2023 Is Shaping Up To Be Another Solid Year for Allison

Equity Analyst

Dawit Woldemariam

We believe Allison will continue to be the top supplier of truck transmissions, despite increasing regulation of emissions by government authorities. The company dominates the medium-duty market, commanding approximately 80% market share in some verticals (school buses, Class 6 to 7 trucks, and Class 8 straight trucks). Allison's strong brand is underpinned by its high-performing and extremely durable transmissions. This has led to the company benefiting from pricing power. 

A key part of the company’s strategy is growth in international markets, where fully automatic transmissions have a penetration rate of just 5%. There’s ample opportunity to gain market share with its high-quality transmissions, which offer better fuel and operator efficiency compared with less expensive manual transmissions. We also think increasing emissions regulations will push more fleet owners to adopt lower-emitting products, a tailwind for Allison. 

Additionally, Allison stands to benefit from the electrification of powertrains. So far, the company has made progress in the bus market with its hybrid-electric propulsion systems. To date, Allison has brought in over $1.5 billion in sales, illustrating its success with next-generation technologies. Longer term, we expect the company’s e-powertrain systems to gain favor with customers. Allison is anchoring its net-zero emissions strategy on e-axles. Before, engines served as the critical integration point for commercial vehicles. Components of the future will be designed with integration in mind, connecting the e-axle, gearbox, e-motor and inverter. 

Allison’s high exposure to the medium-duty vertical dampens cyclicality a bit, as spending on new trucks is largely driven by municipal budgets. Allison estimates approximately 30%-40% of the company’s North America market is tied to municipal spending. In future, we think Allison will continue to invest in e-powertrains for future truck models. In our view, a net-zero emissions world is inevitable, but we believe Allison can use returns from its traditional business to drive investments.

Business Strategy & Outlook

We assign Allison Transmission a narrow economic moat rating, underpinned by intangible assets and customer switching costs. We believe the company’s strong brand and competitive positioning leads to pricing power. Allison’s fully automatic transmissions cost $3,000-$11,000 more than manual transmissions. The average payback period is less than three years. For comparison, automated manual transmissions fetch a $3,000-$7,000 premium to manual transmissions. Customers are willing to pay more to achieve better fuel and operator efficiency. With better productivity, customers can lower their total cost of ownership, driving greater profitability in their operations. 

We believe Allison’s strong brand reputation has led to its solid competitive positioning. The company’s transmissions are high quality, extremely reliable, and durable. The strong performance of Allison’s transmissions empowers customers to lower the total cost of their operations. The company’s products don’t break down as easily, allowing fleet owners to save on maintenance and repair costs. Also, fully automatic transmissions enable better fuel and operator efficiency, thanks to more efficient gear shifting. With manual transmissions, operators manually shift gears to manage power and speed. Inefficient gear shifting can lead to fuel waste and poor acceleration, as well as significant wear on the transmission. These factors can significantly hit fleet profitability. Commercial truck transmissions can have as many as 18 gears, requiring a lot of skill to manage gear ratios efficiently. It can take years to develop that skill. 

On the other hand, AMTs and automatic transmissions require less skill to operate, as the operator is no longer responsible for gear shifting. This leads to significant fuel savings compared with less expensive manual transmissions. AMTs and automatic transmissions serve different end markets. We can break the Class 8 truck market into three categories: straight, day cabs, and long haul. Long-haul operators tend to go with AMTs, given performance characteristics that favor constant speeds over long distances. Conversely, the start-stop nature of straight trucks (refuse collection and mining trucks) and day cabs makes automatic transmissions a more suitable option. 

All in all, better vehicle acceleration, maintenance savings, improved fuel efficiency, reduced emissions, and high residual values combine to be a compelling value proposition for customers. These factors have led to Allison becoming the dominant player in automatic transmissions. In North America, the company possesses strong market share in Class 6 to 7 trucks (79% share), Class 8 straight trucks (78% share), school buses (85% share), and motor homes (44% share). The company does not have a significant competitor in the segment, which allows it to garner 60% share of the global on-highway automatic transmission market. Competition comes from manufacturers of manual transmissions, AMTs, and vehicle manufacturers who have enhanced automatic transmissions originally designed for consumer vehicles. One of Allison’s competitors is Eaton, which produces AMTs. Though, AMTs make up a relatively small part of Eaton’s consolidated business. The company is a diversified power management company primarily focused on serving the aviation market, data centers, utilities, and residential sector. 

