Description

Solid companies within the banking/financial services sector have been perpetually undervalued due to continued recency bias associated with the 2007/2008 financial crisis - any emerging market risk seems to reinforce these valuations.  Many banks trade at mid/high single digit earnings which generally do not reflect a lower discount rate deserved by stringent capital and liquidity regulatory requirements implemented subsequent to the crisis.  Ironically, a recession may be the catalyst needed for high quality banks to receive the multiple they deserve. 

Ally Financial is an easy to understand business:  the company lends/insures the new/used auto industry which it funds with low cost sticky deposits.  Ally trades at 1x tangible book value with management guiding to 16-18% normalized ROTCE implying a mid-single digit earnings multiple.  Although Ally Financial has overearned in recent quarters (mid 20% ROTCE), management has incorporated a 30% point-to-point reduction in used vehicle values from the end of 2021 to 2023 in its normalized guidance.  ~90% of ALLY's auto book is to Prime credit -- and even in a scenario as bad as the Federal Reserve Severely Adverse Stress Scenario (worse than '08), ALLY's TBV would come down to $27.6 per share (which means you would be paying 1.2x today for a company that would due mid teens ROTCE going forward) implying significant downside protection. 

Ally is a cannibal - management has repurchased 33% of shares outstanding since 2016.   11% of the current market cap has been repurchased YTD.  Purchases above book have the effect of reducing book value per share (even if accretive to intrinsic value).  Recent significant buybacks above reported book coupled with MTM noise on its AFS book have artificially suppressed tangible book value per share.  These repurchases will likely drive ROTCE above managements guidance issued at higher TBVps values.   Berkshire Hathaway owns 10% of the company and Punch Card Management (Norbert Lou) owns ALLY as a core position.  Buffett once said in an annual meeting that in banks he is looking for a company "characterized by very little risk on the asset side and very cheap money on the deposit side" which is the general thesis here.  

Ally has a low-cost advantage which allows it to implement a "scaled economies shared" model (Nick Sleep) by taking its low cost model and providing depositors higher interest rates than competing banks.   Ally is an online-only bank which provides substantial cost savings relative to traditional brick/mortar banks - for comparison, Ally's efficiency ratio in the mid 40%'s is substantially lower than the various large bulge banks   (upper 50%s).   Combined with a strong financial value proposition, Ally consistently earns high NPS ratings and has grown deposits for 50+ quarters in a row.  As of 2022Q2 , Ally has $140bn in deposits (2.5mm customers) which represents 85% of its funding sources.  This is up from 64% in the 2nd quarter of 2018 as management has worked hard to replace secured & FHLB debt with retail deposits - this has structurally enhanced the balance sheet which has and will provide sustained improvement in net interest margins.  In the short term, the rapid increase in rates will pressure margins as deposits initially reprice faster than assets - but over the medium term Ally continues to see a strong NIM in the upper 3%.

Ally is the #1 prime auto dealer in the US with >22k dealer relationships.  The primary asset on Ally's balance sheet is Finance Receivables and Loans (~70% of assets), of which 65% relates to $82bn of Consumer Auto Loans (the remaining 35% loans primarily relate to consumer mortgage & commercial auto).  Given the concentration of risk aligned to Consumer Auto, the market is clearly focused on a normalization of the recent boom in auto prices resulting in lower future recovery rates.  It's important to note that although increased used car prices have benefitted Ally by reducing loss severity, the primary driver of used car prices has been supply chain (lack of new car inventory) - lower inventory has reduced Ally's commercial assets by approximately $10 billion and has increased retail trade-in activity, both of which are a headwind to net interest income - this should reverse as car prices normalize (in addition to benefits from repricing the asset book to higher rates).   As of Q2 2022, Ally has a coverage ratio of 3.5% on it's Consumer Auto loans (i.e. has already booked an allowance for loan losses of 3.5% of the portfolio) which can be contrasted to mid 6% of losses implied within the Federal Reserve's Severely Adverse Stress Test.   For perspective, net credit losses for ALLY consumer auto in the financial crisis ('07-'08) GFC peaked at 2.3% of the book - so they are already reserving for more than a 2008 event.  Only 10% of the book is nonprime credit.  The simple reality is that a car is needed to get to work, and is one of the first payments you make in a recessionary environment.  

Base case valuation - Ally trades at single digits earnings and should return mid teens cagr for the sustainable future.  You are buying the company at ~1x its tangible book value ($32.16 as of 2022Q2).   Management is guiding to normalized high teens ROTCE which includes modeling for a 30% point-to-point reduction in used vehicle values from the end of 2021 to 2023.   Given recent buybacks which have taken down reported TBV per share (due to the buybacks being above book - but presumably below intrinsic value), ROTCE may be higher than when guidance was issued. 

Downside risk valuation -Per the 12/31/2021 Federal Reserve Severely Adverse Scenario (worst than the financial crisis), Ally would suffer $1.9bn of pretax net income (arising from $7.8bn in loan losses).  After tax this number is closer to $1.4bn of losses which amounts to about $4.5 per share in losses.   This would take tangible book per share down to $27.6 per share (-17%) which would then be subject to continue growth as the company would continue to be above required capital ratios.  

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Consistent solid fundamental earnings through the cycle.  Survival during the current/upcoming recession.