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: