Allison Transmission Holdings, Inc. (ALSN) Earnings Call Transcript & Summary

All right. Let's get started with the next presentation here. For those that don't know me, my name is Felix Boeschen. I cover some of the machinery and actually truckload stocks here at Raymond James. Today, super excited to have Allison Transmission with us. We do have the company's CFO, Fred Bohley, as well of Ray Posadas, who heads up the Investor Relations efforts. I think how we'll do this is mostly a fireside chat format. So if you do have a specific question, feel free to raise your hand. We'd like it to be as interactive as possible. But before we get into that, maybe Fred, Ray, if you could spend 5, 10 minutes about Allison sort of key overview of the story, key markets you play in and sort of maybe a state of the union of what you're seeing out there, I think that would be helpful and then we will do more Q&A after that.

All right. Ray, do you want to kick this off?

Sure. So for those of you who aren't familiar with Allison, largest global manufacturer of commercial duty fully automatic transmissions in the world, about 60% market share in the fully automatic transmission market for commercial and defense vehicles. The remaining 40%, I would actually break out into 2 buckets. You've got Ford, who's taken their automotive fully automatic transmission and beefed it up a little bit, introducing it into the light end of the commercial vehicle space, primarily via their vertically integrated Ford F-Series. And you have 2 German manufacturers that have invoice that primarily play in the global transit space today. But that's really it. If you're a commercial duty fleet owner and you're in the market for a fully automatic option, in most cases Allison is really the only game in town. We also produce fully automatic transmissions for the mining and hydraulic fracturing space, primarily pressure pumping applications in hydraulic fracturing. That industry has obviously been through a meaningful downturn beginning in 2019, starting to show signs of life. Our results in Q4 2021 were supported by a high demand in the hydraulic fracturing space. Market there is a little bit more evenly distributed. So I would say the top 3 players there consist primarily of Caterpillar, Allison and Twin Disc. Certainly, just given today's environment, we're starting to see signs of a recovery. And I think the climates that we're encountering now is one where you could foresee a sustained period of high demand for hydraulic fracturing applications. I think that's not outside the realm of possibility. And we also produce fully automatic transmissions for defense vehicles, wheeled and tracked. Our wheeled products are built on the same manufacturing lines as our commercial products. They're variants of our commercial fully automatics. On the track side, these are highly sophisticated applications. The fully automatic transmission on our tracked vehicle is not only responsible for velocity and propulsion but also steering and braking tend to be lower volume products with much higher value as well. And then obviously, we have the parts, support equipment and other end market that supports the various end markets that we play in. Premium financial profile, industry-leading margins, substantial cash flow generation, very shareholder-friendly capital allocation track record. That's a bit about Allison. I'll kick it off to you, Fred, to give a bit on our strategy.

Sure. We've been focused over the years in gaining share primarily against manuals and here more recently automated manual transmissions, built the business over multiple decades, as Ray said, have a significant share, best-in-class margins, generate strong cash. But we're now in the middle of navigating a transition to electric vehicles. We've made significant investments over the last 3, 4 years and north of $350 million in investments, went out and acquired piece of AxleTech there, their EVS division. Really been focused on e-axle designs that can run across commercial vehicles from Class 4 up to Class 8, leveraging on our expertise in vehicle propulsion. So as we sit here right now, really the EV opportunity is more near to longer-term opportunities while also making significant investments in our conventional business to drive things forward, high penetration in the developed markets like the U.S., Western Europe, but very low penetration in those emerging markets outside North America, less than 5% share of fully automatics. So starting to look at some of the investments we've put in place, realizing revenue margin gains off of those that I'm sure we'll get into later in this discussion.

Maybe before I ask you about supply chains. I'm curious about the $350 million of EV investments. Was that a commentary specifically around electrification? And was that effectively across CapEx, R&D and M&A. Is that the right way to think about it?

It is. It's -- over the last 4 years, there's the M&A transaction relative to AxleTech, the e-axle architectures. We've been investing in our electric hybrid product, which has been out for 15-plus years, really taking that and being able to do full EV for significant periods of the duty cycle. I really -- because in transit, which has been an early adopter of hybrid electric, you still have a significant resistance to go full EV because of range anxiety, performance of the batteries and cold weather. So invested in the electric hybrid as well as the e-axle designs and so that's CapEx. We stood up our Auburn Hills facility for the production of e-axles. That's a 110,000 square foot building that stood up and ready for production for what -- certainly for the upcoming years and then just straight R&D investment as well.

