Allison Transmission

Allison Transmission delivered 6% growth in its core business to $860 million. The acquired Off-Highway assets from Dana posted sales of $706 million, with growth in all segments except agriculture. Adjusted diluted EPS of $2.73 grew 8% year-over-year, suggesting strong broad-based performance.

Why it matters: The company bumped up its 2026 guidance with revenue up almost 3% at the midpoint and adjusted EBITDA up almost 6%. We find this encouraging given the volatile cost environment and the drastically different margin profiles of the two businesses. The core North America On-Highway business is showing signs of improvement on an improving Class 8 outlook, though Allison’s numbers seem less bullish than peers. Specifically, resolution of EPA emissions regulations should smooth out the balance of sales between 2026 and 2027. The Defense business grew almost 60% with multiple huge contract wins, particularly with European platforms. Though a small base, these results are encouraging.

Long view: While the company didn’t provide direct comparables for the acquired Off-Highway business, it apparently posted growth in all segments outside agriculture, which investors know is depressed. Adjusted EBITDA margins of just under 15% are consistent with last quarter and suggest the business is delivering. Construction and mining were particularly strong verticals, which strikes us as consistent read-through with performance at various peers.

The bottom line: We are increasing our fair value estimate for narrow-moat Allison Transmission to $145 per share from $136 on its improved guidance and the time value of money. Free cash flow generation of $281 million (up 84%) was particularly impressive as the company increased financial leverage to complete the deal. $150 million of debt was repaid in addition to paying its dividend and repurchasing some stock.

Our $145 fair value estimate equates to a price/earnings multiple of 15 times our 2026 EPS target and 14 times on an adjusted basis, which contemplates significant one-off costs related to the Dana acquisition. Earnings are clearly depressed given the depressed volume environment for Class 8 and other vocational trucks. Given the company's likelihood of delivering double-digit EPS growth in the near term, this strikes us as cheap. We believe the company’s valuation multiple has compressed since 2018 on fears that the electrification of commercial vehicles will render companies like Allison obsolete, given their outsize profit exposure to internal combustion engines. However, we don’t regard Allison as a melting ice cube, and subsequent operating performance is increasingly debunking these concerns.

Management has guided to a modest recovery in core Allison in 2026 and more robust growth in the acquired Dana assets. Beyond that, we forecast a 4.5% average growth rate in the core North American on-highway business, and we believe the Dana transaction will allow for an average 4% growth rate outside the US. We believe the off-highway business will drive 5% growth outside North America and 4% in North America. We believe parts and services can deliver 5% average annual growth as the installed base increases across the portfolio. We forecast 9% growth in the defense business, given a small starting base, a slew of recent major contract wins, and ample business development opportunities. Overall, we characterize these growth rates as modest, particularly if the company can legitimately penetrate foreign markets for automatic transmissions.

The addition of Dana will dilute gross margins to 40% near term, but we anticipate synergies and operating improvements can drive as much as 300 basis points of improvement, mainly consistent with management guidance. We forecast selling, general, and administrative expenses will flatline around 11% of sales, and the company will need to maintain 6.5% of sales for ongoing research and development, given the ambiguity and uncertainty around electrification. While Dana likely had lower capital expenditures than Allison, we model that the combined business will increase annual capital expenditures to 4.0% of sales over our forecast horizon. We believe these assumptions allow for synergies from the Dana acquisition, but are far from heroic.

Our stage two forecast period incorporates an estimated investment rate of 35% and earnings before interest growth rate of 3% with perpetual growth of 3%. A 9.3% weighted average cost of capital derives from a market-average cost of equity and the firm’s current capital structure.

