Allison Transmission

Allison Transmission is a diamond in the rough -- it’s a wonderful business operating in a tough industry. It caught my eye because it appears to be both cheap (9x earnings) and good (600%+ returns on tangible capital employed). It has a dominant market position (60% market share) and is buying back huge amounts of stock (⅓ of shares outstanding since 2013).

Given this, I did some research on Allison Transmission and wanted to put my thoughts down on paper. Note that neither myself nor Eagle Point Capital clients own shares of Allison Transmission.

Frequently, you’ll look at a business having fabulous results. And the question is, ‘How long can this continue?’. Well, there’s only one way I know to answer that. And that’s to think about why the results are occurring now – and then to figure out the forces that could cause those results to stop occurring. 

Charlie Munger

As I alluded, Allison is a business experiencing wonderful results. This is atypical of Tier 1 automotive suppliers. It’s generally a tough industry and nobody in it earns returns worth bragging about.

Allison is unique because it appears to have a franchise (i.e. there are no perceived substitutes). When you buy a car, you care about the car’s brand (e.g. Ford or Honda). You don’t care who makes the car’s components, like the brakes or transmission. Lots of companies make good brakes, so OEM’s like Ford and Honda buy whichever is cheapest. Medium and heavy truck owners are different -- they request an Allison transmission when they make an order. Other transmissions are not viewed as substitutes for an Allison.

Why? Allison transmissions end up in trucks that make frequent stops: garbage trucks, school buses, delivery trucks, and dump trucks. An automatic transmission makes this type of driving more efficient and avoids downtime to replace a worn out clutch. Owners are willing to pay more up front for an Allison because they expect it to have a lower total cost of ownership and higher productivity than a cheaper manual.

Allison’s dominant market share protects its franchise: the remaining market isn’t big enough to justify up-front investments in R&D or manufacturing. Allison enjoys a virtuous cycle: it can spend more on R&D because they have a large market to spread the costs over. More R&D makes a better product, which helps Allison increase its market share and economies of scale.

The business is capital light because transmissions have long product cycles. Allison can sell the same transmission over and over by tweaking its software to optimize it for different vehicles. Allison doesn’t start from scratch very often.

As a result, Allison gushes cash. Allison went public in 2012 and has since reduced debt by $1.4 billion, spent $2.4 billion on buybacks (reducing shares outstanding by a third), and paid $600 million in dividends. Today the company’s market cap is $5.5 billion.

Allison also has a large opportunity to grow. Few trucks (~5%) outside of the United States have automatic transmissions. The reason is largely cultural inertia, and it may or may not change. Allison needs to educate end-users (which it doesn’t have a relationship with) about the full cycle cost and productivity benefits of an automatic. It’s uncertain whether Allison will be successful here, but the good news is that Allison’s capital-light business model makes it a low-risk / high-reward bet.

So, what’s the catch? This is a wonderful business trading at just 9x earnings. What could cause the party to stop? Sure, it’s end market is cyclical, but the company can clearly weather a lean year or two.

The reason is that electric vehicles don’t need transmissions. They produce huge amounts of low-end torque and high end power. Buying Allison today might be like investing in horse buggy whips in 1908, on the eve of Ford’s Model T.

This isn’t news to Allison. Allison recently made two acquisitions that give them a presence in electric drivetrains. Right now they make axles with a modular design that fit into existing gas and diesel trucks. The axles contain an electric motor and attach to a battery. Paccar is testing Allison’s drivetrains in its current prototypes.

I see three questions that are critical to Allison's future:

1. Will Allison’s end-market electrify? If so, how soon?

2. If the market electrifies, will Allison’s technology be relevant?

3. If Allison’s technology is relevant, will Allison’s franchise endure?

To invest in Allison you need to answer all three of these correctly. That’s too hard for me. But, if I had to guess, I’d say “yes” to the first two and “no” to the third. 

It looks like electric is the future, though who knows when. If it is, Allison is likely to leverage its existing OEM relationships to get its drivetrains into trucks. However, Allison is likely to make substantial investments into R&D and manufacturing facilities before it gets there.

I have a hard time seeing how Allison will continue to earn extraordinarily high returns on non-transmission products. Allison’s transmissions are specifically sought by end users. To sell a truck, an OEM like Paccar has to buy an Allison transmission, regardless of the price. This gives Allison lots of leeway to raise prices and earn high returns. 

Electric drivetrains are likely to be commoditized. Most autoparts are. Lots of companies are working on electric drivetrains today, and most will be indistinguishable except for price. There's no shortage of companies capable of making an internal combustion engine. I expect the same will be true of electric engines.

In summary, Allison is a wonderful business today because of its transmission franchise. If Allison’s end-market electrifies, they will have to make commoditized products. While the company might survive, it’s unlikely to continue earning the extraordinarily high returns it enjoys today. Uncertainty about Allison’s long-term future makes it a pass for me. 

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