Ally Financial: Potentially Undervalued And Benefits From Auto Segment Growth (ALLY)

Overview

I previously rated Ally Financial (NYSE:ALLY) as a buy in October 2023. It seems that my timing was ideal, as the stock has now moved up over 46% since then. The price appreciation was more severe than anticipated and happened much quicker than expected. At the time of my original analysis, the dividend yield sat at about 4.6%. After the price run, the dividend yield now sits at only 3.3% which is less enticing but on par with the sector median. Therefore, I thought that now would be a great time to revisit and reassess what the current outlook is moving forward.

As a brief overview, Ally is a digital financial services company, operating mainly in the United States and Canada. I emphasize “digital” because Ally is known as an online-only service. They have no physical locations and instead operate mostly online. They operate primarily in the segments of auto lending, insurance, mortgage lending, and corporate.

I think the biggest catalyst over 2024 will be interest rate changes, which I will discuss further below, in combination with the tightening of their finances. Therefore, I maintain my Buy rating on Ally going forward and anticipate further price appreciation over the course of the year.

Interest Rate Sensitivity

With the Fed anticipated to cut rates at some point in the mid-year, the price of ALLY may react dramatically to the upside. Taking a look at the inverse relationship below, we can see now the price of ALLY spiked when rates were at all-time lows. The price also took a dip once rates started rising and now that rates have remained unchanged, we have seen some increases in the price.

ALLY recently reported its Q4 earnings to close off its fiscal year. We can see that net financing revenue has increased substantially over the last decade, and I expect this to continue as long as we remain in a higher interest rate environment. For the full year of 2023, revenue reached $8.2B, which is a 22% increase from 2020 and represents an annual growth of about 7.4%.

Higher interest rates typically translate to increased interest income earned on loans. Since Ally’s core business consists of providing loans, I believe they are able to capitalize on this by collecting a higher amount of interest income. It’s a pretty cool cycle as I understand it because this entices more retail deposits as on the other end of the spectrum, ALLY is able to pay a higher rate on deposits.

By this, I mean the APY that they can offer on savings accounts. It seems that Ally is currently offering an APY of 4.35% on their savings account. These higher, more enticing APYs incentivize people to deposit funds. In turn, these increased level of deposits leaves ALLY with more cash on hand to lend back out for a profit. This cycle benefits all segments that ALLY operates in as well.

As previously mentioned, the price has moved quite inversely to the federal funds rate. I expect that once rates are finally cut, we are likely to see some price upside in the financial sector as a whole. Lower interest rates are likely to stimulate borrowing activity from the consumer market. Consumers and businesses will be able to borrow debt at a much cheaper cost, so this is likely to drive demand across all segments that ALLY operates within. This increased demand will likely result in higher interest income from these loans.

Increased Deposits & Financial Efficiencies

During the quarter, retail deposits increased to $14B. This is an increase of $4.6B year over year, which represents an annual increase of about 48%. Of the total deposits, 92% are FDIC insured, which gives me confidence in future stability. While this is impressive in itself, I also feel it’s important for me to mention that they had a customer retention rate of 97% for the quarter as well. As a customer of Ally, I fully understand why this is the case. Their customer service has always been extremely helpful, quick, and responsive.

To no surprise, the younger Gen Z and Millennial generations continue to make up the largest percentage of the demographic to new customer deposits. The data tells us that the younger generations prefer mobile and online banking. For instance, Millennials and Gen Z are 5x more likely to use mobile banking than their parents.

At the end of Q4, 10% of customers used multiple Ally tools or services simultaneously. The Ally app makes it really easy to view your savings or checking account while also opening a CD or Brokerage account. Their app serves as a hub for all of these components, so as Ally is able to get more customers, I am confident the number of people who use multiple services will increase.

Ally reported EPS (earnings per share) of $0.16. Total net revenue reached $2.1B, and they managed to tighten their portfolio by reducing RWA (Risk-Weighted Assets) by $4B. I say “tighten” their portfolio because this was achieved through cuts in retail auto and other unsecured sectors in order to improve the portfolio. These improvements mean they reduce the amount of capital needed to be held on hand as a buffer and free up cash for more lending. In short, more cash dedicated to lending means more profitability.

They continue to make capital improvements and implement cost savings to improve efficiency. While unfortunate that Ally laid off more than 5% of their staff back in October 2023, it also meant that they managed to achieve $80 million in annual savings. Over the last quarter, management also reported that they were able to generate $100M in capital through tax strategies.

