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Ally Investment Write Up

Ally is the largest online only bank in the U.S. and one of the largest banks in the country with $183bn in assets. The market currently underappreciates Ally’s ability to grow earnings over the next few years, as the stock trades at 9x 2021 consensus EPS and 7.5x 2022 consensus EPS. Personal and Commercial Auto lending and Auto related insurance, account for 90% of Ally's earnings, and auto market fundamentals remain strong with high trade in values for used vehicles and robust auto loan demand. Additionally, Ally continues to increase its dealer relationships, which has led to a substantial increase in auto loan appliations over time. Furthermore, Ally has expanded beyond its dominant position in personal and commercial auto lending into other asset classes including mortgages, personal loans, and commercial loans, as well as into wealth management through its online banking platform.

Ally has doubled its online banking customers over the past four years to 2.2 million, and the percentage of digital customers with multiple products has materially increased during that time frame. In addition to strong loan growth, management has guided to a higher Net Interest Margin (NIM), driven by lower funding costs as high cost secured and unsecured debt is replaced with low-cost deposits. Finally, credit losses should normalize as the economy recovers with strong nominal GDP forecast for 2021/2022. Additionally, Ally plans to ramp up share repurchases, with $1.6bn of repurchases authorized for 2021 (11% of Ally’s market cap).

As a result, Ally should experience meaningful EPS growth over the next few years, and the company has guided to ROTCE expansion from 9% in 2020 to 12+% in 2021 and 15% in 2022-2023. Given that Ally's auto segment represents 90+% of consolidated earnings, the greatest risk to my thesis is weaker auto sector fundamentals, given the cyclicality of end market demand. However, auto sector fundamentals remain strong and are well supported by the macroeconomic back drop. From a valuation perspective, ALLY is cheap trading at 9.2x 21 EPS and 7.6x 22 EPS, and I believe is materially undervalued given my expectation for strong EPS growth over the next few years.. 

Description: Ally was founded in 1919 by General Motors as General Motors Acceptance Corp. (GMAC), changed its name to Ally in 2010, and IPO’d in 2014. Ally has transformed itself over the past decade, becoming the largest online only bank and expanding into additional product lines like mortgages, corporate finance loans, and wealth management. In addition to being the largest online only U.S. bank, Ally is also the largest auto lender in the country, and a top 25 bank by assets. 

Ally operates three business segments: Dealer Financial Services, Mortgage Finance, and Corporate Finance. Dealer Financial Services accounts for 91% of consolidated earnings and provides a range of financial services to auto dealerships and their customers including loans, leases, and insurance products. Corporate Finance accounts for 6% of consolidated earnings and primarily provides senior secured and asset-based loans to U.S.-based middle-market companies owned by private equity sponsors, and loans to asset managers who provide leveraged loans. Finally, Mortgage Finance contributes 3% of earnings and provides a variety of mortgage products to strong creditworthy borrowers. Ally also offers wealth management and personal loans through its Corporate & Other segment. 

Ally’s online bank offers traditional banking products such as checking accounts, savings accounts, and CD’s. Additionally, Ally’s online platform offers Ally Home (home loans, mortgage refinance), Ally Invest (managed portfolios and self-directed trading) and Ally Lending (personal loans). Ally has more than 8.8mn customers which includes more than 4 million Auto customers, 2.6 million insurance customers, and 2.2 million deposit customers.

As an online only bank, Ally has a lower cost structure than its peers who have large bank branch networks. Specifically, Ally has averaged a 47% adjusted efficiency ratio (excluding insurance operations) over the past 5 years compared to a 55-60% average for peers. While investors were initially skeptical of the viability of an online only bank, Ally has proved this model works. Ally has maintained industry leading client retention of 96% as of 4Q20. To retain customers, ALLY pays a higher rate on deposits relative to its peers, as well as through other digital offerings including low-fee deposit accounts with no monthly maintenance fees or minimum balance requirements, ATM fee refunds, and customers can use Zelle to send and receive money from others. Furthermore, Ally has also won numerous consumer awards for its online bank.

Expected EPS Growth underappreciated 

ALLY should grow its EPS at a high rate over the next few years driven by strong loan growth, NIM expansion, lower credit costs, substantial share repurchases, and positive operating leverage. Furthermore, Ally has a demonstrated track record of growing EPS at a high rate since becoming a public company in 2014.

