Window Shopping Part 1: Ally Financial

Bear markets can be an excellent time to find new ideas and grow your circle of competence (if only to distract yourself from paper losses in your brokerage account)

Welcome to the first edition of Window Shopping, a series where I’m going to take advantage of recent market tumult to scan for bargains. On the docket today we have Ally Financial, but writeups upcoming will include Palantir (PLTR) and Open Lending (LPRO).

Now, I’m a big car guy and since I was a kid, window shopping at dealerships for my future Porsche was always so exciting. And as I see many stocks 50%+ off all time highs, I can’t help but get that same level of excitement to buy. Since I’m a contrarian (often to a fault), when I perceive a stock to be hated I often let me inclination for impatience to get the best of me and I buy before I should. It’s happened with previous writeups Vontier and Cinemark and it’s an investing skill I’m trying to refine during this bear market. The best value investors buy after their peers.

So come along with me as we look for ideas to perhaps one day drive off the lot when the time is right.

But First: The Market Backdrop

Wednesday 9/21/22, was FOMC day where Jerome Powell surprised few with another 75 basis point rate hike and stuck to the hike ‘til it hurts mantra dug into at Jackson Hole. The Fed still doesn’t think they’ve hiked enough and I’m not of the economic intellect to argue either way, but what I can formulate an opinion on is how much cheaper on a multiples basis equities as a whole have become as the Federal Reserve’s hikes and very visible hand work their way through public markets.

Below are a few charts from Yardeni research illustrating forward P/E multiples for various S&P indices. It should come as no surprises that as rates have gone up, so too have discount rates and multiples have come down in the opposite direction. Risk assets should get cheaper when capital becomes more constrained. It is important to understand, however, that the Federal Reserve does not make policies based on market multiples and will only blink if earnings come down in a meaningful way across an entire index. By September 2022, the S&P 500 Index has fallen ~22% YTD which has been completely due to multiple compression as earnings have been effectively flat. Given this 22% drop was only for deflating the stimulus balloon, and poor housing data is only starting to come out and shed light on a weakening economic backdrop, it should be a base case expectation for earnings to compress for the S&P perhaps as soon as Q3 reports but surely into 2023. To stoke the bearish flames some more, 40 year high inflation and an unprecedented slide in Treasuries would logically coincide with below average SPX multiples due to atypical risk. Risk assets have been more expensive than the historical average of ~15x - 16x for close to three years now (peaked at 24x) and the SPX has only now returned to the average neighborhood. Since we’re only now at average prices, even with many stocks massively off highs, we cannot call the market any cheaper than it typically is on a long-term basis. And since it isn’t any cheaper on a long-term basis despite 40 year high inflation, war in Europe, food crises, energy crises and an unprecedented YTD performance in U.S. Treasuries, I don’t think there is logical backing to suggest a historically average market multiple is a safe place for this slugfest to settle down at.

On the bright side, looking at the charts below of Russell 2000 small cap multiples, I interpret these valuations as a bit more downtrodden than historical average. These charts could be suggesting that small caps are closer to the bottom than large caps or it could mean the index is heading to significantly cheaper than historical average levels — either of these cases should excite the long term value investor in my opinion. Depending on your strategy, you will utilize this relative cheapness in different ways but it’s important to understand the price of the overall market whether you’re looking to allocate capital on a short or long term basis.

Source: Yardeni

My past writeups on Compounding Numisma have been a reflection of my investing strategy of finding multi year value opportunities in the <$10 billion enterprise value landscape. As an investment banker by day and value investor by night, I only have so much time to come up with new ideas and am simply unable to time the market given the compliance restrictions the bank puts on my account. These restrictions are fair but have forced my investment strategy to cater to more of a long term approach of finding multi year value investments and I think with each day the market drops another percent and liquidity dries up, the window shopping market for us value investors grows. My strategy in recent months was to take several winners off the table during the June - August bounce but I have begun to dollar cost average long term holdings during the recent downdraft (perhaps to a fault depending on how much we have to fall — patience…)

As an anecdote, given my growing excitement for stocks getting cheaper and cheaper, I am living off a fraction of my salary these days and am piling most of it into Schwab to bolster liquidity that I hope to deploy in the right opportunities at the right time. The wise words of Rich Excell “Bear markets don’t end until all capital is destroyed” ring loudly in the back of my mind as I try to control my impatience and wait to buy more Vontier as “cheap” gets redefined from $22 a share to $18 a share to surely <$16 a share eventually… Capital preservation and backstage diligence should be the mantra to stay safe.

