Description

ALLY, the leading US online focused bank, presents itself as an attractive risk reward opportunity given the recent market sell-off.

Ally, formerly GMAC, is a online domestic bank with over $100bn in deposits that is focused on auto lending and is expanding into corporate finance lending and consumer products like Ally Invest, Ally Home and Ally Cashback credit card. For a deeper understanding of Ally’s business model please refer to the excellent description posted by Izmos in July 2017.

The current share price of $22.36 trades at 0.78x TBVPS of $28.6 and the discount appears unwarranted for a business that is posting strong results with significant

EPS (Forecasted 2018E $3.24) and adjusted ROE growth (Forecasted 2018E of 12+%).

Valuation

I am applying 3 valuation scenarios below: i) a base case scenario that follows management medium term guidance and applies conservative exit multiples; ii) an upside case scenario that follows management medium term guidance and applies exit multiples in line with ROE / TVBPS regression; and a iii) worst case scenario that applies the Dodd-Frank Stress Test assumptions required from the Federal Reserve

Base Case Scenario

Upside Case Scenario

Worst Case Scenario

This scenario applies the stress test assumptions from the Federal Reserve, which are modeled to be harsher than the conditions in the 2008-2009 financial crisis, which would impact Ally with $1.9bn of Pre-tax losses over a 9 quarter period and applies a terminal 0.8x p/TBV multiple at the end of the period.

Investor Fears

Increasing cost of deposits pressuring NIM.

Some investors are concerned with the rapidly increasing cost of funding given the competitive nature of Ally’s online deposits, which are less sticky than traditional brick and mortar checking accounts and require continuous increases as interest rates climb higher.

While this dynamic is real and will continue (cost of deposit and total cost of funding increased from 1.35% and 1.94% in Q4 2017 to 1.84% and 2.38% inQ3 2018), Ally’s predominantly auto credit asset base has short duration and quick repricing (approximately 2.5 years for retail loans and less than 100 days for floorplan loans) which has enabled Ally to raise yield in excess of its cost of funding increases.

US Auto Market Cycle

Investors are concerned that the US auto cycle may have topped out and may suffer significant headwinds in the future leading to significantly lower origination volumes and decreases in auto residual values that will impact recovery rates and increase net-charge offs.

While these risks are true and may impact both Ally’s top line growth and profitability as management guidance assumptions assume SAAR levels consistent with the current situation, the risk appears well baked into the current share price.

Specifically, the reduced growth could be substituted with additional share buyback, which would be TBVPS accretive at current price levels.

Regarding the auto credit cycle, Ally has had historical good asset quality and even a very conservative Fed stress test scenarios shows cumulative weighted average loss rates of 4.3% which while significantly impacting profitability, would not irreversibly compromise Ally’s capital ratios and force a major dilutive share issuance.

Summary

While risks related to the auto cycle are present, I see the odds of an investment as attractive.

If I apply a 60% / 30% / 10% weighting to the base, upside and worse case scenarios we have a blended weighted target price of $38.95 for an 74% upside by the end of 2020.

Even in a heavily stressed scenario, TBVPS of $25.1 would still be above the current price levels and Ally should not require any capital injections thus safeguarding our investment principal.

Risks

• Auto Cycle turning downwards rapidly affecting originations, residual value and net charge offs

• Increasing competitive pressure on deposit costs, pressuring NIM

• Inability to diversify beyond auto credit, capping potential for growth

Catalyst

• Favorable 2019 Guidance released in Q1 2019 showcasing EPS / ROE progression
• Accretive share buybacks accelerating increase in TBVPS
• Positive auto cycle news, maintaining SAAR levels around 16-17mm