EPS Growth

During Ally’s 4Q20 earnings presentation, the company laid out a plan to improve its ROTCE from 9.1% in 2020 to 12+% in 2021 and 15% in 2022/2023. For context, Ally generated ROTCE’s in the 11-12% range in 2018 and 2019, but only 9.1% in 2020 due to negative impacts from COVID-19. Ally generated strong ROTCE’s in the 2H20, with a 15.2% ROTCE in 3Q20 and 18.7% in 4Q20, as credit conditions normalized and Ally’s NIM increased. Normalized credit costs and a higher NIM will be key drivers for EPS going forward as described below. 

ROTCE

Loan growth from Auto and other loan categories

Dealer financial services (auto loans/dealer and consumer insurance) contributes 90% of ALLY’s earnings. I expect low single digit loan and lease growth, with retail auto loans growing 2%/yr. and commercial auto loans growing at a high rate in 2022 and 2023 driven by solid auto sector fundamentals described below and Ally’s increase in dealer relationships. Ally’s dealer relationships have increased from 12,400 in 2010 to 18,700 in 2020. Coincidingly, Ally’s consumer applications have increased from 3.7 million in 2010 to 12.1 million in 2020.

Commercial auto loan growth was extremely weak in 2020 driven by lower outstanding floorplan assets as dealers held lower inventpry as a result of lower automotive production levels. Commercial auto loans have also been negatively impacted by a reduced number of GM dealer relationships, which historically had been a key source of commercial loans. 2021 will also likely be a weak year for commercial auto loans, but I expect commercial auto loans to increase in 2022/2023 as dealer inventories normalize.

Loan growth

As mentioned auto sector fundamentals are strong with high used car prices, a strong U.S. economy, and strong demand for auto loans. Low new-car inventory and greater affordability due to low interest rates have driven demand for used cars. On its 4Q20 earnings call, management noted that it expects used car prices to increase by 5% in 2021. Used car loans are a key driver for Ally, making up 55% of Ally’s volumes in 2020, up from 36% in 2015. Shown below you can see the massive increase in the Manheim Used Vehicle Index in late 2020, which has stabilized at a high level in early 2021.

Manheim

Source: https://publish.manheim.com/content/dam/consulting/ManheimUsedVehicleValueIndex-LineGraph.png

In terms of new car sales, after dropping precipitously in March and April, car sales rebounded in late 2020, following massive fiscal and monetary stimulus. While new car sales are below their pre-pandemic levels, sales are expected to increase in 2021 and beyond.

New car sales
Source: https://fred.stlouisfed.org/series/ALTSALES

Finally, auto sector fundamentals are supported by the overall macroeconomic environment. Outside of recessions, commercial and personal auto demand is typically stable to improving. Auto credit metrics tend to be strong relative to other asset classes even for weaker borrowers, and consumers will pay their car loan prior to other debt, as for many people their car is their primary means of transportation as well as concerns that a vehicle can be repossessed easily. The Federal Reserve projects Real GDP to grow at 4.2% in 2021 and 3.2% in 2022. Additionally, consumer balance sheets are in excellent shape as evidenced by record wealth levels, a high savings rate, strong growth in personal income, and high levels of debt affordability driven by low interest rates.

Also housed within Ally’s Dealer Financial Services segment is Ally’s insurance operations which provide warranties for consumers as well as property & casualty insurance, and inventory insurance to auto dealerships. Ally’s insurance business has a strong underwriting track record with a 95.2% Combined Ratio (CR) over the past 6 years compared to roughly 100% for the P&C industry. Insurance has generated revenue of $1.25bn/yr. over the past 3 years (20% of total revenue) and operating income of $226mn/yr. (12% of operating income) over that time frame, and I expect revenue and earnings to grow in line with Ally's auto loan growth going forward. Ally’s insurance business provides another means through which Ally can strengthen its relationship with dealerships and further its competitive advantage within auto lending. Ally has a 78% insurance product penetration rate among dealers it provides wholesale financing to.