So, to keep me distracted, I have been carving through 10-Ks during lulls in the office and on weekends. Don’t worry, I’ve gotten my real work done — can’t afford to get canned during a recession — but it hasn’t stopped me from digging into various names. In this series we’re gonna rip through the key points quickly, so buckle up.

Ally Financial:

The largest prime auto lender in the United States and one of Warren Buffett’s recent bets, I think Ally Financial is a prudent capital allocator positioned well to capitalize on an auto sales volume recovery when it comes. Formerly the captive finance company of General Motors and Stellantis, Ally is a financial services company that mainly provides loan services to borrowers with FICO credit scores above 682. Albeit predominantly auto, Ally also has a mortgage and insurance business and generates additional interest revenues from non-core investments such as bonds.

Ally’s main business line is Dealer Financial Services which is composed of Automotive Finance and Insurance segments. Ally’s main customers are automotive dealerships of which the Company has 14,800 dealer relationships. Dealerships utilize Ally for facilitating the sale or lease of a car. In instances where a customer doesn’t pay for a car purchase in cash, dealerships will work with one of a multitude of lending institutions that will provide the financing for auto sales. As an auto lender, Ally works with dealerships (and, at times, directly with customers) and competes with other auto lenders such as Wells Fargo, JP Morgan, Capital One, community banks and credit unions that may also have lending relationships with dealerships. Ally’s main business is purchasing loans or operating lease agreements from dealerships when a customer buys or leases a vehicle from said dealer. Ally acquires these contracts from dealerships, effectively providing the cash for the loan. Peer competition for loan origination comes down to offering more favorable terms than peers or by utilizing market strength to establish long standing relationships with dealerships which leads to more consistent volume. Therefore, Ally’s loan portfolio is referred to as indirect automotive lending because the Company will purchase loans on a veritable secondary loan market from dealerships and work with the borrowers after the time of sale to ensure repayment.

Ally generates most of its revenue through interest income from and the subsequent repayment of auto loans as well as rental payments on operating lease contracts. Ally’s cash flow statement is integral to understanding how the business operates as it illustrates the “capital intensity” of the business. The main cash outflows for Ally are classified as Purchases of Operating Lease Assets, Originations of Finance Receivables and Loans Held for Investment and Purchases of Available-for-Sale Securities and are accounted for in the “investing” cash outflows section of the CFS but should really be thought of as operational cash outflows since these investments are core to the daily business operations. Ally’s investments in loans and leases represent the direct acquisition of assets which takes the other side of the borrower’s liability. The business’ operations are driven by acquiring loans that will result in repayment from the buyer and it is obviously Ally’s goal to acquire high quality loans which will dependably be repaid. In the case of the leases, Ally acquires not only the future cash flows of the asset — which are the lease payments from the lessor — but Ally also effectively acquires ownership of the car itself which exposes the business to fluctuations in auto prices. Exposure to auto prices is accounted for in the net book value of a lease asset on the balance sheet as after a lease’s terms are concluded, Ally will go back to the automotive market and sell the vehicle, presumably at a price around the book value — hopefully. In a perfect world, Ally sells the vehicle back to the dealer for more than the Company paid but this is rarely the case. To round out the understanding of leases, Ally will depreciate the asset’s carrying value by the assumed annual price depreciation of the vehicle itself, effectively marking to market the price of the car.

For example, if Ally acquires an operating lease for a $30,000 car, Ally will effectively pay the dealership $30,000 for the car and lease the vehicle to the lessor at an illustrative monthly payment of $500. After a year, the value of the vehicle has now depreciated to $25,000 so Ally will book depreciation expense (the only time vehicle depreciation and accounting depreciation align) and the carrying value of this operating lease asset is reduced to $25,000. In 2021 and 2022, given crazy market conditions, the price of the vehicle in this example very well may have stayed at 30,000 — causing the carrying value to stay high and depreciation expense to be low. When the price of the vehicle is rapidly falling, this represents an issue for Ally. Even if we assume the prices are not falling due to economic deterioration and the lessor can still afford the lease payment, at the end of the lease terms, Ally may face a situation where the Company bought a leased car for $30,000, received a ~6% annual yield (consistent with portfolio) which would represent $7,200 of cash flows for a 4 year lease, but at the end turned around and sold the vehicle for $20,000 making it a rather unprofitable lease as a whole. With the stock currently trading for 4.5x LTM net income, this issue is one of several factors contributing to the current cheapness in the stock.