Yes. And I'm curious if you'll indulge me on this, but I think your R&D spend is right around $190 million into next year or this year, I should say. Curious if you have a split versus how much exactly goes to EVs or maybe a run rate you're thinking about longer term?

We do. We're investing across our portfolio. So we've got next generation of controls. We're putting out a new frac transmission, 9-speed architecture in the conventional space, new medium heavy-duty track vehicle that's electric hybrid capable. But when you look across and clearly a lot of the organization is support. But at this point, our spend is pretty even on electrification versus conventional. It's elevated from what it's been historically. We guided to it being up 10% in 2021 over -- in 2022 over 2021. If you look out in the future, I think what you'll see is some of these conventional investments we're making in both from an R&D standpoint and a CapEx will start to come down and some of that transitioned over to investments in electrification.

Okay. No, that's helpful. I realize I got sidetracked about 2 minutes in, but I'm curious if you could maybe comment on the state of supply chains as you see it today. Obviously, a lot of news out of the Russia and Ukraine too. If you could maybe talk about implications if there are any to your supply chain or what you're seeing out there?

Sure. I mean the supply chain continues to be challenged. I'm sure you're hearing that from all companies. Obviously, we've taken that in consideration when we provided our initial guidance for 2022. There will be the supply chain. It's logistics. It's the buffers are shipped out from an inventory standpoint, labor issues at our suppliers, still issues with electronics and chips. The real problem is, again, very little buffer and the challenge with the logistics is you're feeling this stuff real time. Our team has done a really nice job navigating through it, but it is day-to-day supplier by supplier down into your third, fourth, fifth tier of the supply chain. Relative to the conflict, we do disclose our revenues down to 1%. Russia is not a significant market for us, less than 1% of our revenue in 2021 was generated from Russia. We do not have a manufacturing footprint there. Having said that, obviously, the implications are still playing out. Ray touched on where oil prices and what that could mean for the future North American fracking market. We've got defense down this year. And it's really down because U.S. funding in '22 and '23 has been reduced. But certainly with the current situation, it appears that there will be additional funding, the challenges, the supply chain and a lot of times you're 12 months out in attract defense program from placing orders to actually being able to deliver a transmission. I think the wheeled has -- the wheel business, which are variants of our on-highway has some more near-term upside opportunity, whether that's product being sold to the U.S. military or our Western European allies.

Okay. No, that's super helpful overview. I was curious if you could -- because I thought one of the dynamics for you guys is you guys have managed quite well through your supply chain, I would argue, through much of the last year. The OEs have been a little bit of a different story. Curious if you could talk about what you're sort of hearing out of the OE partners as it relates to build projections through the year and sort of what's in the guide versus not from that perspective?

Sure. I mean, it's been challenging for everybody. Our suppliers, ourselves, the OEs, it takes every part, obviously to build a commercial vehicle. We've been able to stay up. I mean we've been in a position to sell transmission sell vehicle propulsion solutions if the OEMs want it. Obviously, through the second half of 2021, a lot of vehicles were built in complete red tag vehicles and the OEMs did a very nice job of working through those in Q4. So I think the backdrop for starting out the first quarter was strong, but there still is a lot of near-term volatility. With our North American OEMs, we have a -- we get forecast 3, 6, 9 month forecast, but it's really a 2-week firm line set. But we're seeing relatively near-term volatility. Somebody may be coming in an unexpected day or 2 downtime where we would presume they're completing vehicles that maybe they were short components. So I'd say some optimism that it's -- that the things are improving, but everything that happens is near term because adequate buffers are just not out there in the supply chain.

And do you think semiconductors is still the key sort of arbiter -- or is there something else that's a bigger pain point at this point?

It's still a pain point. It's not at the level it was in sort of the third quarter time frame. Where you sit right now, a lot of people going after the supply chain and wanting additional demand, additional capacity. Labor is a significant issue, probably larger for us on some of our lower volume components, whether that be the track Defense, the off-highway business. But chips are still an issue, but great unique grades of steel and the lead time on that. So the problem really is if you don't have it in the forecast, it's difficult to get upside demand.