Non-Auto EPS growth 

Outside of its Dealer Financial Services business, Ally’s Corporate Finance business accounts for roughly 6% of consolidated earnings, and has grown meaningfully over the past few years, from 2% of loans outstanding in 2015 to 5% in 2020. As shown below C&I loans have grown at an average of 24%/yr. over the past six years. While that growth rate should come down, I expect C&I loans to grow at a modestly higher rate than the rest of Ally’s loan portfolio.

CI loan growth

Ally’s commercial portfolio is well diversified across sectors as shown in the chart below. Furthermore, asset quality remains benign in this segment, with NCO’s at 0.16% for 2020, with a very light level of reserves at 540% of NCO’s for the year.

CI sectors

In terms of Ally’s other consumer businesses, Ally’s online bank is a key source of loan growth, by increasing its deposit base and cross-selling other products including mortgages, investments, and personal loans. From 2016-2020 retail deposit customers more than doubled from 1.1mn to 2.25mn, while multi-product (Ally Invest and Ally Home) customers grew from 0% to 8% in that time frame and increased 51% y/y in 4Q20. Millennials and younger comprise the largest cohort of new customers, accounting for 67% of new customers in the 4th quarter per management. Ally also acquired Health Credit Services in 2019 to provide medical loans, which since has been rebranded as Ally Lending and also provides personal loans for home improvement, and auto servicing. Currently Ally Lending only has $407mn of loans outstanding, accounting for 0.3% of total loans for Ally. 

Ally’s Mortgage Finance business contributes roughly 3% of overall earnings and makes up a similar percentage of loans outstanding. While the absolute level of loans outstanding has not grown much in this business due to substantial customer refinancing in 2019 and 2020, direct to consumer originations have increased by 300% in 2019 $2.7bn, and 74% in 2020 to $4.7bn. Ally has taken a prudent underwriting approach in its mortgage business. Ally’s mortgage business is extremely high quality, with an average FICO of 776, and an average LTV of 60.1%.

Ally has also demonstrated strong growth in its Ally Invest, which grew its assets 70% y/y to $13.4bn, with a 17% increase in the number of customers to 406K and assets are up from $5.8bn in 2018. 

Retail deposit customers

NIM Expansion

Ally has generated extremely stable NIM’s from 2015-2020 of roughly 2.6%. However, management has guided to a 3% NIM in 2021 and low-mid 3% range in 2022-2023 driven primarily by lower funding costs, as well as higher portfolio yields. While this represents a higher NIM than Ally has generated historically, the company put up a 2.92% NIM in 4Q20, and management expects these trends to continue going forward.

NIM

 

On the funding side, Ally has increased their percent of deposits from 44% to 85% since 2014, while unsecured debt declined from 17% to 7%, and secured debt declined from 31% to 3%. As a result, ALLY’s funding cost has declined from 2.14% in 2014 to 1.88% in 2020. I expect Ally to continue reducing both unsecured and secured debt to bring down its funding costs further. More importantly, Ally can replace higher cost maturing CD’s with lower cost CD’s, due to the decline in interest rates. Specifically, Ally’s average retail portfolio interest expense declined from 2.02% in 4Q19 to 0.97% in 4Q20. Going forward I expect Ally's liabilities to reprice at a lower level, relative to the yield on Ally's investment portfolio. 

Funding Profile

In terms of Ally’s asset base, ALLY’s overall portfolio yield has averaged 4.6% over the past 6 years, although has fluctuated with interest rates from a low of 4.23% in 2015 to a high of 5.11% in 2019. Ally generates a higher portfolio yield than most regional bank peers due to its focus on auto loans and used car loans. Ally increased its retail auto yield from 5.26% in 2014 to 6.77% in 2020, as used car loans increased from 36% of originations in 2014 to 51% in 2020. Additionally, Ally has an elevated cash balance of $15.6bn as of 4Q20, compared to $3.6bn in 4Q19. Deploying that excess cash at a 3% rate (lower than Ally’s overall portfolio yield), would increase Ally’s NIM by 20bps, a significant boost in this environment.