Below is a condensed version of Ally’s historical balance sheet. Highlighted in yellow are the loan and lease assets I have discussed and highlighted in green are allowances for loan losses which account for instances of unlikely repayment and highlighted in orange are Total Deposits and Long-term debt which are the main ways Ally can fund its asset investments. Note that there are dozens of other balance sheet line items, many of which I have hidden for viewing ease as the highlights only represent a portion of the overall business but are impactful for the investment thesis that I am building up to explaining.

Prudent while Capital Intensive

Ally’s business can be rather capital intensive during booms as the Company tries to originate as many safe loans as possible to drive revenue and this capital intensity is high due to times of higher sales volumes or higher individual loan values. In 2021 and 2022 vehicle prices increased dramatically while sales volumes were below historically normal levels. This was due to the massive supply / demand imbalance due to government stimulus that many wanted to spend on cars, but a paucity of vehicles on dealership lots made this difficult. The dramatic price increase showed up in the carrying value of Ally’s loan and lease portfolios in FY2021. However, note how the loan balance remains below 2019 levels in 2021 as Ally’s conservatism and simply lower volumes in the market resulted in fewer originations. The loan balance was also under pressure since a significant portion of Ally’s borrowers used stimulus dollars to pay off car loans early which left Ally with significant excess cash that needed to be reinvested (see the $15 billion of cash in FY2020 and compare it with every other year). In the LTM period before June 2022, originations were higher across the prime market as business conditions improved and Ally felt conditions were safe to increase its loan portfolio and the Company did so without stretching its credit exposure. Regarding operating leases, remember how when Ally acquires an operating lease the Company effectively acquires the car as well. The inflated car prices show up in the Operating Lease Book Value which increased from $8.9 billion in 2020 to $10.0 billion in 2021. But note the reduction of the operating lease balance in 2022 as Ally has taken a more conservative approach, deciding to reduce its lease exposure given the extreme vehicle price increases.

To further demonstrate Ally’s prudent accounting, see below for a breakdown of Ally and Wells Fargo’s allowance for loan losses over time. Both companies increased allowances dramatically at the onset of the COVID-19 crisis but Wells Fargo realized benefits to its earnings by rolling off ~1/3 of these allowances over the next 14 months which became accretive for earnings. Ally on the other hand, has kept these allowances flat since the COVID increase, not realizing profit accretion, running a slightly less efficient balance sheet for the sake of conservatism and remaining prepared for loan delinquencies in case they came (they surely will begin showing up shortly amidst economic deterioration).

I could not find auto-specific allowances for Wells Fargo so the figures below take into account the entire unwieldy business, but the point stressed above remains.

Deposits as a Driver

All banks aim to grow by using the the cheapest form of capital available to them: deposits. Ally has been able to grow deposits at 12% and 8.5% 7 year and 5 year CAGRs, respectively which is very impressive. More deposits on the balance sheet means banks have more capital for making investments to grow the firm, in the case of Ally, that means buying car loans and leases. Below we see where Ally stacks up in terms of deposit growth against other large auto lending peers.

After 2008 when Ally was emerging from bankruptcy and was saddled with debt, the Company had a multi year focus of growing deposits and deleveraging. Over a number of years, equity holders earned meager returns as significant amounts of free cash flow was allocated to deleveraging as the precarious balance sheet gradually trimmed the fat. Over time, Ally has reduced its proportion of debt financing and grown the mixture of deposits and cash. During slowdowns — like during the start of 2020 — Ally tends to increase allowance for loan losses as credit deteriorates while also slowing originations which conserves cash and keeps a lid on risk. As Ally’s loan originations were lower in 2020 and stimulus dollars allowed for early repayment, the Company’s cash balance increased substantially to $15 billion. The increase in cash was a helpful financing source and it allowed Ally to pay off a third of its remaining debt.

Since deposits represent customers’ money that they have the right to withdraw whenever they please, Ally or any bank for that matter cannot grow its assets too far beyond its deposits as solvency becomes an issue. In the case of Ally, if I were a depositor, I wouldn’t be too happy if the bank said I couldn’t withdraw my paycheck because they just had to lease a new Ford Escape because the yield was just too good to pass up — growth in assets has to grow in lockstep with a growth in deposits. The below chart incorporates operating leases as loans since they are funded by deposits. A “safe” loan / deposit is ~80-90% as it represents what percent of client deposits have been used to fund loans. If more than 100% of deposits have been used to fund investments like loans and leases, Ally could be overextending its investments and may need to tap its cash or debt or even sell investments to redistribute capital to depositors when they ask for it. Since 2020, Ally’s ratio has hovered around 90%, creeping up to a very efficient but borderline precarious 97.5% in 2022. This 97.5% should indicate to us that if Ally is to grow earnings through investments in assets, the Company will need to continue growing its deposits which is very possible but will come at the expense of higher interest rates paid to depositors. As the talk of interest rates climbing gains national headlines, the general U.S. population will realize deposits don’t go up when the Fed funds rate goes up which may cause many to impatiently switch to banks with a steadfast focus on growing deposits (which is really only done through higher rates) which could set off significant competition amongst banks which could only mean one thing: Higher rates on deposits, lower net interest income margins.