Yes. Okay. I was hoping you could talk a little bit about your pricing structure, sort of -- I guess what I'm trying to get at a lot of our machinery companies have talked about a very 2H-weighted EPS ramp as raw materials are sort of recouped from a price/cost perspective. You guys are a little bit different. Curious if you could kind of comment on the long-term agreements and how pricing really impacts the model as you think about the P&L through the year?

Sure. We talked about on our Q4 call guidance for 2022. We expect to get about 275 basis points of price. That's made up of a split between commodity pass-throughs as well as its commercial price. With the majority of our North American OEMs, we have long-term supply agreements that do include an element of commodity pass-throughs. Steel, aluminum are the primary pass-throughs. We don't pass through a full 100%. Typically, in any given agreement, we'll pass through about 75% of the raw material, but there's a significant lag depending on the contract. It could be 6 months to a year from a lag standpoint. So that drove us to be in 2021, price/cost unfavorable. Coming into 2022, we're picking up a significant amount of price relative to commodities. The challenge is commodities continue to rise. So we've got things in our guide where we're slightly price cost favorable. Clearly since then, you've still seen an elevation in commodities and we talked about on the call that we were still looking for price in 2022. That's had an impact on our margins. 275 basis points of price, roughly $70 million in price. The cost is really close to that. So when you drop that through, it's hitting you about 100 basis points from an EBITDA margin standpoint. I think the probably one thing that's important to understand is, at some point, this will rotate and when it does rotate the lag will work the other way. We'll have -- when commodities start to come off, we'll have 6 to 12 months where we don't need to pass through the cost savings. And then when we do pass through, we'll only be passing through about 75% to the customers that we have long-term agreements and across our entire commodity sort of portfolio, only passing through about 60%. So when that happens, you're probably looking at 225 to 250 basis points of lift to margin. If you assume you sort of, get back to 2020 level.

Okay. That's super helpful color on the margins. Ray, you mentioned the off-highway business a little bit with the rise in oil prices. Can you kind of walk us through what you're seeing from that perspective, whether that's in the off-highway book or the parts and services where I know you have quite a bit of energy exposure as well.

Yes, sure. Probably help if I just give you a little bit of context. So obviously, the off-highway business for us is one of the more volatile end markets that we operate in and one of the more difficult ones to forecast. Typically, what you would expect to see in a recovery and it really goes back to the nature of the downturn that occurred prior to that. You'll see throughout the downturn, a lot of the equipment just getting sidelined through -- depending on the length of the downturn and the various field service operators out there and how well they take care of the equipment that's sitting on the sidelines, you'll see that equipment begin to deteriorate. Some of it will be cannibalized through the downturn as a means of keeping whatever they have running and going, while minimizing their expenses. So when the recovery starts to take hold, the unknown variable is really what state is that equipment sitting on the sideline in -- is it ready to be brought back into the field right away? Is it going to be a need of some type of overhaul or repair or is it just being cannibalized to the point where it's just no longer eligible for anything like that. So typically, in a recovery, you would start to see the initial uptick in demand through the service parts, support equipment and other end market as parts are required to bring this equipment back online. That has not been the case this time around. What's been unique about this initial uptick in demand is that we're seeing demand from new units. Not necessarily that new frac rigs are being built but you're seeing a lot of component replacement on existing rigs. So replacing the transmission, replacing the engine. So the initial uptick in demand for at least for our purposes, we're starting to see that on the new unit side. So you saw some strong performance in our North America Off-Highway end market in Q4 of 2021. Ultimately, over the long run, as long as activity is taking place, hydraulic fracturing activity is taking place, that's simply going to consume equipment, and that's going to be a tailwind for the off-highway business in general, both on the new unit side and the parts component. The timing of it obviously can vary a bit. But as long as the activity continues to go as we're seeing today. Now the one caveat is, when you listen to the comments from a lot of our customers, you hear a lot about capital discipline and the industry's desire to maintain that discipline, at least for the foreseeable future. Now that could potentially change given everything that's happening in the world right now. But for the time being, you are hearing and you're seeing a lot of discipline in the industry, which simply put could foster an environment where you see, again, sustained demand, higher demand for longer. But ultimately, this is a very volatile end market for us. It is a -- one of our more higher margin end markets. So certainly, one that would be a tailwind for us, if it were to continue at this rate of recovery. But certainly, one that we're focused on and remain focused on. We've made numerous investments. We announced last year our new frac transmission, which is the industry's first purpose-built hydraulic fracturing transmission. Up until now, what you've had and really by all the players in the space, including ourselves, we've taken mining transmissions and adapted them for hydraulic fracturing applications. So while these are very durable rugged transmissions, they weren't purpose-built for hydraulic fracturing. We saw an opportunity to take the decades of learning that we acquired from being in the space, taking feedback from our customers and developing the industry's first purpose-built hydraulic fracturing applications. That would be the FracTran transmission that we announced last year. And more recently, we talked about that particular solution, providing an opportunity for an incremental $100 million in annual revenue for Allison over the long run. So certainly, a product we're very excited to have in the field. Our customers are excited to receive it. We shipped the first unit earlier this year. And we certainly see that as an opportunity to not only gain share but also acquire new customers in the space as well globally. And so when you say $100 million in the long run, I'm curious how many years you guys are measuring the success of this product launch.

