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

We'll go ahead and get it started here this afternoon. Thanks, everyone, for joining us. My name is Luke Junk. I cover vehicle technology and mobility for Baird. Very pleased to have $4 billion market cap, Allison Transmission with us today. Allison is the leading provider of fully automatic transmissions for the on-road and off-road markets. Joining us today from the company, we have Fred Bohley, CFO. We have 30 minutes for this session. So I'll do my best to work any questions in the e-mail is [email protected]. And with that, let's kick off the discussion with some introductory remarks from Fred.

Thanks, Luke. Just briefly one slide, just roll through Allison Transmission at a glance. We're a leading manufacturer of propulsion solutions for commercial and defense vehicles. I think Class 4 up to Class 8, we are the largest manufacturer of fully automatics for commercial vehicles, have about 60% global market share and a leader in electrified propulsion, both electric hybrid as well as full EV. We view Allison as a premier brand. It's a product that customers pay a premium for. We've got differentiated technology. We're able to put in front of our end users, a 2- to 3-year payback with reduced maintenance costs, reduce downtime, more productivity, being able to get more work done in a day, get from point A to point B quicker and fuel efficiency. So Again, certainly, we feel we're well positioned for revenue and earnings growth. Over on the right-hand side, we have the 6 end markets. As we sit here right now, 5 of the 6 end markets are going to be up in 2022 with the lone exception being our defense end market. Our largest market is North American on-highway. Again, heavy start/stop vehicles, Class 4 primarily through Class 8 straight truck, very strong share between 60% to 80% share of all transmissions in those end markets. Outside North America, on-highway, is primarily still manual transmission. So it's a significant growth opportunity for us. We just had a record quarter, highest revenue ever in the third quarter. We were up really across the board in all regions, up in Europe, China and South America. Obviously, South America or China down quite a bit. Our ability to outgrow with penetration activities and certainly feel comfortable there, driving double-digit annual growth. Our off-highway markets, North America, outside North America Off-Highway. Our products, for a family of 4 products go into mining as well as energy, primarily pressure pumping, fracking with North America and China being the driver there. Outside North America, off-highway is more evenly split between mining and fracking, we don't -- from a mining standpoint, we're not in those 2 large captives being Cat and Komatsu, but pretty much sell to the balance of the market. Our defense end market is the only market that's down this year, but certainly arrow pointing strong up there. We've made significant investments and have new programs coming forward. We're in the M88, the MPF programs. And we're seeing the Allies fund. We're in the Abrams battle tank, expect that to go over to Poland and a lot of the Russian equipment that's been put into theater in Ukraine in need of replacement. So definitely positive momentum there. With that, let's move on to the Q&A.

Sounds good. Thanks for that, Fred. So I'll start with what I know is on top of everyone's mind, and that's the macros roll into '23, obvious in focus at this conference, more so this year with rising macro risks. That being said, the commercial vehicle market, not a typical setup for macro risk given constrained production. We've got carb emissions coming in 2024. I don't know but particularly relevant to your business, but it's certainly relevant to commercial vehicle. More broadly as we turn the page to 2023, what are you thinking about as the key macro variables and things that you just want to account for as you think about budgets and whatnot?

Yes. No, it's -- obviously, macro is pretty scary. As you guys all know, all the central banks raising rates trying to slow down the economy. But then as Luke said, you started getting into our individual end markets and you start to get pretty comfortable with the backdrop for 2023. North America On-Highway has been underserved for the last 3 years throughout the pandemic. The OEMs have not been able to produce to demand in 2022, primarily driven by the challenges in the supply chain. And then as you mentioned, the thought initially was that 2023 could be a pre-buy year. I think at this point, because of the emissions change, driving up the cost of the engines and the vehicles. I think at this point, with the continued challenges in the supply chain, the expectation is probably a little bit more steadier through '23 into '24. The important thing I think about our book of business there is we're not in the over-the-road Class 8 line haul, okay? And the reason for that is fully automatic really shines when you do heavy start stop. So that's a market that's moved away from manuals to automated manual transmissions in the over-the-road. But when you look at our core market, Class 4 through Class 8 straight, a lot of vocational applications and a significant amount of municipal exposure. About 30% to 40% of our revenue is driven by municipalities, think school buses, transit bus, fire and emergency, rep use, DOT dumps, snow plows. So that certainly insulates us from any sort of downtick because those municipalities in past down cycles have continued to buy at a regular pace. But as -- if we look at it with the pent-up demand and the fact that to go get a vehicle right now, you're at least 6 months out, there's minimal inventory on the dealers' channels in the dealerships. So a really good backdrop when you get down to the detailed market, but obviously concerning macro environment. And then if you switch to the balance, the off-highway business, North America off-highway almost exclusively driven by frac. And that's certainly a good setup with where oil and nat gas prices is, and you're seeing a lot of capital discipline by the service providers. So we feel like that market is set up for a much more steady run rate versus the historical boom and bust we talked about outside North America On-Highway, we feel like we're able to grow in a down market because penetration is about 5%. We've laid out this year, $250 million in incremental growth opportunities on an annual basis. That's a combination of a new product we're launching for fracking. A market we're going after in the North American regional hall and then a wide money dump opportunity in China. So I think you position that, and then we briefly touched on defense. Certainly, it looks like arrow up there. So when you roll around the 6 end markets, it gives you more comfort but certainly, in our backdrop, our mindset is you always run the business as if there's the potential for a recession. So we're not fully manned up. We're building a satisfying demand today with a significant amount of overtime. So if there is some reduction in total demand, that's a first lever there that is just to reduce the overtime and get cost out that way.