Allison also competes with Cummins, a strong truck engine and transmission manufacturer. Notably, Cummins recently acquired Meritor, a brake and axle manufacturer for long-haul trucks. While Meritor primarily serves the heavy-duty truck market, it has made headway in e-axles, which are shaping up to be the foundation of e-powertrains. Meritor is looking to expand into the medium-duty segment, where Allison operates. Though, we think it’ll be difficult for Meritor to win market share from Allison, which is considered the pre-eminent medium-duty transmission player. Manufacturers highlight in marketing materials that their vehicles are equipped with Allison’s transmissions. We believe both players will commercialize next-generation technologies, meaning customers will likely stick with the same current supplier. 

We believe Allison benefits from high customer switching costs. When fleet owners buy new trucks, they take into consideration their entire fleet. They typically buy one type of transmission and apply it across the entire fleet. This helps fleet-owners reduce the complexity and cost of managing their fleet. For example, if a fleet owner decides to buy a different transmission for each truck, it would potentially increase maintenance and repair costs. We believe fleet owners benefit from using a uniform set of products in their trucks, which curbs additional operating expenses. In addition, we think fleet owners would lose out on some purchasing power by dividing up their purchases across multiple suppliers, as opposed to working with a single supplier. Allison also has a strong aftermarket business, which accounts for 23% of sales. Customers get exclusive access to service parts and equipment. Each year, hundreds of thousands of medium- and heavy-duty trucks are produced, adding to the already large installed base of vehicles. 

We think Allison can leverage its strong brand to penetrate emerging markets with its automatic transmissions. Currently, fully automatic transmissions are utilized in approximately 5% of on-highway commercial vehicles internationally. For the remaining 95% of commercial vehicles, the choice comes down to manual versus AMTs. Manual transmissions are widely adopted in emerging markets, given the low-cost profile. AMTs are higher in price and adopted in markets where economic development is increasing. The low penetration of automatic transmissions is attributable to its premium price. That said, Allison is starting to see increasing interest in its high-quality and extremely reliable products across developing economies. In our view, these benefits will drive higher adoption over the next few years. As economies develop, we believe the total cost of ownership will become a key focus for operators. Said another way, the initial cost of the vehicle will be outweighed by the amount of money saved from improved fuel and operator efficiency. In addition, we expect regulation to be another key driver. Emissions compliance in emerging markets will push operators to adopt Allison’s fuel-saving transmissions, which in turn will reduce vehicle emissions. 

We think Allison is making the right investments currently to prepare for the electric vehicle transition. The company is uniquely positioned to use the strong returns of its traditional business to fund future investments. Returns on invested capital including goodwill have averaged nearly 16% over the past decade, consistently outearning the company’s cost of capital of around 9%. Allison has done a good job developing next-generation products internally, but it has also turned to acquisitions in recent years to enhance its product portfolio. In 2019, the company bought two small companies, Vantage Power and AxleTech. Both companies are making strides in electric powertrains, and we believe they will be instrumental in Allison’s quest to commercialize fully electric powertrains. 

EV adoption will result in internal combustion engines and transmissions one day becoming obsolete. Allison is preparing for that eventual future by investing in its integrated e-axle solution. Traditionally, axles have delivered power from transmissions to put commercial vehicles in motion. Currently, manufacturers are reimagining the role of axles in EVs. With internal combustion engines going away, manufacturers are rallying behind axles as the new cornerstone of vehicles. Allison is already offering customers e-axles (powered by electric motors) in European and Asia-Pacific markets. While we think full EV adoption is at least a decade away (likely closer to two decades), Allison’s forward-thinking approach shows the company is preparing for this eventuality now. 

Manufacturers have divided the shift to EVs into two phases for powertrains. The first pairs electric motors with traditional powertrains (includes axles, brakes, and other powertrain components). This is a readily available solution currently. The next phase is building commercial vehicles with e-powertrains, which integrates all the critical electrical components. These include the inverter, electric motor, gearbox, and e-axle. Integrated vehicle systems give Allison the ability to capture more vehicle content. Furthermore, manufacturers have pointed out that e-powertrains offer more space and are lighter in weight. With extra space, commercial vehicles can be manufactured with larger batteries, improving range capabilities. E-powertrains are also designed to be used across various vehicle types and applications. Manufacturers can more easily plug-and-play motors of different sizes and powertrain components. 

Allison’s electrification strategy dates back a couple of decades. The company has successfully commercialized hybrid-electric powertrains in buses, which is a good first step. In total, Allison has delivered over 9,500 hybrid powertrains since its launch in 2003, capturing over $1.5 billion in sales. Along the way, the company has developed competencies that we think allows it to extend into fully electric powertrains. For example, Allison is now an effective systems integrator (electric motors and transmissions), which has helped customers improve performance (acceleration) and fuel economy. As we highlighted earlier, the ability to integrate multiple vehicle parts will be important in e-powertrains. 

