and end users confidence that their equipment will operate over a wide range of conditions.
Automatic transmissions are intricate mechanisms that are often the most complex powertrain component in internal combustion vehicles. They contain numerous gears and clutch plates that are arranged to optimize fuel economy and acceleration. Allison has been an innovator in commercial automatic transmissions, which are a relatively new development in the heavy equipment industry. In 1956, Allison introduced the first fully automatic transmission for on-highway heavy-duty trucks. Consumers realized an immediate benefit in that less skill was required to operate these vehicles. In commercial trucks, transmissions can have as many as 18 gears, and manipulating such a wide range of gear ratios over different torque conditions–at differing inclines and in a variety of climatic conditions–requires skill that is developed over years. In practice, fully automatic transmissions allow engines to propel vehicles continuously, whereas manual variants have slight gaps as they shift gears. Less skilled operators of trucks and other heavy equipment with manual transmissions employ suboptimal gear engagement patterns, which leads to elevated fuel consumption and poor acceleration that harms fleet profitability. In addition, poor shifting causes significant wear on transmission components, requiring costly maintenance and resulting in out-of-service vehicles.
The complexity of automatic transmissions has dissuaded other manufacturers from entering the commercial automatic transmission market. Allison estimates that it costs $300 million-$400 million to develop a new transmission. Its exceptional gross margins, which have averaged 56% in the past 10 years, may also serve as a deterrent because Allison could selectively cut pricing on specific products to thwart competition. Currently, there are no stand-alone manufacturers of fully automatic transmissions for commercial vehicles other than Allison.
The principal competition for Allison’s products in developed economies comes from manufacturers of AMTs, such as Eaton. These products have vastly different designs, uses, and performance envelopes. In the Class 8 truck market, Allison has a dominant position supplying straight trucks, which includes refuse-collection and mining trucks that have frequent stop-start patterns. In the Class 8 tractor market, which principally services long- and line-haul operators, AMTs dominate because of their unique performance characteristics that favor constant speeds over long distances. Both fully automatic and AMTs reduce the need for highly skilled operators, with each providing better economics over traditional manual transmissions.
In certain applications, fully automatic transmissions are required for safety. In military vehicles, including the M1 Abrams tank, Allison supplies fully automatic transmissions so that unskilled personnel can operate combat vehicles in critical situations. In fact, the U.S. military has been an early adopter and advocate of fully automatic transmissions, which is partially a result of American automotive culture. The typical U.S. soldier has less prior exposure to manual transmissions compared with personnel in other militaries, including those from developed nations in Western Europe. As with other military componentry, reliability can be a matter of life and death. Performance specifications can be high in such applications, which allows Allison to charge hundreds of thousands of dollars for a single transmission for a tracked military vehicle.
Outside North America, the market penetration of fully automatic transmissions is approximately 5% for on-highway commercial vehicles. For 95% of the market, the choice of pure manual versus AMTs depends largely on the level of economic development and regional labor costs. In Europe, which has a cultural tendency toward manual transmissions, truckmakers have largely transitioned from basic manual offerings to AMTs, including those developed internally by truckmakers such as Volvo. We believe that the penetration of AMTs into trucks where fully automatic transmissions are more suitable, such as local delivery vehicles, is partially a result of culture and of prior investments by incumbent truck manufacturers, and not real-world economics.
The penetration of fully automatic transmissions in commercial vehicles in developing economies has historically been low because of the cost, as these products have low take rates when they account for more than 10% of the vehicle cost. As labor costs and traffic congestion continue to increase in these regions, the business case for investing an additional $3,000-$11,000 for an Allison transmission will become more compelling. Meanwhile, many of these regions will experience fuel price shocks and elevated levels of air pollution, which will drive demand for more fuel-efficient, fully automatic transmissions.
Fuel efficiency and improved acceleration have been key selling points for Allison’s products. There is a growing desire by carriers and governments to reduce fuel consumption and air pollution. This has led to numerous electric vehicle pilot projects by incumbent manufacturers, along with new entrants, which have developed prototype electric trucks. Unfortunately for Allison, the optimal applications for its products, such as propelling vehicles that stop frequently, can also be addressed by electric powertrains with existing battery technology. The long-haul Class 8 segment, which will probably be the last diesel holdout, is currently served by AMTs and unlikely to be addressed by any of Allison’s products in the foreseeable future.
As of early 2019, the volume of press headlines touting the benefits of commercial electric vehicles has greatly exceeded the amount of verifiable data generated by commercial EV pilots. Moreover, milestones for the two main Class 8 electric truck new entrants–Tesla and Nikola–have repeatedly slipped. While we remain enthusiastic about the potential of commercial electric vehicles, vested diesel interests, such as Cummins and truck manufacturers, will probably invest heavily to improve diesel economics. This will benefit Allison in the next 10-15 years as transmission technology becomes more advanced and precisely tailored to specific diesel applications. Allison has already taken steps in this regard, such as developing software that provides continuously variable shift scheduling.