Auto Segment Strength

Something else I’d like to highlight is that loan originations within the auto segment totaled $9.6B. This is important because this represents an increase of 10.81% over the prior year, which aligns with the direction of the average monthly car payment. The average car payment is now over $700/month, and it’s clear that Ally is taking in their fair share of this growth.

Retail auto originations yield 10.7% for Ally, and about 40% of this volume comes from people within the highest credit quality tier. Consumer auto-related applications totaled $13.8M for 2023 and of that, only 30% were approved. Ally is raking in the profits while also maintaining risk-adjusted criteria on who they approve for auto loans. 13.8M applications are the highest number of applications received since 2019. In their earnings call, the CEO stated:

Looking ahead, we see our retail auto yield continuing to expand as we originate new loans at higher yields than our current portfolio. Disciplined growth and higher yielding corporate finance and credit card loans, coupled with a continued decline in lower yielding mortgages and securities, are also a tailwind to earning asset yields. Our asset yield momentum is unique in the industry and combined with our strong deposit franchise supports our confidence in our attractive NIM trajectory. – Jeff Brown, Chief Executive Officer

Dividend & Valuation

As of the latest declared quarterly dividend of $0.30/share, the current dividend yield is 3.3%. The dividend hasn’t been raised since 2022, so I do expect a raise by the tail end of this year. ALLY can definitely support a raise with its free cash flow growth and conservative payout ratio. The current dividend payout ratio sits at a healthy 39%. ALLY also has cash from operations totaling $4.7B, which is enough to navigate through any future headwinds or economic uncertainty.

The dividend growth has been stellar despite the lack of an increase. Since 2019, the dividend has grown over 75%. We see that this growth outpaces the major banks like JPMorgan (JPM), Bank of America (BAC), and Wells Fargo (WFC).

ALLY currently has an average Wall St. price target of $40.28/share. This represents an 11% upside from the current price level. As rates are cut, I think this price target is certainly achievable. ALLY’s estimated EPS for 2024 is 3.33, and I think this is attainable when we consider their current revenue growth. Their forward revenue growth is projected at 3.4%, which sits under their 5-year average revenue growth of 6.24% but serves as a conservative estimate in a DCF (discounted cash flow) calculation.

I feel comfortable using the averages for my calculation, since these revenue averages pretty much align with management expectations as well. In their last earnings report, it was stated that expectations were for net interest margin to grow between 3.25-3.3% while other revenue grew within the range of 5-10%. Averaged out, management expects a 4% growth outlook over the next year.

Running a DCF calculation, we can determine a fair price value of $52.17/share by the end of FY2024. This means that when including the current dividend, we can expect double-digit returns over the next year if growth goes as planned and expectations are met. This potential upside equals an upside of about 43%.

Risk Profile

Ally’s debt profile remains mostly stable in outlook, with Moody’s being the only rating agency to have a negative outlook. In my opinion, however, I feel that Ally’s financial picture has improved. For example, their loan-to-deposit ratio has decreased since 2017 and currently sits at 98%. The loan-to-deposit ratio tells us that ALLY is practically using all customer deposits to fund its loan portfolio. While it is efficient from the standpoint of lending, it also can create a layer of risk in situations where liquidity is needed. For reference, the average loan to deposit ratio for US banks was 70% between April 2022 and April 2023.

While a higher loan-to-deposit ratio can potentially lead to higher profitability, it also increases risk. In this scenario, the bank becomes much more reliant on external funding. So while ALLY’s loan-to-deposit ratio is much higher than the average of other US banks, their picture has improved drastically over the last decade.

Takeaway

I believe that ALLY is still a buy despite the price increase. I think the company’s outlook looks great and the catalyst of interest rate cuts may produce a higher upside. Each segment of their business continues to show growth, especially in the auto sector. With a current dividend yield of over 3% and a conservative payout ratio, I suspect that a dividend raise is likely on the horizon. In addition, the price is still undervalued from a DCF perspective and if growth expectations are met, there is a huge double-digit upside potential.

Even though Ally doesn’t have any physical locations, their strong customer retention shows us that physical locations aren’t necessarily needed to succeed. Management has also taken control of their financial inefficiencies by actively decreasing their loan-to-deposit ratio. Therefore, I maintain my buy rating on Ally.