Allison also supplies automatic transmissions to military vehicle manufacturers. Military personnel with limited experience can operate combat vehicles in critical situations. Manufacturers consistently turn to Allison because of the reliability and durability of its transmissions. Limited downtime increases personnel safety during military operations. Another key feature is the electric-only silent maneuverability, which turns off the engine during operations to help reduce enemy detection. The mission-critical nature of Allison’s transmissions gives us reason to believe military customers are sticky. This dynamic also allows Allison to charge a premium price for its military vehicle transmissions. In future, we expect the company to commercialize its hybrid-electric propulsion system in military vehicles like bus markets. 

We do not think Allison’s narrow economic moat faces any substantial threats from environmental, social, and governance risks. Allison has exposure to emissions regulation, but we think the company is investing to position itself as a winner in a net-zero emissions world. These hedges include the development of next-generation products that reduce the emissions of its traditional products to hybrid-electric powertrains and fully electric powertrains. Furthermore, we think additional regulation of emissions by government authorities will likely be introduced gradually over the next decade. This will give Allison time to continue evolving the sustainability of its products and reduce its impact on the environment.

Narrow

Economic Moat

Allison Transmission Hlds

Allison Transmission Holdings, Inc. engages in the design and manufacture of vehicle propulsion solutions for commercial and defense vehicles. The company also manufactures medium and heavy duty fully automatic transmissions and electrified propulsion systems. Its products are used in a variety of applications, including on-highway trucks, buses, motorhomes, off-highway vehicles and equipment, and defense vehicles. The firm also sells branded replacement parts, support equipment, aluminum die cast components, and other products necessary to service the installed base of vehicles utilizing its solutions. The company was founded in 1915 and is headquartered in Indianapolis, IN.

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INDIANAPOLIS--(BUSINESS WIRE)--Allison Transmission, the largest global manufacturer of medium- and heavy-duty fully automatic transmissions for commercial and defense vehicles, has been awarded a contract worth approximately $13 million for the second phase of the U.S. Army's Low-Rate Initial Production contract for the newly named M10 Booker Combat Vehicle, formerly known as Mobile Protected Firepower. Designed to increase the combat power of the Army's Infantry Brigade Combat Teams, the M10.

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INDIANAPOLIS--(BUSINESS WIRE)--Allison Transmission is pleased to announce that Mack Trucks, one of North America's largest producers of heavy-duty trucks, has selected the Allison 4500 Rugged Duty Series™ (RDS) as the exclusive transmission currently offered for its new compressed natural gas (CNG)-powered Mack® Granite® model. This partnership is the latest example of Allison's ability to deliver optimized performance and capability in demanding vocations, agnostic of fuel source for the powe.

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Allison Transmission Holdings, Inc. (NYSE:ALSN ) Q2 2023 Earnings Conference Call July 27, 2023 5:00 PM ET Company Participants Jackie Bolles - Executive Director, Treasury and IR David Graziosi - Chairman and CEO Fred Bohley - SVP, CFO and Treasurer Conference Call Participants Rob Wertheimer - Melius Research Ian Zaffino - Oppenheimer Tim Thein - Citi Larry De Maria - William Blair Tami Zakaria - JPMorgan Jerry Revich - Goldman Sachs Operator Good afternoon, and thank you for standing by. Welcome to Allison Transmission's Second Quarter 2023 Earnings Conference Call.

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INDIANAPOLIS--(BUSINESS WIRE)--Allison Transmission Holdings Inc. (NYSE: ALSN), today reported second quarter net sales of $783 million, an 18 percent increase from the same period in 2022 and diluted EPS of $1.92, a 52 percent increase from the same period in 2022. David S. Graziosi, Chairman and Chief Executive Officer of Allison Transmission commented, “We are pleased to report record quarterly net sales as demand remains strong across our largest end markets and the Allison team remains foc.

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INDIANAPOLIS--(BUSINESS WIRE)--Allison Transmission has released its 2022 Environmental, Social and Governance (ESG) Report designed to provide transparent data on the company's environmental performance, social impacts and how these practices are governed. “Allison and its peers are navigating an evolving commercial vehicle industry in preparation for upcoming changes to emissions standards and increased adoption of electric vehicle technology,” said David Graziosi, Chairman and CEO, Allison T.

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