So certainly, one of the impacts in the macro also is what's going on with energy costs and fuel costs, especially, just so happens, you have a product that directly addresses that. And what I'm wondering is, historically, you've talked about that 2- to 3-year payback on the premium associated with the fully automatic transmission with where fuel costs have been in the U.S., how does that impact the payback? And have you seen a direct relationship in terms of demand for the product this year, borne out of what's going on with energy?

Yes. Thanks. What we've taken with our products, and we can do a lot of things with our electronic controls, how we control the transmission. So we've have marketed software, so you can select our fuel stents. We have a couple of different packages, fuel sents that you can select. And that's additional above and beyond what our transmission normally generates from a fuel economy standpoint. So that's an incremental revenue opportunity. And from a cost basis, basically sunk and its change in calibrations. Relative to the total payback, which is really important because our go-to-market is we go directly to the end users. So the waste management, the Penske, the U.S. food directly to those customers and sell the value of our product in a 2- to 3-year payback. So what's happening is that the OEMs have significantly raised prices on trucks. And the fact that our product makes those commercial vehicles more fuel efficient, but it also reduces maintenance costs, which eliminates downtime as there's no clutch to adjust or replace, we're able to keep those vehicles in operation and they get more productivity moving from point A to B. So when the price of a truck goes up or a commercial vehicle goes up, the value we deliver goes up. And that's -- we've historically been able to get price in a more standard steady-state cost environment. We picked up about 50 to 100 basis points of price annually, which is somewhat unusual for a component supplier in commercial vehicles. Clearly, we're not in a normal cost environment. At this point, we expect to get about 425 basis points a price this year. And there are certainly -- as we model 2023 is spending a tremendous amount of time modeling what the cost is going to look like. But our intention is to have another year in 2023 of outsized price increases as we work to more than cover the cost increases that we continue to see.

And then I think it'd be fair to assume this is a polling question that we've been asking companies across the conference more broadly, but the pricing that you've had this year that's above trend, potentially pricing above trend next year, no reason to think that wouldn't be sustainable on a go-forward basis...

Our view on pricing is we only have one mechanism that's a surcharge. And let me briefly talk to that. So our goal is really to go out and get price in this permanent. But we do pass-throughs on commodities. So we do a pass-through on aluminum and 3 grades of steel to a lot of our customers under long-term agreements. So when we look at our total exposure to raw material, typically with our supply chain, we'll accept the commodity changes real-time in the quarter. That way, we can focus on negotiation on the value-add component. But then we turn around and we can pass that through to the OEMs, but we don't pass it through dollar for dollar. So with the OEMs we have under long-term agreement, on average, it's about a 75% pass-through. When you look at our total book of business, it's about a 60% pass-through, and it lags while we take it on -- from the -- our suppliers real-time in the quarter, it's about a 6- to 12-month lag. So the importance of that is as commodities have continued to go up, unfortunately, we've had to absorb that in our margins, but if you model commodities going back to pre-pandemic levels. that's going to pick up 200 to 225 basis points of margin really with no activity on our part just with those surcharge methodology, flowing back through on us passing through reductions, but only at $0.60 on $1, and then lagging and not passing them through for the first 6 to 12 months. That's this year for 2023, that's about 125 basis points of price. As I mentioned, we're getting 425 basis points of price. So the other 300 is what we would just call commercial price. It's negotiating with our customers. It's not across the board. We have long-term agreements with customers that we certainly intend to honor. But as they come off of those agreements, clearly understanding what's happened to cost profiles. You're in a position to pass on higher price. And as we roll into 2023, we do not see inflation rolling off. We're -- as we look at this, we're managing this business as if we're going to continue to see inflation, and we're putting ourselves in a position to pass on price. And if you want long-term certainty on price, that's -- we're willing to provide that, but that's going to come at a cost because of the risk profile.