We like Allison’s larger electrification strategy, as it has carefully timed investments to address market demands. Since 2003, Allison has delivered over 8,000 hybrid-electric bus powertrains, which has enabled it to be become a market leader in such offerings. In 2019, it acquired two companies that possess significant portfolios of electric powertrain intellectual property. AxleTech, which is based in Michigan, sold its electric vehicle systems division to Allison for $123 million in April. It focuses primarily on off-highway and special-application vehicles. That same month, Allison acquired Vantage Power, which is based in the United Kingdom, for $17 million. Vantage has developed several novel electric powertrain and telemetry solutions. Neither entity has any significant revenue; both were acquired solely for their intellectual property.
Given the growing interest in commercial electric vehicles, we believe Allison’s recent acquisitions were wise investments. The enthusiasm for such products appears to exceed current battery technology in that energy density is inadequate for many commercial applications. We believe that electrification technology will ultimately catch up to meet user requirements, either in the form of higher-energy-density solid-state lithium ion batteries or of hydrogen fuel cells. In either case, Allison’s core transmission business will be harmed because its automatic transmission technology will not be used in these applications. Moreover, Allison is unlikely to command the same leverage it has today by providing electric powertrain components to vehicle manufacturers. When full electrification of commercial vehicles takes hold in 10-15 years, by our expectations, Allison is likely to be one of numerous suppliers of electric powertrain components. Some of these vendors already have a significant head start in electrifying commercial vehicles. Therefore, we believe Allison will be unable to maintain its economic moat for the 20 years required for a wide moat rating.
Technology Disruption a Risk
As with the commercial vehicle manufacturers, Allison faces risks from powertrain technology disruption and economic cycles. Much of the world’s commercial fleets rely on diesel technology that requires significant aftermarket support infrastructure. Electric powertrains, which aim to reduce fuel costs and improve air quality, will not use automatic transmissions or require the same levels of service. We believe that the adoption of electric powertrains will ultimately have negative effects on the entire diesel ecosystem. Improvements in battery energy density and improved economics of fuel cells will likely be key determinants of commercial electric vehicle adoption.
Because of the threats that electric powertrains pose to the larger diesel ecosystem, which includes manufacturers, independent dealers, refiners, and parts suppliers, we believe that entities in this market will take dramatic steps to improve diesel economics and environmental impacts. This should benefit Allison in the next decade as engine and truck manufacturers seek more sophisticated transmissions that are more tightly integrated with other powertrain components and vehicle sensor systems.
In 2019, several fleets expressed interest in employing electric commercial vehicles, which have generated significant headlines. Concurrently, manufacturers of such vehicles have pushed back their timelines repeatedly and have failed to release critical vehicle specifications. We think there is a growing gap between the commercial vehicles hype and the real-world capabilities of such vehicles given existing battery and fuel cell technology. We therefore believe that threats to Allison’s core business model will not emerge for more than 10 years. Meanwhile, Allison has taken selective steps to augment its electrification capabilities, acquiring two businesses with significant electric powertrain intellectual property.
We believe Allison is on solid financial ground despite poor ratings by major credit rating houses. Moody’s and Fitch rate Allison’s corporate credit at Ba2 and BB, respectively. Both ratings are near the upper end of the non-investment-grade range. After being acquired by private equity interests, Allison’s balance sheet had $4.2 billion in intangible assets and $4.0 billion in debt in 2008. It currently has $3.0 billion in intangible assets and $2.5 billion in debt.
We believe that Allison will generate $2.2 billion in free cash flow over the next four years. Therefore, we are comfortable that the company can easily refinance or repay its next major maturity, a $1.1 billion term loan, due in 2022. Allison has two other senior notes due in 2024 and 2027, of $1.0 billion and $0.4 billion, respectively. We believe that it will be able to either refinance or repay these loans, given its current free cash flow trajectory. From 2008 to 2018, the net debt/EBITDA ratio declined from 11.1 times to 2.1. We estimate that it will increase to 2.5 by 2023 as Allison experiences more normalized margins after a buoyant truck buying cycle between 2017 and 2019.
Allison benefits from tax accounting rules that allow it to pay very little in cash taxes. Between 2009 and 2018, it paid approximately $249 million in cash taxes on $2.76 billion in pretax income, which equates to a cash tax rate of 9%. On its federal income taxes, Allison can write its goodwill and other intangibles down, which leads to significant cash tax savings. Management anticipates $315 million in federal income tax deductions annually through 2021 and $185 million in 2022. At the end of 2018, the net present value of these deductions was approximately $220 million.