Capital Allocation Nation

When the originations market began to bounce back as the economy recovered from the COVID shock, Ally returned to the market to rebuild its loan portfolio after being met with a significant influx of cash and a smaller loan book. Partially due to slower sales volumes which led to fewer investment opportunities for Ally, Ally decided to dedicate a significant portion of the excess cash on the balance sheet and incoming free cash flow generated from operations to repurchase stock. Ally has repurchased a LOT of stock in the last 6 quarters and this has been made possible in part due to the effort to deleverage. As I alluded to before, Ally used to be highly leveraged, funding most of its operational investments with long term debt.

Recall from above how deposits have grown rapidly in recent years. On the flip side, look below at how the Company has reduced its long term debt balance…

…which has allowed Ally to allocate more free cash flow to equity holders through share repurchases as the balance sheet was shored up. Since buybacks became the predominant capital allocation strategy in 2016, Ally has wiped out ~6% of its float each year on average while net income has grown at a 16% CAGR since 2016.

Additionally, when analyzing FDSO on a quarter by quarter basis (which more clearly indicates the magnitude of repurchases since there is a shorter time period between reporting periods which brings down the average of FDSO) Ally wiped out 14.2% of its public float from Q1 2021 to Q2 2022.

But to reiterate: this growth in buybacks and growth in net income was made possible by deposit growth. Ally will need to continue growing deposits in the future to finance continued growth in net income of the same rate which could require increasing interest rates for depositors and compressing margins. The other choice for Ally is to sustain the current deposit levels and thus sustain the current loan and lease balances and funnel all excess cash into repurchasing stock.

Capital allocation is at the root of everything Ally does and the Company has shown an ability to allocate wherever the yield can be found after ridding itself of debt. Free cash can go to repurchases when the earnings yield is high or to growing its loan/lease book when those yields are high. Ally’s optionality makes it very attractive for investors looking for consistent yield.

Growth? You’re Missing the Forest Between the Trees:

Ally trades for ~4.5x LTM earnings which means the market not only isn’t currently pricing in net income growth but is actually pricing in a significant decline. This decline in earnings will most likely occur in large part from the interest expense Ally will pay to depositors. Below we see deposits, interest expense on deposits and the resultant rate over time. When interest rates were slashed to near zero in 2020, Ally had no one standing in its way to slash deposit rates as well which is what all banks did. Well, these deposit rates stayed low in 2020, 2021 and so far throughout 2022 which allowed Ally to fully capitalize on the snapback in economic activity with capital that was practically free! They could use deposits costing 0.70% per year and go out to any car dealership that was selling anything with wheels for 10%+ over MSRP and slap a 7% interest rate on it and drive that sucker to the bank!

Banks are still flush with deposits and have no need for more deposits heading into an economic slowdown and this could mean banks are set to be more profitable for longer until they see a need to increase rates and incur higher expense. As rates may increase in the future, competition between banks will heat up and Ally will have to increase deposit rates in order to stay competitive. Ally has been known for its relatively “high” deposit rates in recent years, but deposit rates remain very low relative to the yield the Company earns on car loans and leases. Ally offers a 0.25% yield on checking accounts with more than $15,000 and a 2.1% yield on money markets within checking accounts. A fraction of the ~7% yields of Ally’s assets.

*As an aside, if that 2.1% excites you, please close the page, you aren’t a value investor*

The decline in profitability is partially due to these deposits getting more expensive, partially due to the market’s expectations that Ally will have to increase its provisions for loan losses, partially due to the market getting worried that car demand will fall off like housing demand, etc. Blah, blah, blah, lots of fear, some of it valid, but it all comes together to “rationalize” why a Company with a dominant market position, consistent deposit growth, an ROE usually around 9% and 14% fewer shares outstanding than 6 quarters ago trades for <5.0x earnings.

The question becomes: is that too cheap? Frankly, I’m not sure, but let’s illustrate this value in a couple ways.

First, Ally has historically traded at a 9.5x P/E. If we’re conservative and drop this down to 8.5x as an appropriate multiple to pay for the stock, we can more readily understand what the current stock price of $30 and LTM EPS of $7.01 is pricing in.