Declining credit costs

Normalized credit losses are another key EPS growth driver. Ally increased provisions from $1.0bn in 2019 to $1.4bn in 2020 driven by concerns around COVID-19, in-line with other U.S. banks. I expect provisions going forwad to be in a more normalized range around $1.1bn, which will increase 2021 Net Income by $231mn relative to 2020. Ally is well reserved with  reserves/loans at 2.78% as of 4Q20, well above historical averages. Ally’s credit metrics have held up well through 2020 with net charge-off’s at 0.63%, well provisioned with provisions/NCO’s at 188%, well above Ally’s historical average of 105% from 2014-2019. Provisions are also high relative to NPL’s at 216% in 2020, compared to an average of 141% from 2014-2019. As a result, Ally’s balance sheet is in strong shape and I expect provisions to decline from 2020’s elevated level going forward.

Credit Metrics

Increased share repurchases

Ally only repurchased $104mn of shares in 2020, as the Federal Reserve halted bank share repurchases in early 2020 due to COVID-19. As a result, ALLY’s capital ratios increased considerably as ALLY ended the year with a CET1 of 10.6% (+110bps y/y) well above the Fed’s requirement of 8%, and management’s target of 9%. Ally has $3.7bn of excess capital above the Fed’s 8% target, and $2.2bn of excess capital above the company’s 9% target. Ally’s board recently authorized share repurchases of $1.6bn for 2021, representing 11% of ALLY’s market cap! Ally will likely return over 100% of net income to shareholders in 2021 and I expect Ally to return 90-100% of net income to shareholders in later years, in line with other large U.S. banks.

Capital ratios

Positive operating leverage

Ally should benefit from positive operating leverage over the next few years per management. I expect Ally’s adjusted efficiency ratio (excluding insurance operations) to improve from 50.3% in 2020 to 46.4% by 2023, as comp expense declines 110bps from 20.6% to 19.5%. Furthermore, I expect other expenses (technology, corporate functions, etc.) to decline slightly from 28.9% in 2020 to 28.4% in 2023. For context, Ally’s adjusted efficiency ratio averaged 47% from 2014-2019, and increased in 2020 due to higher comp expense.

Adjusted Efficiency ratio

Risks

Auto sector cyclicality

As shown above, auto sales are highly cyclical, and Ally’s Auto segment accounts for 90+% of the company’s earnings. Specifically, Ally’s EPS declined 12% in 2020 partially due to weak auto demand, as well as higher credit coss. The biggest risk facing Ally is a sustained downturn in the sector leading to weak loan growth and higher credit costs. Most of ALLY’s peers have much greater business line diversification across consumer (auto, mortgage, credit cards, personal loans, wealth management), commercial banking and capital markets. However, ALLY is working to improve the diversification of its loan portfolio as described above, although I expect auto to contribute roughly 90% of earnings over the next few years.

Greater exposure to interest rate environment than peers

Ally generates a higher percentage of net interest income than its peers, as a result ALLY’s has greater exposure to interest rates and the steepness of the yield curve.  Larger banks typically generate 50% of their revenue from net interest income (NII) and 50% from non-interest income, while Ally’s make up is roughly 75% NII and only 25% non-interest income.

Valuation

Ally is cheap trading at 9.2x consensus 2021 EPS and 7.5X consensus 2022 EPS. At $41.64/share I believe Ally is currently 55-68% undervalued relative to my fair value assessment of $65-$70/share, based on 12-13x my 2022 EPS estimate of $5.28. Furthermore, Ally's share price could likely double in the next two years based on 2023 EPS estimate of $6.14, assuming a 13x multiple. While I don’t expect Ally to trade at a market multiple given the inherent cyclicality in auto lending, Ally's P/E multiple should expand given my expectation for strong EPS growth and improving returns on capital, as outlined above. I believe the valuation disconnect exists because of Ally’s concentration in Dealer Financial Services, and Ally's uniquqe operating model as an online only bank. Ultimately, I believe Ally’s online banking model serves as a competitive advantage due to its lower cost structure as well as the fact that digital banking is preferred by younger consumers, serving as a key growth driver through Ally Home, Ally Invest, and Ally Lending. Ally has also shown how resilient this funding model is with 96% client retention through 4Q20. Furthermore, Ally has demonstrated strong risk management and underwriting as evidenced by its strong credit metrics in 2020 despite the COVID-19 pandemic.

Financials

Ally model

Disclaimer
This article is not to be taken as financial advice and is not recommending the purchase or sale of any particular securities. This information is meant merely for informational and discussion purposes only. Please do your own research or seek out a licensed financial professional for help with personal finance and investment decisions.

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