Description

SYF, DFS, and ALLY have common characteristics:

• Spinoffs / carve-outs from much larger companies

• Operations in competitive areas of consumer finance

• Shareholder value creation by pursuing very focused / niche strategies and cultivating good management culture

• Perpetually undemanding valuations, which have caught the attention of the VIC community (these stocks have been written up 5-10 times each)

ALLY is particularly interesting right now due to:

1. Rate-cycle dynamics (current peak rates and inverted yield curve mask earnings) 

2. Shifting from investing in competitive strength to harvesting from prior years’ investments. 

The onboarding of the new CEO and that CEO’s assessment of the business reveal clues to #2 (more below)

Given that ALLY has been written up seven times and most recently in February 2024, I will focus particularly on fleshing out uncovered topics from prior write-ups, especially management culture and how ALLY has invested in competitive strength and will now harvest from that strength. 

That said, let’s first cover how the rate cycle is currently masking ALLY’s earnings power. Miser861’s February write–up well covered this subject and called for $17 of EPS by 2026. While $17 is optimistic for me, I see a base case with EPS exceeding $10 within 2-3 years: 

Notes: 

• Adjusted tangible BV per common share strips out preferred equity, unlike how ALLY reports it. 

• Actual dividends will certainly be lower vs. my model. Rather, I’m modeling future share repurchases as dividends for model simplification. I think it's very likely to see much higher cash return 12 months from now due to capital build and earnings acceleration

I’m comfortable with the ramp-up in earnings because the auto portfolio is currently under-earning by 2.4% due to: 

• Auto loans are issued at fixed rates for 6-year terms. In 2019 - 2021, 6-year treasury yields were between 0.2% and 1.4%, and grew to >4% in September 2022 (where they’ve been ever since). Loans issued in 2019 - 2022 will roll off and be replaced in 2025 - 2028

• Yield curve is inverted. Auto lending is based on the long end of the curve (six-year rates at 4%). Ally’s funding is based on short-duration demand deposits. As the yield curve steepens, Ally’s NIM will expand. 

The exact timing of EPS normalization will depend on the timing of the Fed’s rate cuts. However it is inevitable whether it happens in one year or four years. Either way, I think it will become quite obvious within 24 months, and the stock will double: 

What remains to justify this thesis is how this organization can earn >30% ROTE in competitive business lines. The short answer is that Ally has a “customer obsession” (CEO Rhodes’ words from the Q2 call) in two very focused niches of financial services (auto dealerships and digital deposits). They’ve made significant investments accumulated over years to serve these customers.

 I’ll expand upon this in three sections: 

1. Good culture and management

2. Investments in competitive strength in auto dealerships business

3. Investments in competitive strength in deposit gathering

In #2 and #3, I think Ally is at a lifecycle moment where difficult investments have been made, and the company will increasingly harvest benefits. 

Good culture and management:

First on Michael Rhodes, the new CEO: Rhodes is a highly demanded and respected executive, as evidenced by his recent hire to be CEO of Discover. His discussion on the Q2 call also indicates a sensible focus and vision for Ally. Rhodes spent much of the Q2 call praising Ally’s culture and competitive strength. Although it’s not uncommon for CEOs to exaggerate their company’s strength, this is a different situation as Rhodes has only just arrived, and his praise sets high expectations for where he should take Ally from here. 

Specific comments from Rhodes highlighting Ally’s culture: “Before joining Ally… I heard a lot about the culture, and that was a key factor in my decision to join. I learned quickly that everything I've heard with the culture was true. The opportunity to lead Ally and do my part to nurture our culture brings me immense pride. I'm convinced that one of the many things that truly sets Ally apart is our extraordinary purpose-driven culture centered around our lead core values and our do-it-right approach to serve customers, communities, and employees. Our culture isn't just a buzzword.”

On management pay, Ally has good incentive alignment:

• Managers and executive officers own over 2M shares (not including unvested stock units), or ~$45M worth of stock

• Chairman of the board Franklin Hobbs earns ~$0.4M in total compensation, 60% of which is payable in stock. Furthermore, his current stock holdings is worth >$6M. Between the stock-based compensation and his holdings, his wealth is far more levered to how the stock does than to his job security

• CEO Michael Rhodes, having just joined earlier this year, doesn’t own shares, but within three years (if he hits incentive goals based on TSR and ROTE), he’ll own >$20M in stock. Moreover, ~70% of his total compensation for the coming three years is in stock, and >90% of his total comp is based on incentive targets tied to TSR and ROTE. His certain cash comp is $1.0M annual base salary plus $0.9M sign-on bonus

Investments in competitive strength in auto dealerships business:

Both of Ally’s key businesses require robust systems and excellent service, which can only be accomplished through years of cost and effort. As Rhodes said on the conference call, “we deliver a differentiated value proposition as both high tech and high touch.” 

In the auto dealership business, partner dealerships increased from 16K → 22K over the past 10 years through delivering great service and caring for dealers’ needs. On the systems side, Ally focuses both on the end customer experience (easy payment technology) and the dealerships’ needs (fast automated approval process, alternative financing suggestions if Ally turns a loan down, etc.). The dealership relationships have also opened emerging and fast-growing business lines including dealership corporate financing and niche insurance products. 

Due to this playbook, Ally has grown auto loan applications by 4.4% CAGR for ten years, ~2% higher than the industry.

Two more comments from Rhodes are revealing: 

• “The technology and human capital investments required to win in prime auto are significant. What this team has built is unique and has driven a remarkable transformation during our time as a publicly traded company.”

• “As an outsider, I admired Ally's auto business. When I got here, I realized it's even stronger than I appreciated.”

Investments in competitive strength in online deposit gathering:

Similar to the dealership-linked businesses, success comes down to great systems and excellent customer service. 

Again, Rhodes is quotable: “Everyone wants to build a digital bank, and this team did better than anyone… with leading customer service, consumer-friendly product offerings, including no overdraft fees, and a frictionless all-digital user experience.”

I am an Ally customer (checking account), and the experience has been much better than as a checking account customer with Bank of America. The fees are lower. It’s much easier to speak to a representative (24-7), and the online tools are far more usable.

In today’s environment with short-term rates at ~5.3%, Ally’s deposit portfolio is costing 4.2% on $152B, suggesting it’s worth ~$1.6B per year in lower interest paid (before cost of operating the business). This is mostly a fixed-cost business (due to the systems required), so as it grows, it will be worth more.

Conclusion: where does Ally go from here? 

After Rhodes spent the Q2 prepared remarks praising what Ally has built, analysts gave him two chances to say how he’ll change the strategy and invest in new areas. Instead, he was clear that his focus is on executing the already developing plan: 

• “I am incredibly fortunate to walk into a situation with a strong several years ahead of us, and I believe we are uniquely positioned in our industry with a very attractive earnings ramp. And so it's very important to me that we execute.”

• And further: “so you can imagine that you want to double down on where you have a real reason to win. And so you look at that, and I'm just very pleased with where we are.

• And further: “the best use of capital right now is really the things that we do very well and have defensible reasons to win.”

Nothing could be clearer. That’s not to say Ally isn’t pursuing growth, but that growth will leverage already-developed strengths, such as offering adjacent products to the 22K dealers they already work with.   

Meanwhile the biggest area of earnings growth will come from waiting for rates to normalize.

Catalyst

Earnings growth, both due to rates normalizing and executing the gameplan as articulated by CEO Rhodes