Description

Ally Financial earns a decent 8-9% ROE, has an idiosyncratic self-help cost of funds story, and has long-term upside through its best-in-class online bank franchise. Using some fairly un-heroic assumptions of 1X adj. TBV ($24.63) plus credit for 50% of its DTA, Ally is worth about $25.60 / share, a 23% return over its current stock price of $20.89.

Concerns over auto credit quality have seemed to dampen investor enthusiasm, but I believe Ally is well-positioned to ride out this credit cycle and significant capital impairment seems unlikely.

Financials

Core ROE calculated as Core Net Income over period avg. adj. TBVPS

Company Overview

Ally used to be known as GMAC and started as GM’s captive finance company. After a very rocky financial crisis and transition period (ResCap, TARP, to name some pleasant memories), Ally has emerged as a more streamlined and efficient company focused on its core US Auto business while steadily diversifying its smaller Mortgage and Corporate Finance businesses. The company operates in three main segments: Dealer Financial Services, Mortgage Finance, and Corporate and Finance. (Cars, houses, and middle market companies, but mainly just cars).

Breakdown of revenues by segment:

Dealer Financial Services: This is Ally’s core business. Ally provides auto loans and leasing for new and used vehicles to US retail and commercial customers. The company also has strong dealer relationships and provides funding for dealer purchases of used and new vehicles via wholesale floorplan financing, provides other misc. dealer-related loans, and also owns extensive infrastructure for servicing auto loans and an industry-leading auction platform (SmartAuction) for dealer-to-dealer and other wholesale transactions. Outside of lending, Ally also provides insurance to cover dealer inventories as well as certain consumer insurance products such as extended mechanical / roadside insurance .

Central to Ally’s auto strategy, is to own the dealer relationship - lending to the dealer builds opportunities for insurance and other financing products to be sold as well as leading to more retail loans. 81% of dealers who use Ally’s floorplan financing also use Ally’s insurance products (https://www.bamsec.com/filing/4072917000067/1?entity_id=40729&hl=166744:166867&hl_id=4ktjdyob7). So even though the Auto business was once a captive finance company for the GM and Chrysler brands, Ally has had decent success at shifting more originations towards what it terms as its “Growth” segment (dealers representing various other brands such as Ford, Nissan, Kia, Hyundai, or Toyota and RV dealers and some used car-only dealers).

Credit quality in this segment is rightly a big focus right now, especially with subprime fears. We’ll devote a section to discussing this later in the write-up.

Mortgage Finance: Well, there used to be ResCap…. Since then, Ally’s mortgage operations have shrunk considerably... In recent years, it has mainly consisted of buying high-quality jumbo and low-to-moderate income loans from third party originators. In late 2016, Ally began some limited direct origination operations though - with the current strategy being selling the conforming loans and holding the jumbo loans on balance sheet. Mgmt is very focused on not getting into MSRs and maintaining a much more limited rep and warranty risk - all very sensible things to do given Ally’s history with mortgages.

Still, I think this push into mortgages makes sense, they’re getting into this space in a methodical and relatively conservative manner and the opportunity is undeniably there. Just to drive the point home, over 40% of Ally’s deposit customers are Millennials (https://www.bamsec.com/transcripts/10460682?hl_id=vjeafjosq) and it makes complete sense to have a mortgage product ready to go for those customers. I expect the mortgage to grow steadily in the coming years.

Corporate Finance: Corporate Finance provides cash flow and asset-backed loans to primarily US middle market companies. This segment, along with the Mortgage segment, represent Ally’s efforts to diversify its asset-side away from just Auto. It’s a very sensible strategy, but Ally still has a ways to go as it’s Corporate Finance segment represents only ~2.2% of Ally’s average earning assets. That said, the Corporate Finance segment delivers good margins and ROEs and mgmt hopes to double the business over the next three years (https://www.bamsec.com/transcripts/10508261?hl_id=njxp8ydbm).

Auto Credit Quality - Boxing the Downside

Auto lending actually performs quite well vs other consumer financial products - people have an extra incentive to make car payments given how crucial they are to many people's daily lives. That said, auto credit quality and subprime in particular has been softening recently.

