Fears Over Ally Financial Overstate The Risk (NYSE:ALLY)

Ally Financial (NYSE:ALLY) is trading like a bank that is struggling when the reality couldn’t be more different. This is an exciting and durable business with extremely strong earnings power and platforms for future growth. Fears over a recession and weakening used car prices have caused Mr. Market to shoot first and ask questions later when it comes to ALLY and various other financial services companies. Long-term investors would be wise to take advantage of this opportunity to invest in ALLY at current prices, which is right around 50% of my estimate of intrinsic value. I wrote a comprehensive article on ALLY after Q3 earnings, but I wanted to update things a bit as I believe so strongly in this investment.

I recently was in the market for a new car. With used car prices tanking after their historical rally over the last few years, the value investor in me considered buying one. I noticed that interest rates on used car loans were often being quoted at 9-12% by the dealerships, which didn’t surprise me given what has been going on, and as someone that has followed ALLY and others in the sector for many years. Those are some pretty high yields on secured debt, especially in an economy that while struggling, still has very low unemployment, which is the leading driver of loan losses. Many banks have been pulling out or reducing their exposure to auto lending in anticipation of further weakening. This has opened the door for ALLY to continue to grow market share and originate very attractive loans, while constantly refining its credit models to account for further weakening in both the economy and used auto prices. I’d love to buy retail auto loans at 9-12% rates even into a weakening economy, especially if I had ALLY’s capabilities to quickly repossess and maximize recovery on loan defaults.

In my search for a car, I found myself also going to new car dealerships. I noticed that inventory was starting to build up a bit, which is good for ALLY commercial lending to dealerships, which helps finance that inventory, and has historically been one of the safest credits out there. These loans typically come with lower yields than retail auto, but they adjust upwards with rates. The paltry inventory problem exasperated by supply chain issues over the last two years caused this business line to decline, but I expect things to improve in Q4 and into 2023. Higher inventory levels will also help ALLY’s insurance business, which has been a nice profit center for the company over the years.

Another source for concern for investors about ALLY has been that it is a more liability sensitive business than some other banks, which have been able to keep their deposit costs extremely low despite the substantial interest rate increases over the year. ALLY has been rapidly growing its deposit franchise since becoming a bank, and key to that growth is that it pays relatively high interest rates on savings. While ALLY has been offsetting some of these costs by raising the rates on its loans, there will be some margin compression. In Q3 the net interest margin dropped to 3.83% from 4.06% in Q2, but this was still up from 3.68% a year ago. The estimated original yield on retail auto loans grew to 8.7% in Q3, up from 7.8% in Q2, and 7.1% in Q1. Net interest margins will likely dip lower in Q4 but then should stabilize from there in my opinion. While the Fed is likely to keep raising rates a bit longer, the bond market and Chairman Powell’s recent commentary, suggests that we are likely closer to the end of the hiking cycle. Every yield curve is massively inverted, which almost always suggests a recession is imminent, if we aren’t already in one, which I believe is a legitimate argument to make.

If we are in a recession, why would you want to own a bank with credit exposure, especially to auto loans? CECL accounting is a major gamechanger in that banks must now reserve for their expectations for future losses over the life of the loans, incorporating some recessionary scenarios. This is a much more conservative accounting rule, which market participants don’t seem to fully appreciate. When a bank is growing loans like ALLY has been doing, including rolling out credit cards and other higher yielding products for the first time, revenue is deferred because the company is establishing reserves right up front. In Q3, total loans grew by $4B, which drove a $133MM provision build as an example of this phenomenon.

ALLY’s retail auto coverage reserve increased by 5 basis points to 3.56%, which is 22 basis points higher than CECL day-1 levels. The total consolidated loan loss coverage increased by 3 basis points to 2.71%, mostly led by loan growth. The total reserve increased to $3.6B, which is still $1B higher than CECL day-1 levels, and three times the levels of 2019 prior to CECL. Under ALLY’s CECL methodology, the 12-month reasonable and supportable period assumes unemployment increasing slightly above 4% over the next 12 months, before it gradually reverts to a historical mean of about 6.5%. ALLY is also importantly incorporating declining used car prices into management’s loss assumptions of 1.4-1.6%. The annualized retail auto net charge-offs were 1.05% in Q3, up from .54% in Q2, but down from 1.38% in Q3 of 2019 to put into context. The 30-day delinquency rate rose to 2.93% from 2.52% in Q2 but is down from 3.32% in Q3 of 2019.

Ally likely over-earned during the Covid insanity period, as used car prices went ballistic, allowing the company to mint money on returned leases and repossessions. As an investor, if I can buy a business that can consistently generate mid-teens return on equity, at a discount to tangible equity, I start to get really excited. When that same company has been a strong underwriter of credit risk and has successfully improved its business model to become much more durable, I feel that much better about things. ALLY’s deposit base changed the game for the company as it no longer had to rely on capital markets to fund its loans, which can freeze up in times of economic turmoil like we are seeing right now. This means that as other banks pull back, ALLY adjusts its credit box, raises prices, and focuses on the cream of the crop of loans. While credit losses will increase, the new higher yielding and more stringently disciplined loans will work their way through the portfolio leading to higher profits in a few quarters from now.

ALLY’s tangible book value per share has been declining like many other banks due to mark-to-market losses in its securities portfolio, due to higher interest rates. If we see long-term rates stay flat or continue to go down, book value per share should start to grow again. The stock pays a dividend of roughly 4.5% and trades at around 6 times normalized earnings, and a little over 3 times trailing earnings. While the regulatory environment is not conducive to many major bank mergers, I do believe ALLY would be an exceptionally strong candidate to be acquired. Its digital presence and high margins would be a major asset to just about any bank in the nation, or abroad looking to expand into the USA. Santander USA was acquired last year by Santander (SAN) at a substantial premium to Ally’s current valuation, and I’d argue ALLY is a vastly superior company, with better credit quality to boot. Bottom line, I’ve been increasing my allocation to ALLY and plan on continuing to do so on further weakness.