Description

A confluence of factors befell Ally over the last two years to knock the share price and earnings down 60% peak to trough. I believe there’s a very high probability that the fundamentals have bottomed and Ally has a strong multi-variable, multi-year earnings tailwind ahead of it. I think that looking out a few years the stock could triple, with minimal short term downside risk even in a moderate recession scenario. 

Ally’s earnings are somewhat more counter-cyclical than most other banks.  Their deposits are high beta, high cost online savings deposits with almost no low-interest operating deposits.  Their assets are fixed rate five year car loans.  Ally’s NIM compresses in a tightening cycle.  Most large banks of Ally’s size have low beta operating deposits and floating rate C&I loans, so they benefit from higher policy rates.  At a time when bank earnings generally have exploded higher, Ally’s earnings have been crushed:

Fed Funds futures, and Fed commentary, suggest that this tightening cycle is likely at or near an end, though the timing is certainly debatable.  Good progress has been made on slowing inflation and more forward looking inflation measurements are within reach of Fed targets.  Ally management also believes that NIM is nearing the trough, though Fed Funds expectations have crept higher recently.

It’s likely, but not a certainty because there are infinite possible outcomes, that if there was a recession and Fed Funds was cut to 1-2%, Ally EPS would explode higher.  In the short run, asset yields would stay close to stable and deposit cost would be cut dramatically.  Loan yields are fixed in the medium term, and both auto loans and the securities portfolio have some room to reprice higher as pre-2022 vintages originated when Fed Funds was 0% roll off.  This scenario could produce record high NIMs, in contrast to management’s more tempered 4% NIM mid-term guidance that the sell side is anchored on.  The reason being that today’s loans were originated at higher yields than at any time since Ally’s IPO.  The period from 2014-2021 was not a normal banking environment, and I doubt the next several years will look like those years given profligate fiscal policy.  Because heretofore Ally has only reaped the downside of a higher rate environment, I don’t think the market is discounting the upside of it and are underestimating the coiled spring that Ally is sitting on.

Even taking into account elevated provisions at say 2% of loans in a moderate recession, in a 2% Fed Funds scenario I think Ally could be on a $10/share EPS run-rate at the bottom of the next recession.  The main thrust of what I’m saying here is that I don’t think trough NIM and peak provisions will coincide here, unlike with most banks.

Another factor that drove the stock down and also protects the downside from here, is that Ally has taken $4 billion ($13/share) in mark to market losses on their bond portfolio.  Ally very stupidly maintained an irresponsibly high duration going into the tightening cycle.  But their loss is now our gain, as that loss either accretes back into book value through maturities, or possibly reverses rapidly in an easing cycle.  Losses on their long bonds can get worse before they get better, but real yields are about as high as they’ve been in the last 20 years.

The duration of the bond portfolio is something like 10-12 years at 12/31/23, roughly the same as it was at 12/31/21, so a 1% movement in rates would produce about a $10/share mark to market gain or loss. 

One downside to the bond losses is that Ally is currently 1% below their target capital ratios, so I don’t think they can do any buybacks for a few more quarters.

Another risk is that used car prices have been elevated since covid due to a persistent new car supply deficit.  When this condition normalizes, collateral values could fall by 20% if they return to trend.  It’s worth noting though that CPI has inflated 18% cumulatively since the end of 2019, so a return to inflation-adjusted trend might be closer to 10%.  A 1% decline in collateral values translates to a 2 bps increase in charge-offs, so a return to trend prices in one year could increase charge-offs by 30-50 bps in that year.  This is very material but not devastating as Ally would easily still be profitable in that year.  Even at current low NIMs, such a delta in charge-offs could be the difference between $3 EPS and $2 EPS.

Nominal used vehicle price index:

CPI-adjusted used vehicle price index:

What do the out-years look like?  Plugging Fed Funds futures into Ally’s P&L looks like this today:

               2024  2025    2026

NIM         3.6%  4.45%  4.9%

NII          6.7     8.6      9.8

Total rev  8.7   10.7       12

Opex       5.0    5.1       5.2

Provisions 2.1   1.5       1.7

EBT         1.6    4.0       5.0

EPS         4.00   12        17

So pre-tax could triple, if you believe Fed Funds futures.  At $36 Ally trades at 14x 2023 EPS, 9x 2024 EPS and 1x 12/31/23 tangible book.  Assuming the same valuation on 2026 earnings, the stock could triple.  Additionally, once capital is built back to target levels, I think that the company can buy back at least 30% of the shares over the next three years.

Catalyst

Rate cuts