Given that the bulk to today's concerns are around subprime, keep in mind that only 8% of Ally’s overall loan portfolio is subprime auto (https://www.bamsec.com/transcripts/10104377?hl_id=nkd-o9wnm) and Ally’s subprime loans  currently running at a low teens % of retail auto originations (https://www.bamsec.com/transcripts/6022640?hl_id=4jycovm4q). Ally is also not a deep subprime lender and they typically lend at the higher-end of the credit spectrum when it does originate subprime auto loans (https://www.bamsec.com/transcripts/10460682?hl_id=vyadscwnx).

That being said, charge-offs and delinquencies are increasing and there is some degree of pressure on near-term earnings as provisioning increases:

There are many many analysts who keep a close eye on auto trusts etc. and who have a very good sense of the month by month performances of various loan vintages / types. It would be difficult to provide more near-term and granular insight then they can. However, I find it instructive to box a very bad downside scenario in Ally’s auto business by imagining the impact of an 08 financial crisis on the business:

First, we find the below 2008 lease impairment and loan loss provision rates:

* Only total lease assets reported, so N. American lease assets estimated based on % depreciation of N. American Auto

** Total segment assets from: https://www.bamsec.com/filing/119312511047688/1?entity_id=40729&table=85 and https://www.bamsec.com/filing/119312511047688/1?cik=40729&table=85

Next, applying them to Ally’s current portfolio we find that we can expect ~$6.77 per share impact on BV from write-downs and provisions, a 27.5% hit relative to today’s adj TBV of $24.63 although capital ratios are all adequate post-the hit (See below). Obviously this is still a very severe scenario and is purely illustrative, but I would argue this should actually provide a good degree of comfort in boxing Ally’s downside risks from auto credit quality worries.

* Illustrative example which assumes no earnings or tax benefit offset. Practically speaking you can consider the earnings to be eaten up by the inevitable bump up in depreciation from remarketing losses in an 08 scenario

Capital Ratios from: https://www.bamsec.com/filing/4072917000140/1?cik=40729&table=112

Ally Bank - Funding Benefits and Upside Potential

A key part to understanding Ally's attractiveness is Ally Bank. Ally Bank provides near to medium term benefits with its potential to lower Ally’s cost of funds (Ally is still in the mid-innings of a dramatic shift in its funding structure as it increasing relies on deposits), while also providing a long-term option to service an increasing share of the future US consumer’s financial needs.

Ally is widely considered to be one of the top online bank franchises (Kiplinger recently named Ally best online bank and best bank for millennials). I’d encourage you to compare banking online with Ally versus the experience you get with a much larger bank’s online experience - the difference is quite noticeable. This has translated into impressive and steady deposit growth - not growth primarily from fast money brokered deposits, but growth from primarily much more sticky retail consumer deposits.

This deposit growth is allowing Ally Bank to fund an increasing percentage of Ally’s originations and also represents a much lower-cost of funding that is replacing higher cost debt that is rolling off.

• Ally Bank’s has been funding an increasing percentage of Ally’s originations. Originations funded through the bank currently stand at 85% and this share is expected to increase over time (https://www.bamsec.com/filing/119312517141011/2?entity_id=40729&hl=2964:3038&hl_id=eyqjulorm).

• There’s an estimated $0.45 - $0.60 EPS benefit to Ally just from replacing maturing unsecured debt with lower-cost deposits over the next several years

Ally has done tremendous job building its online bank imo and is very well-positioned as banking increasingly moves online. Mgmt is capitalizing on this positioning by now also moving into wealth management with its acquisition of TradeKing last year (now integrated with Ally Bank and rebranded as Ally Invest). I’m not factoring this into the valuation and not to get too crazy here, but I think Ally has a real shot of being a much more major part of the financial lives of US consumers. They’re obviously not there yet, but they have an online banking platform that gives them a real chance.

Catalyst

- Increasing capital returns via continued repurchases and dividend increases. Ally's 2017 capital plan which increased the dividend and bumped up the share repurchase plan by 9% was just recently approved: https://www.bamsec.com/filing/4072917000230?cik=40729

- Auto credit recovers and the market once again thinks that auto loans are the best thing since sliced bread.

- Steady earnings improvements driven by the natural lowering of cost of funds as Ally Bank financing replaces more and more higher-cost unsecured debt.

- Finally, every financial analyst's favorite: long-term BV growth.