Further, from 2016 - 2020 before earnings per share launched in 2021, Ally was dependably reporting EPS ~$2.90 which I think is a fair base EPS considering how much deposits and thus assets have grown and after giving credence to the mortgage and insurance businesses. However, it’s also important to remember that the count of shares outstanding has been reduced by 14% due to repurchases, so the real base is a 14% higher EPS of $3.31 given shares are intrinsically worth 14% more. Assuming this EPS, we can see below the implied P/Es across a range of stock prices. Remember, Ally trades at 4.5x P/E right now, but this is only because earnings are projected to fall and justifiably so.

The chart above is important and should be judged independently by everyone intrigued by Ally. I started this writeup by discussing how the SPY has only now reached a P/E near the historical average and a subsequent decline in earnings has only begun to be priced in. At $30, Ally, too, has just now returned to a historical P/E around 9.0x… when you account for the collapse in earnings. If we use the 8.5x P/E that I suggested is more representative of a sketchier macroeconomic environment, Ally’s fair value considering this basic EPS projection is ~$28.

Regardless, the stock is already pricing in a pretty massive massive decline in earnings, but given 2021 and 2022 EPS were temporarily inflated from unsustainable deposit rates, is the stock still cheap? I personally don’t think so (yet) because there are many things that can still go wrong within auto:

1. The values of the cars on Ally’s books can (will) decline in price which will lead to significant depreciation expense which brings down EPS.

2. Allowance for loan losses may continue higher as credit gets squeezed. Ally’s prudence is a positive here as allowances have been high since 2020, but they still may have room to climb.

3. Deposit rates are surely not going lower any time soon and customers Fed up with the Fed may be more keen on pivoting to banks with “high” deposit rates (I swear if you guys sell stocks to chase deposit yields…)

4. I have no conviction on where auto sales volumes go in the next 12 - 24 months. I hope they go higher, I’ve been bullish on automotive for a while and think pent up demand will cause a rush to buy when prices come down. But I also think Ally stock has more room to fall if there are any signs of softening auto demand and customer trends to keep on waiting to buy that car they’ve been dreaming about since 2020. The macro investors will write articles about why an auto slowdown will cause Ally to go bankrupt again and that will allow us to buy the stock for cheaper if we’re patient.

A Potential Outcome

With all of that said, let’s walk through an example to hammer it home. Like I’ve been focusing on, income derived from operating leases and auto loans drive Ally’s revenue. Expenses such as deposits, interest on debt, depreciation, allowance for loan reserves among other ancillary expenses detract from revenue. Below, with conservative assumptions, we arrived at a 2023 net income of $1.193 billion. Utilizing the current market capitalization of $9.465 billion as of market close 9/22/22, Ally’s implied P/E is 7.94x — lower than the historical average which I think is justified. Even though the stock is cheaper than normal in terms of a decently conservative — albeit not stress tested — net income projection, I don’t think it fully factors in the risks I mentioned above. If the market continues to sell off and people keep worrying about an auto loan meltdown, Ally will likely keep getting cheaper and we’ll be ready to capitalize.

Again, right now, we’re just window shopping. We outlined prices where Ally will get truly cheap (~$25-26) at which time we may walk in the store and see if we can’t negotiate an even lower entry with Mr. Market.

Until then, I’m excited for what Berkshire’s 13-F for Q3 looks like when it drops, I reckon Mr. B will own quite a bit more of Ally than the last filing. This is because Buffett got rich not worrying about the macroeconomy and short term industry headwinds. With Ally, he isn’t making a bet on car loan delinquencies, he’s making a bet on capital allocation and I think its a very good bet.

To round it out with an optimistic touch, I’ve written about Ally under the assumption that earnings fall in the next few years and don’t recover. Let’s remember that Ally put up $7 of EPS on relatively low sales volumes. What happens when the OEMs crank out supply, prices correct to normal levels and pent up demand for car purchases eases? The world is scary right now, but is it really so scary that car sales volumes don’t reach historical averages again during the decade ahead when the OEMs are shoving EVs down our throats? Seems unlikely.

The world very well could get scarier, but if we stay greedy amidst the fear — and buy some Palantir (stay tuned for a future writeup) — our portfolios will be just fine in the long term.

Disclaimer: Not investment advice. The author does not hold stock in the discussed security and is not planning to open a stake in the next 48 hours. The author was not compensated for writing this article and no opinions in this article reflect the opinions of the author’s employer or its affiliates. DYODD.