Sure. So we announced a number of opportunities to gain for incremental revenue during our most recent earnings call. I would put the time frame for those opportunities at about 3 to 5 years…

Okay. And I presume that includes the regional haul series, which I think we should talk about as well. Curious if you could talk about that launch, how it's going and sort of your expectations this year and maybe into '23.

Sure. The regional haul series is a variant of our 3,000 series. So it's a proven transmission. We made some small internal changes to both improve fuel economy and durability. So we ultimately raised the torque rating up from 1,250 foot pound to 1,450 foot pound. We have customers that use it in regional hall, but on the light end, the 3000 series, so they have experience with it. We've launched it with the best-in-class warranty, 750,000 mile warranty. The product is lighter than the automated manual transmissions in the marketplace, so about 10% wider. It's 8% better fuel economy than our current 3,000 series. And really, what's key is you're in there competing against a couple of large vertically integrated OEMs in Volvo and Daimler. And both of them have released the product in addition to Navistar. It will not cover all of the regional haul market. Think about that as about a 80,000 unit market on average, addressable with that transmission, probably 25,000 to 30,000 regional haul tractors. Our share is really low right now, about 5% -- so the next 3, 4, 5 years, we believe we can take that share up from where it's at close to what we consider sort of Allison's [ S ] type of shares. So think about moving it to share in sort of the 60% range. Sales team is very excited. It's got the right value prop, very quick payback to customers, 2 to 3 year payback. You can get more work done. You can accelerate from 0 to 25 significantly better while saving on fuel economy. So when we look at that, think about, call it, 25,000 addressable opportunity. We get able to pick up, say, 12,000 additional transmissions, maybe more at an ASP of about 8,000, which is how you get to the $100 million incremental. That's just North America. Clearly, we're looking at opportunities for that product outside North America as well.

We have just over 5 minutes left. I did want to talk about electrification a little bit. It seems that a lot of players are kind of going into the e-axle space. I'm curious if you could talk about the competitive landscape as you see it. And specifically, what I'm curious about, you guys gave a stat not too long ago, one of your conference or earnings calls, I should say, about the content opportunity being 3X to 11x higher than say in automatic transmission. Curious if you could walk through what gets you to the high end versus the low end. And how far along you think OEs are in that decision-making process?

Sure. So I'll start with the first part of the question on competitive dynamics there. So EV, I would say, and this is something I think a lot of investors aren't aware of, but EV is not anything that's new to Allison. Electrification has been something that the company has been working on for decades. I mean on the extreme end, going back to the 1990s as part of GM, we were working on the first electric cars. We launched our first electric hybrid for transit bus back in 2003. Since then, it's become one of the more successful electric hybrids in the market. We've had our fully electric -- I'm sorry, our fully automatic conventional transmissions operating on fully electric trucks all over the world for years. This is something that we've always seen as a mid to long-term opportunity, perhaps leaning more so towards the long-term. In recent years, with the sort of momentum that electric vehicles, in general, have gotten, at least at least from a narrative perspective, -- you're starting to see a lot of different players in the industry start to focus on EV, ourselves included. We've certainly been investing to develop that technology as well. We made the acquisition in 2019 of the Electric Vehicle Systems division at AxleTech. We identified the electric axle architecture early on as a preferred solution and something that lends itself quite well to developing efficient, sophisticated differentiated solutions for electric trucks, propulsion solutions, I should say, for electric trucks. You're starting to see a number of both legacy conventional suppliers as well as new entrants looking for opportunities in this space. And so a question we get often, specifically around the e-axle is why would a transmission manufacturer be better positioned at say, a conventional axle manufacturer to develop an electric axle. And it really goes -- the answer to that question really goes back to the technology itself. I would suggest that an electric axle is much more similar to a propulsion component. And by that, I mean an engine or transmission than it is to a conventional axle. The propulsion componentry on a conventional vehicle, they're generating power. They're generating torque. They're analyzing sensor data. They're making decisions with respect to that power and torque generation. They're controlling the vehicle. And so you're simply moving those propulsion components from the front of the vehicle, underneath the hood to the back in between the tires. And so other than the placement of the unit, I would suggest that it doesn't have a tremendous amount in common with a conventional axle. So areas where an Allison Transmission would be able to differentiate itself would be our core expertise in vehicle controls. Think about what a fully automatic transmission does today on a conventional vehicle. Certainly, the engine supplies the power. The transmission controls the application of that power. We control acceleration, deceleration, we can detect if the vehicle needs additional power because it's going up a steep grade or you might be hauling excess weight. We're analyzing all of this today on vehicles, and we're making decisions real time. And so all of this expertise is core to the development of electrified propulsion, where the value in an electric propulsion system is not derived from any single component. Think about what's in there for a moment, electric motors have been around forever, batteries have been around forever, gearboxes have been around forever. The value in an electric propulsion system comes in the integration of the system. How do you accomplish all of these different components to work together and talk to each other throughout the entirety of the duty cycle? And whoever can do that in the most energy-efficient manner possible is going to be exceedingly well positioned to develop a best-in-class solution for that area. I just want to make sure I don't run out of timing.

You go, we've got a couple of minutes. I think you touched on the range because I think it has quite a bit to do with what you just talked about.

Sure. So the primary hurdle today for electric propulsion is economic. At the end of the day, these vehicles work, electrical propulsion works, no one questions the technology. It's can you do it in an economic way. If you need to start tacking on batteries onto these vehicles to make sure that they can accomplish the range that's required, is that going to eat into your payload capacity. How much weight are you adding on to that vehicle? How much cost are you adding to this vehicle? Being able to develop flexible, efficient solutions is key to bringing the economics of the electric truck down in order so that one day, the electric truck may actually be competitive with conventional. We're simply just not there yet today. Today, the cost of an electric truck in most cases, the total cost of ownership is multiples versus a conventional and we haven't even started talking about infrastructure and the support that would be required in order to sustain an electric fleet. But certainly, the challenges are meaningful. The work needs to continue to evolve these solutions so that the economics one day won't make sense. And that's going to be accomplished. Really, it's going to be a collaborative effort across the entire drive trend. I mean the vehicles need to evolve. The propulsion solutions need to evolve. Today, you're still in an environment where you're taking conventional vehicle chassis and adapting them for electric propulsion. As these vehicles, as these applications evolve, you're going to see vehicles and propulsion solutions that are specifically designed to be electric vehicles. You're going to see these vehicles begin to evolve. And so we're in early stages today, everything that you see on the road now very much remains in prototype stage, very much low volume. There isn't a tremendous amount of head-to-head competition. Right now, OEMs, they have their doors wide open. If you have an electric solution, they want to work with you. They want to see what it is that you're bringing to the table. They want to get their hands on your hardware. They want to put it in a truck, you evaluate it for themselves. And so it's an area that we have been working with many of our partners in the industry for quite some time. We're focused on partnering with the right OEMs that are focused on the technology. You hear a lot from our peers within the industry about specific applications that they may be on today. You hear a frequent amount of announcements from certain companies out there. I would say we are more focused on the technology itself. We're working with everybody. And I would suggest that putting out x number of announcements today is not necessarily going to be indicative of your success when this technology is actually ready for prime time.

Fred, Ray, that takes us to 30 minutes. So I'm going to say thank you very much for joining us today, and we'll leave it there.