We assign Allison Transmission a narrow economic moat, underpinned by intangible assets and customer switching costs. We believe intangible assets in the form of the company’s strong brand and competitive positioning lead to pricing power. Allison’s fully automatic transmissions run $3,000-$11,000 more than manual transmissions. The average payback period is less than three years. For comparison, automated manual transmissions, or AMTs, fetch a $3,000-$7,000 premium over manual transmissions. Fully automatic transmissions enable better fuel and operator efficiency thanks to more efficient gear shifting. Customers are willing to pay more to achieve better fuel and operator efficiency. Improved productivity reduces customers’ total cost of ownership and improves profitability in their operations.

Allison has cultivated a strong reputation and dominant market position (as much as 80% share in certain vehicle categories) because its transmissions are high-quality, reliable, and durable. AMTs and automatic transmissions serve different end markets. We can break the Class 8 truck market into three categories: straight, day cabs, and line-haul (or long-haul). The start-stop nature of straight trucks (refuse/collection and mining trucks) and day cabs makes automatic transmissions more suitable. Better vehicle acceleration, maintenance savings, improved fuel efficiency, reduced emissions, and high residual values combine to create 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 6-7 trucks (79% share), Class 8 straight trucks (78% share), school buses (85% share), and motorhomes (44% share). We see further support for this in Allison’s best-in-class EBITDA margins in the mid-30s. However, the company appears to serve niche markets of limited overall scale.

The company does not have a significant competitor, which allows it to command 60% share of the global on-highway automatic transmission market. Competition comes from manufacturers of manual transmissions, AMTs, and vehicle manufacturers that have enhanced automatic transmissions originally designed for consumer vehicles.

Allison also derives a narrow economic moat from customer switching costs. The company’s products don’t break down as easily, allowing fleet owners to save on maintenance and repair costs. A single supplier like Allison can significantly reduce the complexity and costs of managing customers' large fleets. Fleet owners benefit from using a uniform set of products. Allison also has a strong aftermarket business, which accounts for 23% of sales. Customers get exclusive access to service parts and equipment.

Despite the advantages conferred by its narrow economic moat, Allison operates in a very niche territory. Currently, fully automatic transmissions are used in approximately 5% of on-highway commercial vehicles around the world. The low penetration of automatic transmissions is attributable to their premium price. One of management’s key growth strategies is focused on markets outside the US. Allison has been very successful in North America due to its high-quality and extremely reliable products. As economies develop over time, we anticipate more commercial vehicle operators will focus on total cost of ownership and realize the potential savings from Allison’s products in terms of improved fuel and operator efficiency. Moreover, we expect environmental regulations could be another key demand driver of adoption of automatic transmissions if emerging markets look to meaningfully reduce emissions. We believe international expansion was a key driver behind management’s recent decision to acquire Dana's off-highway assets, which skew heavily to Europe and India and should offer significant opportunities for distribution synergies.

The almost existential issue facing Allison and its long-term competitive positioning revolves around vehicle propulsion solutions in a world without internal combustion engines. We think Allison is making the right investments today to prepare for the electric vehicle transition. It 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. EV adoption will result in conventional engines and transmissions one day becoming obsolete, but this transition is occurring at a far slower pace than many investors likely anticipated, mainly due to the complexities of electrifying very heavy commercial trucks and vehicles. Allison is preparing for that eventual future by investing in its integrated e-axle solution. Traditionally, axles deliver power from transmissions, which is how commercial vehicles move. Today, manufacturers are reimagining the role of axles in EVs as the new cornerstone of power transmission in 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 decades away, we appreciate management’s forward-thinking approach.

Allison could gain share overseas, especially in emerging markets, based on the quality of its network and product offerings.

The company could replicate its success in the off-highway segment, where it has historically lagged.

Allison could achieve market leadership in e-powertrains, sowing the seeds for its future success.

The company might not gain traction overseas due to the insufficient value proposition to go automatic.

Allison could fall behind in electric propulsion because different technologies lead the way or because it can’t achieve the same dominance as with combustion engines.

The Dana deal introduces execution risk, margin dilution, and more commoditized products, a potential risk for future deals as well.