So speaking of the risk profile, you mentioned it in your overview of just going around your different end market exposures, the muni exposure that's inherent in the North American on-highway business. Can you just talk about that customer specifically? And yes, how healthy are your municipal customers today, whatever happens in the economy?

They're very healthy. They represent about 30% to 40% of the book of business and specifically in North America. They're in the same position than our municipal customers are. They cannot get the number of vehicles that they need. Probably the only exception there is transit properties because of the -- of where ridership has been. But if you look at the balance of the book, reuse fire, and emergency, school bus, DOT dumps, the demand is there.

Okay. Let's talk about outside North America, you mentioned that you see double-digit annual growth is something that you'd be comfortable with going forward, a very strong year-to-date in that business as well, including in the third quarter. Can we just unpack the strength that you've seen in that business this year in terms of some of the specific drivers?

Sure. And it's Yes. It's been a focus of us really since we've been public. Growing that business outside North America. What's happened over time is the business that's addressable has expanded. And by that, we sell a product, if it's more than, say, 10% of the total cost of the vehicle, we have a hard time getting the math to work on that 2- to 3-year payback. So what's happened is the vehicles have moved up the emissions curves so the engines and the emissions devices have gotten more expensive. They've added safety features. So the total number of vehicles that we feel we can put that 2- to 3-year payback has expanded. So you start with that. And then like we see here in the States, there's very few cars with manual transmissions. You're seeing the same thing in the emerging markets where they're just moving away from manual transmissions. So then you have a group of drivers that the pool of candidates for commercial vehicles that just don't have the experience. So that's also quickening the adoption from manuals to what we call automaticity. And the reason I say automaticity is we're not going to win all of that business. There are some duty cycles where automated manual transmissions will be successful. And there's some were fully automatic, will be successful, but that trends in front of us. So that's the backdrop in which you're operating, which is a really strong backdrop, then it's about -- we're selling right now in the easiest places to sell. So by that, the most severe, the more difficult duty cycle is the more our product shines. It's got a bulletproof reputation. So when we talk China, I briefly mentioned the wide-body mining dump. That's a product that the Chinese were using a commercial vehicle dump truck. And they would just blow through that thing in about a year and just leave it behind. They willing to pay up for a standard off-highway rigid dump. So they developed a truck that's in between. It uses the variant of our 4,000 series. So our largest on-highway product that we've made investments in. It's a 7-speed. It's got the gear ratios allow it to haul hire GVWs. So our transmission is going into those wide-body mining dump opportunities. We sized that at about a $50 million opportunity early in the year. We're probably going to be halfway through that. And then we'll probably have $25 million. We may have slightly undersized it. So that's -- it's an off-highway application that shows up in on-highway because we put -- we do that by our products. But outside North America, it's usually transit bus, refuse. Those are 2 really difficult duty cycles, we're a fully automatic will shine. And then you move out to more severe service type of vehicles. We talked about on our earnings call, the success we've had down in South America in agriculture with ag sprayers, where we've gained a significant amount of the Argentina market, and there's a significant advantage in soft oil, being able to control the vehicle with a fully automatic. We've gained some recent releases in Brazil. So that's an opportunity that we're pursuing. We've had really strong performance in Southeast Asia. So you've seen the Japanese setting up shop in the likes of Malaysia, Thailand, and trucks developed for emerging markets, and they're -- upon setting those up, they're releasing them we're fully automatic with our product, and they're going to -- within Southeast Asia, they're going up into the Middle East. They go into South Africa. Australia has been a really strong market for us. So it is broad-based. But as I mentioned, this quarter, with that record net sales, we were up in Europe, which historically, we've had our Russian business. So even in spite of that, we were up through Asia, including China and then up in South America. So the team is very focused and have got -- we got really good technology for them to sell.

Okay. I got about 10 minutes left here. I want to talk about electrification, realizing that the commercial vehicle market is certainly at a leg to what's going on in light vehicles, probably 3, 5-plus years depending on your viewpoint, but higher mind share among investors. And I want to start just with the foundational question, which is conceptually, how does Allison view the role of gearing and automaticity in an EV. And clearly, in a combustion vehicle, there's a clear payback in terms of fuel savings. Is there a similar opportunity in EV? And I guess I'll dovetail that with -- from just a competitive standpoint, you're coming at this with a different set of IP and lens and saying, yes, actual provider, how can you differentiate versus those sorts of players as well?

