It has become harder to find opportunities today than it was a year or two ago. Despite this fact, and with more work, we will continue to follow a consistent philosophy to find new ideas. Fortunately, there are still high-quality businesses we think the market is not valuing appropriately.
Let’s use Allison Transmission (ALSN) as an example. ALSN is a global leader in automatic transmissions used in a variety of on- and off-highway applications such as garbage trucks, delivery trucks, buses, and military vehicles. Their product results in fuel economy savings, lower maintenance costs, and can utilize less skilled drivers in a number of applications. Without boring you with the details, ALSN generates very high operating margins due to high barriers to entry (technology, brand, scale, and service network). The business generates substantial amounts of free cash flow and is able to grow revenues over time, aided by market share gains in underpenetrated markets around the globe.
If the business is so great, why can you get it at a good value?
ALSN is not a simple or easy story and it has some issues that create opportunity.
The balance sheet is not pristine – Yes, there is higher leverage. However, given the very high levels of free cash flow generated, the debt maturity profile, and where we are in the cycle, it is not a concern.
There is a large private equity overhang and the float is small – Carlyle and Onex continue to be large shareholders. We are happy to have them aligned with us and their oversight has helped transform the business. Over time, we would expect them to sell down their position, but believe they also see the value in the business and are in no rush. These sales will also increase float size – which is less of a concern for us, but will likely help to further increase the multiple the market is willing to pay.
Some of their end markets have been performing poorly – This is true but this is also why we were given the opportunity to acquire shares at attractive prices. While off-highway (mining- and energy-related) and military have been weak, they are now a small percentage of the total business and have stabilized – eliminating a major drag on the consolidated business. We care about what is going to happen, not what has already happened.
It doesn’t look cheap on GAAP EPS – While GAAP earnings are important to consider, there are major limitations. In the case of ALSN, there is a substantial difference between GAAP EPS and free cash flow per share due to taxes and other, significant, non-cash items. At the end of the day, dividends, buybacks, acquisitions and capital expenditures are funded with free cash flow, which is why it is the more important metric. So while ALSN does not initially appear to be cheap, we see value.
Over time, we believe there are many ways for ALSN to create value for shareholders (organic growth, ongoing efficiency improvements, share repurchases, etc.). We are happy to have accumulated a position at attractive prices, driven by factors which do not bother us given our belief in the business and time horizon.
So while it is harder to find good opportunities today we believe that by following a consistent process, value can be created for Cambridge unitholders over time.