Yes. So a lot in there, and lets -- you start with what's the right architecture for commercial vehicle. I think you certainly got to talk about when do you think the adoption -- what the adoption curve looks like. So right now, there's no real volume or scale. So we are really focused on solutions, but we really want to have them ready and we're baselining against our fully automatic technology. We want to deliver a better solution. But clearly, we want to be there when the market's there. And candidly, it's really not there yet. So we're fielding product, we're learning, but you step back to gearing within - gearing within electrification and then really what architecture? So we believe -- and that -- we made the investment back in 2019 in AxleTech in their electrified division. And I'd say in the '17 time frame, as we looked at the landscape and was it going to be multispeed central drives, was it going to be e-axles? And the way to think about e-axle is it's not really an axle. It just happens to sit where the axle sits. But in effect, what do we have sitting there where the axle sits? Multi-speed gearing is very important. You need to be able to have that multispeed in order to size your motors appropriately. And ultimately, if you can get the most efficient package, that can either drive smaller batteries or more range of your vehicle. And batteries is certainly the high-cost driver and in the area where you need to see the most improvement in order to get to -- get to a payback that the end users want. So it's a challenging group of end users. They're getting delivered solutions better than they ever had with internal combustion, and that continues to improve. So that's the baseline that you've got to come in and be able to compete against. And like I said, you're not in a position where you can take your electrified solution and really run it side-by-side if anybody because there's just not enough hardware out there to do that. So we like -- we're baseline against ourselves. We think about why should we have the right to win. It starts with -- it certainly -- technology is important. And we talk about our technologies in that space. We believe we have more efficient architectures. We have parallel access gear architectures. We think that gives us some efficiencies versus our competitors. But the most important thing will be, as it always is in commercial vehicles, you have to deliver something that meets the reliability durability. You're going to have to be robust and live. We have a lot of experience in battery management. We have over 9,000 electric hybrids fielded. In that case, we're controlling the battery. We're controlling the propulsion. So we bring that forward as well. We understand the end users. We know how -- exactly how they use the vehicle. So in any given year, we'll download over -- or provide over 5,000 unique calibrations. So 5,000 different variations of software to tailor the vehicle to do exactly what the fleet wants. So we bring that level of expertise and you're going to need to be doing the same thing, whether it's internal combustion or an electrified. And as we look at it, this is not going to be a one-size solution. It's not going to be a market that goes to one technology. You're going to have clean-burning diesel, CNG, alt fuels, hybrid electric, and fully electric. So we feel well positioned, but we would -- this is more of a mid- to long-term opportunity and we're timing our investments to meet the market when it's going to be there.

So let's talk about a couple of aspects of that. So first would just be where you find customers right now? What kind of strategic conversations are you having? I know you opened a new facility that can help with some of the real-world testing and data and whatnot. Yes, what is the status in 2022 of those activities?

Yes. So we've -- in Auburn Hills, we've set up a factory for low-rate production. You mentioned our tests and our vehicle environment and electrification facility. In there, we're able to do all-season testing on all sources of fuel, full EV, fuel cell. That's the other thing that's important when you think about the architecture is you want to be agnostic to whether it's battery electric or fuel cell, which we are. And then longer term, it opens up the Class 8 line haul market for us. We're not in there today because there's not a tremendous amount of shifting obviously. But whether it's battery electric or fuel cell, that's got the opportunity really to double the size of our market that's addressable in North America.

Okay. And then I got you here, you are the CFO and I have to tell you to put the CFO hat on. So R&D and investment and how you scale that in the P&L. Just how do you think about 2023 incrementally for the base business versus the future opportunities?

Yes. I would start with we're benefiting from what we've done in the past. So while we got after cost in the pandemic as everyone did, we continued full speed on our R&D programs. And our engineering test employees were in every day. And we -- that's why you're seeing this cadence of products we're able to deliver right now. As we look forward to 2023, and really in any given year, I'd start with - we don't think of R&D as a percent of sales. We look at R&D as what are the individual opportunities, what's the appropriate -- what's the risk-adjusted return? Does it make sense to make those investments? We have investments that we're completing that are rolling off. We have new investments that we're making. So we generate 35% EBITDA margins. So if we can put the cash to work within the business, we're going to do that. And you've seen that with us funding engineering R&D as well as capital expenditures, while still generating close to $500 million in free cash. But the point is, going into 2023, I don't see a step change up or down from an engineering R&D standpoint. Certainly have some things rolling off, but we've got some things ramping up as well. Over time, we'll see fewer investments in conventional internal combustion, more new technology. But it really is an exciting time because we have -- whether it's electrification, conventional, we've never had this many products under development. And now you're seeing them launch and you've seen the benefit to the top line and us outgrowing our markets and dropping through and generating more cash. And it's really a credit to everything that the team has been able to do through what's been distant unbelievably challenging in the last 3 years.

Okay. Well, unfortunately, we're out of time here. So we'll leave it there. If you want to continue the conversation, however, Fred will be available for a breakout session starting in 5 minutes in the Oak room. And the next set of presentations overall, it also begins in 5 minutes. Please join me in thanking Fred for the presentation today.